Rants, Raves, Reviews

The Economy will Crash and Burn

By Gary R, in , posted: 17-Apr-2007 13:28

I am not an economist and do not necessarily understand all the workings of the NZ economy merry-go-round but I do understand this:

1. We have the highest interest rates in the western world. This means an influx of overseas money earning a fantastic return.
2. Money is so easy to obtain I have banks, credit card companies and private financial companies wanting to throw money at me every day
3. The exchange rate is at a two year high so imported goods are getting cheaper and exporters are suffering
4. Government spending is accelerating and it is debatable whether or not we are getting good value for money.

The Reserve Banks says that as consumers we are spending too much money and the housing market must be cooled. The government says that tax cuts proposed by National would fuel inflation more than Labour welfare packages such as Working for Families.

And I am the piggy in the middle being played as a pawn by both the Reserve Bank and Labour. Consider this:

Because we are a small economy most of the goods we purchase are imported. The more imported goods we purchase the bigger the imbalance between what we export (earn) and what we import (spend). For example each time petrol goes up in price this has a negative effect on the balance of payments.

The more money the government spends the greater the pressure on monetary policy which also has a negative effect on the exchange and interest rates. Because we are competing in a global market our goods become more expensive and exporters either take it on the chin and maintain prices to compete or they increase prices to offset the increased cost of money and lower returns, either way they lose sales which forces a rationalisation and job lay offs.

As a consumer the Reserve Banks says that I am spending too much but the high exchange rates means cheap goods (especially electronics) so every one can now afford to own a PC and an LCD TV. My own spending increases because basic necessities like a mortgage, rates, petrol, electricity and food keep rising in price. The effect for me is that each week more and more of my diminishing financial resources are spent to feed the family and provide the necessities of life so my increased spending is not some materialistic consumer rampage it is mearly required to keep my family and I clothed, fed, housed, mobile and warm.

Apparently I am also a naughty boy for being 'obsessed with housing'. Yes, I do have two houses, one is a rental so I am apparently (in part) responsible for the economy and where it is. But consider this:

On one hand the Reserve Bank has increased interest (and probably more rises are due soon) to incredibly ridiculous rates because I am obsessed with housing and need to be reigned in. On the other hand we have a government that wants to throw money at people so they can get into their first home. Then we have the analysts telling us that home affordability is at a record low because house prices keep rising due to immigration and other factors. We are also told that people such as myself are too highly geared to property and that we do not have enough money in the bank. It seems that the only 'weapon' our lame Reserve Bank has to reign in inflation and naughty people like me is to raise interest rates to even more ridiculous levels. Luckily for me I saw what was going to happen sometime ago and fixed my interest rates for a long time but if I was coming off fixed interest rates in the next few months the net effect could be this:

Just suppose that the Reserve Bank increases the wholesale interest rate by .75 percentage points over the next few months the interest that banks charge me would increase to (just a guesstimate here really) say 9.5% fixed for two years. The effect to me would be an increase of 18% p/week that I have to pay in interest alone compared to what I pay now. This increase would actually make me hit the wall financially, there is no way I could afford it. Now I can see where this is leading:

People would need to sell their houses and the market would become flooded. Buyers would be reluctant to pay high interest rates and there would be an excess of houses on the market, sellers will have no choice but to reduce their asking price. Property values would drop meaning that lots of honest hard working kiwis would suddenly be put under pressure by the banks to sell because they could no longer afford the repayments and because debt to equity levels would become dangerously skewed in the wrong direction. Effectively this is a negative equity situation where your house is worth less than what you owe the bank. In these extreme situations banks would force mortgagee sales to get their money back and you will end up with nothing.

And what would I do? Quite simply I would buy more housing because there will be bargains and if people who are too highly geared are forced to sell there will be even more of a glut of renters looking for places to live. Every rental property I add to my portfolio means less tax that I have to pay which is great for me. At some stage the housing market recovers and prices start to rise so I sell my rentals and reap the tax free capital gains. Of course I do have to pay some money back to the government from being negatively geared but what the hell someone else is paying most of my mortgage.

Slapping me a wet stick is not going to change my habits but if I or others do hit the wall financially because of the increased interest we will be knocking on the door of a government welfare agency looking for a hand out. The more money the Reserve Bank and Labour take off me the less money I have to clothe, feed and house my family.

I believe that if Labour wants to cool our economy they should start by setting the example and curb their own spending. They should also be considering what down stream effect election lolly scrambles such as interest free student loans, Working for Families and first home grants actually have on the economy overall for all New Zealanders not just the few who directly benefit.

I am a realist, the government will not look after me in my retirement so I have no choice but to do this myself. I just want Labour and the Reserve Bank to stop punishing me because I am building a secure financial future for my family through property.

The economy is like a car - Labour are hard down on the accelerator, the Reserve Bank is trying to pump the break while I am strapped to the ball bar and that brick wall in the distance is getting closer and closer. Sooner or later there will be a crash and hopefully I will be able to get up, brush myself off and walk away.

