Financial Stability Report May 2015 RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2015 1 Reserve Bank of New Zealand Financial Stability Report Subscribe online: http://www.rbnz.govt.nz/email_updates.aspx Report and supporting notes published at: http://www.rbnz.govt.nz/financial_stability/financial_stability_report/ A list of registered banks’ credit ratings is published at: http://www.rbnz.govt.nz/regulation_and_supervision/banks/prudential_requirements/credit_ratings/ Copyright © 2015 Reserve Bank of New Zealand This report is published pursuant to section 165A of the Reserve Bank of New Zealand Act 1989. ISSN 1176-7863 (print) ISSN 1177-9160 (online) 2 RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2015 Financial Stability Report May 2015 Contents 1. Overview 4 2. Systemic risk and policy assessment 6 3. The international environment and financial markets 15 4. Financial risks to the New Zealand economy 24 5. Financial institutions and infrastructure 40 6. Key developments in financial sector regulation 55 Appendices 1. Summary of regulatory initiatives 60 2. Reserve Bank enforcement 61 3. Introduction to the New Zealand financial system 61 A. Investors and the New Zealand housing market 13 B. Improvements to the New Zealand household balance sheet statistics 36 C. Implications of a lower milk payout for indebted dairy farms 37 D. Gross versus net housing lending 53 Boxes RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2015 3 Chapter 1 Overview The financial system is sound and operating effectively, supporting growth in the economy. Bank capital, liquidity and funding buffers remain above required minima, while asset quality and underlying profitability are strong. Regulatory changes over recent years have helped to improve prudential standards for banks, non-bank deposit takers (NBDTs) and insurers. There has been continued progress in processing claims related to the Canterbury earthquakes, although significant uncertainties remain. The financial system continues to face three key areas of risk. Household sector debt is high relative to incomes and house prices are overvalued on several measures, particularly in Auckland where prices have increased rapidly in recent months. The rise in Auckland house prices reflects ongoing supply constraints, increased demand driven by record net immigration, low mortgage interest rates and increased investor participation. House prices have become very elevated in Auckland, and financial stability could be tested if prices were to fall sharply, which could occur if adverse economic conditions led to a reduction in debt repayment capacity. In contrast with Auckland, house price inflation in most other parts of New Zealand has remained relatively subdued. Following recent consultation, the Reserve Bank is establishing a new asset class for bank loans to residential property investors. These loans 4 will attract a higher risk weighting than for owner-occupier mortgages, requiring more capital to be held against these loans. The Bank is also proposing some changes to its policy on high loan-to-value ratio (LVR) lending to recognise the financial stability risks arising from housing market conditions in Auckland. The changes, which are proposed to be introduced from 1 October 2015, involve a new restriction on loans to property investors in the Auckland region with an LVR of greater than 70 percent (i.e. to set a speed limit on such loans at close to zero). For all residential lending outside the Auckland region, the Bank is proposing to increase the existing speed limit for loans with an LVR of greater than 80 percent from 10 to 15 percent, to recognise relatively subdued housing market conditions outside Auckland. The Bank will issue a consultation paper in late May to outline these proposals in further detail and seek feedback. The second area of risk for the financial system relates to the dairy sector, which is experiencing a sharp fall in incomes in the current season due to lower international prices. Around 11 percent of farm debt held by farmers with both negative cash flow and elevated LVRs. Financial stress in the dairy sector could rise markedly if low global milk prices persist beyond the current season. The extent of recovery in Chinese milk demand, following a large build-up of inventories in 2013, will be an important influence on global milk prices. RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2015 The third source of risk arises from global financial conditions, which remain extremely loose, in part reflecting recent monetary easing in Europe and Japan aimed at supporting economic recovery. Low interest rates are encouraging investment in riskier assets, leading to a reduction in credit spreads, reduced market volatility and rising prices for both financial and real assets. High and rising asset prices could become a point of vulnerability when interest rates begin to return to more normal levels. There is also a risk that the current benign market conditions could unwind in a disorderly fashion, affecting the cost and availability of offshore funding for New Zealand banks. a review of current bank capital requirements in light of global and domestic changes affecting the banking system in recent years. The Reserve Bank is continuing to make improvements to its financial oversight regime. Good progress has been made on the stocktake of registered bank and NBDT regulations, with public consultation on specific proposals expected to take place in the second half of 2015. The Reserve Bank also expects to consult with the banks later in the year on a best practice guide for the conduct of stress tests, following a review of the models and processes used by the major banks late last year. With the financial system facing significant and increasing risks, it is critical that banks maintain their capital and liquidity buffers, and apply prudent lending standards. Banks should ensure that any new capital instruments continue to maintain loss-bearing capacity, in view of the significant risks the sector faces. The Reserve Bank plans to undertake RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2015 5 Chapter 2 Systemic risk and policy assessment The banking system continues to operate effectively, with capital, funding and liquidity buffers above regulatory minima. The financial system has vulnerabilities in three main areas. Mortgage debt levels are high, and house prices in Auckland are rising rapidly from already-elevated levels. Dairy sector debt remains high and concentrated, and dairy incomes are under pressure. Low global interest rates are contributing to benign conditions in debt markets and rising asset prices, which might not be sustainable. In light of the increasing risks associated with the Auckland housing market, the Reserve Bank will consult on proposed changes to its loan-to-value ratio (LVR) policy, including a new restriction on loans to Auckland property investors with an LVR of greater than 70 percent. The Bank is also proposing to increase the speed limit from 10 to 15 percent for residential mortgage lending at LVRs of greater than 80 percent outside of the Auckland region, to reflect the relatively subdued housing market conditions. The vulnerabilities facing the financial system highlight the importance of maintaining current financial system buffers and applying prudent lending standards. Banks are seeking more cost-effective ways to manage their capital, but this should not come at the cost of financial system resilience. 