Alan Bollard: Coping with global financial and economic stresses
Address by Mr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the
Canterbury Employers' Chamber of Commerce, Canterbury, 30 January 2009.
Paper by Mr Alan Bollard and Mr Tim Ng for the above-mentioned speech.
The original speech, which all the figures and tables can be found on the Reserve Bank of New Zealand's website.
* * *
1. The great turbulence
The period known as the Great Moderation has ended. That era, roughly dating from the
mid-1980s to the mid-2000s, was characterised by strong growth, low and stable inflation,
and internationalisation of trade and financial flows. By the end, it was also associated with
very large imbalances of savings and investment, and a consequently very large increase in
the stocks of credit outstanding. These imbalances and excessive credit stocks remain
evident at the household, business and national levels.
The process of correction to these imbalances has revealed vulnerabilities in the world's
major financial institutions and financial systems. The supply of credit is under severe
contractionary pressure, putting immense pressure on economic activity everywhere. Central
banks, financial regulators and governments around the world have taken, and are
continuing to take, extraordinary action to limit the damage to the financial system and global
economy.
This speech looks at what the next few years may bring. I first review the story so far, in the
international and domestic economies. I then look at how the correction process might play
out over the coming year or so. New Zealand is better-placed than many of our trading
partners to weather the crisis. This is for both structural reasons, and also because of the
remedial policy actions we have already taken and are positioned to take if necessary.
Finally, I discuss the road ahead. I look at how New Zealand households, firms and banks
can be expected to cope with the stresses, and how we will use policy to smooth the ride
where we can.
2. The story so far
Since the onset of the crisis in 2007 there has been a rapid-fire succession of extraordinary
events and policy interventions. Some of the higher-profile triggers of market volatility are
shown in Figure 1, overlaid upon the spread between US short-term interbank interest rates
and the market's expectation of future official interest rates. Normally this spread is close to
zero. The difference from zero is a measure of the level of financial market dysfunction. As
Figure 1 shows, this measure of dysfunction waxed and waned considerably through the
period, but was substantial throughout.
Figure 1. Disruptive events and the US 3-month LIBOR-OIS spread
Source: Bloomberg
This is but a small fraction of everything that has been relevant, for obvious reasons of
space. In the rest of this section I try to knit it together into a single story, probably risking
oversimplification along the way. The narrative here is necessarily linear, but that obscures
many important feedbacks and interactions. These feedbacks are a very real part of
understanding and coping with the turmoil.
It is no accident that the massive simultaneous surges in the prices of commodities, equities,
housing and other real estate around the world since the mid-2000s until 2007 matches the
surge in credit. In hindsight, this correlation can be explained fairly simply as the mutual
reinforcement of a number of powerful factors. Emerging market countries, especially in Asia,
ran high rates of national savings out of the earnings from strong export-led growth. As world
oil prices surged, national savings in oil exporting countries also increased rapidly. Finally,
the developed world ran fairly loose monetary policy as part of the recovery from the 2000-01
recession. In this environment, the premium charged for credit risk fell to low levels through
the middle part of the decade (Figure 2). The growth in asset prices in the latter part of this
period increased capacity for secured borrowing, adding further stimulus for credit growth.
Figure 2. Spread between US 10-year sub-investment grade corporate bond yields and
US government bond yields
Source: Datastream
Figure 3. Credit-to-GDP ratio
Sources: IMF, Datastream.
Together, these factors enabled the funding of an extraordinary rate and diversity of financial
innovation and credit creation in the developed world, and very substantial increases in the
ratios of credit to GDP in developed countries, particularly the UK (Figure 3).
Also fuelling the credit growth through the period was a shift of the major US and European
banks away from the traditional "originate to hold" banking model towards an "originate to
distribute" model, which for a range of reasons was seen as more profitable. In "originate to
hold", mortgage and other credit originations typically stay on the originating bank's balance
sheet until maturity. In "originate to distribute", the credit originations are securitised and sold,
removing them from the originating bank's balance sheet. A typical securitisation would
involve, along the way, the creation and sale of derivatives based on the securitised
exposures, further increasing the fee-earning potential of the underlying origination in an
environment of voracious demand for risk.
