Opinion: The 12 steps to ending NZ's foreign debt addiction

The following is my speculation of what might happen over the next couple of years, given I think the era of easy and cheap short term foreign debt is over for New Zealand. This fundamental nature of this development is not understood publicly in New Zealand and I'm keen to lay out how I think it could unfold and what it might mean for consumers, businesses and our financial institutions. These 12 steps to ending New Zealand's foreign debt addiction should be read  with my pieces earlier today on bracing ourselves for a debt implosion and how to cut NZ$1.5 billion a month in spending.  A big caveat here is that the various global rescue plans might work brilliantly and then we would return within a month or two to a world of double digit lending growth at mid single digit interest rates, although I think this is now very unlikely. That's because the nature of global banking and the shadow system of leveraging debt upon debt has been destroyed irrevocably by the collapses and nationalisations of the offending investment banks. The impending collapses of hedge funds and many insurers will deepen the crisis.  These 12 steps to ending New Zealand's foreign debt addiction are based on a few key assumptions and facts. Firstly, New Zealand spends much more than it earns. It does this by running a current account deficit that is currently over 8% of GDP, which is funded by often short term borrowing on international money markets. This will have to drop to under 4% of GDP. To simply keep our debt to disposable income level at around the current 160% (which is already above the 130% seen in the United States) we have to stop spending and borrowing around NZ$1.5 billion a month.  We must do this to avoid getting deeper into foreign debt and triggering a crisis via sovereign credit ratings downgrades and a complete currency collapse. It is also being forced on us right now by the hopefully temporary closure of the non-Australian inter-bank lending markets. Here are the 12 steps. We are currently at around Step 6.

1. Global Credit Crunch emerges - Mid 2007 This started in June/July 2007 when Bear Stearns warned of rising delinquencies in some of its US sub-prime mortgage instruments. This caused international interest rates to rise sharply and interbank borrowing to slow. This was the beginning of the de-leveraging that has now turned into a pefect storm of margin calls, asset fire sales, new share sales, asset sales, asset revaluations, share price collapses and further margin calls . It has snowballed from there to cause the collapses of Bear Stearns, AIG, Lehman Bros, Washington Mutual, IndyMac, Fannie Mae and Freddie Mac, and the forced sales of Merrill Lynch, Wachovia and CountryWide Financial. In Europe it has claimed Dexia, Fortis, Bradford and Bingley and 3 Icelandic banks. 2. Finance companies in New Zealand start collapsing - Late 2007 Finance companies started falling over in May 2006 with Provincial Finance and Western Bays Finance collapsing, but they were largely linked to bad car loans in Auckland. The real collapses started in July 2007 when Bridgecorp fell over. It exposed the heavy lending of many finance companies to often speculative property developments via second mortgages and 'mezzanine debt instruments' that were capitalising interest.  A series of collapses in June and July of this year including Strategic, Hanover, St Laurence, Dorchester and Dominion were partly blamed on the global credit crunch. This was because some banks who might have refinanced completed projects or sales to investors got cold feet. Our full Deep Freeze list of the frozen finance companies, investment funds and mortgage trusts is here.  3. House prices start falling - Early 2008 In February house prices started falling and are now down around 6% from their November 2007 peak. We forecast in February a 30% fall in average house prices over the next two years. The fall in house prices caused or coincided with a slump in property sales volumes and home lending growth. The growth in home equity that helped drive home equity withdrawal has ebbed as house prices have fallen, restricting retail sales. 4. Banks tighten credit standards - Mid 2008 Banks such as ASB's Sovereign and non-banks such as GE Money tightened lending standards in September. Sovereign stopped lending more than 80% of a home's value and has made it much harder to lend without documents proving the borrowers income. Anecdotal evidence emerged that banks started restricting 'top-up' loans and reduced credit card limits. 5. Financial crisis shocks Northern Hempisphere banking systems - late 2008 The collapse of Lehman Brothers froze inter-bank lending as banks feared their colleagues were sitting on toxic time bombs of derivatives linked to Lehman or other collapsed institutions. Short term interest rates on money markets spiked and inter bank lending, particularly across borders stopped.  6. Governments guarantee bank deposits and pump equity into troubled banks - late 2008 US, UK, European and Australasian governments guarantee bank deposits or beef up bank deposit insurance schemes to avoid runs on banks by worried depositors. UK, US and European governments nationalise or part-nationalise banks to pump much needed cash into balance sheets to try to build confidence and restart frozen inter-bank lending. 