6 Risk assessment The financial system remains sound… The financial system remains sound and is continuing to support growth in the economy. Bank capital and liquidity buffers have increased markedly in recent years, and continue to exceed minimum regulatory requirements (table 2.1). All banks currently meet Basel III capital requirements, including the capital conservation buffer that was introduced in early 2014. Banks are exhibiting strong underlying profitability, allowing them to build capital through retained earnings. Profitability has increased over the past year, driven by improving asset quality, growth in net interest income and cost containment (see chapter 5). Low long-term interest rates are presenting a challenge for the insurance sector, although a declining cost of reinsuring liabilities in global markets has benefited general insurers and created downward pressure on pricing. There has been continued progress in paying out claims related to the Canterbury earthquakes. As at 31 March 2015, insurers have paid $24 billion in earthquake claims. Several insurers have significantly RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2015 increased their ultimate cost estimates, which the Reserve Bank now estimates will total $33-38 billion. There remains a risk of negative surprises to individual insurers. Table 2.1 Key banking system prudential indicators (annual averages) 2007 2013 2014 Current regulatory minimum Tier 1 capital ratio (% of risk-weighted assets) 7.8 11.3 11.4 6 (8.5) Total capital ratio (% of risk-weighted assets) 10.6 12.5 12.5 8 (10.5) Return on assets (%) 1.08 0.98 1.13 n.a. Loss-absorbing capacity Funding and liquidity risk Core funding ratio (% of lending) 65 Liquid assets (1-month mismatch ratio) n.a 6.4 6.2 0 Non-resident funding (share of total funding) 38.3 31.1 29.6 n.a. 30 15.9 14.3 n.a. Rollover of offshore debt (< 3m, % of annual GDP) 85 85 75 Source: Registered banks’ Disclosure Statements, RBNZ Liquidity Survey, RBNZ Standard Statistical Return (SSR). Note: …and has improved its funding profile. New Zealand’s elevated external debt, mostly issued by the larger banks, is high by international standards. As this offshore debt needs to be rolled over, this creates an exposure to volatility in global funding markets. Banks have continued to reduce their reliance on short-term offshore funding markets, resulting in a rise in the core funding ratio and a decline in rollover requirements in recent years (table 2.1). Much of the rise in core funding has been achieved through an increase in deposit funding, which grew above or near lending growth between 2010 and 2013. Although deposit growth has remained relatively strong, it is no longer exceeding growth in bank lending (figure 2.1). Figure 2.1 Lending and deposit growth (annual, % of GDP) 25 % % Lending Deposits counted as core funding 25 20 20 15 15 10 10 5 5 0 0 -5 2000 2003 2006 2009 2012 -5 Source: Statistics New Zealand, RBNZ Liquidity Survey, RBNZ SSR. Note: ‘Deposits counted as core funding’ includes haircuts made as part of the liquidity policy, which increase according to the size of the deposit. The dotted line shows growth in deposits measured by the SSR, prior to the introduction of the liquidity policy. The regulatory capital ratios in brackets include the capital conservation buffer of 2.5 percent that consists of common equity Tier 1 capital. Banks may operate within the buffer but are subject to constraints on capital distributions. The core funding ratio in 2007 is an approximation based on SSR data. RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2015 7 Banks are competing actively in lending markets. Access to finance has improved significantly since 2010 for both businesses and households. Banks are becoming more willing to supply credit due to strong profitability and the ready availability of funding. Banks are currently competing actively for new mortgage lending, particularly for low-LVR mortgages. Sharp falls in long-term wholesale interest rates since November have prompted a significant re-pricing of longer-term mortgage rates (figure 2.2), resulting in five-year fixed mortgage rates being offered at historic lows. Figure 2.2 Mortgage interest rates 11 % % 10 Floating 1 year 2 year 5 year 11 10 9 9 8 8 7 7 6 6 5 5 4 2008 4 2010 2012 2014 Source: interest.co.nz. Note: Computed as a simple average of the mortgage rates for the four largest banks, inclusive of specials applied to low-LVR lending. New mortgage commitments have increased in recent months on a quarterly basis. As discussed in box D, there is a substantial divergence between new mortgage lending and growth in net housing debt (figure 2.3). This divergence is thought to largely reflect increased debt repayment rates by existing borrowers since the Global Financial Crisis (GFC). New lending is the most relevant metric for assessing the role of 8 credit in the housing market and the associated financial stability risks. With substantial new lending, mortgage rates at historic lows, and banks eager to attract new customers, there is a risk that the underlying asset quality of mortgage lending will decline. This could reduce the resilience of both banks and borrowers to any future housing market downturn, and hamper the ability of banks to provide credit effectively throughout the credit cycle. Figure 2.3 Mortgage approvals and housing credit growth (annual, % of housing debt) 18 % % Housing credit growth 15 60 50 Mortgage approvals (RHS) 12 40 9 30 6 20 3 10 0 2005 2007 2009 2011 2013 2015 0 Source: RBNZ Housing Approval Survey, RBNZ SSR. Note: Mortgage approvals are an approximation of actual mortgage origination trends. Low global interest rates are supporting financial market sentiment. Long-term interest rates have declined sharply since November 2014, significantly pushing down wholesale interest rates in New Zealand. A major contributing factor has been monetary easing in Europe and Japan. Low interest rates are supporting global financial market sentiment by encouraging investment in higher-yielding assets, as reflected in low credit risk spreads and asset market volatility. Prices for both financial assets such as equities and real assets such as property RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2015 have been increasing sharply in many countries. High asset prices may not be sustained when interest rates begin to return to more normal levels, representing a potential source of vulnerability for both investors and financial systems. This risk would be more pronounced if low interest rates and the search for yield drove asset prices to levels that could not otherwise be justified by economic fundamentals. There is also a substantial risk that the current benign conditions in financial markets unwind in a disorderly fashion, with implications for the cost and availability of offshore funding for New Zealand banks. Low interest rates in the US have been playing a role in stimulating demand for high-yielding assets, and the potential for tighter US monetary policy may prompt a destabilising outflow of capital from emerging market debt, high-yield corporate bonds and equities. Tensions in the euro area have increased again in recent months and could also disrupt financial markets significantly, although markets are better positioned to cope with instability than during the peak of the sovereign debt crises in 2010. Finally, economic growth in China is slowing alongside a moderation in the property market. While this slowdown is not causing a marked increase in financial stress at present, a sharp contraction in China could reduce world trade, disrupt global capital markets, and lead to a significant decline in export incomes in both Australia and New Zealand. Housing market risks have increased. House price inflation slowed across New Zealand in the first nine months of 2014, in large part due to the introduction of a speed limit on high-LVR mortgage lending in October 2013. More recently, Auckland house prices rebounded strongly over the summer of 2014-15, reflecting