Monthly Economic Indicators September 2015

Executive Summary#

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Analysis#

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GDP data released in September showed that economic activity rose a softer-than-expected 0.4% in the June quarter, following the 0.2% rise in the March quarter. This represents a significant slowdown from 2014 with sub-trend growth (i.e. less than 0.6% quarterly growth) being reflected in increasing spare capacity as evidenced by the unemployment rate rising and weak non-tradables inflation.

In addition, further declines in business sentiment and consumer confidence, combined with growing concerns around the international outlook and recent bouts of market turbulence, show that risks to the near-term outlook are skewed to the downside. It is likely that annual growth (December quarter 2015 versus December quarter 2014) may fall below 2.0% by the end of 2015 when accounting for the softer-than-expected June quarter outturn.

That said, monetary conditions have eased, with a further 25 basis point OCR cut at the September MPS and a continued depreciation of the trade-weighted exchange rate index (TWI) through the September quarter. This will support a pick-up in growth further out.

Headline GDP growth below expectations...#

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Real production GDP rose 0.4% in the June 2015 quarter, following the drought-affected 0.2% rise in the March quarter. Overall, growth fell short of Treasury (0.7%) and market expectations (0.6%) and was the second consecutive quarter of sub-trend growth. Growth in output from the June quarter a year ago eased to 2.4% and growth in the June 2015 year from the previous June year slowed to 3.0% (Figure 1).

Figure 1: Real production GDP

Source: Statistics New Zealand

A recovery in agricultural output, as drought conditions subsided, and an increase in oil and gas extraction as a new oil well opened (and another reopened) supported a solid rebound in primary industry output (up 2.1%) in the June quarter.

The bounce-back from drought was also evident in the goods-producing industries with hydro-electric production and food manufacturing rebounding in the quarter. However, non-food manufacturing contracted as a shutdown at the Marsden Point oil refinery drove a decline in total manufacturing output. Construction activity rose 0.8% driven by infrastructure investment. Overall, goods-producing industries’ output rose 0.4% in the June quarter.

Services industries’ growth was a mixed bag. Business and ICT services’ activity both expanded by over 2% in the quarter. Housing-related services also rose strongly, reflecting the pick-up in housing market activity seen through the middle of 2015 (the seasonally-adjusted number of sales rose 6.8% in the June quarter). These increases were offset by falls in basic material and agricultural machinery wholesaling. Transport and warehousing, and recreational services activity declined post the Cricket World Cup, leading to overall services industry output rising 0.5% in the June quarter.

…and expenditure growth also subdued#

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Expenditure GDP growth was also subdued, rising 0.2% in the June quarter (0.3% in the previous quarter), with strong domestic demand offset by a large drag from net exports.

Household and general government consumption expenditure rose 0.9% and 1.0% respectively. Non-residential investment rose 2.2% as plant and machinery investment rebounded (up 10.6%) after the near 10% fall in the March quarter in its customarily noisy fashion. Infrastructure investment rose strongly and commercial building investment also contributed. However, total investment growth was tempered by a flat outturn for residential investment, reflecting soft residential consenting in the first quarter of 2015 as the Canterbury residential rebuild plateaued. In addition, stocks rose in the quarter with total domestic expenditure contributing 1.3 percentage points to the overall outturn.

However, net exports were a drag on growth with exports contracting 1.1% and import volumes rising 2.3%. The contraction in export volumes was driven by dairy and meat products as well as metal, machinery and equipment, although another large rise in tourism expenditure and surge in volumes of other agricultural products provided some offset. The rise in import volumes was driven by petrol and avgas (also related to the Marsden Point refinery shut-down) and intermediate goods imports.

Moderate growth over the rest of 2015 is expected…#

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Treasury expects around trend growth (0.6% per quarter) over the second half of 2015 supported by strengthening housing market activity and high migration-led population growth (annual net migration rose to over 60,000 in the year ended August 2015). This will provide a solid base for overall GDP growth. The tourism sector continues to grow rapidly (Figure 2), and residential dwelling consents surged 20% in July (with that higher level largely holding in August). Combined with the large pipeline of commercial building work, this shows that construction will remain an important driver of growth, despite the earlier-than-expected plateauing of residential building activity in Canterbury.