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Comment by Grant17, on 17-Apr-2007 14:45

You've raised some interesting points here Jama, and not being involved with rental property myself, I'm keen to understand a little more as to your rationale:

1) I presume you own your rental property through an LAQC or similar arrangement where any losses may be offset against your personal income, thereby reducing tax.

2) In doing this, you (or your accountant) have to calculate the net shortfall i.e. the amount by which your received rent fails to cover mortgage interest, rates, insurance, maintenance etc.

3) The bottom line is that you have a monthly loss of $X which is used to offset other income, thereby reducing your tax by 39% of $X (assuming you are earning more than $60k per year).

4) However, the other 61% of the loss has to be borne by you out of your after-tax income.

In the past few years where house prices have kept going up year after year, that hasn't caused any problem; your loss has been covered several times over each year by the capital gain.

However, we now have a double-whammy where interest rates are at very high levels and therefore house prices are unlikely to keep rising, in fact they may even fall. Many people have been pointing this out for a few years, and as you put it: "the brick wall in the distance is getting closer and closer".

If there is a price crash in the housing market, and you buy another rental property at a "fire sale" price, wouldn't this just be digging you deeper into the hole?

If such an investment was cashflow-positive from day one, I could understand your thinking, but it would take a tremendous reduction in housing prices for that to occur, given that rates, insurance and interest rates keep going up relentlessly year after year.

Because of net-positive immigration, house prices are unlikely to fall substantially any time soon, perhaps never. Yet all the while, interest rates keep rising and now they are saying that perhaps the Kiwi $ will remain high for several years.

This is of great concern, especially to exporters. The only thing I know for sure would help the situation is if the government curbed their spending, as you say. Yet they are unlikely to do this, because they are desperate to retain power at whatever cost.

As a borrower, you are caught between a rock and a hard place right now, and I share your concerns.

Author's note by Jama, on 17-Apr-2007 15:47

Yes through an LAQC vehicle. You can also claim depreciation of chattels, travel (checking on the property once a fortnight), having the lawns mowed, etc. Everything that is an expense. The downside is that the claimed depreciation must be paid back to IRD if and when you sell the house. There are ways around this for example you can sell the LAQC shares to a family trust (preferably once it is profitable) as ownership in the property does not change just the shareholding in the company. This way you avoid paying back the depreciation to IRD but you lose the benefits of an LAQC hence why you should wait until it is profitable. Of course talk to your accountant first and do not take what I am saying as being completely correct...

From my perspective I have a big mortgage but I own a lot of equity in my properties so if I purchase a property at a fire sale price I simply tighten the belt further and suck up the loss for the first year until I get my tax rebate. The first year is the hardest. The gain for me comes from an eventual rebounding property market. I am not after a quick return I am following the cycle of the property market. Buy low sell high or something...

Comment by NadNailer, on 17-Apr-2007 16:09

Great post! You are exactly right on pretty much everything in your post. Except one.

"I just want Labour and the Reserve Bank to stop punishing me because I am building a secure financial future for my family through property"

There is risk investing in property when utilising leverage. When you took on debt, you accepted the risk that interest rates may rise. By blaming the Reserve Bank for making your life more uncomfortable, you are ackowledging that you are not taking responsibility for the risks that you accepted.

In fact the Reserve Bank is probably helping you in the long run. House prices cannot march on forever. At some point they will flatten out. When the flatten out, if inflation is still high, the real value of your investment with reduce, because inflation is eating away at it. House prices may not nominally reduce, but inflation will ensure that they do.

The other side of the coin is that higher interest rates reward savers. Anyone with a predominantly fixed income portfolio (term deposits, corporate and gov bonds) will be cheering the rate rises. Inflation is the enemy of savers. Higher interest rates means more interest payments and lower inflation.

When interest rates start to decline, the stock market investors will be happy too.

If I were you, I'd be most worried about the government removing the tax benefits that you currently enjoy from being negatively geared. There's not too many investments where you get rewarded for making a loss. Perverse as it is.

At the end of the day, invest in a wide variety of assets and you'll always have something to be happy about, and you'll never have to fear change.

Author's note by Jama, on 17-Apr-2007 16:23

Thanks NadNailer you are right! Hence why I fixed for a long time. I hope to ride out the storm. Before owning property I rented but had a huge amount of money invested but it annoyed me that I had to give the government 33% of every interest dollar earned. I was earning so much interest that I was effectively living rent free! Oh well I have tried everything really - unit trusts, shares, gold, fixed term, on call and now property.

Comment by mistywindow, on 17-Apr-2007 16:43

Any responsible government (contradiction in terms?) would:

1. enforce current law regarding tax on capital gains;
2. introduce crystal clear capital gains tax on property other than the family abode;
3. screw down on the crazy consumer credit - require a 20% deposit for all consumer purchasing and no payment holidays;
4. stop non-residents buying land;
5. slash government spending except on research and development;
6. give big tax cuts on the one hand but take it back on the other with compulsory super contributions;
7. require employers to contribute to the compulsory super, which impost would be partially offset by lower interest rates.