ongoing supply constraints, record net immigration and low and falling long-term mortgage rates. House prices in March were 16.9 percent higher in the Auckland region than a year earlier, compared with an annual increase RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2015 of 3.2 percent for the rest of the country. In contrast to the rest of New Zealand, Auckland house prices are now significantly higher relative to household incomes than at the peak of the mid-2000’s boom (figure 2.4). This increases the potential for a sharp price correction in response to adverse economic or financial conditions, such as a rapid increase in unemployment, a reversal in population inflows, or a sharp rise in mortgage rates. Figure 2.4 House price-toincome ratio across regions Ratio 8 Ratio 8 New Zealand Auckland 7 7 Rest of NZ 6 6 5 5 4 4 3 3 2 2001 2003 2005 2007 2009 2011 2013 2 Source: REINZ, Statistics New Zealand. The LVR speed limit is adding to household and bank resilience by reducing the proportion of borrowers with small equity buffers (see the ‘Policy assessment’ section below). However, rising price-to-income ratios suggest that new buyers in Auckland are becoming more indebted relative to their incomes than previous buyers. Another characteristic of the Auckland market has been increased investor purchases over the past year, at the same time that rental yields have reached record lows (box A). International evidence suggests that high debt-to-income owneroccupiers and leveraged investors both have relatively high default rates during severe housing downturns. As a result, the potential for a sharp 9 correction in Auckland house prices to cause a significant rise in bank loan losses has increased since the last Report. Indebted dairy farms are coming under stress… The dairy sector is currently experiencing a difficult season. Fonterra’s forecast milk payout for the 2014-15 season is $4.50 per kilogram of milksolids (kgMS), down sharply from the $8.40 payout in 2013-14 (figure 2.5). Despite many farms being in a position to manage down working expenses, around one-quarter of dairy farms have negative cash flow for the 2014-15 season (see box C). The sector’s vulnerability to reduced incomes is increased by elevated indebtedness, despite moderate growth in borrowing since 2009. Approximately 30 percent of dairy debt is concentrated among the most indebted 10 percent of farms. Indebted farms are particularly vulnerable to a period of reduced cash flow. Figure 2.5 Fonterra payout and global dairy prices Fonterra payout (RHS) GDT price index (USD) GDT price index (NZD) Index 400 $/kgMS 10 8 300 6 200 4 100 0 1999 2 2002 2005 2008 2011 2014 0 …and are vulnerable to another low payout season. Financial stress in the dairy sector could rise markedly if low global milk prices persist beyond the current season. Cash flow in the 201415 season will be boosted by around $1.50 per kgMS due to deferred payments from the strong 2013-14 season, but deferred payments from the current season will be significantly lower. Financial stress would be exacerbated if low milk prices led to falling rural land prices. The ensuing reduction in equity buffers could prevent indebted farmers from drawing on credit lines and result in a rise in loan defaults in the sector. As at March 2015, aggregate rural land prices were approximately flat on an annual basis. This suggests that low interest rates and a reasonable longer-term outlook are supporting demand for farmland, despite the difficulties of the current season. Some recovery in global milk prices is expected in the 2015-16 season, although there is considerable uncertainty over the timing and extent of the recovery. Prices rose temporarily in early 2015, partly reflecting prospects of reduced production in New Zealand, but fell again in March and April. Global dairy supply is increasing due to rising production in the US and the removal of quotas on milk production in Europe. Russian sanctions on milk imports are also adding to global supply. Recovery in Chinese milk demand, following its large build-up of inventories in 2013, will be critical to supporting demand. Assessing the balance of these global forces is difficult, but there is a significant risk that milk prices remain low for an extended period. Source: Fonterra, GlobalDairyTrade. Note: 10 Payout figures in chart include dividends. RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2015 Policy assessment Table 2.2 LVR policy indicators Indicator September 2013 September 2014 Latest Funding and capital buffers need to be maintained. House price inflation - national (annual 3-month moving average) 9.4 5.0 7.7 Banking system capital and liquidity buffers have both increased markedly since the GFC. With the financial system facing significant and increasing risks, it is critical that these buffers are maintained and prudent lending standards applied. Banks have advised that they plan to start making use of new capital instruments allowed under Basel III. Banks should ensure that new capital instruments do not lead to a reduction in loss-bearing capacity. The Reserve Bank plans to undertake a review of current capital requirements in the context of global and domestic changes that have occurred in the banking system in recent years. This follows a review of capital requirements recently undertaken in Australia as part of its Financial System Inquiry. House price inflation - Auckland (annual 3-month moving average) 16.4 8.6 16.9 Housing credit growth (annual growth, %) 5.8 4.7 4.8 New lending with LVR > 80% (% of mortgage commitments) 24.4 7.3 6.1 Mortgage debt with LVR > 80% (% of mortgage debt) 20.5 15.8 15.1 The moderating effect of the speed limit on house price inflation has weakened. Source: Registered banks’ Disclosure Statements, RBNZ New Residential Mortgage Commitments Survey, RBNZ SSR, REINZ. high-LVR mortgages declining markedly following the imposition of the speed limit (see figure 4.4). (iii) Current house price inflation is well above sustainable levels in Auckland, with Auckland house price inflation running well in excess of household income growth. (iv) In contrast, housing market conditions have eased in Christchurch and are relatively subdued in the rest of the country. House price inflation outside Auckland is currently tracking broadly in line with household income growth (figure 2.4). Table 2.2 summarises key indicators related to the LVR policy. Four particular observations can be drawn: (i) (ii) As the Reserve Bank expected, the LVR speed limit appears to have had its major impact on annual house price inflation during the first year of operation. Despite this, the Bank believes that the removal of the speed limit would release pent-up demand and risk a surge in house price inflation. The policy has had an ongoing effect on the resilience of both borrowers and lenders to a housing downturn, with the stock of RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2015 The Reserve Bank believes the imposition of the LVR speed limit has helped to reduce the risks associated with a future housing downturn. International experience suggests that high-LVR lending is correlated with a higher probability of default and greater loss given default. In 11 addition, with fewer stressed borrowers forced to sell, a house price correction is likely to be more moderate, in turn reducing the negative spillovers to the rest of the economy. However, in the Bank’s view, the LVR speed limit is now playing a much weaker role in dampening house price growth in Auckland. The Bank plans to create a new asset class for residential property investors… Following feedback from a consultation on the definition of residential property investment lending earlier this year, the Reserve Bank is establishing a new