Financial stability: Dark cloud over NZ's economy as interest rates jump

The Reserve Bank's latest report on the state of New Zealand's financial stability warns a global economic slowdown threatens our own outlook and predicts consumer spending to slow as households face higher mortgage repayments and a decline in wealth as house prices fall.

There's also a threat of a large number of home loan borrowers heading into negative equity if house prices keep tumbling. Currently, about 2 percent of borrowers are in negative equity, but that could jump considerably if prices fall by a further 10-30 percent. 

The average percentage of people's disposable income used on debt servicing is expected to jump from 9 percent to 20 percent based on current mortgage rates. 

"While our financial system as a whole is resilient, some households and businesses will be challenged by the rising interest rate environment," Reserve Bank Governor Adrian Orr said.

Orr's deputy, Christian Hawkesby, said New Zealand has high levels of employment and a sound government fiscal position, but the economy isn't immune to global pressures.

"Rising household debt servicing costs and declining household wealth will put pressure on domestic spending in the near term, but we are confident that the financial system is well placed to support the economy," he said.

"Banks' capital and liquidity positions are strong, and our recent stress tests have demonstrated banks' resilience to severe economic scenarios."

'Global supply shocks'

The Reserve Bank's second Financial Stability report for 2022 outlines the latest developments in New Zealand's financial system and the impacts from abroad. 

Although most countries have now removed COVID-19 restrictions and related global supply chain issues have eased, the report said Russia's invasion of Ukraine has "sparked a large increase in global commodity prices, particularly for energy, metals and food". 

These "global supply shocks", as well as the "lagged effects" of significant fiscal and monetary policy stimulus pumped into the economy during COVID-19, "have caused inflation to rise substantially across major economies to higher levels than had been anticipated by policymakers".

"After a decade of low interest rates and muted inflationary pressures, central banks are having to tighten their monetary policy settings at a faster pace than in previous tightening cycles," the report said. 

"In doing so, they aim to ensure that high inflation does not become embedded in inflation expectations. Financial market pricing indicates a substantial monetary tightening over the next two years."

The Consumer Price Index released last month showed annual inflation in New Zealand was 7.2 percent in the September quarter, higher than expected. 

The Reserve Bank's next Monetary Policy Statement (MPS) will be released on November 23, but in October it pushed the Official Cash Rate (OCR) up 0.5 basis points to 3.5 percent, the highest since 2015. The OCR is predicted to hit about 4.1 percent in 2023.

It also comes "potentially at some cost to activity and employment", the report said. 

"The rapid rise in interest rates over the past year presents a headwind to global economic growth," the report said.

"Historical experience provides little indication as to the economic impact of the current tightening cycle, particularly given the public and private debt burdens that have built up across both advanced and emerging economies in the past decade."

The Reserve Bank said these potential risks could threaten New Zealand's economic outlook, especially if there is a severe downturn in any of our major trading partners. This could lead to reduced demand for exports, leading to lower household and business income.

"A tightening in global financial conditions would also raise debt servicing costs for New Zealand households and businesses, and the government," the report said.

Reserve Bank Governor Adrian Orr.
Reserve Bank Governor Adrian Orr. Photo credit: Getty Images.

Mortgage rates

Central banks' decisions to push up their cash rates have a flow-on effect on interest rates. 

That's demonstrated by a graph provided by the Reserve Bank showing the large increase in two-year wholesale interest rates over the past year across Australia, the Euro Area, the United States and New Zealand.

Financial stability: Dark cloud over NZ's economy as interest rates jump
Photo credit: Reserve Bank.

"The rising interest rate environment and deteriorating global economic outlook have also seen prices decline across a broad range of asset classes in recent months," the report said. 

"In New Zealand, house prices have fallen 11 percent since their peak in November 2021, with notable divergences across regions."

Borrowing capacity has been reduced by rising mortgage rates, loan-to-value ratio restrictions, and tougher serviceability assessments following changes to lender processes

"House sales have fallen to levels seen in the aftermath of the global financial crisis (GFC), and housing lending growth has slowed considerably in recent months. 

"The relative attraction of buying a property compared to renting or investing elsewhere has declined, given the outlook for mortgage rates, the still high level of house prices, tax policy changes, and the potential for further price falls."

However, the Reserve Bank still believes house prices in New Zealand are "above sustainable levels".

"A continued gradual decline in prices towards more sustainable levels remains desirable for long-term financial stability," it said. 

"However, a sharper or deeper decline remains a plausible outcome, given the strength of the run-up in prices over recent years, and the potential self-reinforcing effects from negative market sentiment."

That decline in prices means some borrowers who purchased their homes in 2021 are now in negative equity, meaning their mortgages are larger than the current market value of their property.

Currently, 1.9 percent of the total housing stock is in negative equity. However, if prices fall a further 10 percent, 7.3 percent of the stock would be in negative equity. The report found 38 percent could be in negative equity if prices fall a further 30 percent. 

Financial stability: Dark cloud over NZ's economy as interest rates jump
Photo credit: Reserve Bank.

The Reserve Bank said house prices have already fallen 11 percent from their monthly peak in November 2021. 

In August, it said house prices "are assumed to decline by 16 percent in total from their monthly peak in November 2021."

The significant repricing of household mortgages "will slow the volume of consumer spending", the report said.

The report found the average percentage of disposable income dedicated to debt servicing is expected to rise from a recent low of 9 percent to 20 percent, based on current mortgage rates. 

"Repayment increases will be particularly significant for many households that first borrowed in the past two years," it said. 

A deterioration in the labour market would lead to added stress on households, the report said.

"In these situations, lenders are likely to be able to provide relief in the form of term extensions or temporary interest-only periods for households unable to fully absorb the repayment increases they may be facing."

The National Party responded to the report on Wednesday morning by saying "mortgage mayhem" is on the way.

"These findings are gravely concerning and portray a bleak future for Kiwi mortgage holders. I worry particularly about recent home buyers whose prospects look particularly grim,' said finance spokesperson Nicola Willis. 

"New Zealand households are already facing a cost of living crisis and today’s report confirms it’s only going to get worse. While things are already financially tough, the future looks even tougher for many Kiwis."