Most economic and financial reports are dry and boring but there is one notable exception and it was published this week.

The exception is the Reserve Bank’s Financial Stability Report, which is published in May and November each year.

This document, which is available on the Reserve Bank of New Zealand website, is well written, clearly laid out, has a large number of excellent graphs and gives a good summary of the state of the domestic financial system.

The report paints a subdued picture of the domestic economy but it isn’t all doom and gloom.

The Reserve Bank’s view is best summed up in its opening paragraph: “The stability of New Zealand’s financial system is being challenged by continuing strains in financial markets, the sharpest contraction in global economic activity in at least 30 years, and an extended period of weakness in the domestic economy.

“Unlike many other developed countries, however, New Zealand has not experienced significant distress in its banking sector, nor has the availability of credit to households and businesses tightened to the same degree.”

In other words the situation is not great in New Zealand but it is better than in most other countries.

Why is that?

The simple answer is housing, our housing market has held up remarkably well compared with many other countries. A graph in the report shows that house prices in the United States have fallen 30.6 per cent from the peak, by 18.4 per cent in Ireland, 18.3 per cent in the UK, 9.0 per cent in New Zealand, 6.5 per cent in Spain and only 4.0 per cent in Australia.

The housing market is extremely important for a number of reasons including:

Just over 56 per cent of total bank lending, excluding inter-bank lending and offshore loans, is to individuals mainly in the form of residential mortgages. Approximately 15 per cent is to both business and agriculture.

New Zealanders are hugely dependent on residential property as this asset class represents 97 per cent of individual net wealth compared with 81 per cent at the end of 1998 and 72 per cent in 1988.

We are far more reliant on housing, in terms of wealth, than any other Western country as residential housing represents 61 per cent of net individual wealth in Canada, 75 per cent in France, 68 per cent in Germany, 46 per cent in Japan, 65 per cent in the UK and 46 per cent in the United States.

Our huge exposure to housing means that if this market sinks we will go down with it. To date this has not happened, although the market was weak through most of 2008.

What does the Reserve Bank have to say about the household, business and agriculture sectors?

As far as households are concerned, a period of consolidation is under way as individuals exercise increasing caution, curtail spending (particularly on discretionary items), increase savings and reduce debt.

For most households this transition is relatively smooth because of the decline in interest rates and income tax cuts.

However the Bank notes that a “substantial majority” are likely to experience more severe financial distress, particularly as unemployment rises.

The older age group is also under pressure as the returns on their investments, particularly from fixed-interest securities, declines.

The Reserve Bank expects unemployment to rise and residential property prices to fall further although it doesn’t predict by how much and notes that there has been a pick-up in housing activity. Business is the poor cousin of the New Zealand economy for a number of reasons including:

Individuals pour most of their equity into residential housing and there is little left for business investment.

Only 14.4 per cent of bank lending goes to the business sector compared with 19.6 per cent in mid-1998 (see table).

The banks love property as 66.6 per cent of total lending is to either residential or commercial property compared with 61.7 per cent in June 1998.

In addition much of the agriculture lending is probably secured against land.

Some business lending has been secured against residential housing and appears in the bank lending statistics under residential mortgages. The problem with this is the banks lend to these business people on the basis of the value of their house rather than the viability of their business.

This does not lead to an efficient economy and many of the small companies that will go under this year were funded by bank borrowings, secured against residential property, where the banks did little monitoring.

The Reserve Bank states that businesses are facing an extremely challenging operating environment and many “remain deeply pessimistic about the outlook for profitability”.

The central bank notes there has been a big increase in business debt, particularly by overseas companies that have borrowed from their parent.

Banks are becoming more cautious about extending credit to the business sector and the total amount of business credit has contracted since peaking in December 2008.

Reduced capital expenditure has led to a reduction in credit demand but “it is also evident that a significant minority of borrowers, particularly smaller firms with weak or unproven cash flows, are having difficulty in obtaining credit on affordable terms”.

The biggest potential time bomb is agriculture, particularly the dairy sector. The Reserve Bank has consistently warned about high debt levels in the farming sector and has backed this up with compelling statistics.

In its May 2008 report there was a special section showing that entrants to the dairy sector since 1997 were highly geared. In the November 2008 document there was a graph showing that agriculture debt had risen from 130 per cent to 467 per cent of agriculture GDP since December 1990.

The latest Financial Stability Report shows that the agriculture sector now has total borrowings of $43.6 billion with dairy farming accounting for 61.5 per cent of this, grain, sheep and beef cattle producers 26.1 per cent and other agriculture activities 12.5 per cent.

The problem is twofold because many dairy farmers are highly geared, particularly new entrants, as is Fonterra. This double debt situation will be a major problem if dairy realisations don’t improve.

A number of graphs in the latest Financial Stability Report show the agriculture sector in poor light, relative to other industries, in terms of interest cover, debt to equity ratios and earnings performance.

The bank believes that as a general rule “family farms” are in a better position to cut costs but the sector is vulnerable to any further tightening in credit availability and further weaknesses in realisation prices.

In conclusion, the Reserve Bank believes New Zealand is weathering the international economic storm remarkably well although this crisis is not over and the country remains vulnerable to further disruptions on world financial markets because of our dependence on offshore funding.

Our banking system has not experienced the distress seen in some other countries although there has been a sharp increase in impaired assets.

The banks are continuing to lend but lending criteria have tightened and some businesses are reporting difficulties in obtaining credit.

In other words, we will see this crisis through as long as there isn’t a further deterioration in international financial markets.

Most of the country’s economic units are in reasonable shape although there are a number of households, businesses and dairy farmers with far too much debt.

Excessive debt is always a problem when credit conditions deteriorate.

Banking Lending – Business is the poor cousin

Lending to Mar 09 Jun 08 Jun 03 Jun 98
Households 56.4% 56.8% 56.3% 53.3%
Agriculture 15.0% 13.9% 12.8% 10.7%
Business 14.4% 14.5% 17.0% 19.6%
Commercial property 10.2% 9.4% 8.4% 8.4%
Government, finance 4.0% 5.4% 5.5% 8.0%
  100% 100% 100% 100%
Total ($ billion) 290.4% 278.2% 148.5% 103.0%

Figures exclude offshore lending and lending to other M3 organisations