residential property investor class for banks. This is expected to attract a higher risk weighting than owner-occupier mortgages. The adoption of the new residential investment class and capital treatment is consistent with the international evidence showing larger loan defaults for investor loans than for loans to owner-occupiers during periods of housing market stress. In line with the preferences of the vast majority of bank submissions, the current residential mortgage asset class will be restricted to owner-occupiers only. Any mortgage secured on a home that is not owner-occupied will be classed as a residential investment property loan and allocated to the new asset class. This permanent change to the bank capital framework is expected to take effect from 1 October 2015 for new mortgage lending. outside Auckland. Accordingly, the Bank is proposing a package of changes to macro-prudential policy. The proposed changes include: • restricting loans to property investors in the Auckland region with an LVR of greater than 70 percent (i.e. to set a speed limit on such loans at close to zero); • retaining a speed limit of 10 percent on loans to owner-occupiers in the Auckland region with an LVR of greater than 80 percent; and • increasing the speed limit for all residential lending outside of the Auckland region to 15 percent for loans with an LVR of greater than 80 percent. The aim of the proposed changes is to reduce the financial stability risks of a sharp housing market downturn. The changes are expected to achieve this by lowering house price inflation in Auckland and reducing the exposure of banks to riskier loans. The Reserve Bank intends to issue a consultation paper in late May to outline these proposals in further detail and to seek feedback. Subject to the outcome of the consultation, the Bank is proposing that the changes outlined above will take effect on 1 October 2015. …and is proposing to tighten the LVR policy. The Bank believes additional temporary measures are required to help contain rising housing market imbalances in the Auckland region, which continue to pose a threat to future financial stability. The proposed measures also reflect international evidence that investor loans tend to be riskier in severe downturns for a given LVR. The Bank considers it appropriate to recognise the more subdued housing market conditions 12 RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2015 Box A Investors and the New Zealand housing market1 Housing investors have consistently accounted for over one-third of property purchase transactions over the past decade, with the share rising slightly following the introduction of loan-to-value ratio (LVR) restrictions in October 2013 (figure A1).2 Sales to investors in the Auckland market have picked up in line with the rise in sales activity since November, and this is likely to be contributing to recent strength in Auckland house prices. Investors are also a key source of new mortgage credit demand, with property investors accounting for approximately onethird of new mortgage lending over the six months ended March 2015. Figure A1 Investor house sales share by region 44 % 42 % New Zealand 44 42 Auckland 40 40 38 38 36 36 34 34 32 32 30 2006 2008 2010 2012 2014 30 Source: CoreLogic NZ. Although New Zealand has not experienced a financial crisis associated with the housing market, a range of international evidence suggests that defaults on investor lending tend to be significantly higher than for owneroccupiers during severe downturns. For example, Irish investor mortgage default rates were around 20 percent higher than total mortgage default rates in the two years following the GFC. Default probabilities were estimated to have been significantly higher than owner-occupiers at any given LVR.3 Evidence from the UK and the US also finds that default rates were relatively high among investors in severe downturns.4 The Reserve Bank’s proposal to apply higher risk weights to investor lending, and introduce a differential LVR threshold for investors relative to owneroccupiers in Auckland, is consistent with this evidence. A key driver of the higher default propensity of residential property investors is higher debt-to-income ratios (income gearing) relative to owner-occupiers. For example, an investor who has borrowed to buy four houses will end up with much larger negative equity relative to their labour income, if house prices fall, than an owner-occupier with just one house and a similar LVR. Higher income gearing reduces the incentive for the investor to continue servicing the outstanding loans, resulting in a greater tendency for investors to default when they have negative equity. Another possible reason for the higher risks associated with investor lending is that investor house purchases have, in some countries, tended to be concentrated in areas with high expected capital growth. These expectations are often based on recent house price appreciation. Note: Investor house sales refers to purchases made by buyers owning multiple properties. 1 The Reserve Bank plans to release more detailed material on investor lending in New Zealand in coming months. 2 For the purpose of this box, investors are defined as those purchasing to let the property rather than for owner-occupation. RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2015 3 See Lydon, R and Y McCarthy (2011) ‘What lies beneath? Understanding recent trends in Irish mortgage arrears’ Central Bank of Ireland Research Technical Paper, 14/RT/11; and Kelly, R and K McQuinn (2014) ‘On the hook for impaired bank lending: Do sovereign-bank linkages affect the net cost of a fiscal stimulus?’, International Journal of Central Banking, 10(3), September. 4 See Haughwout, A et al. (2011) ‘Real estate investors, the leverage cycle, and the housing market crisis’, Federal Reserve Bank of New York Staff Report 514; and Wilcox, S (2013) ‘Rebalancing the housing and mortgage markets – critical issues’, Intermediary Mortgage Lenders Association. 13 Evidence from the US suggests that increases in house prices prior to the GFC were particularly pronounced in regions where the investor share of house purchases increased.5 In turn, areas with rapid house price inflation experienced relatively large house price falls in the aftermath of the crisis. In New Zealand, a significant proportion of property investors have large portfolios, implying a large degree of gearing relative to their underlying labour income. For example, the 2014 ANZ Residential Property Investment Survey shows that 26 percent of surveyed investors held seven or more investment properties (figure A2).6 Around half of investor commitments are at LVRs of more than 70 percent. Preliminary Reserve Bank survey data suggests that investors tend to make greater use of interest-only loans, which may partly reflect investors’ ability to offset Figure A2 Distribution of investors by number of investment properties 100 % Full-time investors Medium investors Large investors Small investors 80 100 80 60 60 40 40 20 0 % 20 2010 2011 2012 2013 2014 mortgage expenses against personal income for tax purposes. As a result, investor loans are likely to retain a higher level of gearing over the long term than their owner-occupier counterparts. The risks associated with investor lending are likely to be greatest in the Auckland region. Rapid house price appreciation in Auckland has compressed rental yields, and this is likely increasing income gearing among Auckland investors. Auckland rental yields are at record lows, while national yields are close to their 10-year average (figure A3). Relatively strong capital gain expectations among Auckland investors may explain why they are willing to accept such low rental yields. According to the 2014 ANZ Residential Property Investment Survey, investors in Auckland expected house price inflation to average 12 percent per annum in the region over the coming five years, compared to 8 percent nationwide. CoreLogic data also show that investors in the Auckland region are more likely to use mortgage finance than investors outside the Auckland region. Figure A3 Gross rental yields by region (3-month moving average) 7.25 % % New Zealand 6.75 Auckland (RHS) 6.25 5.75 4.00 3.50 3.75 Note: Small, medium, large, and full-time investors are defined as those holding 1-3, 4-6, 7-10, and 11 or more properties, respectively. 