NZ financial system stronger in last 6 mths, but faces significant challenges, Reserve Bank says; Warns on China; Eyes further NZ$ strength

By Alex Tarrant

New Zealand’s financial system has strengthened over the last six months, but faces significant risks from a challenging international environment affecting emerging economies like China, the Reserve Bank says.

The Bank encouraged the government to keep reducing its operating deficit, which it said would make New Zealand less vulnerable to external economic shocks.

The private sector also needed to keep strengthening its balance sheets. However, some increase in credit growth was necessary to sustain economic growth rates, the Bank said.

Releasing the Bank’s twice-annual Financial Stability Report, new Governor Graeme Wheeler said despite challenges, financial market sentiment had improved since May.

That improved sentiment had led to a rise in the New Zealand dollar, despite a fall in New Zealand’s terms of trade.

A period of further strength in the currency remained possible, the Reserve Bank said.

Sentiment up

“[Improved sentiment] partly reflects further monetary easing around the globe, which has kept interest rates at unprecedented lows, and various measures to help manage the crisis in the euro area by supporting the financially distressed member countries,” Wheeler said.

“The uplift in sentiment has improved the major New Zealand banks’ access to global funding markets over the past few months and has contributed to upward pressure on the New Zealand dollar,” he said.

New Zealand banks had continued to build their liquidity and capital buffers, giving them greater ability to cope with future periods of financial market volatility or a slowdown in economic growth.

“The banks are comfortably meeting existing regulatory requirements for core funding and are well placed to meet the increase in the core funding ratio from 70 to 75 percent that comes into effect on 1 January 2013,” Wheeler said.

Profits had recovered to near pre-crisis levels although rates of return on equity remained lower due to recent increases in capital ratios, he said.

New Zealand’s financial system had reduced its overall reliance on external funding over recent years due to the recovery in private savings. This had been reflected in rapid growth in retail deposits and muted credit growth.

“In contrast, the public sector’s net external liabilities have increased given recent fiscal deficits,” Wheeler said.

“In order to reduce New Zealand’s vulnerability to external economic and financial shocks, it is important that the public sector continues to reduce the fiscal deficit and that the private sector continues to strengthen its balance sheets,” he said.

China slowdown

Expectations for global growth had been pared back over recent months, with weak activity in the euro area and signs of a slowdown in China and other emerging economies, the Reserve Bank said.

However, financial market sentiment had improved since the last Financial Stability Report in May.

“The rise in sentiment has been underpinned by a string of market positive outcomes. These include signs that Greece’s new government is committed to remaining in the euro area and an agreement by euro area finance ministers that Spanish banks will be provided with up to 100 billion euro in rescue loans,” the Reserve Bank said.

“Sentiment has been further bolstered by the German Constitutional Court confirming the legality of the region’s proposed new bailout fund – the European Stability Mechanism (ESM) – and the ECB’s new bond-buying programme known as Outright Monetary Transactions (OMT) announced in early September.

“The US Federal Reserve’s announcement of a third round of quantitative easing in September has further underpinned market confidence,” the Bank said.

Bank funding costs

The improvement in market sentiment over the past three months had resulted in an increase in debt issuance by both US and European corporate in response to a considerable narrowing of yields.

The recovery in debt markets had also enabled New Zealand banks to issue debt at considerably lower spreads than earlier in the year, taking some pressure off funding costs, the Reserve Bank said.

Indicative estimates showed a decline in spreads of around 50 basis points compared to six months ago.

“The availability of funding has also improved, with banks able to obtain enough long-term funding to cover most of their expected requirements for the coming year,” the Reserve Bank said.

“However, the cost of swapping foreign currency funding into New Zealand dollars (NZD) – the basis swap – remains elevated and accounts for more than half of the landed cost of funding in some instances,” the Bank said.

“The high  basis swap spread partly reflects the subdued issuance of NZD securities by offshore entities in the Kauri, Eurokiwi and Uridashi markets. New issuance has replaced only a portion of maturing debt in those markets with the outstanding stock continuing to fall.

“As a result, the availability of counter parties for the banks to swap their foreign borrowing back into NZD through the basis swap market has declined,” the Reserve Bank said.

Underpins NZ$

The improved sentiment had also led to a rise in the New Zealand dollar both against the US dollar and on a trade-weighted basis due to a more ‘risk-on’ environment.

“While a return to a ‘risk-off’ environment could see the exchange rate shift lower in line with recent declines in the terms of trade (export prices relative to import prices), a period of further strength remains possible,” the Reserve Bank said.

“This would particularly be the case if New Zealand’s relative growth outlook continued to be perceived  as favourable, despite the lower terms of trade,” it said.