In the short run, the New Zealand economy is likely to deteriorate, and another credit rating downgrade can't be ruled out.
Credit ratings have been all over the headlines of late – both the US and countries in Europe have suffered downgrades, while New Zealand has also had a downgrade from two out of the three major agencies (Fitch and Standard & Poors) to AA. So what are ratings, why do they matter, and what are the politics associated with them?
In short, they're opinions by rating agencies as to creditworthiness. In terms of countries, that includes how sound the economy is and whether the country is able to repay its debts. Because it is an opinion, the judgement will sometimes be wrong, but in rating corporations’ debt issues and countries, their judgements are usually vindicated. Particularly if you’re in a different country from the one where you’re lending, the credit rating proves a useful signal.
Because ratings look at creditworthiness, or more specifically, at the probability of default – defined as failure to repay the full amount due when it’s due – they will also relate to interest rates. In general terms, the worse the credit rating, the higher then probability of default, and the higher the interest rate will be. Lenders identify a higher risk of not getting repaid, and want a higher interest rate to compensate themselves for this.
So how risky is New Zealand, and is our credit rating appropriate? Could we be subject to further downgrades?
Government debt is not a major problem, despite the attention given to it by politicians (gross debt was $65 billion at June 30, 32.5 percent of gross domestic product, while net debt was only just over 20 percent of GDP). However, if future governments do not reduce the current budget deficit (which could be $15 billion or more in 2011-12), government debt could become more important.
The main risk lies in private debt. As at June 30, net foreign investment in New Zealand exceeded foreign investment by New Zealanders by $140 billion, equivalent to 70 per cent of GDP. This is large by international standards, and much of it is debt requiring regular interest payments, putting a burden on the balance of payments current account.
The main reason for New Zealand’s debt having grown to this extent has been our continuing balance of payments deficits on current account. We have absorbed foreign funds as both debt and equity to pay for our spending being greater than our income, and this has resulted in the gradual buy-up of our banks, farms and other assets by foreigners.
The only way we can stop the buy-up of New Zealand is by increasing our savings, so that we spend less internationally, and that we can then afford to finance the ownership of New Zealand ourselves. This is one of the reasons why the major parties are both looking at extending KiwiSaver contributions.
A change to New Zealand’s pattern of current account deficits is not going to happen quickly, and when it does occur, it will likely involve a downward shift in the value of our dollar relative to all currencies, increasing the costs of imports. Petrol at $3 a litre, anyone?
Dr David Tripe is director of banking studies at Massey University's College of Business.