Alan Bollard: Investing in a low inflation world
Address by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the Auckland Club and
the MBA Business Meeting, Auckland, 14 October 2003.
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The theme of my speech today is "investing in a world of low inflation". New Zealand has succeeded in
achieving a low inflation rate and keeping it stable for more than a decade now. The average CPI
inflation rate since 1992 has been just 2 per cent per annum, as against an average of 12 per cent per
annum in the 1970s and 1980s.
I have chosen my topic because I fear that, currently, too many New Zealanders are taking higher
risks than they realise in their investment and borrowing strategies, because they don't understand
that investing in a low inflation environment may be quite different from investing in the high inflation
environment of earlier decades.
Some of these risks arise due to the mix of assets New Zealanders are investing in. I suspect that too
many households may be over-exposed to real estate investment, and that too many are becoming
increasingly exposed to relatively high risk financial investments, without fully appreciating the risks
involved. Also, there are some risks relating to the extent of borrowing being undertaken by
households, which has left many households with very high levels of debt.
Before getting into these issues, let me briefly say why I think this topic is important, and why the
Reserve Bank takes a close interest in the issue of saving and investment.
Households making well-informed saving and investment decisions not only make themselves better
off, but also contribute to the stability of the financial system and growth across the economy.
Of course, at any point in time, not all New Zealand households are in a position to save and invest,
and not all savers can afford anything other than a house as their investment. Currently, about one
third of households own their house mortgage-free, putting them in a good financial position to
consider a range of investments. A further third live in a house they own, but with a mortgage, and for
these households a strategy of reducing the mortgage as quickly as possible may make a lot of sense.
The remaining third live in rented accommodation, and some of these households may have a strategy
of saving to buy their own home.
However, for households in any of these categories, if their financial position and scope to invest in a
range of assets improves, important decisions about investment strategy arise. Those strategies often
involve investing greater proportions of funds in financial investments, as opposed to housing,
increasing the need to be well-informed about the risks involved.
Clearly, unsound investment and borrowing decisions can have severe consequences for individuals
and families. Households with high levels of debt and exposure to investments that are riskier than
they appreciate could potentially face painful problems. Some may find that the rate of return on their
investments is considerably less than they had thought it might be, or even that their investments
make a severe loss. Some may find that the debt they have accumulated takes a lot longer to pay off
than they had expected - and indeed considerably longer than it would have in the years of high
inflation. Some households may find, as a combination of all these things, that they are not well placed
to cope with the "rainy days" that occur from time to time, such as higher interest rates, a recession, or
a loss of employment.
Here, the data on household balance sheets in New Zealand tell an interesting, but not a comforting,
story. Households have been borrowing heavily over the last 10 years or so - as nominal interest rates
have halved and finance has become easier to obtain - and household debt compared to income is
now at the highest levels on record. Debt now stands at about 130 per cent of income, as against just
65 per cent in 1990.
As I noted already, about half of New Zealand's homeowners have fully paid off their mortgage and
have little other debt. Mortgage debt is concentrated within the 25 to 45 age bracket, with some
homeowners in this category carrying high levels of debt for a lengthy period of time. Such households
now may be much less well placed to cope with the unexpected than others in their position once
were.
The high level of borrowing by New Zealand households is also reflected in data on household
leverage - that is, the ratio of household debt to the value of the house. The leverage ratio has drifted
upwards in the last 20 years or so, from 15 to 20 per cent in the mid 1980s to around 30 per cent
today. Australia and the US have seen similar trends.
Finally, as far as the numbers go, the debt servicing burden of households (including those owning
rental property) has been broadly constant over the last 10 years at around 10 per cent of household
income. However, this has been in an environment of falling nominal interest rates. Nominal interest
rates are now at historically low levels. An important question to ponder, therefore, is how would
households cope with an increase in interest rates, now that average debt-to-income levels have
essentially doubled. Interest rates have been relatively stable in recent years, but there will inevitably
be times when pressures on inflation will require interest rates to rise.
Why is the Reserve Bank interested in this?
Obviously, individuals and families may find themselves in difficulties as a result of poor investment
and borrowing decisions. My concern is not only about that, but also about the wider economic
implications of any such difficulties.
The financial health of households is important for the stability of the New Zealand financial system
and the New Zealand economy. Households that borrow do so almost entirely from banks, and lending
to households makes up about 40 per cent of total bank lending. Therefore, the ability of households
to service their debts is crucially important to the health and soundness of banks and the broader
financial system.
