Treasury analyses the risk and resilience in the NZ economy to the global impacts of Greece and China

This article was first published as a 'Special Topic' in Treasury's July Monthly Economic Indicators report.

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The Budget Economic and Fiscal Update discussed a number of risks which might impinge on the outlook for the New Zealand economy. Amongst them were a marked slowdown in China’s economy, possibly sparked by a fall in house prices, and a weaker recovery in the euro area as a result of high levels of sovereign debt and banking sector weakness in peripheral economies. The risk of Greece defaulting on its debt or being unable to reach a further funding agreement with its European partners was seen as a particular risk.¹

Both of these risks became elevated in the past month, but the Chinese equity market was the cause for concern rather than the housing market. By the end of the month, the immediate risks appeared to have lessened, but concerns remain about future developments in both economies.

This topic briefly recaps recent developments and then looks at the transmission channels to the New Zealand economy if those risks were to eventuate. It concludes that while they could have a material impact on the NZ economy, it is relatively well placed to adjust to such shocks.

Greek debt crisis to the fore in late June...

The Greek debt crisis came to a head in late June when negotiations between Greece and its European partners broke down, the Greek Prime Minister called a referendum on the latest proposal from its creditors, the existing bailout expired without any extension, and Greece went into arrears in its repayments to the International Monetary Fund (IMF). As a result of these developments, the European Central Bank (ECB) capped its Emergency Liquidity Assistance (ELA) to the Greek banking system; this in turn led to the imposition of capital controls in Greece, with banks closed for three weeks and limited cash withdrawals available from ATMs.

Although Greek voters rejected the latest proposal from their European creditors, negotiations recommenced with Greece submitting fresh proposals for spending reductions, tax reforms and other policy changes. After protracted negotiations over the weekend of 11-12 July, agreement for a third funding arrangement was reached subject to passing of “prior actions” by the Greek parliament and approval of the proposal by other European parliaments (where required). These conditions were met, preparing the way for formal negotiations on a fresh funding arrangement. As a result, Greece’s European creditors arranged a bridging loan from the European Financial Stability Mechanism (EFSM) which allowed Greece to clear its arrears with the IMF and repay the ECB on 20 July.

However, a new funding arrangement still has to be agreed and more reforms be passed by the Greek parliament. In addition, the IMF and European Union Commission consider that Greek debt is unsustainable, and Greece’s economic competitiveness needs to be restored. As a result, risks remain and some commentators still consider that Greece is likely to leave the European Monetary Union in the next few years.

...but limited financial contagion in Europe

Although Greek bond rates spiked at the height of the debt crisis, spreads to German bunds in other peripheral European bond markets did not spike to the same extent (Figure 1). This could be taken either as an indication that markets considered that an escalation of the Greek debt crisis was unlikely, or that if it did escalate contagion to other financial markets in Europe would be limited. The latter view is supported by the steps that European authorities have taken since the previous Greek bailout in 2012 to strengthen the financial system and support peripheral economies’ bond markets; for example the ECB’s quantitative easing policy whereby it is purchasing government bonds in secondary markets. In addition, most Greek debt is now held publicly and so European banks are less exposed.

Sharp fall in Chinese equity market...

The China Securities Index 300 (CSI300, an index of 300 stocks traded on the Shanghai and Shenzen stock markets) peaked at 5,354 on 8 June 2015, up 145% from a year before (Figure 2). Its ascent had been particularly rapid since late 2014, doubling in value since November.

The rise in the Index was supported by a number of factors: the People’s Bank of China (PBoC) was reducing interest rates (Figure 2) and banks’ reserve requirement ratios at the time in order to offset slowing economic growth and further monetary easing was expected; falling house prices may have encouraged some investors to switch from property to equities; the government was taking steps to liberalise financial markets, for example by connecting the Shanghai and Hong Kong share markets; in addition the government provided funding for margin trading (leveraged borrowing to buy shares); and there was general encouragement for investing in the share market to give firms another source of capital in addition to bank lending.

Prices fell sharply in the second half of June and reached a low of 3,663 on 8 July, down 32% in one month. The immediate trigger for the fall was a clampdown on the use of margin finance in response to concerns about an equity bubble. Concerns that the economy was slowing may also have been a factor (although the market had been rising even as the economy was slowing), as well as prospective monetary tightening in the US and concerns about euro area financial stability.

When equity prices began to fall precipitously, the authorities stepped in to halt the fall. Interest rates were reduced further (Figure 2), trading was halted for selected firms, there was a temporary ban on the sale of selected stocks by major shareholders, initial public offerings were suspended, additional liquidity was provided and a market stabilisation fund established. The market stabilised temporarily in mid July, but then fell by 10% again in late July before steadying.

...but limited impact on other markets...

The fall in Chinese share prices had some effect on other equity markets, especially in Asia, but it is difficult to distinguish that from the impact of the Greek crisis. Exchange rates were also volatile. There was some increased risk aversion in global financial markets, with increased demand for US Treasury bonds, and both the Federal Reserve and Bank of England mentioned global risks as factors which might delay monetary tightening.