"Originate to distribute" enabled a greater amount of credit creation to be supported by the
same amount of financial system capital. It also made it harder for the institutions involved in
the process of credit supply and derivative creation to assess their credit risk exposure and
price it, because of the greater number of independent institutions involved, and the
complexity of the transactions and instruments. The institutions involved came to depend on
credit rating agencies for the apparently simple risk summary contained in a credit rating.
In the event, the rapid growth and diversity of financial institutions and products ran well
ahead of the ability of financial institutions to understand their risk positions, of rating
agencies to translate the new exposures that were created, and of regulators to ensure that
financial institutions were managing risk prudently. Long-standing, well-conceived banking
practices were abandoned as financial institutions focused on maximising short-term
profitability. The mutually reinforcing strengths of real and financial demand showed up first
in rising prices in the commodity and asset markets. As debt-funded consumption and
investment in the developed world surged, generalised inflation pressure began rising.
As suggested in Figure 1, the first obvious signs of credit over-extension appeared in
mid2007, as credit impairment on US subprime mortgage exposures began to surface. Money
market spreads rose quickly in the US and Europe as frictions emerged in the cash markets.
Soon, the credit quality and liquidity of other types of asset-backed securities and derivative
instruments became subject to doubt. The frictions spread further and markets in which risk
is traded away became dysfunctional. Financial institutions became increasingly unwilling to
deal with each other as uncertainty about who was exposed, and how badly, became more
and more enlarged.
As 2008 progressed, it became obvious that the financial dysfunction was taking a lot longer
to clear than expected. Innovative products with strong credit ratings proved less than robust.
Unanticipated concentrations and correlations of risk were suddenly revealed - including
within the largest global banks and credit insurers. The substantial increase in the diversity
and sophistication of financial products and institutions turned out not to have reduced
systemic risk through diversification. The fragmentation of risk had not enabled individual
institutions efficiently to isolate, hedge and transfer risk. Understanding of risk had become
lost in translation as risk was traded across institutions and national borders. Measured
regulatory capital that had seemed bountiful up until 2007, now looked thoroughly
inadequate.
When risks began to crystallise and losses emerge, the destabilising triggers of ratings
downgrades, asset price declines and market illiquidity turned out to have more viciously
compounding effects on credit availability than anticipated. The willingness of financial
institutions to deal with each other broke down. The continued operation of the global
financial system turned out to depend on a far larger number of individual markets and
institutions than had been assumed. Liquidity bottlenecks in some arcane products and
markets, such as monoline bond insurance, became suddenly obvious.
US and European financial system conditions deteriorated significantly in the second half of
2008, especially following the failure of the major US investment bank, Lehman Brothers, in
mid-September. Other sizeable financial institutions in the US and Europe - including AIG,
the world's largest insurance company at the time - failed or were restructured during this
time. Confidence and the sense of rational discrimination by investors and depositors among
Northern Hemisphere financial institutions evaporated.
The feedback between increasingly restricted credit and the slowdown in the housing market
and general economic conditions became much more significant. Drastically revised
prospects for world growth produced a commodity price slump (Figure 4).
By the end of the year, world equity markets had lost in the order of US$30 trillion - half their
value (Figure 5). Real house prices in the US and the UK had fallen from their peaks by a
third and a quarter respectively, with still no sign of deceleration in their rates of descent
(Figure 6).
Figure 4. The cycle in international commodity prices
Sources: Bloomberg, Reuters
BIS Review 11/2009
Figure 5. Equity prices
Source: Bloomberg.
Figure 6. Real house prices
Sources: National data sources, Datastream, RBNZ estimates.
The synchronisation of equity market cycles across the world has been remarkable, not least
because it has included parts of the world with financial systems less directly affected by the
problems in the US and Europe, such as most of Asia. The degree of synchronisation in
house prices, though, is even more historically unique. It has occurred mainly, but not
entirely, in the major English-speaking countries (including New Zealand and Australia),
where the increase in household leverage was particularly enthusiastic.
Combining the plunges in value of these two major asset classes implies that households,
businesses and sovereign wealth funds all lost massive amounts of wealth. The fall in US
house prices alone suggests a typical loss of half the wealth of households in their prime
earning years - more than US$50,000 for every US homeowner, or US$4 trillion in total.1
The international policy response
Through the turmoil, the authorities in the major Northern Hemisphere economies escalated
their responses, as it became clear that successive interventions were at best only holding
back the tide.