Figure 2: Quarterly travel services exports

Source: Statistics New Zealand, the Treasury

The speed at which the economy adjusts to the sharp declines in export income and the resultant lower New Zealand dollar (NZD) will be crucial to the outlook, particularly with a more uncertain global economy lingering in the background.

…but risks skewed to the downside in the near term...#

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Leading indicators such as consumer confidence and business sentiment continued to ease through the September quarter, highlighting the downside risks to the near-term outlook. Both the ANZ-Roy Morgan (quarter average) and Westpac McDermott Miller consumer confidence measures fell below their respective long-run averages, foreshadowing a slowing in household expenditure growth (Figure 3).

Figure 3: Private consumption growth and consumer confidence

Source: Statistics New Zealand, Westpac-McDermott Miller

The ANZ business outlook confidence measure averaged around six-year lows in the September quarter. Employment and investment intentions also eased further and the Westpac Employment Confidence Index fell again in the September quarter, indicating a softer labour market outlook. Treasury expects the unemployment rate will rise above 6% in coming quarters and will likely lead to softer wage growth. Firms’ own activity expectations (which more closely align with GDP growth) also declined to a six-year low, led by agriculture.

…with agricultural production outlook subdued and risks of drought...#

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In fact, the agricultural industry had its lowest activity outlook reading on record in August. In that respect, Beef and Lamb New Zealand released their provisional stock numbers for the 2015/16 season, which showed sheep, beef and dairy herds are 4.1%, 2.2% and 2.8% below their respective levels in the prior season. Lambing percentages have also been lower this spring. With El Niño well and truly entrenched, the probability of drought conditions developing over the summer months is elevated. If realised, this could lead to further production declines and weaker-than-expected export volumes and GDP growth.

…although easier monetary conditions will support a pick-up in growth further out#

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That said, monetary conditions have continued to ease, and this will support a pick-up in activity further out. The RBNZ reduced the OCR by a further 25 basis points at the September Monetary Policy release – the third consecutive cut to the official rate since June – citing the softening in the economy and the need to return medium-term inflation to the mid-point of the policy target band. The policy assessment also stated that “A further easing in the OCR seems likely. This will depend on the emerging flow of economic data.” Markets are currently pricing a full cut by early 2016.

In addition, the further 8.2% depreciation in the TWI in the September quarter (12.8% in the September year) will support exporters and import-competing firms. 

Nominal GDP growth spikes higher …#

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Nominal GDP rose 2.2% in the June quarter, supported by a 1.0% rise in the total terms of trade, as the temporary lift in dairy prices through the March quarter flowed into the trade data. Annual average nominal GDP growth has eased from 8.1% in the June 2014 year to 2.8% in the June 2015 year.

The terms of trade are expected to fall in coming quarters as the dairy price falls since March flow through into the trade data (notwithstanding the recent rises on the GlobalDairyTrade auction). This will reduce nominal GDP growth and, in combination with lower interest rates, is expected to lower tax revenue growth through the 2015/16 fiscal year relative to the Budget Update forecast. The Financial Statements of the Government for the year ended 30 June 2015 are scheduled for release on 14 October.

…leading to a smaller than expected widening of the annual current account deficit…#

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The annual current account deficit widened to 3.5% of GDP in the June quarter, from a revised 3.4% in the prior quarter (Figure 4). The deficit was narrower than Treasury and market expectations due to positive revisions to education exports and stronger-than-expected growth in other travel services exports (international tourism). The annual current account deficit was considerably narrower than forecast (-4.6%) in the Budget Update given the terms of trade have not fallen as quickly as anticipated, travel services exports growth has been stronger than forecast and the upward revisions, particularly to education exports.

