OCR on hold as global risks dominate

6 December 2011

For immediate release

RBNZ Observer Update: OCR on hold as global risks dominate, says HSBC

Domestic developments continue to take a back seat...
...with global risks expected to keep them on hold this week
We still see the economy on a modest recovery path, though global concerns are starting to impact local confidence

Global scene to dominate

The Rugby World Cup has come and gone and looks to have supported growth in the second half of the year. Commodity prices have also remained at elevated levels, providing support for rural incomes, although they have started to decline.

There are also early signs that global financial developments are starting to have a negative impact on the local economy. Local PMI and PSI indicators have turned down and bank funding pressures are building. New Zealand’s banks are still significantly exposed to international funding markets, with around 30% of their funding from offshore.

With indicators for Asia showing signs of slower growth and Asian banks being affected by European deleveraging, the outlook for commodity prices is also less secure than it was. Having leveraged into the run-up in commodity prices in 2007-08, farmers have been more hesitant to invest this time around, and with global risks building, these investment plans are likely to be held back further. With the rural sector highly reliant on credit, any increase in the cost of bank funding that puts upward pressure on interest rates could discourage rural investment.

On the more positive side, interest rates are still at very low levels, which continue to provide support for the economy. Reconstruction of Canterbury has also barely gotten started, which suggests that the support it will provide to growth is yet to come. With much of the rebuild pre-funded, this boost to growth does not rely on global conditions.

The weaker global environment and risk of further negative financial shocks has seen the RBNZ back away from its previous plans to remove its ‘emergency setting’ policy sooner, rather than later. With the labour market a bit weaker than expected and inflation coming in below forecasts, the RBNZ is also likely to flag some domestic grounds to wait a bit longer and assess global risks.

We expect the RBNZ to be on hold on Thursday. The statement will likely give a clearer view on the RBNZ’s current thinking and is expected to be less hawkish than September’s statement. However, we still expect it to suggest that the next move will be up.

Balancing local and global risks

The RBNZ has for some time suggested that ‘if recent global developments only have a mild impact on the New Zealand economy, it is likely that the OCR will need to increase’.

Clearly, global risks remain heightened, which will likely keep the RBNZ on hold this week.

But the real question is whether global developments will mean more than a ‘mild’ impact down the track? Our view remains that the local economy is on a modest recovery path and that New Zealand is well-placed to see growth pick up further next year, barring a global financial calamity.

In the short run, the Rugby World Cup has clearly boosted retail spending, which is expected to be a key support for growth in Q3. While employment growth was weaker than expected in Q3 and the unemployment rate remained stubbornly high, hours worked continued to rise, which is a positive sign.

Next year’s growth will get a boost from the reconstruction of Canterbury, which has been slow to get started this year. This is a significant amount of spending, with government estimates suggesting NZD20 billion worth of rebuilding, and is largely pre-funded, so not particularly susceptible to rising funding costs. This should provide solid support for growth in 2012 and is a key reason why we still expect growth to pick up next year.

However, there are some signs that other parts of the economy are being negatively affected by global developments. The PMI suggests the manufacturing industry – albeit small in New Zealand – has weakened, and the PSI shows that the services industry is weakening. Although still at high levels, commodity prices have come off their peaks. While overall business conditions are still positive, these pockets of weakness will likely make the RBNZ more hesitant.

There are also signs that inflationary pressures are more contained than expected. Headline inflation was weaker than expected in Q3, falling to 4.6%. Stripping out the impact of tax changes on inflation, the statistics bureau indicated that inflation was running at 2.5%, still in the upper part of the target band, but not a key concern on its own. Measures of inflationary expectations have also remained in the upper part of the RBNZ’s target band, though they have eased a bit recently.

A key risk is that global developments have an additional impact on New Zealand through a further decline in commodity prices, and thus weaker growth in trade, or through an impact on bank funding costs.

Commodity prices still remain at elevated levels, though they have come down from their peaks. Thus far, trade has remained a key support for growth, although a downturn in New Zealand’s major trading partners, particularly in Asia, is a key risk.

Funding costs for banks have risen, and although the amount of funding that needs to be rolled over within 90 days has fallen in New Zealand from a high level of over 50% in 2008, it is still around 25% of all bank funding. For parts of the economy reliant on bank funding, particularly the rural sector, this could be a channel of risk from the global financial issues, if it leads to higher effective interest rates.

Bottom line

The RBNZ is expected to be on hold this week.

The tone of the statement will be the key thing to look out for. We expect it to still suggest that the next move is up, but we will be looking for hints to assess the timing.

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See attached press release for more details
RBNZ_Observer_PreORC_comment_061211.pdf

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