3.25 1995 1998 2001 2004 2007 5 See Haughwout et al. (2011). Source: Department of Building and Housing, REINZ, RBNZ calculations. 6 Similarly, data from CoreLogic shows that multiple property owners (MPO) with five or more properties accounted for 36 percent of overall MPO purchases in recent months. Note: 14 5.50 4.50 4.25 Source: ANZ Residential Property Investment Survey. 6.00 5.00 5.25 4.75 0 6.50 2010 2013 3.00 Rental yields are calculated using Department of Building and Housing average rents and REINZ house prices. RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2015 Chapter 3 The international environment and financial markets Global interest rates have declined sharply since the last Report. Both the European Central Bank (ECB) and the Bank of Japan (BoJ) have expanded their quantitative easing programmes in response to low growth and deflationary risks, resulting in an increasing divergence from US monetary conditions. Low global interest rates continue to encourage investment in higheryielding assets, although asset market volatility and credit spreads ticked up in late 2014 alongside falling commodity prices. In this environment, offshore funding costs for New Zealand banks have remained favourable and long-term interest rates have declined. There is an elevated risk that current benign conditions will unwind, resulting in a sharp increase in the domestic cost of credit. Key threats to global markets include disruptions associated with US monetary policy normalisation, renewed tensions in the euro area, or a more rapid economic slowdown in emerging markets. RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2015 Growth prospects are diverging… Economic developments among the world’s major economies have been mixed (figure 3.1). In the US, the economic recovery remains intact, despite several indicators of economic activity slowing in 2015. A strengthening US labour market, rising consumer spending, lower oil prices, and accommodative monetary policy are all supporting economic activity. In contrast, Europe continues to experience difficult economic conditions, with unemployment across the euro area above 11 percent and several countries experiencing deflation. After contributing strongly to global activity in recent years, China’s growth rate is slowing, although growth among New Zealand’s other trading partners in Asia is more stable. 15 Figure 3.1 GDP growth (annual average) 12 % 2000-2007 average 2008-2012 average 2013 2014 2015 forecast 10 8 % 12 10 8 6 6 4 4 2 2 0 0 -2 China Rest of Australia New Asia Zealand US Euro area Japan -2 Source: Haver Analytics, RBNZ. …with risks around weak growth in Europe… Some of the preconditions for recovery in Europe are being established, with a substantial fall in the euro boosting competitiveness, and the fall in oil prices acting to increase household purchasing power. The ECB has greatly increased its quantitative easing programme in 2015, and this is leading to rising asset prices and improved business confidence. However, any recovery is likely to be slow and uneven across European countries. Growth in lending across the euro area has remained very weak (figure 3.2), partly reflecting low bank profitability and still elevated non-performing loans in peripheral European economies. Many of these peripheral European countries are experiencing persistently weak growth, with high levels of indebtedness constraining consumer spending and business investment. Stimulatory monetary policy has helped reduce the spread between German government bond yields and yields in most peripheral economies since November, which should help lower interest costs for domestic borrowers. The one 16 exception has been Greece, with increasing speculation that Greece might leave the euro. While the euro area is better positioned to cope with such an event than during the height of the sovereign debt crises in 2010, there remains the potential for further market disruptions in an environment of persistently weak growth. Figure 3.2 Private sector credit growth in selected economies (annual %) 20 % Euro area New Zealand US China (RHS) % 40 15 30 10 20 5 10 0 0 -5 2000 2002 2004 2006 2008 2010 2012 2014 -10 Source: Bank for International Settlements (BIS), RBNZ Standard Statistical Return (SSR). …and slowing growth in China. In recent years, China’s growth has been driven by very high rates of investment and property development, associated with a rapid expansion in credit and property prices. Property market sales and prices have since started to fall moderately in small and medium-sized cities (figure 3.3). Lower construction volumes are also feeding through into declining output in the heavy industrial sector. Property price inflation has been showing signs of stabilisation in recent months, partly due to a loosening in domestic monetary policy. Long-term financial market structural reforms, including policies aimed at countering risks from lending outside RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2015 the regulated banking sector, have been designed to help support longterm financial stability. Figure 3.3 Chinese residential property market indicators (annual % change) 20 % % 120 Prices 15 Buildings sold (RHS) 90 10 60 5 30 0 0 -5 -10 2007 -30 2009 2011 2013 2015 -60 Source: Haver Analytics. A rapid unwinding of property imbalances could result in a sharp slowdown in Chinese economic growth and increasing loan losses. The large number of loans made outside the regulated banking sector in recent years could be especially vulnerable to such a downturn. There are also new concerns around rapidly rising equity prices, with the Shanghai stock exchange composite index more than doubling in the 12 months to the end of April. China is the world’s largest commodity consumer, the number one or two trading partner for 50 countries, and one of New Zealand’s largest trade partners. China’s slowing growth rate directly affects New Zealand via lower export volumes and agricultural commodity prices, and indirectly via lower export-led growth in Australia and weaker global growth. Any associated disturbance to global financial markets could also compromise the cost and availability of offshore funding for New Zealand banks. RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2015 Global monetary policy is accommodative. The ECB and BoJ have both significantly increased their quantitative easing programmes in 2015, in response to falling inflation and weak growth. Although US monetary policy is also highly stimulatory, improving growth prospects have seen the Federal Reserve gradually withdraw its quantitative easing programme. Market expectations of an increase in the policy rate, for the first time in over six years, have also increased. Figure 3.4 shows an indicator, developed by the Reserve Bank, of the policy rate for the world’s major economies that would result if the zero lower bound on interest rates were not binding. The recent quantitative easing undertaken in Japan and the euro area is estimated to be equivalent to a large cut in policy interest rates, to significantly negative levels. In contrast, the implied policy interest rate for the US has gradually increased since early 2013. Figure 3.4 Estimated shadow interest rate for major advanced economies (90-day rate) 4 % % Euro area Japan US 4 UK 2 2 0 0 -2 -2 -4 -4 -6 -6 -8 2009 2011 2013 2015 -8 Source: Research by Leo Krippner, see http://www.rbnz.govt.nz/research_and_publications/ research_programme/additional_research/5655249.html  Note: Shadow interest rate is an estimate of the short term interest rate that might prevail if the zero lower bound were not binding. 