Figure 4: Current account components

Source: Statistics New Zealand

…but still led by further deterioration in the annual goods deficit…#

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The annual goods deficit continued to widen, lifting from a $0.5 billion deficit in March to a $1.5 billion deficit (-0.6% of GDP). The deterioration was largely due to lower dairy export values compared to the June quarter of 2014, reflecting the declines in dairy prices over the past year. There have been positive offsets, from higher horticultural and meat exports, reflecting both stronger volumes and prices. Lower oil prices have also helped contain annual import value growth to 3.5%, with growth driven by the extra $1.1 billion in aircraft imports over the past year as Air New Zealand continues its fleet upgrade.

…offset by stronger travel services exports#

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The annual services surplus was larger than expected, increasing by $0.6 billion to $2.8 billion (1.2% of GDP). The solid rise in travel services exports over the past year has been supported by a structural increase in expenditure from Chinese tourists, and a recovery in traditional tourism markets.[1] The depreciation in the NZD will provide additional support to an already burgeoning sector. In the year ended June 2015 education services exports were valued at $3.0 billion, up $487 million on the prior comparable period, while tourism expenditure was up $1.7 billion to $7.8 billion.

The annual income deficit remained broadly steady at 3.8% of GDP. New Zealand’s net international liability position fell to 62.2% of GDP ($149.7 billion) at the end of the June quarter – which as a percent of GDP is the lowest since 1991. The improvement has been driven by smaller current account deficits supported by the 40-year highs in the terms of trade, and positive market price movements.

Annual current account deficit expected to widen further…#

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The annual current account deficit is expected to continue widening and reach more than 4% of GDP by the end of 2015, before widening sharply to close to 6% over 2016 as the large falls in dairy prices between March and July continue to lead to a deteriorating annual goods deficit. The annual merchandise trade deficit continued to widen, from $2.8 billion in July to $3.3 billion in August in-line with these expectations (Figure 5).

Figure 5: Annual merchandise trade balance

Source: Statistics New Zealand

…although recent dairy auctions remove some downside from the current season#

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Dairy prices have risen 48.3% over recent GDT auctions from their 4 August low, with forward market pricing indicating another solid rise at the 6 October auction. That said, prices remain considerably lower than forecast in the Budget Update. Global demand conditions have not changed materially, suggesting the improvement reflects the downwardly revised outlook for New Zealand dairy production this season. Fonterra in their recently announced annual financial results stated that they expect milk production to be at least 5% lower in 2015/16 season.

The increase in Fonterra’s forecast 2015/16 farm gate milk price from $3.85/ kg MS to $4.60 with unchanged dividend guidance of 40-50 cents is positive for dairy farmers. However, a significant number will still have negative cashflow this season. The sector as a whole will still need to reduce expenses and/or increase debt levels by around $1.9 billion (Treasury estimate) to cover the short-fall in working capital this season.

International outlook softens in September#

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The outlook for the international economy weakened in September as concerns increased about growth in emerging market economies, particularly China.  The US Federal Reserve (Fed) kept its Funds Rate on hold at its September meeting, mentioning recent global developments. Financial market volatility eased from August, but remained relatively high.

Federal Reserve holds rates...#

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The Fed kept its Funds Rate on hold at 0-0.25% at its September review (Figure 6). The decision reflected a cautious tone on inflation and recent global economic and financial developments. In addition, the Fed’s interest rate track was lowered 25 basis points (bps), indicating a more gradual pace of hikes and a lower interest rate of 3.5% in the long term. Chair Yellen indicated an October increase is possible, and that the Fed expects to hike rates this year.

Figure 6: Central bank policy interest rates

Source: Haver

...but US recovery continues#

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The US economy continues its recovery: June quarter GDP growth was revised up from 0.9% to 1.0%; annual non-farm jobs growth continued at 2.1% in August; the unemployment rate fell 0.2% points to 5.1%; and annual growth in hourly wages rose to 2.4%, supporting retail sales growth of 2.2%. Developments in the housing market remain positive on balance and consumer confidence strengthened.  The picture is less positive for the manufacturing sector with a fall in the ISM (PMI) from 52.7 in July to 51.1 in August and a 0.4% fall in industrial production in the month, reversing the previous month’s surge.  Core CPI inflation (ex food and energy) remained low at 1.8% in the year to August.