The initial response to the deterioration in liquidity conditions in 2007 was an increase in
central bank money market operations, designed to increase the volume and availability of
cash in the banking system. Variously, central banks widened the range of collateral they
would accept in return for cash, relaxed the conditions on which they would grant emergency
lending, encouraged banks to use emergency lending facilities, and arranged swap lines with
each other to ease foreign exchange shortages in offshore markets.
Troubled financial institutions had to be rescued with the use of public funds, in cases where
the institution's failure was deemed to be a threat to the stability of the system. The UK
government announced a blanket guarantee of all deposits of Northern Rock, the mortgage
lender, in September 2007. Major US investment bank Bear Stearns was acquired by JP
Morgan Chase with financial assistance from the US Federal Reserve in a deal announced in
March 2008.
Subsequently, as the problem widened and developed into widespread public concern about
the fundamental solvency of some major financial institutions, governments in many
countries moved to restore confidence with more sweeping measures. The coverage limits
under deposit insurance schemes were extended or, in some countries, removed altogether.
System-wide guarantees of other bank liabilities were introduced also.
In the second half of 2008, central banks responded to the intensifying risks to the economic
activity with rapid reductions in official interest rates, in some cases coordinated. Many
governments announced large fiscal stimulus packages.
The large-scale nationalisations of the financial system and acquisition of financial risk in the
Northern Hemisphere have distorted incentives, and this will have to be addressed in the
future. More immediately, the expansion in the public balance sheet, combined with the
financing burden of the fiscal stimulus packages, have reduced fiscal resilience and
constrained the scope for future fiscal action. The elevated risks to fiscal and external
sustainability are already being priced and watched closely by sovereign credit rating
agencies. The ratings of a number of Northern Hemisphere countries have already been
downgraded.
The New Zealand version
The emergence of money market frictions in the US and Europe in the second half of 2007
spilled over onto New Zealand shores instantly. The spread between local short-term
interbank interest rates and expectations of official rates rose, reflecting the increased
premium on liquidity worldwide. However, although there was a degree of friction in trading
conditions, money generally continued to flow.
As a precaution, the Reserve Bank introduced a range of measures to expand the scope of
our money market operations, along the lines of those taken by central banks elsewhere, in
order to ease the liquidity pressures that had emerged in the local interbank market. As the
international turmoil continued into 2008 and deepened, we broadened our liquidity facilities
further, primarily as a precaution to ensure that the banking system could handle any
additional liquidity pressures were they to arise.
The international financial turmoil arrived at a time when a number of local finance
companies were already under pressure, largely due to credit weaknesses specific to that
sector and to particular institutions. The failure rate in the non-bank deposit-taking sector
increased as funding became more difficult to obtain. However, the solvency of the core New
Zealand financial system was not in doubt, and still is not. We stepped up our usual
prudential supervision activities with banks, both to increase the chances of detecting
problems and to ensure that banks themselves were doing everything they could to mitigate
their liquidity and other risks.
Table 1 lists the major changes to Reserve Bank's liquidity facilities and liquidity
management processes to date.2
Table 1. Changes to New Zealand liquidity management arrangements
Announcement Measure
date
2007 23 Aug Eligibility of New Zealand bank bills for acceptance in the overnight
reverse repurchase facility
2008 7 May Eligibility of AAA-rated New Zealand residential mortgage-backed
securities and New Zealand wider government sector debt for acceptance
in Reserve Bank liquidity operations
Extension of the maximum term of the overnight reverse repurchase
facility from one day to 30 days
9 Oct Eligibility of residential mortgage-backed securities in Reserve Bank
liquidity operations prior to the securities receiving formal ratings
29 Oct Establishment of reciprocal currency swap line with United States Federal
Reserve
7 Nov Introduction of Term Auction Facility for injection of cash for terms up to
12 months
Introduction of Reserve Bank bill tender
12 Dec Eligibility of highly rated New Zealand corporate securities and New
Zealand dollar asset-backed securities in Reserve Bank liquidity
operations
The Australian and New Zealand Governments also introduced guarantees of bank liabilities
around the time that they were introduced offshore. In the New Zealand case, it was seen as
prudent to ensure that depositors remain confident in an environment of extreme global risk
aversion and uncertainty. The guarantee of wholesale liabilities was a precaution to
maximise the ability of local institutions to participate in international funding markets while
they remained disrupted.