As well as influencing the banking system, household investing and borrowing behaviour affects
financial stability in New Zealand through the country's external financing. Household borrowing that is
not funded by domestic savings must be financed offshore. Partly as a result of strong household
borrowing over many years, New Zealand has a very high ratio of net external financing relative to our
GDP - indeed, one of the highest ratios of any advanced economy. Currently, New Zealand's net
financing from offshore stands at about 90 per cent of GDP, compared with just 60 per cent for
Australia, 25 per cent for the United States and 15 per cent for Canada.
New Zealand's high dependence on external financing creates a risk that foreign lenders may at some
time become more reluctant to increase their exposure to New Zealand. This would raise the premium
we would have to pay in order to maintain access to offshore funding. Foreign lenders may even seek
to withdraw their existing funds in New Zealand, especially if perceptions about the New Zealand
economy, rightly or wrongly, take a turn for the worse. A sudden reduction in foreign lenders'
willingness to continue to fund New Zealand borrowing would force the New Zealand economy
through a sharp and painful adjustment - possibly including a drop in the exchange rate, a jump in
interest rates and gyrations in economic activity. If too extreme, the strain of these adjustments could
undermine the proper functioning of the financial system, which would worsen the economic
disruption.
I should say at this point that, as far as we can tell, the system remains well placed to weather most
plausible scenarios. Asset quality, capitalisation, risk management capacity and the state of parent
banks are all strong. New Zealand is comfortably servicing its external debt, supported by a healthy
economic growth rate and a robust capacity to earn foreign exchange. Hedges are in place to reduce
the impact of exchange rate movements on New Zealand's external obligations. But this healthy
situation notwithstanding, we would of course be remiss if we did not continue to watch developments
closely for signs of financial vulnerability.
Lastly, we are interested in investment and borrowing behaviour because it affects economic growth.
New Zealand's growth in the past has probably been lower than it could have been, partly reflecting
poor savings and investment. The high and variable inflation environment prevailing in the 1970s and
1980s was no doubt one of the main factors hindering effective saving and investment, by making it
difficult for investors to discern well-performing from poorly-performing investments.
Low and stable inflation now obviously helps, but the fact remains that the quality of our investment
decisions is crucial for our future economic growth. Wise investment increases productivity and the
economy's real rate of return, producing better growth and higher standards of living. And wise
investment, in turn, means individual investors exercising good judgement and effective scrutiny when
making their personal investment decisions.
So, with an eye on sparing households unnecessary grief, mitigating risk to the financial system, and
maximising economic potential, how should we invest in a world of low inflation?
Let us start with the simple idea that the objective of investment is to maximise the expected rate of
return for a given level of risk, over a particular period of time. Risk is the potential variability of the
investment's return, including, in the extreme, the possibility that the investment might lose some or all
of its value. For example, the investment might go bust, it might be difficult to realise the value of the
investment when needed or required, and economic factors such as exchange rate or interest rate
movements might cause the value of the investment to fluctuate.
It is a fact of life that investments with higher promised rates of return generally carry higher levels of
risk. This rule applies right across the spectrum of different investments - from low-risk propositions
such as bank deposits and government bonds, through to higher-risk ones such as corporate bonds,
subordinated notes, real estate and equities.
The second important idea is that, when looking at the return on an investment, one should distinguish
between the nominal return and the real return. The nominal return is the return received in cash flow
and in capital gain before taking into account general price inflation, while the real return is the
nominal return less the general inflation rate over the life of the investment. For any given level of risk,
the higher or lower the inflation rate, the higher or lower the promised nominal return, generally
speaking. But it is the real return that investors need to focus on - for it is the real return that
determines whether the investor has gained or lost in making the investment. In today's low inflation
environment, investors need to remember that an investment's apparently low nominal return may
represent in fact quite a worthwhile real return.
The drivers of real returns vary depending on the type of investment, but ultimately come down to
certain basic fundamentals, such as growth in the economy and in particular industries, market shares,
and company productivity. And, of course, all of these factors also affect the risk attaching to the
investment.
How does low inflation fit into this?
Take real estate. New Zealanders have a fondness for investing in housing, currently holding around
half their assets in that form. Most of this is owner-occupied housing, but an increasing proportion is
investment in rental housing. New Zealanders are investing in rental housing to a significantly greater
extent than in earlier years, with the proportion of private rental housing having risen from less than a
fifth of total private urban dwellings in 1991 to around a quarter in 2001. I suspect it has risen further
since then.