China data continues to reflect slowdown...#

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Monthly indicators for China continued to be weak, with the exception of retail sales which increased 10.8% in the year to August, supported by property sales. Industrial production growth remained weak at 6.1% in the year to August and was reflected in exports also declining 6.1% from a year ago and imports contracting 14.3%. Fixed asset investment growth fell to 10.9%, its slowest pace since 2001, and the Caixin manufacturing PMI fell to 47.0 in September, its lowest reading in more than 6 years, indicating below-trend growth and reflecting weak export orders resulting from subdued external demand. Annual inflation rose to 2.0%, but remains below the government’s 3% target. Analysts are expecting further monetary easing by authorities over coming months in the form of lower interest rates and/or bank reserve requirements, or fiscal stimulus.

...and Asian regional outlook revised lower...#

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Weak growth in China is affecting the outlook for other economies in the region.  The Asian Development Bank (ADB) lowered its regional outlook for 2015 and 2016 from 6.3% for both years to 5.8% and 6.0% respectively. The revision is owing to a slower-than-expected recovery in developed economies, leading to slowing growth in China and India and other economies in the region. The ADB expects China’s growth to slow to 6.8% in 2015 and 6.7% in 2016, down from 7.2% and 7.0% respectively previously.

...as Australian growth slows to 0.2% in June#

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The Australian economy grew 0.2% in the June quarter and 2.0% in the year, below trend and expectations. While the domestic economy (apart from investment) remains solid, the slowdown in China is taking its toll with exports declining 3.3% in the quarter. Mining and construction growth was also weak, with mining production down 3.0%. The terms of trade continued to decline, falling 3.4% in the June quarter and down 29% from their 2011 peak.  As a result, the current account deficit increased to 4.7% of GDP in the June quarter from 3.3% in March.

The Australian labour market continued to pick up in August, with employment rising 2.0% from a year ago and the unemployment rate fell 0.1% points from July to 6.2%. The RBA held the policy rate at 2.0% (as expected) and acknowledged that global developments, particularly the slowdown in China, have increased the risks to the outlook.

Mixed data from euro area...#

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The recovery in the euro area continued, but at a slow pace.  June quarter GDP growth was revised up from 0.3% to 0.4%, the unemployment rate remained at 11.0% in August (a three year low), and industrial production increased 0.6% in July, to be up 1.9% in the year. Inflation remained low in September with the core CPI increasing 0.9% for the year, but the headline measure fell to -0.1%. The ECB kept its policy rate and QE programme unchanged, but downgraded its GDP and inflation outlook, reflecting the slowdown in emerging market economies. ECB President Draghi reassured markets by saying the Bank was prepared to act if required.

...but UK labour market strengthens#

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The UK labour market strengthened in July with the unemployment rate falling to 5.5% from 5.6% and annual earnings growth of 2.9%, up from 2.6% in June. However, the improvement is yet to be reflected in consumer demand. Retail sales volumes rose 0.2% in August and growth has been slowing recently. Core CPI inflation fell to 1.0% in August from 1.2% in July. Low inflation has some analysts pushing out from early next year their expectations of when the BoE will start to raise interest rates.

Financial markets remain volatile#

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Financial market volatility eased in September but uncertainty remains, particularly around China’s equity market. The timing of the initial hike by the Fed and the pace of subsequent increases are also sources of uncertainty, particularly for emerging markets.  Commodity prices remained weak and equities fell further towards the end of the month.  The NZ dollar was relatively steady over the course of the month, but fell 2.2% from August on a trade-weighted basis.

Special Topic: Relationship between mortgage and wholesale interest rates#

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How banks set mortgage rates relative to the Official Cash Rate (OCR) is important for how monetary policy affects the economy. This month’s special topic focuses on how the relationship between wholesale rates and their corresponding mortgage rates has changed, the possible reasons for these changes and whether they are likely to be permanent.

The topic concludes that the increase in the spread between wholesale and retail interest rates since the GFC is largely a result of changes in funding costs for banks arising from market and regulatory changes. With the regulatory change being permanent, the increase in spreads is likely to remain. This suggests that for a given retail rate the neutral 90-day rate is lower than prior to the GFC.