In our monetary policy operations, we monitored the weakening in the domestic economy for
signs of pressure coming from the international credit turmoil. Domestically it was clear that
the economy was weakening from the housing downturn, although there were offsetting
factors from commodity prices remaining fairly high and the Asian and Australian economies
remaining fairly robust, until quite late. The Reserve Bank began cutting the OCR in July
2008, in response to the weight of accumulated evidence pointing to reduced need for tight
monetary policy. This was despite headline CPI inflation having reached 4 percent for the
year to June 2008, mainly due to the influence of record high petrol prices.
During the worst months of 2008, as the rate of deterioration in the outlook sharply
increased, we cut the OCR in steps that are very large by the usual standards of monetary
policy operation (Figure 7). The rapid abatement of medium-term inflation pressure in New
Zealand was such that we saw, and still see, a period of monetary stimulus as now
warranted to keep inflation consistent with the target.
Figure 7. New Zealand Official Cash Rate
Source: RBNZ.
3. The road ahead
We are now in a period where financial, monetary and regulatory policymakers around the
world are fully occupied in understanding the mess, and in making the transition back to
more normal economic conditions as orderly as possible. At the same time, underlying the
cyclical volatility and noise are longer-run structural shifts and trends that policy needs to
allow to come through.
Booms and busts
The extraordinary surges then collapses in global credit, asset and commodity prices all now
resemble, with the benefit of hindsight, overshoots followed by undershoots. The reversal in
the price of credit and tightening in credit availability has been extremely abrupt. Most
countries are not yet seeing slowing credit volume growth, due to the masking effect of
drawdowns of existing credit lines. However, major international financial markets and banks
are now much less willing, or completely unable, to provide new funding, even at very high
spreads and with various forms of government support. Anomalous pricing and the
breakdown of normal arbitrage between markets is widespread. These are not normal
conditions, but an over-correction that should reverse over time as confidence and capacity
to trade return.
If history is a guide, housing and equity markets will also overshoot, or may have already.
Housebuilding activity in the US has essentially ground to a halt, but the US population
continues to grow and needs somewhere to live. Some overshoot of house prices on the
downside is probably unavoidable to restart demand for housing and, eventually, new
investment. The question is how to limit the downside's extent. Similarly, while there is
undoubtedly an overhang of investment at inflated asset prices to be worked off, equity price
falls below fair value are how markets typically work to generate opportunities too attractive
to pass up.
Finally, the commodity price rise and fall is very large. Oil prices alone quadrupled between
2004 and 2007, before crashing back to the 2004 levels where they are currently. Explaining
price movements, let alone gleaning the medium term trend in prices, is very difficult in liquid
markets with limited short run supply elasticity. On balance, the underlying trend in real
commodity prices over coming decades is probably still upward. Financial market hubris
during the upswing, and its opposite in the downswing, probably played a significant role in
amplifying the cycle.
The fundamentals of supply and demand continue to argue compellingly for underlying
strength in prices. For dairy products, for example, we still believe emerging market incomes
will grow strongly over the medium term, underpinning growth in demand for protein and a
more Westernised diet. For hard commodities, the physical and technological constraints on
supply seem difficult to surmount. Whatever the case, large swings in commodity prices
seem likely to remain with us in coming years, as supply and demand pressures lever more
strongly on limited inventory buffers.
Very noisy signals in credit, asset and commodity prices have resulted in what now look like
material misallocations of resources in a range of industries over the past few years. Here in
New Zealand, there has been a dairy land price boom, which has spurred large amounts of
investment in dairy-related industries, in some cases highly leveraged. The house price
boom does not seem to have left us (or Australia) with a significant oversupply of housing
(unlike the US, for example). It has, though, produced a large increase in household and
developer leverage.
The global recession
Comparisons of the present world recession to previous recessions, and even to the Great
Depression of the 1930s, are rife. To be clear, the state of the global economy and the
outlook are very serious, but we are nowhere near Depression-level economic conditions.
