BNZ economists warn that economy is at an inflection point; businesses must consider 'a variety' of scenarios in order to be aware of the risks to their operations

BNZ economists are warning businesses that at the moment they need to be aware of a "variety" existing scenarios that could pose risks to their operations.

In an "Economy Watch" note, titled: Focus on Risk Management, BNZ's head of research Stephen Toplis said the fact that the Reserve Bank would be raising interest rates "significantly" over the next year or two suggested that borrowers needed to "do some serious risk management around their debt".

"This is not to say that all and sundry should rush out and fix their borrowing rates, as fixed rates are already pricing in a significant increase in the cash rate. But understanding interest rate risk at this juncture is a must."

Ultimately, he said the extent of future rate increases would be be highly dependent on the combination of the movements in the New Zealand dollar and commodity prices.

"And we stress that it is the combination that matters, not just one or the other."

Toplis said the RBNZ was assuming that its Official Cash Rate would rise steadily to around 5.25% by March 2017 and that the New Zealand dollar would gradually falls back in value to a Trade Weighted Index level of 75.3 (from a current level of 80.9) over the same period.

"This is the nirvana scenario, and we all know that nirvana and reality are rarely the same thing.," Toplis said

There were, he said, two "very plausible" alternatives to this scenario that should be contemplated "by all".

"Firstly, it should be recognised that New Zealand commodity prices (in aggregate) appear to have peaked. In particular, the GDT (GlobalDairyTrade) auctions have already revealed a 20% drop in prices over the last twelve months. These prices only impact a very small proportion of current dairy sales as much of our production is sold forward at a fixed price. But, eventually, average prices will reflect the marginal prices revealed in the auctions. We not only believe that this will be the case but we are also anticipating significant further declines from current levels.

"And this is where things could, potentially, get very interesting.

"If investors in the New Zealand dollar fail to recognise the future impact of falling commodity prices on the currency but, instead, focus on all the relatively positive things about New Zealand, then the NZD could go from strength to strength. Against a backdrop of falling commodity prices this could mean only one thing – a lower interest rate track."

Toplis said if this happens, then:

• There is less need for businesses to protect against rising interest rates;
• Exporters will need to contend with more pressure on returns (and/or hedge against it);
• Importers will be dancing in the streets;
• The New Zealand economy will become increasingly imbalanced as domestic demand is supported by low interest rates while exporters suffer; and
• The housing market will get even more overvalued.

But he said "equally plausible" alternatives should also be considered.

"It may well be that international investors, who already see the NZD as overvalued, react quickly to further news of commodity price declines and then rush to sell it such that it drops precipitously, in a very short period of time, forcing the Reserve Bank into raising interest rates much more aggressively than currently believed possible."

Under this scenario, Toplis said:

• Importers need to be very highly hedged to protect against cost increases;
• Exporters should be totally unhedged;
• Holders of debt should be fixing aggressively; and
• Homeowners should be prepared for house price falls.

"We too, have adopted a fairly nirvana-like central scenario for our forecasts," he said.

"But when an economy is at a point of inflection, as ours currently is, then we cannot stress enough that a focus on risk management is very important.

"It is imperative, at this juncture, that businesses contemplate the potential impacts of a variety of alternative scenarios in order to, at least, be aware of the risks to their operations and, when possible and appropriate, mitigate them.

"Any business can make money when times are good and there is no volatility. The real winners, however, are those that effectively manage change in a manner that allows them to maximise risk-adjusted returns across the economic cycle."