Mortgage spreads have risen significantly following the global financial crisis...#

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In the four years before the global financial crisis (GFC), the spreads between the new customer floating mortgage rate and the 90 day rate, and between fixed mortgage rates and their corresponding swap rates averaged around 180 basis points (bps) and 90 bps respectively (Figure 7). However, following the GFC these spreads all increased significantly – by 100-150 bps depending on the time to maturity, although the spreads for fixed mortgage rates have declined by 50-100 bps since 2012.

Figure 7: Mortgage spreads

Sources: RBNZ, Haver

...but was this just a result of less competition in the banking sector?#

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To see whether the increase in spreads was owing to reduced competition in the banking sector since the GFC, the pre-GFC and post-GFC retail bank margins were compared. Before mid-2008 they averaged 230 bps and since 2011 they have also averaged 230 bps, suggesting that the increase in spreads between mortgage and wholesale interest rates does not reflect a change in bank competition from the earlier period.  In addition, the structure of the banking industry has not changed significantly over this period.

New liquidity regulations were introduced following the GFC...#

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In order to see why the spreads between wholesale and retail interest rates have increased since before the GFC, it is necessary to look at changes made as a result of the GFC.  During the GFC it became apparent that banks were unable to access liquidity in global financial markets as a result of the crisis. When confidence diminished, some bank customers wanted to access their deposits, but some banks were unable to provide these funds and so required their government to provide temporary relief.  In view of those developments, the RBNZ introduced the Basel 3 Liquidity Policy (BS3) to improve liquidity in the NZ banking system and provide a buffer in times of crisis. 

The regulation requires NZ banks to hold a minimum core funding ratio (CFR). The CFR is a comparison between an estimate of the bank funds that are stable and can be assumed to stay in place for at least one year (core funding) and the core lending business of the bank that needs to be funded on a continuing basis. The RBNZ adopted this regulation in March 2010 with a CFR of 65% to be achieved by April 2010 and subsequently increasing to 70% by July 2011 and 75% by January 2013.

Sources: RBNZ – SSR (Part B), Treasury estimates

This new policy led banks to change the sources of their funding. The BS3 regulation deems retail and long-term wholesale funding more likely to stay in place, and so qualifies as part of core funding; consequently these sources of funding increased as a percentage of total bank funding to meet BS3 (Table 1).[6] As a result of the BS3 regulation, banks became indifferent between retail funding and long-term wholesale funding, so if the cost of long-term wholesale funding rises (internationally set), banks will increase their deposit rates until they reach the point of indifference.

...which contributed to increased bank funding costs#

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Following the collapse of Lehmann Brothers in October 2008, banks’ cost of funds increased significantly. As that cost cannot be observed directly, the marginal cost of funding[7] was adopted as a proxy in this study. The increase in the marginal funding cost can be traced to the significant rise in short-term[8] and long-term[9] wholesale funding costs, as banks experienced difficulty accessing funding markets (Figure 8).

Figure 8: Weighted marginal funding cost

Sources: RBNZ, Haver, Treasury estimates

Following these developments, as banks knew the liquidity regulations were about to be implemented and long-term wholesale funding costs were exceptionally high, they funded most new credit from retail deposits. As a result, competition for retail funding[10] increased and its cost rose significantly. In February 2009 the six month deposit rate rose above the OCR for the first time since 2005.

In the post-GFC period, long-term wholesale funding costs declined owing to increased liquidity provided by central banks in global financial markets, increased risk appetite, and higher issuance of NZD bonds by offshore entities (which reduced hedging costs). These factors, along with stronger household deposit growth relative to growth in residential mortgage loans, lowered bank competition for deposits, reducing the retail funding premium. Since the end of 2014, household deposit growth has exceeded residential mortgage loan growth, leading to the retail funding premium declining further (Figure 8).

Marginal funding costs do not account for the entire increase in new customer mortgage rates#

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The increase in the marginal cost of funding is able to explain some of the difference in mortgage spreads before and after the GFC. However, as the mortgage spreads including the marginal cost of funding are still circa 100 bps higher than before the GFC, they are not sufficient to explain the entire change (Figure 9).

