Opinion: NZ should brace itself for a debt implosion

There was a lot of hope early this week that the global financial and banking system may have survived the worst of the Credit Crunch. An awful lot of official fingers were shoved in the dike to hold back a torrent of collapses. The US government pumped US$250 billion into the balance sheets of America's 9 biggest banks and led a global attempt to unfreeze inter-bank lending by provided an "unlimited" supply of US dollars for central banks to pump into their markets. Europe's governments announced plans to pump US$2.5 trillion into their banks. Britain spent 200 billion pounds to buy controlling stakes in two of its biggest banks. All of them cut interest rates. Most have either announced blanket deposit guarantees or sharply increased the safe deposit thresholds for their deposit insurance schemes. Phew, the stock markets thought, in a relief rally on Monday that was the biggest since the 1930s. By Friday the doubts had set in again as fears about a global recession splashed cold water on everyone's faces. Global stock markets gave up most of Monday's gains by Friday. We are far from out of the woods. But let's step back a bit from the amazing events of the last few weeks and ask two key questions: what caused the Credit Crunch and how will it change the way we do things? The immediate answers are 'too much debt', and, 'we'll have to learn to live without too much debt.' Some bracing facts about our level of indebtedness are needed to convince New Zealanders how serious the situation is. Firstly, New Zealand households are much more indebted than those in America blamed for all the sub-prime debt that triggered the credit crunch. Our household debt to disposable income ratio has risen to 163% from 110% in the last five years. This is well above the 130% seen in the United States. Our household debt servicing cost to disposable income ratio has risen to 14.4% from 9% 10 years ago. Our debt servicing burden rose above America's for the first time ever this year. New Zealanders borrowed more than NZ$50 billion extra from foreign banks and investors in the last 30 months. We did it through our banks. The Credit Crunch has now frozen global credit markets, making it difficult for our banks to easily and cheaply roll over that debt every few months. That heavy borrowing was reflected in our high current account deficit and the borrowing needed to service that current account deficit. For the last five years or so much of that borrowing was used to pay for imports and to invest mostly in each others houses, pushing up house prices. But there has been an ominous change in the last year or so. We have stopped borrowing so much to invest in housing or pay for imports. We are now borrowing to pay the interest on the previous borrowing. New Zealand's interest payments and dividend payments to the rest of the world accelerated to a record NZ$4.44 billion in the June quarter. About NZ$2.2 billion of that was interest payments. Our foreign borrowings rose a further NZ$1.6 billion in the June quarter. This means we borrowed more simply to pay the interest on the previous debt. This is like using a credit card to pay the interest costs on the mortgage, but on a national scale. The man credited with the discoveries that unleashed the atomic bomb, Albert Einstein, once said this: "The most powerful force in the universe is compound interest." He was right. Compound interest on unpaid debt will destroy everything in its path. New Zealand has an atomic bomb of debt which is about to blow up the New Zealand economy for a decade or two. If we are lucky the Reserve Bank and our major banks will be able to manage a controlled explosion that leaves plenty of walking wounded but is not fatal to everyone. The worst case scenario is an almost complete cessation of new lending. The best case is a sharp reduction in new lending growth spread out over two to three years. This is where the changes of behaviour have to come in. New Zealanders generally, our politicians specifically, and our banking system in particular have to acknowledge a massive change of behaviour is needed. Put simply, we need to stop borrowing more overseas as a percentage of GDP and actually reduce it. We must do that because if we don't our creditors will do it for us in a more violent way. That means not borrowing any more overseas for a decade or so. In real terms that means New Zealanders need to stop spending and borrowing around NZ$1.5 billion a month or NZ$375 per person. Here's a few ideas. To put that into context, about NZ$1.7 billion worth of residential property was sold in September. Total retail sales were NZ$5.3 billion last month. Reducing spending on this scale will require massive changes in behaviour. Here's a few ideas. I'm not the only one that believes a serious adjustment is coming. Westpac economist Brendan O'Donovan says New Zealand now faces a painful adjustment to lower spending whether we like it or not. "The mechanism for adjustment will be a lower exchange rate, tighter lending standards, and reduced credit creation," O'Donovan said in this report. "Possible longterm side effects will be greater banking sector regulation and more stringent capital requirements. This is the long-overdue cure to the economic ill of excessive borrowing. Like many cures, it will be painful but ultimately restorative to our long-term health." Nouriel Roubini, the Head of Economics at New York University's Stern Business School sees major sources of stress remaining in the global finance system that mean the rescue packages are likely only to prevent a meltdown, rather than reverse the process of 'de-leveraging' indebted consumers and financial institutions. "Major sources of future stress in the financial system remain; these include;

• the risk of a CDS (credit default swap) market blowout, the collapse of hundreds of hedge funds,
• the rising troubles of many insurance companies, the risk that other systemically important financial institutions are insolvent and in need of expensive rescue programs,
• the risk that some significant emerging market economies and some advanced ones too (Iceland) will experience a severe financial crisis,
• the ongoing process of deleveraging in illiquid financial markets that will continue the vicious circle of falling asset prices, margin calls, further deleveraging and further sales in illiquid markets that continues the cascading fall in asset prices, and,
• further downside risks to housing and to home prices."