In the 1970s and 1980s, when inflation was well into the double digits, house prices generally
increased at a brisk pace in nominal terms, though with considerable volatility. In real or
inflationadjusted terms, however, house prices were even more volatile and there were significant periods
when house prices fell in real terms, as in the middle of the 1970s and late 1980s. For much of the
1970s and 1980s, housing was not a particularly attractive investment, unless of course one bought
and sold astutely, getting timing right, taking advantage of trends in particular locations, and reading
demand and supply with good foresight.
As a matter of arithmetic, not everyone can outperform all the time. For every buyer there is a seller,
and had investors looked at the real return achieved on average across the whole market, they might
have felt that their exposure to housing was excessive through the 1970s and 1980s.
Since the early 1990s, house prices have generally outpaced the inflation rate - that is, they have risen
in real terms. That is especially the case in the last year or two, during which we have seen a dramatic
increase in real estate prices in many areas throughout the country - arguably too much so. And this
reflects the inherent volatility of real estate prices, whether in housing, farm land, commercial property
or industrial property. Investors need to be mindful that the laws of gravity apply not only to Newton's
apple - they also apply to asset prices, including house prices. In real estate, the "laws of gravity"
relate to things like population, income, household formation and the earning potential of the asset.
And this is where the low inflation environment matters for those who borrow to invest in real estate. In
the 1970s and 1980s, there were sharp falls in real terms in house prices and other property prices -
typically immediately following a period of dramatic increases - but it was comparatively rare for prices
to fall in nominal terms. This meant that if someone were forced to sell in a downturn, the value of the
house would probably still be above the value of the debt on the house. Inflation would have shielded
the investor from insolvency, at least in that respect.
In contrast, in a world of low inflation, fluctuations in house prices can result not only in falls in real
terms, but also falls in nominal terms. The risk for investors who borrow almost all of a house's sale
price is that the value of the house could fall below the debt they owe. That is probably fine, as long as
the investor can continue to service his or her debt. But it could cause real problems in the event that
the debt can no longer be serviced - such as when interest rates rise sharply, or incomes fall. In that
situation, if the investor is not covered by mortgage protection insurance and is forced to sell the
property during a downturn, his or her insolvency on paper might become very real indeed.
In view of the increase in household debt in the last 10 years or so, the increasing tendency for people
to own a house for investment purposes, and to enter that investment very highly geared, it is possible
that some households are now quite vulnerable.
That vulnerability is also related to the effect that low inflation has nowadays on the funding side of the
household balance sheet. In the days of high inflation, most New Zealanders could rely on their
nominal incomes also inflating quite rapidly. This meant that, even with the high nominal interest rates
prevailing at the time, households that borrowed on debt-servicing terms at the limit of affordability
would find their debt-servicing burdens becoming more comfortable, and the real value of their debts
declining, fairly rapidly.
This is not the case today. Low inflation means that nominal incomes are rising much more slowly than
in earlier years. As a result, the burden of debt servicing lasts for longer, and the real value of debt is
eroded less rapidly. The period of vulnerability associated with debt-servicing being just affordable
now lasts considerably longer.
Some home owners and investors are well aware of the compounding impact of high debt levels on
adverse events such as loss of employment or income. They adjust their investment and borrowing
behaviour accordingly. However, I think there remain many in this country - and indeed in other
countries like ours - whose behaviour suggests that they might not understand the risks they are
taking.
Leaving real estate aside now, what other investments are available, and how does low inflation affect
the equation? After bank deposits, probably the most commonly understood financial security is
equities. History shows that equities can deliver a superior long-term rate of return, but also that equity
returns over short periods of time can fluctuate quite a bit. New Zealand investors tend to know this,
having suffered in the 1987 crash, and have been rather cautious ever since. This caution and the
small size of the domestic market, which limits local options, have contributed to New Zealand
households not building up financial assets to the same extent as has happened in the US. However,
it has also meant that New Zealand household balance sheets did not take such a hit from the
techwreck and post-9/11 downturns in the markets.
Investors in equities should be in for the long haul, to allow time to smooth out the inevitable
fluctuations in share prices that occur from year to year. Also, because you can never be sure about
any particular company, industry or region, if you are buying shares you should spread your
investments across a diversified range of equities.
What about interest-bearing securities? One of the consequences of reducing inflation to low and
stable levels is that nominal interest rates on all types of these instruments have fallen substantially.
