It is a very strange world when changes to credit margins (spreads) are having a much larger impact on overall cost of borrowing than changes to the underlying market interest rates.
With market interest rates now so low, changes to credit margins are proportionally playing a much larger role in overall interest rate risk and interest cost for borrowers. Credit spreads are only going one way at the moment and that is up.
Even before the NZ sovereign credit rating downgrade last week, bank borrowing costs from offshore debt markets were increasing as global investors become super cautious again and worry about bank failures in Europe. The credit default swap market pricing for the Aussie banks for a 5-year term has moved up from 140 basis points (1.40%) in late July before the US debt ceiling fiasco to 325 points (3.25%) today. Market 5-year interest rates have not moved by 132% over that time period! Whilst the NZ arms of the Aussie banks are not borrowing large dollops of funds from the European debt markets at the moment, the scale of that increase must transfer through to their overall funding margins eventually.
The question is whether the local banks have managed their funding risk (the risk of margins increasing and not being able to access the term of funding you desire) better on this occasion than what they did in the GFC in 2009? On that occasion they were caught badly on borrowing too much too short from offshore debt markets. The RBNZ Core Funding ratio requirements have since reduced that reliance and risk; however borrowers are still at risk to bank funding risk management performance.
The immediate question from the media is by how much will the home mortgages interest rates go up by due to the credit rating downgrade? So far, the impact on term swap interest rates has been muted with only a five point increase in the three-year swaps and 10 points in the 10-year swap interest rates. Over coming months I do not think we can expect any great change or movement in these term swap rates, however the bias has to be for higher rates later in 2012 if and when the global economy gets going again. The impact on home mortgage rates is negligible at this point, however corporate borrowers have to expect higher lending margins from their banks if they are refinancing over coming months.
The credit rating downgrade came as a surprise to most on Friday morning, however perhaps not to the chaps at the NZDMO who must have heard a whisper and tendered $1 billion of bonds on Thursday, when their normal weekly tender amount is only $300 million. Overall, tax payers have benefited from the NZDMO front-running their borrowing requirements this year as a risk management precaution against risks like credit rating downgrades and global market turmoil.
Like exchange rates, sovereign credit ratings are relative indices and at “AA” the NZ Government’s foreign currency, long-term credit rating still ranks equally with Kuwait, Slovenia and Spain. We are above the AA- ratings of Taiwan, China, Japan and Saudi Arabia.
NEW ZEALAND DOLLAR MARKET COMMENTARY
Lower Kiwi dollar value will help GDP growth
The events and forces that were expected to turn the Kiwi dollar out of the 0.8000’s and drive it downwards have prevailed and delivered the lower currency value. The list is long and constructive - lower global growth, weaker US sharemarkets, interest rates lower for longer, lower commodity prices (particularly WMP), a weaker Euro currency value on no credible solution to the European debt crisis and finally the “coup de gràce” hitting the screens early Friday morning as Fitch downgraded NZ’s sovereign credit rating.
No-one was really expecting the rating agencies to suddenly mark New Zealand down at this time, however given the high external debt levels and Current Account deficit the prospect of lower commodity prices and higher internal budget deficits going forward on top, was enough to turn Fitch’s and S & P’s measurement metrics. However, it did seem that Fitch suddenly realised that New Zealand’s external debt to GDP ratio was above other AA rated countries and it was an outlier that could not be allowed. Our total external debt ratio to GDP has actually reduced over the last three years; however what has changed is the investment world has become much less tolerant of high debt levels as a result of the European debt crisis. Our ability to service and repay debt has not materially changed, the world’s sensitivity to debt has changed and a lower sovereign rating is the result.
The pressure is now firmly on the National Government to meet their forecasted return to budget surplus by 2014/2015. The task is much harder than a few months ago due to higher Christchurch earthquake costs and slower GDP growth reducing tax revenues into the Government.
The Government needs the economy to grow and, as always, that can only come from the engine room of the export sector. Thankfully, the now lower NZ dollar value will be a boost to exporter’s confidence, output and profitability.
Can the Government do more to help exporters?
The economy needed a lower exchange rate and it is being delivered by the markets (thanks partially to the credit rating agencies). It remains to be seen whether the National Government has any innovative economic policy initiatives to keep our exporters competitive and on the front foot.
The Minister of Finance, Bill English talks about our exporters needing to be competitive; however, what is he doing to foster that position? Managing foreign exchange risk is an important part of export success. Exporters who just hope that the currency will go their way have been found out in recent times and their businesses and the export economy has been worse off because of the lack of currency hedging.
One small, however important, way the Government could contribute to export success (hence stronger GDP growth) is providing a “hand-up” by specific credit support to small exporters so that they can hedge the NZ dollar currency risk longer term. Most banks restrict small exporters to a maximum term of 12 months for forward contracts. A few years back our advisory firm tried very hard to implement a FX hedging credit support scheme through the NZ Export Credit Office that would have provided longer term currency hedging facilities to small exporters over and above the short-term credit horizon of their banks. Such credit support schemes for FX hedging have been introduced by the Governments in Canada and Australia. Unfortunately, the proposed scheme here became bogged in the bureaucratic mire they call Wellington with Government mandarins finding plenty of ways not to do it, rather than to do it. It is these types of initiatives that need to be implemented to allow exporters to have the financial strength and security to expand and create jobs. Unfortunately the request for the low-risk credit support from the Government came at the wrong time with Crown guarantees to retail depositors being called up on the finance company collapses.
It is always sad to see exporting companies laying-off workers (as Canterbury Leather International did last week) citing the high NZD/USD exchange rate as the reason they lost competitiveness and business. Exporters without hedging policies and programmes are risking shareholder’s money and their workers livelihoods; you would think politicians and Government officials would understand this.