There was also some additional weakness in commodity prices; iron ore prices also recorded a 32% fall over the same period as Chinese equity prices, but from an already low base. They have since recovered slightly. How much of the recent decline in dairy prices is attributable to the share market fall is uncertain, as dairy prices continued to fall after the temporary stabilisation of the share market in mid July. Buyer sentiment may have been affected, given China’s importance to NZ’s dairy exports. Weaker economic growth in China and high dairy stocks, along with the imbalance in global dairy supply and demand, are the more important factors in the current weakness. (See discussion of recent dairy prices on p.5 above.)

...and on the Chinese economy...

However, the impact of the share market fall on China’s wider economy, including demand for dairy products, is not expected to be large:

• share values spiked briefly and households had not yet responded to the increase, so any response to the decrease is likely to be limited;

• the total market capitalisation of China’s share market is small relative to the size of the economy (equivalent to around 40% of GDP) compared with most developed economies (around 100% of GDP);

• although retail investors account for around 80% of market turnover, only 8% of households invest in the share market;

• shares account for only 10-15% of household financial assets (compared with around 50% in the US), reducing any wealth effects from the losses, whether realised or potential;

• business investment is unlikely to be adversely affected by the fall because even at the peak equity issuance accounted for only 5% of fundraising, compared with bank loans and corporate bonds at 75% and 10% respectively.

...but it may have other effects...

However, the share market fall may have other less tangible effects on China’s economy. It may have an adverse effect on consumer confidence, but retail sales had been easing despite previous increases in consumer confidence. Another possible impact is that GDP growth in the year to June was boosted by increased activity in the financial sector; to the extent that reflected higher share trading, the fall in the market may contribute to slightly lower growth in the second half of 2015.

The fall in the share market does not appear to pose a threat to financial stability, and may be positive in the long run given that it reverses a rapid increase before it became entrenched. The debt on leveraged share purchases is estimated at only 1.5% of total assets in the banking system.

...and raise deeper concerns

Another concern with China’s share market fall is that, rather than leading to weaker demand, it is itself a sign of slower economic growth. Indicators of economic activity have remained relatively robust so far (albeit against a background of slowing growth). However, the Caixin flash manufacturing PMI fell from 49.4 in June to 48.2 in July, indicating below-trend industrial growth. On the other hand, recent movements in the share market were influenced by a range of factors, most of which were not economic (including promotion of the stock market via official state media outlets), so it may not be a good indicator of economic activity. That said, the volatility in the market may discourage some local and foreign investors in the future and set back China’s financial liberalisation and reform agenda.

Impact on New Zealand minimal so far...

So far, the Greek debt crisis and the fall in China’s share market have had limited impact on global financial markets and the world economy, largely because the crises appear to have been temporarily resolved and the risks have declined. However, a more sustainable solution to Greece’s debt still needs to be found and China’s share market may have further to fall. The effect on New Zealand has also been limited so far, but it is worth considering how such risks would impact on the New Zealand economy if they developed further. The risks differ in each case and the effects would also be different.

Direct trade impacts from a financial crisis in Greece would be minimal as Greece accounted for only 0.1% of goods exports in 2014. However, the European Union accounts for around 12% of goods and services exports and a wider European financial crisis would have a larger impact on demand for New Zealand products and services.

In the case of a financial crisis in China which led to a more pronounced slowdown than currently expected, the impact on New Zealand would be more direct. China accounted for 17% of goods exports in the year to June 2015, with 76% of that concentrated in dairy, meat, forestry, wool and seafood exports. The recent fall in the share market is not expected to impact directly on consumer demand in China (for the reasons discussed above), but if it did it would lead to large falls in prices for these commodities. New Zealand could also be impacted by falling demand for services exports from Chinese consumers. China accounts for 10% of New Zealand’s services exports, with 20% growth in the past year, mainly in tourism and education. There could also be an indirect effect via Australia from weaker demand in China, particularly for mineral resources, as lower growth in Australia (our largest export market) would also impact on New Zealand.

There would also be an indirect effect via the rest of east Asia which accounts for 16% of NZ goods exports (excluding Japan).

In addition, a financial crisis, arising from either Greece or China, would lead to higher commercial interest rates and risk premiums, making offshore borrowing more expensive for New Zealand banks. Wealth effects, as asset prices fell, would also be important in such a case, as well as the impact on business and consumer confidence leading to lower investment and consumption.

...but NZ’s policies and frameworks are sound

However, New Zealand is relatively well placed to withstand a global economic or financial shock. The key points of resilience are:

• a floating exchange rate which has already started to adjust to the weakness in commodity prices that has occurred for other reasons;

• flexible monetary policy and room to reduce the policy rate further to offset any increase in offshore funding costs;

• regulatory changes since the global financial crisis have increased the strength and resilience of the banking system, e.g. the core funding ratio and “mis-match ratios” ensure that banks have stable funding and can meet immediate cash needs in the event of a crisis;

• bank capital requirements have been tightened to increase resilience and Basel III capital requirements were introduced in January 2013;

• the Reserve Bank could provide additional liquidity to the banking system, as it did during the global financial crisis;

• the Crown’s fiscal position is relatively strong and net debt is low, providing room for the government to cushion any adverse shock to the economy.

There are currently no signs that a financial crisis is developing from either of these risks, but if one were to develop it would have an effect on a small open economy such as New Zealand’s. However, the policies, frameworks and strength of public finances would buffer its impact on the economy.

1. Risks and Scenarios chapter, pp.54-55, http://www.treasury.govt.nz/budget/forecasts/befu2015/ befu15-5of11.pdf