7. NZ banks unable to borrow on foreign wholesale money markets - Late 2008 This has been the case for about three weeks. New Zealand banks are still lending to each other and their Australian parents, but are unable to borrow on inter-bank markets in London and New York. Significant amounts of short term foreign borrowings are set to be refinanced in coming weeks. New Zealand's current account deficit of over 8% demands that more money needs to be borrowed on these short term markets every few weeks. This is the moment of truth for New Zealand's economy and its banking system. If these inter-bank markets do not unfreeze shortly then banks will have to significantly scale back new lending to consumers, small businesses and corporates, and look elsewhere for funds. Term deposits from Mums and Dads are increasing fast to help fund the lending, but more than a third of lending is funded via these short term foreign wholesale markets and increased local saving is not enough. 8. NZ banks use a special borrowing facility offered by the Reserve Bank - Late 2008 This has not happened yet, but may be necessary if short term money markets remain closed for much longer. The Reserve Bank has offered to lend the banks money in return for mortgage backed securities, even if they have not got their credit ratings yet. If this happens it will be a sign of significant stress within the banking system. This could happen as soon as early November. It may force the Reserve Bank to direct the banks to lend more carefully and force the banks' parents in Australia to put up more capital. 9. Significant new lending stops - Late 2008 to mid 2009 The shortage of short term foreign debt and the need for the big banks to preserve cash will force themto  curtail new lending drastically. New home loans are likely to require loan to value ratios of 50% or less and loan to income multiples will drop below three. Credit card limits will be cut sharply. Unused overdrafts will withdrawn. Small and big business lending for new investment will grind to a halt. Dairy farm purchase lending will stop. The Reserve Bank will direct or encourage bank lending to essential sectors and small businesses and may have to lend directly to large corporates by buying their commercial paper. A sharp global downturn, the drying up of credit on inter-bank markets and rising defaults on mortgages in Australia and New Zealand force the big Australian banks to make big new provisions for losses and raise capital, possibly from the Australian and New Zealand governments through part or whole nationalisations. Dividends are suspended and banks slash thousands of workers. The New Zealand dollar falls below 45 US cents. 10. House prices collapse, unemployment over 7%, deep recession drags - mid to late 2009 New Zealand house prices collapse a further 15% and Australian house prices fall 10-15% as the effects of the ongoing lending freeze for new loans hits the market, meaning only low LVR and cash-only deals are done with distressed sellers. Mortgagee auctions increase signficantly for chronically behind borrowers, but banks either hold back or are forced back from widespread forced mortgagee sales. Unemployment rises over 7% in New Zealand and GDP continues to contract through to the end of 2009. Banks rebuild their balance sheets and begin tentatively lending more to businesses under government direction, using growing local retail deposits as their source of funding. New Zealand's Official Cash Rate is cut repeatedly to 4.5% by mid 2009. 11. Capituation. Discretionary spending grinds to a halt and house purchases stop - Late 2009 Discretionary spending on cars, restaurants, clothing, holidays, consumer electronics and entertainment slows to a trickle. GDP has fallen a cumulative 5% from its peak in late 2007. New Zealanders have reduced spending by at least NZ$1.5-NZ$2 billion a month and are adding NZ$1 billion extra a month to bank term deposits. Unemployment rises over 8%. Global recession ends and foreign inter-bank lending resumes at much reduced level. Strong export sector revenues, heavy government infrastructure spending and significant tax cuts start to drag the New Zealand economy out of recession.  12. Recovery begins - Early 2010 Debt to GDP ratio stabilises at 150% of GDP and foreign borrowing resumes at much lower levels. House prices bottom out 30% below their November 2007 levels and Australian house prices near their bottom at 20% below their peaks. Banks have built their tier one capital levels to well over 10% and resume more normal lending practices. Housing loan to value ratios above 50% but below 70% restart. Credit card limits are stabilised and the corporate commercial paper market resumes. Unemployment stabilises around 8.5%. GDP growth resumes in mid 2010. Banks are restricted in their loan to value ratios at 70% and must retain at least 10% tier 1 capital. Governments begin selling bank stakes back to investors. All derivatives markets are heavily regulated. Bank remuneration is regulated. 'Interest free' lending promotions are banned. 'Cash-back' car loans are banned. Same day property sales are banned. The Government Deposit Guarantee is extended indefinitely through a deposit insurance scheme limited to a threshold of NZ$100,000 per account. Losses on investment properties are ringfenced for tax purposes.