That said, we can certainly learn from the Depression experience.3 Then, as now, the global
financial system became seriously incapacitated. Concerns about the state of the
international economy came in waves. In the present case, markets would take heart from
announcements of major official intervention, such as the bailout of the major investment
bank Bear Stearns in the US, to be followed by new bouts of adverse news and further
reversals of confidence, such as in response to the non-bailout of Lehman Brothers.
However, in macroeconomic terms the outlook is considerably better. In world growth terms
we are somewhat below the early 1980s recession - that is, worse than the growth troughs
in the early 1990s and early 2000s (see Figure 8). Unemployment rates will certainly
continue to rise, but peak well short of the levels reached in the Depression. Then,
unemployment rates rose well above 20 percent in many cases. Policy frameworks were
much less well-equipped to handle the slump. In some cases, policy responses such as
tightening of some fiscal settings and trade protectionism, and prevailing macroeconomic
management frameworks such as maintenance of the gold standard, seriously exacerbated
the initial problems.
Figure 8. World GDP growth since 1970, and IMF forecasts for 2009-2010
Sources: IMF, Datastream.
Compared to previous global recessions, the current one has some distinguishing features. It
originated in the US financial system and quickly spread to the European one, eventually
spreading across most regions of the world - but by different means. In the European case,
the financial system vulnerabilities were both directly generated by US-originated credit
exposures, as well as through a sharp reappraisal of the consequences of the credit boom
and adverse relaxation of credit standards within Europe itself. Elsewhere, and especially in
Asia, the transmission has been through more conventional trade and commodity price
channels, as the East Asian financial systems, including the capacity of the official sector to
withstand financial shocks, have remained fairly robust.
To date, Asian and many other emerging market economies have been less affected than in
previous episodes. This resilience so far is very different from the crises of the past two
decades. However, the adverse impact of the developed world recession on Asian exports
and investment is now showing quite strongly. It is not clear how severe the impact may
ultimately be.
What is needed for stability to return to the world financial system?
Two fundamental conditions are needed for conditions in the global financial system to return
to normal. First, housing markets in the US and UK need to stabilise. As suggested earlier,
there is a natural limit to how far housing market activity can fall. Second, sufficient capital as
a buffer against risk and as a base for growth needs to be restored to Northern Hemisphere
financial institutions. The sufficiency of capital then needs to be transparently observed by all
in the market in order for confidence to return and normal financial trading to resume. This
latter process may well drag on beyond this year.
So far, the running total of credit losses declared by US and European financial institutions
since the crisis began still exceeds the amount of new capital raised (Figure 9). And, there
remains uncertainty about the level of losses still to be crystallised, or still to be generated as
a result of the recession. Financial institutions and authorities face the formidable challenge
of establishing credible estimates of the losses still to be borne and the exposures still to be
covered, and then finding the new capital to get the financial system back on its feet.
Figure 9. Cumulative credit losses by region and total new capital raised
Source: Bloomberg
Meanwhile, the massive fall in household wealth since 2007, with largely unchanged
household debt, means that the financial outlook for households across the developed world
(especially those who "leveraged up" in the boom phase) is now much less healthy,
especially in view of the increased threat of unemployment and the reduced fiscal strength of
government. Households are likely to respond to this in two ways - first, by cutting back
consumption and investment and increasing savings; second, by selling assets to pay off
liabilities.
Both processes will keep downward pressure on asset prices and drag on economic activity
for many years, probably beyond the return of normal financial market conditions. Much more
cheap credit than was sustainable was taken up over many years, not only by the Northern
Hemisphere financial sector and household sector but also certain elements of the corporate
sector (the US auto industry, for example). In the early part of the process, the impairment of
the financial system will actually force the household and corporate sectors to reduce debt,
as the opportunities for leveraged investment in housing and other assets will be much
reduced. This increased propensity to save may blunt the impact one might otherwise expect
from fiscal and monetary policy stimulus.
Finally, external surplus-running emerging markets, especially in Asia, will have strategic
consumption and investment choices to make. Their broad development strategy in the early
to mid-2000s was to grow national income by exporting cheap consumer goods to
developed, largely deficit-running, economies. This strategy will now be less viable given
household and national financial retrenchment, and pressure on exchange rates to fall to
assist in the reduction of imbalances, in the West. Asian governments will need to generate
large increases in consumption and domestic investment demand, to replace the gap left by
exports, if they are to continue growing at the high rates needed to meet their national and
social development objectives.
