Govt's guarantee scheme headache

OPINION: Although there are encouraging signs that key economic and financial indicators may be showing the early signs of recovery, eagerness to see the corner turned is causing many to overlook some of the difficult legacies that events of the past two years will leave behind.

In New Zealand's case, one of the most problematic legacies will be that of the Crown's retail deposit guarantee scheme.

From an investor perspective, until October 12, 2010, when it is currently set to expire, the effect of the guarantee scheme is to separate default risk (the risk of a guaranteed company defaulting on its payments to investors) from loss-of-money risk (the risk that investors will actually lose money following a default event). For investors considering deposit options, the loss-of-money risk they face when investing with any of the 94 deposit takers currently covered under the scheme is the same no matter what the return on offer. In any such case, loss-of-money risk is ultimately backed by New Zealand's AA+ sovereign credit rating.

The effect of the guarantee scheme is therefore to remove from investors the need to undertake normal investment due diligence on companies that are covered under the scheme, and who they are considering depositing with. Investors need not concern themselves with demanding a return premium to compensate them for accepting greater credit risk.

While investors worked their way through what the guarantee scheme actually meant, significant market distortions began to emerge. In financial markets, distortion is simply another word for opportunity, and in this case the opportunity was for investors to profit handsomely from riskless price arbitrage. Smart or smartly advised investors quickly took advantage by securing substantially higher rates of return on fixed-term deposits, at no greater risk.

In the last quarter of last year, quick investors were able to secure a government-guaranteed return of more than 10% pa on a 12 or 18-month finance company debenture, almost double that on offer at the time from an equivalent, and also government-guaranteed, bank term deposit.

Predictably, retail money flooded back to the 28 finance companies now accepted under the scheme. Reserve Bank data shows that, in the final quarter of last year, household deposits in finance companies grew by a net $550 million, an annualised increase of more than 40%.

To stem the flow, finance companies turned to basic economics, responding to excess demand by reducing deposit rates. Rates on debentures maturing within the guarantee period have since plummeted to nonsensical levels, to the point where a number of second and third-tier finance companies are currently offering one-year deposit rates significantly below those available from the major trading banks. Some finance companies have stopped taking new money altogether.

Although true that pricing distortions like these are no more than short-term anomalies which will correct once the guarantee ends, it is what happens beyond the guarantee period that is now causing many finance companies the greatest concern. To protect liquidity, finance companies must take great care to match their lending and borrowing maturity profiles. With almost all new debenture deposits taken out during the 10 months since the scheme's launch timed by investors to mature within the guarantee period, very few finance companies currently have surety of liquidity beyond October next year. As a result, most finance companies are not writing any new lending beyond next October, which is already weighing heavily on domestic medium-term credit availability.

So what does all this mean? Firstly, it is important to recognise the often overlooked but fundamental importance of the role that finance companies play in New Zealand's lending mix. Because they are able to respond quickly and flexibly to borrowers, finance companies meet a need for credit that banks cannot, or will not, meet. In many cases, finance companies have been recently lending to borrowers that banks have in the past, but will no longer, lend to.

More directly, the Crown guarantee must go. Leaving it in place in its current form risks major long-term disruption to the logical order of efficiency, availability and pricing in domestic credit markets.

But the Crown faces a major problem in how to unwind the scheme without itself disturbing credit markets. The cold turkey option of simply not continuing the scheme in any form beyond October next year would be very high risk.

To do so would likely result in major disruption to domestic credit availability, and could quite possibly result in another wave of finance company collapses as companies find the inevitable exodus of investor funds that would follow unmanageable. With the Australian guarantee scheme already extending a year beyond that of New Zealand's, there is also a broader capital flight risk, which has the potential to significantly and negatively impact all local deposit takers.

How the Crown is able to unwind the scheme while ensuring minimal disruption to financial markets will be one of the government's key policy challenges over the next few months, and probably years. Irrespective of how exactly this unfolds, the ongoing silence from policymakers on how they propose to deal with the October 2010 expiry is already resulting in serious and increasingly urgent concern among lenders and those that rely on funding for their businesses.

If the current uncertainty continues, ironically it will be the guarantee scheme itself that ends up presenting a continuity threat to domestic credit markets and, ultimately, the speed with which the real economy is able to recover.

John Kidd is head of research with sharebroking and investment banking firm McDouall Stuart Securities.

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