Published 19 July 2006
Reserve Bank governor Alan Bollard’s views on the housing market have to be recognised because of his position in influencing change. Now he has warned farmers about paying too much for rural land, which he says has been moving along the same upward spiral as house prices.
Dr Bollard spoke about rural land issues to Federated Farmers on Tuesday, and in doing also elaborated on points he’d made about house price escalation last week (check the link to that story, containing a large slab of Dr Bollard’s address, below).
Despite giving recognition to a wider array of influences in the house-price picture, however, Dr Bollard still seems to ignore the Reserve Bank’s own role in helping price escalation.
His picture of farm price escalation for Federated Farmers was simplistic. He acknowledged changes in land use, especially the major expansion of dairying into the South Island, then chose graphs which eliminated the nuances. Land uses have changed as investors have chased higher returns from alternatives â€“ a chase which Dr Bollard sees as raising land values beyond a rate allowing reasonable returns.
The trouble in analysis there occurs when the new land price is matched against the return from the old use, and from Dr Bollard’s address it seems that’s what he has done. It may still be that the return from a new use doesn’t offer a reasonable return on the new land price, but the address doesn’t show any recognition of that.
After talking about New Zealand‘s “tyranny of distance” helping to limit biological incursions, Dr Bollard moved on to the land price issues:
The other major feature through this period has been some big changes in land use, especially the major expansion of dairying into the South Island, helped by good prices, warmer climates, irrigation technologies, and Fonterra’s general confidence about the future. Of course not all of the buoyant international prices have been received by New Zealand farmers, because of the recently strong New Zealand dollar.
Despite this, we do still have a problem of imbalance ahead of us. As New Zealanders have enjoyed this strong period of growth, they have invested heavily in housing, with consequent increases in household prices. A central bank might prefer to “look through” a period of asset price inflation, rather than trying to address it with tighter monetary policy.
That is an issue that is still argued about overseas. We did not feel we had the option of sitting back and waiting for the market to “burst”, for 2 reasons – the housing market has been an indicator of very strong activity through the broader economy; in addition, strong house prices have made New Zealanders feel richer and in turn spend very freely, bidding up prices elsewhere.
As we approached this problem, the Reserve Bank encountered an issue that has been around in lesser form before: we increased the official cash rate at a time when G3 economies, worried by deflation, were running the loosest monetary policies for 30 years. We could influence short-term rates, but took a longer time to see this coming through on effective mortgage rates, because banks were able to restructure mortgages to fixed term and fund at lower international rates.
This is not to say that monetary policy was impotent through this period; merely that its effects were slower to eventuate. This made it necessary to pre-signal to householders the pipeline impact. It also makes it harder to judge the timing of monetary policy moves around the business cycle with as much precision as we might like. Interestingly this is a problem that other central banks overseas are now also starting to worry about, though their economies are at an earlier stage in the cycle.
The collateral problem this caused was that as we tightened monetary policy, the $NZ looked increasingly attractive to offshore investors. This was by no means the only driver of $NZ strength (which in the medium term has been more affected by our terms of trade), but for a while it was a significant one. In particular, during 2005 we saw a strong demand offshore for uridashi & eurokiwi bonds denominated in $NZ.
Of course we might like to blame offshore investors for the resulting pressure on our trade-weighted index, but the other side of the account has been New Zealanders’ continuing demand for mortgage finance, and the banks’ willingness to supply it.
The impact of this boom on the household sector has been quite marked: as house values have risen, both households & banks have been keen to increase mortgages and leverage up financing. Householders feel richer (as indeed they may be if house prices stay high) and borrow & spend more off the back of that. And rather than diversify their wealth, they have been more inclined to invest further in housing – directly & indirectly.
Household balance sheets have more assets & more debt, so are much bigger in gross terms. They, however, look much less balanced because such a dominant proportion of their assets are held in housing, with a relatively small proportion of wealth held in equities, bonds & other instruments. This is in contrast to other OECD countries.
This is worth focusing on because the same phenomenon is happening to a large extent in the farming sector. Farmers are unusual because statistically they constitute both households that consume and businesses that produce, thus complicating analysis of balance sheets. But when we look at farms as a business we see some trends that look rather like urban households.
Farmers with strong pay cheques over the last 5 years have been responsible for some of the pressure on housing and on second homes around the countryside (one reason why this housing boom has been much more regionally diverse than the Auckland-dominated house boom of the mid-1990s).
In addition, agricultural land prices have been bid up significantly, a consequence partly of good commodity prices, partly of farm aggregation, partly due to productivity increases, partly due to Fonterra-supply effects and partly due to the availability of cheap credit. We have seen a strong period of lending to the farming sector. These are largely rational reasons why farmers might be willing to pay higher prices.
However these values are changing the nature of some farm balance sheets: it has become increasingly hard to try to rationalise prices paid for land using estimates of the future flow of income from the land.
Such estimates have always revealed a “rural lifestyle premium” for agricultural land, but this premium is now starting to look rather unrealistic. Higher prices for land have looked reasonable when compared to product prices in past years. Returns to farming were very good until 2003, as the unusual mix of high international commodity prices and a low $NZ combined to make farming more profitable than any time in the past 30 years.
But do high land prices today reflect the future income stream available from the land, or past effects? Farmers are effectively saying they expect good export prices to continue into the future. But for land prices to continue to grow at these rates requires improbably high increases in export prices & productivity. There appears to be a gap opening up between land values & expectations of returns. Future investment decisions should not be based on the expectation of ongoing double-digit growth in land values.
An important part of farming is the management of risks. At any time the sector needs to be able to withstand a combination of risks from poor weather, falling land prices, unhedged exchange rate pressures, trade restrictions, animal disease & falling commodity prices, especially in an environment of rising operating costs.
Agricultural lending, at about $28 billion, now represents around a third of registered bank lending to the corporate sector in New Zealand.
I should emphasise that when we examine rural sector balance sheets & bank lending exposures we do not see generic signs for financial-sector concern. The Reserve Bank’s Financial stability report suggests banks do not look over-committed in the agricultural sector and farmers are unlikely to renege on debt. What concerns us more is that we could be heading to a period of lower economic returns from over-investment in land.
At the moment the New Zealand economy is moving into a rebalancing period. A strong domestic sector is weakening, while the export sector is gradually strengthening, helped along by a softer $NZ. With our current account deficit over 9%, this is a rebalancing that has to take place. From an overall economic viewpoint, we are pleased to see it under way.
The big question for us is: will this rebalancing take place during a period of continuing strong world growth & good commodity prices? This is, of course, a complex question, but there is some reason to be optimistic – there is evidence that we may be enjoying not just one-off factors, but a better enduring trend in prices for our production than has been the case for some time. It is not quite the story of the 1960s again, but medium-term prospects do look better than the turbulent 1980s & 1990s.
19 July 2006: Bollard puts inflation attack in international context
Attribution: Bank release, story written by Bob Dey for this website.