17 Central banks in many other countries have also eased monetary policy over the past six months (figure 3.5). Several European countries outside the euro area reduced policy rates to help counter the appreciation of their respective currencies, partly driven by the ECB’s quantitative easing programme. The most pronounced examples are Sweden and Switzerland, which have implemented negative policy rates. A number of commodity-exporting countries, including Canada, Norway and Australia, also reduced interest rates, in part reflecting lower commodity prices. The People’s Bank of China has responded to slowing growth by providing liquidity to the banking system, reducing reserve requirements, and through two interest rate reductions in November 2014 and February 2015. Figure 3.5 Official interest rate changes (October 2014 – March 2015) Turkey China India Peru Australia Canada Israel Switzerland Iceland Denmark Romania Sweden Norway Emerging markets Other developed economies Europe -100 -75 -50 -25 Basis points 0 Source: Individual central bank websites. Global bond yields are at historic lows…. Extraordinary monetary policy easing, falling global inflation and concerns about the global growth outlook have pushed long-term bond yields in many countries to historic lows (figure 3.6). Falling yields have 18 been particularly evident in Europe, where almost one-third of sovereign bonds now carry a negative yield. This partly reflects the influence of increasingly stimulatory monetary policy in lowering yields at shorter maturities. Despite the rise in US short-term interest rates, US bond yields also reached historic lows at many longer-term maturities in late 2014. Figure 3.6 10-year government bond yields 8 % Australia Japan UK % Germany New Zealand US 8 6 6 4 4 2 2 0 2004 2006 2008 2010 2012 2014 0 Source: Reuters. …encouraging investment in higher-yielding assets. Low and falling global bond yields are encouraging investment in higher-yielding assets. Equity markets have been particularly buoyant (figure 3.7). Low global interest rates have also been associated with compressed credit spreads on higher-risk assets (figure 3.8) and low asset market volatility (see figure 3.9). These risk measures remain low, but have increased towards their long-run averages, partly reflecting sharp declines in commodity prices in late 2014. This environment is boosting demand for physical assets such as residential and commercial property. As discussed in chapter 4, low interest rates are a key factor RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2015 supporting demand for these assets in New Zealand. Higher asset prices could become a point of vulnerability in the future if they fall sharply as interest rates return to more normal levels. Figure 3.7 Benchmark stock price indices (1 January 2012=100) Index 250 Index 250 US Germany Australia New Zealand Japan 200 200 150 150 100 100 50 2012 2013 2014 2015 50 Low global interest rates have also prompted large-scale capital flows from low- to high-yield countries. This resulted in significant capital flows to emerging markets in the years following the GFC. More recently, rising interest rate differentials between the US and Europe have increased the relative attractiveness of US assets for European investors. In the month following the ECB’s expanded bond purchase announcement, bond funds domiciled in the US saw inflows that were around triple that in any other month in 2014. Some emerging markets have experienced capital outflows, reflecting a slowing growth outlook and declining yield differentials to the US. For example, China saw a net $324 billion of capital outflows in 2014 compared with an inflow of $56 billion in the year prior.1 There are risks around the normalisation of US monetary policy. Source: Reuters. Note: Indices shown are USA S&P500, Japan Nikkei 225, Germany DAX, Australia S&P-ASX200, and New Zealand NZX50. Figure 3.8 Corporate bond yields (spread to government bonds) 20 % 16 % US investment grade Global investment grade US high yield Global high yield 20 16 12 12 8 8 4 4 0 2002 2005 2008 Source: Barclays Capital. RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2015 2011 2014 0 Market disruptions associated with the US moving to tighter monetary policy are one potential trigger for a rapid unwinding of current benign conditions. For example, a significant increase in US long-term interest rates could reduce the ability of emerging market debt issuers to raise new capital and rollover existing debt maturities. The overall rollover requirement for emerging market corporate enterprises’ debt is estimated to rise significantly in coming years. An increasing reliance on offshore debt markets is of particular concern for some net-debtor emerging markets, which are more vulnerable to an abrupt pull-back in foreign capital. Non-financial corporate borrowing has also increased in some surplus economies, including China. Disruptions to emerging market capital flows could spill over to New Zealand via increased volatility in global financial markets. 1 Kwok, D and T Wang (2015) ‘Capital outflows & RMB exchange rate’, UBS Global Research Macro Keys, February. 19 The sensitivity of markets to unanticipated disruptions, including those associated with a disorderly transition to tighter US monetary policy, could be amplified by tighter market liquidity in both foreign exchange and fixed income markets. Structural changes in markets, including changes to capital-adequacy regulation and the changing composition of market participants, have also reduced market-making capacity. An example of how tighter liquidity can lead to abrupt price movements was the removal of the Swiss franc floor in early 2015, which saw a rapid escalation in foreign exchange market volatility (figure 3.9). Figure 3.9 Global asset market volatility Index 350 S&P 500 (VIX) US Treasury bonds (MOVE) G7 currencies (JPM, RHS) 300 Index 30 25 200 20 150 15 100 10 50 5 2007 2009 2011 2013 2015 0 Source: Bloomberg. Commodity prices have declined... Many commodity prices have declined sharply since early 2014 (figure 3.10), in part due to concerns about slowing economic activity in China, the world’s largest commodity consumer. For certain key commodities, including energy and industrial metals, increased global supply has also contributed to downward pressure on prices. Falling commodity prices have reduced incomes and intensified downward pressures on exchange rates for emerging market commodity exporters, including some of New 20 Figure 3.10 Global commodity prices (USD, January 2000=100) 35 250 0 2005 Zealand’s trading partners in Asia. These trends pose additional risks for economies that rely on offshore funding. Index 600 500 400 Index 600 Agriculture Metals Energy Dairy 500 400 300 300 200 200 100 100 0 2000 2003 2006 2009 2012 2015 0 Source: ANZ, International Monetary Fund (IMF). Note: See datasheet for the composition of the IMF indices. The IMF agricultural index does not capture the basket of New Zealand’s key agricultural exports. …with implications for Australia and New Zealand. The New Zealand economy is exposed to these commodity market pressures, with prices for dairy products almost 50 percent below their early 2014 peak (see chapter 4). A sustained weakening in metals prices, particularly the price of iron