Part 2: Moral Hazard & The NZ Banking System

26th Oct 2021 | Ben Pauley


In the last blog, we defined Moral Hazard and gave a recent example of the theory, commenting on the Global Financial Crisis and how the government bailouts may have created moral hazard for financial institutions, borrowers, investors and lenders around the world.

Today I wanted to hone in a bit more on the home front and certain things we have seen in the last 20+ years which raise concern for me. I want to stress that the below is merely my musings on the happenings within the New Zealand market, and not an official report or statement on the stability of New Zealand’s financial sector or the economy.

The NZ Agricultural Boom

The first topic I wanted to raise was the leverage of our nation’s most treasured business sector, Agriculture. New Zealand is regarded as one of the best dairy farming nations globally, with our milk commanding great premiums and demand worldwide. In 2016, NZ was the second largest exporter of dairy products in the world behind Germany. The turn of the century saw a huge increase in the consumption of dairy in China and other Asian countries. This gap needed to be filled, and NZ jumped straight in fulfilling 91% of the demand for dairy imports into the nation (>500,000 tonnes). This spurred a boom in dairy in NZ, with ever increasing milk powder prices and conversions of huge swaths of farmland from sheep and beef to dairy.

Overleverage in the Agriculture Sector

This all needed to be financed, and was done so with gay abandon. Agri debt in New Zealand grew from ~$12bn in Jan 2000 to >$47bn in mid 2010. This enormous growth was financed primarily by the main banking sector in New Zealand, and eventually caused significant stress on many parties in the agri sector. A lot of lending was made based on farming valuations (occasionally valued by the bank manager) and ended with many farmers highly geared.

What has since happened is that lending standards have become significantly more strict, overseas buyers have been banned, and several politically motivated laws have been passed that add cost and difficulty in the sector. Liquidity has dried up.

Instead of seeing defaults, sales and a correction in asset values, we have instead seen the banking sector in NZ keep several farms on life support- either allowing them to continue ad infinitum on interest only or indeed capitalize their interest payments. The Banking sector has deemed agri too big to fail.

This has seen underinvestment into the sector, inefficiencies for both the farms and banks (their capital is tied up) and a quasi-zombie like state for many farms.

New Zealand’s Covid Response

From farming, let’s move onto Covid. If we think back to March last year, there was a real fear of a complete economic meltdown. Economies were completely shut, cross border travel halted, and trade fell off a cliff. It was a difficult time for many, and the government and banks stepped up. The OCR was cut to 0.25%, mortgage holidays were available at the click of a button, and the messaging given out to all banks regarding businesses was ‘do not let any fail’. This was heartening to many as something entirely outside their control had ripped away their livelihoods. There can be problems here though.

Impact on Interest Rates and Savings

The fall in interest rates has had a huge effect on house prices, with nationwide growth in values well beyond 20%. It has also begun to lead to inflation, as I spoke about in an earlier blog. The mortgage holidays and rhetoric from the banks is more what I want to focus on, however. Sound economic theory suggests that savings are good, these are funds that you set aside for both capital expenditure and a ‘rainy day’. It is savings, not consumption, that lead to wealth.

There is an argument to be had that, while a level of protection is required, carte blanch offering private bailouts (as these were in effect) can create a moral hazard. Doing so doesn’t encourage people to save and set aside for that rainy day or capital expenditure, people do not see the downside. This approach was required as the national savings rate was 0.5% in the March 2020 year.

For context, that means someone earning a net income of $100,000.00 was saving just $500.00 ($10 per week). This meant that as a nation we didn’t have the depth of savings to survive a downturn and fall or loss in income. In free market theory, there should be an economic correction with a downturn in consumption, fall in prices, reduction in debt and return to savings. People will adjust, some will suffer, but as a nation, long term we will be better off.

This didn’t happen, instead we saw a sharp drop in interest rates, mass money printing and a huge spur of consumption and creation of capital. Currently, and this has improved of late, the prevailing savings interest rates in banks are below 1.5% giving little incentive for people to save. The problem isn’t being solved and the public was bailed out. Moral Hazard.

In Part 3 of this series next week, we speak more about what these bailouts can result in and what may be to come.

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