The net financial flow from East to West that characterised the middle part of this decade will
as a consequence need to fall somewhat, even if it doesn't reverse. As the large emerging
markets such as China and India continue to develop amid these large shifts in global
economic and financial currents, the reduced dependence of the world on consumption and
investment in the West and consequent shift of political power will accelerate.
New Zealand's position
New Zealand, like the rest of the Asia-Pacific, has thus far held up better than many
developed economies. The global financial crisis hit the Northern Hemisphere first, and
hardest. The transmission of the shock to us through Asia and Australia - which together
account for half our trade in goods - has been slower than the transmission from the US to
Europe. However, we haven't escaped unscathed either financially or economically. New
Zealand investors have lost money. Sectors of the New Zealand economy exposed to
external demand have weakened sharply.
A few factors count in New Zealand's favour. The parts of the US and European capital
markets that have been most damaged are investment banking, hedge funds, private equity,
sovereign wealth funds, and stock, bond and derivatives markets. New Zealand's direct
exposure to these parts of the international capital markets, and to complex derivatives or
structured credit products, is very light. Our banking system is well-capitalised, vanilla, and
mortgage lending is generally on good credit quality. The large Australian banking groups, of
which the major New Zealand banks are a part, are now among the largest and
highestcredit-quality banks in the world.
Also, our established track record for transparency in our regulatory institutions, sound
management of the public accounts, and forward-looking monetary policy are well-regarded
internationally. Through this episode, we have attracted relatively little adverse attention in
financial markets.
Finally, New Zealand's freely floating exchange rate is an effective buffer against the current,
internationally sourced, shock. The downturn in international commodity prices, as well as
international investor risk aversion and the contraction of liquidity in the global financial
system, have led the value of the New Zealand dollar to fall against all the major currencies
(Figure 10). This has been especially the case against the Japanese yen - the currency of a
country that typically runs a current account surplus, unlike the others in the New Zealand
TWI. Not only does depreciation cushion the incomes of sectors exporting goods and
services priced in foreign currency, it also acts powerfully and in the right direction to
encourage the reduction of national debt and re-balancing of sectoral demand that is needed
in New Zealand, as a deficit-running country. As a small, open economy with flexible product
and labour markets, we should be better positioned than many others to re-orient production
and income generation in response.
Figure 10. New Zealand TWI4
Source: RBNZ.
However, there are also some negative features about New Zealand's situation. Our
exposure to the global commodities trade is particularly evident now, with the commodity
price volatility currently. The overall impact on New Zealand depends on the balance
between imported (oil) and exported (agricultural) commodity prices. Usually commodity
price rises and falls see the New Zealand terms of trade rise and fall more or less in concert,
because of the greater proportion of commodities on the export side than the import side.
This is the pattern we are seeing currently, with the terms of trade having fallen about 10
percent so far since early 2008.
With open capital borders, defensive monetary or financial system policy actions taken by
bigger economies can cause collateral damage to smaller ones. Guarantees of financial
institution liabilities, or provision of official credit facilities, inevitably have to have boundaries,
to limit the risk of the sovereign granting the guarantee or credit. But in an environment
where depositors and investors are panicky, and the appetite or capacity to take risk is
limited, the boundary will inevitably generate a rush of funds to the safe side, putting
pressure on governments, even in countries with safe financial systems, to "match" the
actions taken abroad. We saw this illustrated clearly in October last year with the extension
of government guarantees of bank liabilities overseas.
Finally, even though our banking system is vanilla in terms of credit risk, it has vulnerabilities
resulting from the need to fund domestic lending activities by offshore borrowing. As is well
known, New Zealand has been running a large external deficit for some time, mirrored by a
severe household savings imbalance. This imbalance grew even larger during the credit and
house price boom. The banks have been funding this shortfall of domestic savings mostly
with short-term debt ("commercial paper") issues, which need to be renewed every few
months. The increase in New Zealand's external vulnerability was the reason for Standard
and Poor's placing New Zealand's foreign currency credit rating on "negative outlook",
increasing the focus on the economy's adjustment to the imbalances and the