ore, has also led to weaker growth momentum in Australia. The Reserve Bank of Australia has been gradually reducing interest rates since 2011, which will help with the transition from mining-led investment growth to other sources of domestic demand. As a result, New Zealand interest rates have increased relative to those in Australia. RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2015 Low interest rates have been associated with strong house price growth in several major Australian cities, alongside rapidly growing lending to investors. A sharp correction in Australian house prices associated with a reduction in debt servicing capacity has the potential to increase stress for some Australian banks. Such a scenario could also possibly have implications for the subsidiaries of the large four banks operating in New Zealand. However, the Australian Prudential Regulation Authority (APRA) has noted its intention to monitor carefully for any signs of loosening lending standards, and has issued guidelines to banks on appropriate lending behaviour. The recent Financial System Inquiry also made recommendations that are likely to result in an increase in the amount of capital held against housing loans. Falling global interest rates have pushed NZ interest rates lower… Falling global interest rates have increased the attractiveness of relatively high-yielding New Zealand bonds, resulting in a decline in government bond yields. The sharpest drops occurred at long-term maturities, mirroring trends seen in the US (figure 3.11). New Zealand 10-year government bond yields hit a historic low of 3.11 percent in February 2015. The relative demand for New Zealand government bonds has also increased in recent months. The spread between US and New Zealand 10-year government bonds fell to 112 basis points in March, the lowest level since the March quarter of 2007. RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2015 Figure 3.11 New Zealand and US government bond yields 5 % NZ (Q3 2014) US (Q3 2014) NZ (Q1 2015) US (Q1 2015) % 5 4 4 3 3 2 2 1 1 0 2 Year 5 Year 10 Year 0 Source: Bloomberg, RBNZ calculations. Although the share of New Zealand government debt held by offshore investors has remained broadly stable, strong international demand for this debt is reflected in a rise in offshore bond holdings over the past six months (figure 3.12). A high relative yield has also been associated with strong issuance of NZD bonds by non-residents, including a record $2.1 billion of Kauri bond issuance in January (figure 3.13). Holdings of NZD-denominated bonds have been trending up since the start of 2012 as new issuance has outstripped maturities. The expansion in the quantitative easing programmes of the ECB and BoJ suggests that yields in key developed economies are likely to remain exceptionally low, and this could support demand for NZD assets for an extended period. 21 Figure 3.12 Offshore NZ government bond holdings $bn 50 % Holdings % Total holdings (RHS) 100 40 80 30 60 20 40 10 20 0 1994 1997 2000 2003 2006 2009 2012 0 2015 Source: Bloomberg, RBNZ. Figure 3.13 Non-resident NZD bond issuance (3-monthly total) Source: Reuters. $bn 15 Uridashi/Eurokiwi issuance Kauri issuance Outstanding non-resident NZD bonds (RHS) $bn 75 12 60 9 45 6 30 3 15 0 2004 0 2006 2008 2010 2012 2014 …and supported the NZ dollar. New Zealand’s relatively strong growth and high interest rate differentials continue to support the NZD. The NZD has appreciated against a range of currencies since the last Report, with the exception of the USD (figure 3.14). The Trade Weighted Index (TWI) appreciated 4 percent in the six months ended March 2015, taking the index to within 5 percent of its record highs in mid-2014. The NZD/AUD reached a historic post-float high of almost 99.8 cents in March. Although there has been a helpful depreciation in the exchange rate in recent weeks, Reserve Bank analysis suggests that the real exchange rate, on a trade weighted basis, is above its sustainable level. This implies that the NZD could fall sharply if current benign conditions in global markets reverse, resulting in a reduction in appetite for NZD-denominated assets. Figure 3.14 New Zealand exchange rate (% change, 30 Sep 2014 – 31 Mar 2015) 15 % % 12 15 12 9 9 6 6 3 3 0 0 -3 -3 -6 EUR AUD GBP JPY USD TWI -6 Source: Bloomberg, RBNZ calculations. 22 RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2015 Bank wholesale funding costs remain relatively low… Funding conditions remain favourable for New Zealand banks, with the cost of funding from a variety of stable funding sources remaining near post-crisis lows (figure 3.15). The rise in global financial market volatility in late 2014 and early 2015 played a role in a modest widening in the landed cost of long-term offshore funding, particularly at longer terms. However, banks have had little need to issue significant amounts of offshore funding due to relatively strong growth in deposits (see chapter 5). Funding spreads on deposits, and long-term wholesale funding sourced from the domestic market, have remained stable since the last Report. Figure 3.15 Bank funding costs (3-month average, spread to benchmark rates) Basis points 300 Basis points 300 250 250 200 200 150 150 100 50 100 Long-term wholesale - domestic Long-term wholesale - offshore 6-month retail funding 0 Jun-11 Jun-12 Jun-13 50 Jun-14 …although hedging costs have increased for some currencies. A rise in the cost of hedging some currencies into NZD may explain some of the modest increase in offshore funding costs (figure 3.16). The cost of hedging euros or yen into NZD has increased markedly, due to an increase in the cost of first swapping these currencies into USD. This development in large part reflects the increased quantitative easing programmes by the ECB and BoJ, which have increased the supply of funding in yen and euros. This has resulted in a decline in the relative supply of USD funding, increasing the cost of hedging these currencies into USD. With non-resident issuance of NZD-denominated bonds picking up in early 2015, the cost of hedging USD into NZD has declined slightly since November. Figure 3.16 Hedging cost for 5-year debt (basis swap spreads) 0 Basis points 150 NZD/USD NZD/EUR 120 NZD/JPY Basis points 150 120 90 90 60 60 30 30 0 Source: RBNZ Liquidity Survey, RBNZ SSR. Note: Benchmark interest rates are the relevant swap rate or bank bill rate depending on the term. Long-term wholesale includes new debt issues with a term of between four and seven years. -30 2004 0 2006 2008 2010 2012 2014 -30 Source: Bloomberg. Note: RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2015 NZD/EUR and NZD/JPY basis swaps are indicative levels derived from the NZD/USD, EUR/ USD, and USD/JPY basis swap spreads, and do not account for transaction costs. 23 Chapter 4 Financial risks to the New Zealand economy Financial risks have increased since the previous Report, in large part due to growing imbalances in the housing market. House price inflation has picked up significantly in Auckland in recent months, driven by constrained supply growth, falling mortgage interest rates and strong net immigration. Auckland house prices have become increasingly stretched relative to rents and incomes, increasing the likelihood of a disruptive correction. Dairy incomes have declined significantly in the current season. Milk prices remain well below their peak in early 2014, and continued weakness in prices could markedly increase financial stress in the dairy sector. This vulnerability is exacerbated by high levels of dairy debt, concentrated among a small number of more vulnerable borrowers, and the potential for farm land prices to fall significantly. New Zealand has a high level of net external debt. Increased private sector investment and lower farm incomes could worsen the net external debt position in coming years, increasing the vulnerability of the domestic economy to disruption in global financial markets. 