It ain't gonna happen and we are heading for big trouble which will be exacerbated by the rapidly growing global concern about "food miles".

Importing people and exporting jobs is not smart.

Comment by juha, on 17-Apr-2007 16:44

I wouldn't worry... people have been saying for the past six-seven years that the market would crash.

It didn't.

The government is keeping net immigration high to stop this from happening, so unless Auckland house prices in particular and the rest of the country in general catch up with London and other areas where people come from, property will just carry on going up... and up... and up...

Kind of tough if you're young and starting out though, but I guess they can move to Australia or elsewhere, and come back when they can afford to live in NZ again.

Comment by Grant17, on 17-Apr-2007 16:51

Personally, I believe that investing in Local and Overseas Equity Markets is a more rewarding route to save for my retirement than via property, but that is just my preference.

I'm not saying that anyone should put all their spare cash into the equities, but given that most of us own our own homes in NZ, we have a substantial investment in the property market by default. I think it makes sense to diversify and spread your risk by also investing in a different asset class than property.

For anyone who has a mortgage, it is true to say that paying it off will be their best possible investment. How else could you earn 8% or more after tax without taking considerable risk? After the mortgage is paid off, they can sensibly look at other investment options.

I can understand why some people would not touch the sharemarket with a 40 foot barge pole. All I can say is that it has paid off handsomely for me. I have investments I can buy or sell with the click of a mouse and I don't have to worry about collecting the rent, arranging maintenance etc, etc.

Comment by Dave Green, on 17-Apr-2007 18:32

Ahhh I remember the heady days of 1987 when everyone said you couldn't lose on the sharemarket. Well, they said that before it all came tumbling down.

Here we are again and everyone is gearing themselves up with big debt to fund investment in property because... you can't lose on property investment. I am having a strange sense of deja vu.

The simple fact is that several big economies in the world (mostly Western) seem to be growing (and ours along with them) because of a huge property inflationary bubble. Unfortunately this is a false economy because, as you pointed out, we are spending more than we are earning and this is funded by debt. Sooner or later all those nice people who are loaning us this money are going to realise that our economy isn't big enough for us to pay it back. This very situation is just starting to happen in America, hence the big downward slide in the value of the US$.

I forget what the actual debt level each NZ owes, but its a hell of a lot more than it was 10 years ago. We have the biggest property bubble in the whole world, and are close to the world leaders in debt per capita.

Like you I can see the brick wall getting closer and closer. The longer house prices keep rising the less any of stand a chance of walking away unscathed. With the rising dollar we are actually earning less as a country than before, as our exports are worth less.

I hate to sound negative, but... it'll all end in tears :-)

Author's note by Jama, on 17-Apr-2007 18:54

Yes - I lost on the sharemarket in 1987 - remember Equiticorp! I have since invested in the sharemarket again with mixed results. At least with housing everyone needs some where to live, nobody needs to own shares.

Comment by sbiddle, on 17-Apr-2007 19:02

NZ's monetary policy is seriously flawed. Anybody who's done basic enonomics will tell you that.

The scary thing is a lot of people in NZ stand to loose a lot of money when (not if) the crash happens. It is coming. Like it or not.

Author's note by Jama, on 17-Apr-2007 19:06

Yes - I lost on the sharemarket in 1987 - remember Equiticorp! I have since invested in the sharemarket again with mixed results. At least with housing everyone needs some where to live, nobody needs to own shares.

Comment by Bob Rolland, on 17-Apr-2007 19:17

First off, your post is though provoking.

If I were you I'd sell up now while prices are high before what you suppose might happen happens. Then buy again when it does.

I'm not an economist either, but I wonder why the government hasn't enacted legislation to encourage an increase of supply in property?

One thought though. The Reserve Bank interest rate hikes don't just effect property owners. No matter what its target is, the interest rate effects all users of credit.

Comment by antoniosk, on 17-Apr-2007 19:54


We get it - you lost in Equiticorp (like some of us others as well!)

Good article btw. Voting National then?

Author's note by Jama, on 17-Apr-2007 20:20

Thanks A - yes and of course I will be voting National.

Comment by freitasm, on 18-Apr-2007 08:07

Or this: http://www.kiwiblog.co.nz/2007/04/1000_extra.html

Comment by KevDaly, on 18-Apr-2007 08:45

Actually, there's another reason the economy will crash and burn: the rest of the world is likely to increasingly embrace "buy local" campaigns, which for a country that basically exists to ship agricultural produce long distances is a disaster.

Time to evacuate.

Comment by juha, on 18-Apr-2007 18:22

I thought this story from Business Week would amuse (and maybe lead to another blog post).

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