Rodney Dickens argues the responses of governments and central banks to the global financial crisis have laid the foundations for the next crisis/crises

By Rodney Dickens*

The financial crisis is dead.

Long live the financial crisis.

First there was the share market crisis in the early 2000s that the Fed responded to with super low interest rates.

The super low interest rates played a part in fuelling a US housing bubble and encouraged the repacking of US housing mortgages into super geared securities that were sold to investors all around the world.

The unravelling of this pseudo-Ponzi scheme triggered the 2008 financial crisis.

Governments responded to the financial crisis by borrowing massive amounts of money to fund spending that offset some of the negative impact of the crisis on economic growth.

Central banks responded with super-low interest rates and quantitative easing that refuelled housing markets and debt levels.

The responses of governments and central banks to the financial crisis have laid the foundations for the next crisis/crises, just as the super-low interest rates in the early-2000s laid the foundation for the financial crisis.

China and Japan are of particular concern in this context. The aggressive Chinese response to the crisis means it is now one of the ticking time bombs we particularly focus on in our economic and forex reports, while Japan is in a class of its own when it comes to government debt levels.

This Raving puts the Japanese and Chinese threats in perspective and offers a special deal to those interested in getting access to our monthly economic and forex reports.

Only some global developments matter lots to NZ

Prior to the financial crisis there was no general link between NZ economic growth and economic growth in the G7 major Western countries (left chart).

The correlation between 1992 and 2007 was 0.05 (i.e. there wasn't a link).

The financial crisis temporarily brought a range of things into synchrony, including NZ and G7 GDP growth. But now NZ and G7 growth are back to largely doing their own things.

NZ's reliance on overseas funding is one of the key reasons why extreme global events like the financial crisis can have a major impact on NZ.

The right chart shows the % of total bank funding from non-residents. When the crisis stuck in earnest in late-2008 38% of total bank funding came from non-residents (i.e. effectively overseas).

In response the Reserve Bank (RB) has forced banks to focus more on domestic funding among other things, but banks still access just over 28% of total funding from non-residents, with this share starting to increase again following the OCR hikes delivered by the RB this year (i.e. banks are potentially responding to the increase in domestic funding costs by borrowing more from overseas where funding costs haven't increased and may have fallen this year).

This has watered down the impact of the OCR hikes, with that being an issue covered in our pay-to-view reports.

The lack of a general link between local and global economic growth is because at any one time NZ has a range of specific factors driving growth that can be quite different from the factors driving global growth (e.g. divergences in monetary and fiscal policies; divergences in population growth; special factors like Canterbury rebuilding and the government initiatives to boost residential building).

However, because banks continue to obtain a significant amount of funding from overseas NZ will remain vulnerable to global shocks that impact on the international financial sector.

Global financial risks

The financial crisis isn't dead because of the high government debt levels that still exist in the crisis countries (adjacent chart). NZ is included in the chart to put the debt levels in the crisis-countries in perspective.

When it comes to debt Japan is at the top of the pile and therefore is high on the list of countries that could at some stage in the future deliver a shock to the global financial system.

It is something of a contentious issue, but as a rule of thumb if gross government debt is 100% of total economic activity or GDP a country is considered at potential risk of debt default.

This risk has been greatly reduced especially by the actions of central banks in the crisis countries (i.e. delivering super low interest rates that help keep interest costs for governments down and in some cases printing money to buy government debt).

But the high debt levels and already low interest rates greatly limit the scope for governments and central banks to respond to any future shocks.

Japan is of particular importance as a potential source of a future financial shock because it has made limited progress in reducing the government operating balance or fiscal deficit (adjacent chart). Consequently, government debt as a % of GDP continues to grow.

The challenges facing the Japanese government and central bank are made worse by a falling and ageing population that has direct relevance to funding the government debt. As covered in our monthly economic reports, Japan has embarked on a doomed experiment that has resulted in a snap election to be held on 14 December.

Whatever the result of the election it will be followed by equally doomed policy initiatives. Japan is a ticking time bomb, albeit one with a remarkably long fuse.

The outcome of the policy initiatives have major implications for the NZD/JPY, as covered in our monthly Forex Prospects reports in which we have been correctly warning about what would happen to the yen and NZD/JPY as a result of the Japanese "three arrows" experiment that is dubbed Abenomics after the Prime Minister.