As an example, the average 90 day interest rate in the 1970s was just over 10 per cent, and in the
1980s was around 17 per cent. In the 1990s, the rate fell to 8 per cent, and today stands at a little over
5 per cent - the lowest in many years. Interest rates on other instruments have fallen similarly.
In real terms, of course, interest rates have not fallen anywhere near as substantially over the years,
and remain attractive for investors, particularly relative to the real interest rates available in many other
countries. Indeed, the real interest rate on interest-bearing securities today is considerably higher than
was typical during the high-inflation times in the late 1970s and early 1980s. Taking tax into account
widens the gap even further, because tax rates are applied to nominal, rather than real, interest
income.
Investors in interest-bearing securities are thus better off now than they once were. But people who
rely heavily on interest-bearing securities for their incomes have nevertheless seen a fall in their
incomes, in nominal terms. I fear that this reduction in nominal income, coupled perhaps with "money
illusion" - that is, thinking in nominal rather than real terms - may be encouraging some New
Zealanders to invest in higher yielding securities, in order to reduce the short-term impact on their
cash flow position.
In this drive to achieve higher rates of return, some investors may be taking higher risks than they
appreciate - especially if they think in terms of the nominal interest rates that they used to receive in
earlier years. For example, just a dozen years ago, low-risk securities regularly offered double-digit
interest rates. Today, an equivalent low-risk security might only yield 5 or 6 per cent, or even less. To
invest in securities offering the same nominal yields as were once available, investors now have to
accept considerably greater risk.
Perhaps reflecting this behaviour, deposits outside of the banking sector are growing quite rapidly.
There are also reports of growing retail investment in higher-risk types of securities such as
subordinated notes, capital notes, asset-backed securities, and interests in apartment buildings. These
and other kinds of more complex investment products typically offer high yields, but that usually
reflects higher levels of risk. For example, it may be that the investment ranks behind other debt
obligations of the borrower, exposing the investor to a greater risk of loss if the borrower defaults. In
other cases, the yield being offered may be linked to the performance of particular underlying asset
markets, which may themselves be quite volatile.
There is, of course, nothing inherently wrong with investors taking greater risk. For their own
protection, however, they should be fully aware of the risks they are taking, rather than simply thinking
in terms of the nominal interest rate offered.
Given all this, what should a wise investor do?
First of all, seek advice! This applies especially if an investment product looks complicated. There are
many sources of information to assist in making investment decisions, including material published by
public agencies such as the Office of the Retirement Commissioner, and by reputable members of the
savings and investment industry. There is also the advice of professional experts. Naturally, the quality
of advice is only as good as the quality of the person giving it, so if an investor chooses to use an
investment adviser, the investor would be wise to check the adviser's qualifications and accreditation,
experience, track record and independence.
Checking the provenance of investment products and firms is all the more important in New Zealand
because regulation of financial investments here is not highly paternalistic. The general approach of
the Reserve Bank Act for bank deposits, of the Securities Act for financial securities, and of legislation
for other forms of investment is to promote the proper functioning of the financial system as a whole,
and not the performance or soundness of particular institutions. Laws relating to the financial system
set extensive and tough disclosure requirements, so that individual investors can judge for themselves
the risks and returns they are facing and make decisions accordingly. As noted earlier, low and stable
inflation supports their ability to do this.
Investors not prepared to be intensively involved in the day-to-day management of their investments
have the option of engaging a professional to manage directly their financial affairs. There are many
professional investment management services available. Although some professional service
arrangements are pitched at those with sizeable sums to invest, there are also management services
for those making smaller investments. Finally, managed-fund products such as unit trusts offer the
smaller investor a combination of reduced risk through diversification, and the portfolio-management
services of an investment professional.
Vigilant and open-eyed investment strategies benefit not only investors. Households making
wellinformed investment and borrowing decisions are better able to cope with rainy days, and better
prepared for their retirement years. Soundness in the household sector undergirds the stability of the
financial system, and of the economy as a whole. Finally, intelligent scrutiny of investment proposals,
including the creditworthiness of financial companies, crucially helps weed out poor performers and
improve good performers, promoting effective resource allocation and growth across the economy.
For all these reasons, it is important that investors take all the steps they can to better understand the
nature of the risks attached to their investment and borrowing decisions. This includes thinking in
terms of real rates of return, rather than nominal rates. If we - each of us - can learn to become
smarter and better informed, we will all be better off, individually and as a nation.