|Source: BMI, 18 April 2013|
|Cash Rate (%)||2.5||-||2.5||3.0|
After putting in a false break of resistance, the New Zealand dollar has reversed sharply to the downside in recent days. We believe that the unit is likely to retest its channel support at around US$0.8250/NZD, and a break through this level, which is highly likely, would be a sign of more severe weakness.
|Channel Support Up For Retest|
|New Zealand - Exchange Rate, US$/NZD|
We continue to hold a bearish medium-term outlook for the currency, given its expensive valuations and our downbeat outlook for foreign demand of New Zealand financial assets. On a real-effective exchange rate (REER) basis, the currency unit is now trading back near to the 2007 and 2011 peaks. The subsequent reversals upon reaching these levels on the two previous occasions suggest that there is limited support for valuations to head higher from their current levels.
While expensive valuations by themselves are not a major concern, it is the combination of a record high REER and record external indebtedness that concerns us. We expect foreign demand for New Zealand's financial assets to wane over the coming months. The improving outlook for the New Zealand economy has fuelled the banks' optimism for another uptick in the house prices. This has led to heated competition for mortgages by various credit institutions which has driven down fixed and floating interest rates charged on these loans. As a result, we have seen interest costs as a proportion of disposable income fall to levels last seen in 2002. Record low policy interest rates have also aided the growth in mortgage debt.
|Banking Sector Still The Biggest Borrower From Foreigners|
|New Zealand - Breakdown Of International Liabilities (%)|
Although the pick-up in economic activity and house prices led to stronger growth at the end of 2012, the lack of further interest rate cuts and slow income growth could halt this improvement. We do not expect further rate cuts from the Reserve Bank of New Zealand (RBNZ) and given that the ratio of house prices to disposable income is currently close to historical extremes (11.9 times as of Q412 versus 12.3 times at Q108 when prices started declining), we see little upside for house prices at this point. Moreover, we see a growing likelihood for the central bank to implement macro-prudential tools (such as restricting the loan-to value ratio and increasing capital requirements for banks) which will dampen demand for housing loans and lead to a reduction in house price in the coming quarters.
These measures from the central bank will likely lead to a reduction in banking sector profitability, and possibly a rise in instability. Given that the bulk of foreign investments have been flowing into the banking sector (accounting for 42% of total international liabilities), a fall in the sector's profitability will likely trigger a reduction in investor demand. Furthermore, there is a risk that weaknesses in foreign markets could also impact the risk appetite of these foreign investors. Indeed, since most of the banks in New Zealand are subsidiaries of Australian companies, we believe that a correction in the Australian property market is likely to push parent banks to reduce funding and investments in foreign subsidiaries (including those in New Zealand) to shore up their local operations. Moreover, the recent sharp declines in gold prices and European equities are a reminder that another global credit crunch is more than a remote possibility, and could similarly choke off external funding for New Zealand banks. This would put further downward pressure on the New Zealand dollar.
Risks To Outlook
That said, there is a possibility that the cooling measures implemented by the central bank could be insufficient (given the Bank's cautiousness to avoid choking off positive sentiment) and house prices could continue to remain at elevated valuations. Although we believe that such a scenario would eventually lead to the RBNZ and government implementing more cooling measures, it could support the New Zealand dollar at current levels for slightly longer than we forecast.
Meanwhile, the expansionary monetary policy that major developed countries are pursuing could attract foreign bond investors to further invest in New Zealand debt given their higher yields and low debt-to-GDP ratio (total crown debt is approximately 50.2% of GDP). Moreover, the promising improvements in the activity levels for both manufacturing and service sectors in Q113, together with the government's launch of asset sales could further attract more foreign investors to increase their holdings of New Zealand assets and boost the currency. Overall though, we hold a below-consensus view on the economy (see 'Strong 2012 Growth Masks Deleveraging Risks', March 21 2013).