The Chinese threat

China doesn't rate as a threat in terms of central government debt, but debt default risk of shadow banks is a major issue (i.e. institutions largely acting as banks but outside the regulatory net).

The adjacent chart helps put the Chinese threat that is very different from the Japanese threat in perspective. It shows capital spending as a % of total economic activity or GDP.

Capital spending includes spending on residential building, non-residential building, infrastructure, plant, machinery, equipment and inventories.

It is normal for capital spending to be a high percentage of GDP for a period in developing economies, as has been the case in the past in the likes of South Korea, Singapore and Japan. But China has taken things to a totally different level that goes well beyond what can be justified by it experiencing rapid economic development.

The dramatic surge in capital spending in China since 2008, much of which has been funded by lending by shadow banks, reflects the policy response to the financial crisis. Chinese export receipts plummeted as a result of the financial crisis and as a result imports also plummeted (adjacent chart). There were mass closures of exporters and huge layoffs.

This was more than just an economic shock because in China there is an unwritten contract between the government and the people (i.e. if the government delivers jobs and increased wealth the population in general won't rebel against Communist Party rule).

The negative impact of the financial crisis on Chinese economic growth was a potential threat to the political system so the government responded in a range of ways to boost capital spending.

In part as a result of the role vested political interests have played in the capital spending decisions, the returns from many of the projects low or negative.

This poses a threat because of the lack of income from the projects to pay the interest and capital repayments on the borrowing.

Another challenge is that capital spending is now so high, it is extremely hard to grow it at the pace needed to meet the official GDP growth target of 7.5%, while to keep capital spending growing requires even more debt.

Residential building is a key part of the Chinese capital spending boom, but far from the whole story. It is important because around 25% of total Chinese economic activity is reported to be directly or indirectly linked to residential building.

The left chart below shows that the floor space of residential building started almost doubled between 2008 and 2011 and continues at high levels.

Part of the economic development in China is rapid urbanisation (i.e. peasants becoming factory workers and requiring housing). But much of what has been built isn't close to being affordable for these people and has instead been bought by investors, with Chinese investors lacking alternatives investment options.

The result has been tens of millions of vacant apartments. The floor space of new building selling has fallen significantly, resulting in the prices of new houses starting to fall (right chart below). The best fit in the right chart is with the floor space of residential building sold leading or advanced by four months.

This year developers have responded to a range of government efforts to boost the level of building, with the left chart showing the rebound in the floor space of residential building started this year.

But so far the government efforts to boost buying have failed. Consequently, the stock of unsold apartments has increased significantly and developers are discounting to try and move stock, but falling prices will be an impediment to boosting buying. The fall in new apartment prices isn't close to enough to make them affordable for workers.

The Chinese apartment building boom is much like the Auckland boom in the 2000s that collapsed and the current booms in Sydney and Melbourne that are similarly at risk of collapsing as covered in our monthly economic reports.

The worst case scenario is lots of Chinese property developers going bankrupt, lots of shadow banks collapsing, a major negative shock to Chinese economic growth and employment, political mayhem and the risk of a global economic and financial shock.

But where China is different is the vested interest the government has in perpetuating the boom in residential building and capital spending more generally. The government and the Peoples' Bank of China have already implemented initiatives designed to encourage buyers (e.g. reducing the high deposit requirements, reducing disincentives for owning more than one apartment and most recently a cut in interest rates).

But these initiatives are delaying what is likely to be an inevitable and sizeable fall in the level of residential building.

Developments in China, like those in Japan, have the potential to have a significant impact on NZ, including on interest rates and the exchange rate.

Chinese developments are even more relevant to Australian prospects because of the importance of Chinese residential building to iron ore prices. Our monthly economic reports offer valuable insights into all of these factors and more.

There are other mechanisms by which international developments impact on NZ, including exports, interest rates and the exchange rate, with these linkages covered in our monthly economic reports. We are currently offering a six month free trial to the monthly economic reports (contact denise@sra.co.nz if you want to take up this December only offer).

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*Rodney Dickens is the managing director and chief research officer of Strategic Risk Analysis Limited.