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OCT 13

LVR limits part of the new normal

The implementation of loan to value “speed limits” by the Reserve Bank of New Zealand (RBNZ) has stimulated a good deal of media comment. From first home buyers who now need to save a higher deposit, to Labour vowing to make an exemption for first home buyers and regional exemptions, as well as banks seeing direct limits on their ability to write more and more debt.

While this criticism is understandable for those who now feel the additional restrictions, this prudential activity is highly important and part of the new thinking for central bankers around the world. Some continue to see prudential controls as separate and distinctly targeted at financial stability but many others see interest rates and prudential intervention as complimentary. Indeed the RBNZ has said the “speed limits” might be equivalent to a 0.3% increase in interest rates, while John Key suggested a higher estimate of 0.5%. The other principle advantages of “speed limits” over changes to the OCR is the policy can be targeted directly at the asset bubble problem, without creating more pressure on the exchange rate that would likely follow an interest rate increase.

In New Zealand the RBNZ is clear that first and foremost the intention of this policy is to support financial stability, even a modest fall in asset prices would leave those who are highly leveraged (high loan to value ratio mortgages) in negative equity, owing more than the asset is worth. This can lead to defaults, putting pressure on the stability on the financial system; this was exactly what we saw with the Global Financial Crisis, particularly in the U.S.

The introduction of these restrictions on high loan to value ratios (LVR) helps to stem this risk by directly limiting the amount of risky debt that can be taken, helping to slow the growth of the borrowing generally, and particularly that borrowing that is highly leveraged and vulnerable to asset price reductions.

This introduction is also an attempt at curbing New Zealand’s asset price inflation generally, especially in Auckland and Christchurch which have seen the highest level of growth.

There are broader issues, the housing market has not responded well to demand and the deeply embedded investment incentives and culture of housing speculation in New Zealand. Housing is seen as a relatively low risk, high-return investment, driven by the expectation that prices will always rise over time and in the end return a tax free capital gain. There is no future for an economy that sees more debt supporting higher asset prices, a successful economy must produce. The imbalances need to be targeted in order to incentivise more investment in productive activity and ultimately a more sustainable and prosperous economy.

Around the world, since the onset of the Global Financial Crisis (GFC) we have seen a divergence from the accepted best practise of one target (inflation), one lever (policy rate) monetary policy. The GFC taught us that stable inflation alone does not guarantee economic success and financial stability. These ideas are covered by Economist Olivier Blanchard, in the first chapter of “In the Wake of the Crisis”.

Some believe now we have two main targets, price stability, targeted through using the policy rate, and financial stability, targeted through prudential tools, such as bank reserve requirements, LVR limits etc. Following this view is the belief that these two can be targeted separately. But the problem with this thinking is it ignores how related the two targets are, and that the possible tools have effects on both targets and other important areas such as the exchange rate.

Blanchard makes the case that future monetary policy will be more complex, targeted at specific problems in the economy and made up of many targets and many instruments. This means looking into how these tools can work together to achieve an inflation target, financial stability, while also taking into consideration other very important targets, such as the exchange rate, asset prices, debt levels and the unemployment rate.

This is clearly where the world’s central banks are moving, with the Federal Reserve, European Central Bank and Bank of Japan all using measures and targets previously viewed as highly unconventional.

In New Zealand, the Reserve Bank has made moves to protect our financial stability, with changes to banks capital adequacy requirements, and recently the LVR limits. This is a step in the right direction and is the right thing to do given the debt fuelled asset price inflation. But looking forward, there are more targets and prudential tools which can be adopted, particularly to give the RBNZ the ability to tackle our overvalued exchange rate.

If the RBNZ chooses to increase the OCR to deal with inflation pressures this will have the effect of appreciating our exchange rate, putting further pressure on exporters and import competing manufacturers, which directly hits their margins and competiveness. This is a serious trade off which the RBNZ must consider, and is a compelling reason for more tools to tackle these issues together, adopting the mindset outlined by Blanchard; many targets and many instruments.

tags: lvr, loan to value ratio, rbnz, speed limits, interest, financial stability, monetary policy
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