24 Households Auckland house price inflation has rebounded strongly… The possibility of a sharp fall in house prices remains a key threat to financial stability, in the context of elevated household debt levels and house prices that are high relative to fundamental measures such as household incomes and rents. House price inflation eased in the year following the introduction of the speed limit on high loan-to-value ratio (LVR) lending in October 2013. In the Auckland region, where prices are particularly stretched, house price inflation has since rebounded strongly (figure 4.1). In contrast, house price inflation has eased significantly in Christchurch and remains moderate in the rest of New Zealand. RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2015 Figure 4.1 House price growth by region (annual 3-month moving average) 30 % % Auckland Christchurch Rest of NZ 20 30 20 10 Figure 4.2 House sales and housing credit (quarterly) Number 40000 Credit growth as a percent of the value of house sales (RHS) Number of house sales % 60 30000 50 10 40 20000 0 -20 2000 30 0 -10 -10 2003 2006 2009 2012 2015 -20 Source: REINZ. 70 20 10000 10 0 2000 2003 2006 2009 2012 2015 0 Source: REINZ, RBNZ Standard Statistical Return (SSR). Note: Grey bars account for a one month lag between house sales and credit. The number of house sales is now similar to prior to the introduction of the LVR speed limit, after falling 16 percent between September 2013 and June 2014 (figure 4.2). Although the volume of house sales remains well below levels seen prior to the GFC, the value of those sales is approaching record nominal levels. New loan commitments for housing have accelerated over the past year in line with the increased value of sales, but growth in the outstanding stock of housing credit has remained modest. This reflects an increase in repayments by existing mortgage holders and the reduction in the average LVR of new borrowers due to the speed limit on high-LVR lending (see box D). …driven by tight supply… A significant imbalance between the demand for and supply of housing has been a key factor behind recent increases in Auckland house prices. New building has been low relative to population growth, leading to a sustained rise in the average number of people per dwelling (figure 4.3). Consent issuance has accelerated markedly in recent years, and is expected to be boosted by the Auckland Housing Accord that allows for fast-tracking of resource consents. However, there are significant factors limiting land supply that will make it difficult to achieve the scale of residential building required to meet current and expected population growth and reduce upward pressure on house prices.1 In contrast, rental growth and house price inflation in Christchurch have been easing in recent months as new housing supply becomes available. 1 For more detail, see Spencer, G (2015) ‘Action needed to reduce housing imbalances’, http://www.rbnz. govt.nz/research_and_publications/speeches/2015/action-needed-to-reduce-housing-imbalances.pdf RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2015 25 Figure 4.3 Populationto-dwelling ratio Ratio 3.1 Ratio 2.7 Auckland Table 4.1 Housing market conditions House price inflation Canterbury (RHS) 3.0 2.6 Rest of NZ (RHS) 2.9 2.5 2.8 2.4 2.7 2.6 1996 2.3 1999 2002 2005 2008 2011 2014 2.2 Source: Statistics New Zealand, RBNZ calculations. NZ Date Auckland Mortgage rates 2-year 5-year Annual (3-month average) Best available rate (%) Net immigration PLT Annual (000s) September 2013 9.4 16.4 5.45 6.55 15.2 September 2014 5.0 8.6 5.75 6.79 45.4 March 2015 7.7 16.9 5.19 4.99 56.3 Source: interest.co.nz, REINZ, Statistics New Zealand. Note: September 2013 represents conditions prior to the introduction of the LVR speed limit. September 2014 represents market conditions at the time of the November 2014 Report. Best available rates include lowLVR specials. …combined with falling mortgage interest rates and strong net immigration. The financial system is vulnerable to a sharp house price correction… As shown in table 4.1, the recent rebound in house price inflation has been underpinned by a sharp fall in mortgage interest rates and further increases in net permanent and long term (PLT) immigration. Longerterm mortgage rates, in particular, have fallen significantly, with the best available five-year rate down 180 basis points between September 2014 and March 2015. Annual net PLT immigration currently stands at an alltime high of more than 56,000, around half of which represents inflows into Auckland. This compares with 45,000 at the time of the November Report, and 15,000 just prior to the introduction of the LVR speed limit. Interest rates are expected to remain low for an extended period, and strong immigration may continue due to New Zealand’s relatively favourable economic prospects. When combined with the existing shortage of supply, these conditions suggest a substantial risk that Auckland house price inflation will not abate for some time, despite house prices already being heavily stretched relative to incomes and rents. Rising imbalances in the housing market increase the risk of a subsequent sharp fall in house prices, which would lead to financial stress among some borrowers. A significant correction in house prices could be triggered by a range of factors, such as a sharp economic downturn leading to a marked deterioration in the labour market, or a sharp increase in mortgage interest rates. Any downturn could be amplified by a withdrawal of speculative interest in residential property or a reversal of immigration flows. Financial distress among households could transmit to banks through increased losses on housing loans, and lower banking sector profitability due to weaker economic growth. International experience during the GFC demonstrates how financial stress in the household sector can have major consequences for the real economy, with consumption and investment falling amid tighter credit conditions and efforts by borrowers to reduce debt. 26 RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2015 …but the LVR speed limit is limiting the associated risks. As noted in chapter 2, the speed limit on high-LVR lending has limited the increase in financial system risk associated with the housing market. The level of house prices remains lower than would otherwise have been the case. The share of outstanding mortgage borrowers with high LVRs has also declined considerably (figure 4.4), thereby decreasing the probability of default and expected loss given default for any given house price correction. Increased household equity buffers are also likely to limit the extent to which house prices fall during periods of market stress, by reducing the likelihood of a significant increase in forced sales for borrowers with negative equity. Figure 4.4 High-LVR mortgage loans (% of total bank mortgage lending) 25 % 90≤LVR 80 $5m 12.8 0.6 13.4 Domestic market 6.7 5.8 12.5 Offshore market 7.3 7.7 15.0 Equity Figure A3.2 Sectoral banking system assets (as at December 2014) 250 $bn Consumer Other Non-property Housing Dairy Property $bn 250 200 200 150 150 100 100 50 0 50 Household Rural Business 0 Source: RBNZ SSR. Figure A3.3 Net international investment position (% of GDP, latest available) Ireland Spain New Zealand Australia United States Italy France Sweden United Kingdom Canada Korea Austria Belgium Netherlands Germany Japan Switzerland -100 % -50 0 50 100 150 Source: IMF, Statistics New Zealand. Source: Registered banks’ Disclosure Statements, RBNZ Liquidity Survey. 62 RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2015