Figure 9: Mortgage spreads plus the marginal cost of funding

Sources: RBNZ, Haver, Treasury estimates

The fact that the marginal cost of funding does not explain the increase in spreads since before the GFC is partly because of a limitation of the data. The new customer mortgage rate series shows only the advertised rates and does not include special or discounted rates offered to borrowers. These special rates offered since mid-2014 would lower the fixed mortgage rate series, decreasing the spread from the corresponding wholesale rate. Data in the RBNZ’s May 2015 Financial Stability Report showed that 2-year fixed mortgage rates including specials[11] have ranged from about 20 bps lower than the equivalent standard mortgage rate series in May 2014 to 60 bps lower than the equivalent mortgage rate series in March 2015.

Average funding costs can explain the difference though#

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To overcome the limitations of the data for new customer mortgage rates, a comparison between the effective mortgage rate[12] and the average funding cost[13] banks face (as opposed to the marginal funding cost) shows the relationship between bank funding and mortgage rates. In the pre-GFC period there are two distinct phases –2002-2004 and 2006-2008. In the transitional period (2004-2006), the Reserve Bank tightened monetary policy so both short-term wholesale rates and deposit rates increased significantly, but – as many mortgage rates were fixed – the spread between mortgage rates and wholesale rates declined by around 180 bps (Figure 10). 

Figure 10: Effective mortgage rate less average funding costs

Sources: RBNZ, Haver, Treasury estimates

The spread then peaked in early 2009, as bank funding was very expensive, despite the OCR being at an all-time low of 2.50%. Since the middle of 2011, the spread has remained between 300 and 350 bps as mortgage rates have largely moved in line with average funding costs.

What does all this mean?#

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The increase in bank funding costs, owing to the CFR and changes in market pricing of risk, led to higher mortgage rate spreads and so borrowers faced higher mortgage rates. The CFR effectively requires the full cost of risk to be priced into bank funding costs, which banks have transferred to their customers. The CFR is permanent, indicating that the increase in mortgage spreads is a permanent shift higher (provided market pricing of risk remains unchanged) and bank competition is unlikely to erode it in the future. The result is that the spread between mortgage rates and the OCR is higher, suggesting that for a given retail rate the neutral 90-day interest rate is lower now than it was prior to the GFC.[14]

Funding costs in the future#

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While funding costs have been relatively stable since 2012, there are risks that they will increase. Some of these risks are:

• An international event that pushes up long-term rates. This would result in higher wholesale funding costs for banks. In turn, competition for retail deposits would rise and banks would increase retail deposit rates until the indifference point. Bank funding costs would then increase as a result of higher rates from both these sources of funding, increasing mortgage rates for a given OCR.
• The issuer credit rating of NZ banks is downgraded. While the standalone credit rating of NZ banks has recently been downgraded by Standard & Poor’s owing to their exposure to the Auckland housing market, the issuer credit ratings of the big four banks in NZ (higher credit-rated parent companies), Kiwibank (subsidiary of NZ Post), and Rabobank New Zealand (the local unit of Dutch bank Rabogroup), remained unchanged. If the credit ratings of Australian banks were downgraded (parents of the big four banks in NZ), this would likely result in long-term wholesale funding costs of the big four banks in NZ rising. The overall result would be the same as above – higher funding costs through long-term wholesale and retail rates, resulting in higher mortgage rates for a given OCR.

A sharp increase in credit growth creating additional demand for deposits locally. If the supply of local deposits did not increase to match the additional demand, banks would source more of their funding from offshore wholesale markets. International borrowing rates would be unlikely to rise (as NZ banks’ demand would be marginal), unless a risk premium was associated with the increase in credit growth. In that case, domestic deposit rates would be likely to rise to match the offshore funding rate faced by the banks. This scenario is more likely to play out with longer-term borrowing as banks would be more likely to seek increased deposits for floating mortgages rather than long-term wholesale funding.

Notes

New Zealand Key Economic Data#

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30 September 2015

Quarterly Indicators#

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Monthly Indicators#

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