By Ranjani Ponnuchetty
The Reserve Bank is warning the risk to our financial system has increased in the past six months.
In releasing the biannual Financial Stability report, the central bank's governor Graeme Wheeler says the country's economy continues to perform well despite a deterioration in the outlook for global financial stability and heightened risk related to the dairy and housing sectors.
In May, the Reserve Bank announced new LVR measures to curb house prices in the country's largest city.
Mr Wheeler says a sharp downturn could challenge financial stability given the large exposure of the banking system to the Auckland housing market.
"While it's still too early to judge the effect of the recent policy changes, they are expected to help moderate pressures on Auckland house prices, and will improve the resilience of bank balance sheets to a housing downturn," says Mr Wheeler.
The central bank has slashed the official cash rate (OCR) three times this year alone, with another rate cut expected next month.
With inflation nowhere near the Reserve Bank's target mid-point, they've been forced to make a move on the OCR to stimulate the economy.
However, the report says it is low interest rates which have contributed to the housing demand.
"Mortgage rates have declined over recent months to hit new record lows, in line with cuts to the OCR and declines in long-term interest rates."
As LVR restrictions have been eased outside Auckland, the Bank is now closely monitoring the recent rises in house price inflation in some areas like Hamilton and Tauranga.
Despite the lower mortgage rates, the debt service ratio for an Auckland borrower is near its previous peak in 2007, illustrating the significant affordability pressures in the region.
New Zealand's dairy sector remains the second-biggest threat to our banking system as the recent lows in dairy prices place a strain on indebted farmers.
Dairy prices have been the lowest for more than a decade and the 2015-16 season will be the second consecutive season of negative cash flow.
"The banks are working with dairy farmers experiencing difficulty, and it is important they continue to take a medium-term view when assessing farm viability," says Deputy Governor Grant Spencer.
Farmers are responding to the cost pressures by reducing staff, cutting back on supplementary feed, capital investment and research and development over the past year.
"The banks' losses on dairy exposures are expected to be manageable but they need to ensure they set aside realistic provisions for the likely increase in problem loans," says Mr Spencer.
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