James Lee is CEO of New Zealand investment and advisory group FNZC which has announced it will change its name to Jarden in the middle of the year.
A version of this opinion piece ran in the New Zealand Herald on 29 March 2019
Against a backdrop of global volatility and geopolitical uncertainty, and a couple of significant New Zealand specific issues, it’s shaping up to be an interesting year in our capital markets.
There are plenty of big topics to dominate the headlines. These include micro issues like whether the listed equity markets will give up recent gains, or macro issues like what the foreign exchange and interest markets will do around Brexit, China’s slow down or looming trade wars.
Looking at the state of New Zealand’s capital markets, we’re seeing a couple of significant issues emerging which, considering their combined potential impact, need real focus and analysis to quantify the impact on our economy.
Discussions currently underway on the merits of the proposals from Sir Michael Cullen’s Tax Working Group and the changes at the Reserve Bank proposed by Governor Adrian Orr, have potential to impact both the short and long term market environments in New Zealand.
These are structural issues that change capital formation – not just cyclical ones that impact short-term profits.
Both proposals have their origins in an economy where for some time the housing market was going up and up. But given house prices are cyclical – and the latest cycle in New Zealand of them rising appears to have faded – these proposals need to be carefully re-considered in this new market environment.
Likewise, the timing of implementing not just one, but two such significant proposals – against what is markedly different economic backdrop to when they were initially considered – should be enough to give pause.
Does the inherent problem we were originally trying to fix still remain once these two proposals take effect? What are the anticipated or unanticipated structural consequences of the proposals, particularly in terms of capital formation in New Zealand?
We think the potential impact to the economy from each proposal may lead to a fundamental change in capital formation, structurally changing the cost of sourcing debt and equity.
Capital formation is how an economy uses equity and debt in conjunction with ideas and people to grow. In turn this determines tax revenue, the availability of new jobs, funding of new ideas, and replacement of our infrastructure. It’s a critical agenda item for a nation to get right.
An entrepreneur borrowing against their house to start a business, a developer borrowing to subdivide, a company issuing new shares to fund an acquisition or a government issuing infrastructure bonds to fund a new light rail network – these are all examples of capital formation in action.
When capital markets are efficient and working well, they connect users and suppliers effectively, lowering the cost of borrowing, and lowering the cost of sourcing equity.
Getting the combined cost of debt and equity as low as reasonably possible, is ultimately the core purpose of a capital market. That combined cost is called a company’s cost of capital because the less expensive it is to raise money, the easier it is for a company to invest, take risk, build factories, make acquisitions and grow.
The Reserve Bank’s announcement that it would like to create a safer banking system is noble. But before we seek to make changes the question must be asked – how unsafe is our current system?
By changing the capital requirements and other rules, as the Reserve Bank is proposing, banks will need to accept lower returns and less growth. Invariably this has two impacts: the cost of borrowing goes up while the availability of funding declines.
This affects every person and business who uses capital because the suppliers of debt capital will have less to provide and it will be more expensive. This directly increases the cost of capital across the New Zealand economy, lowers the investment, and ultimately reduces capital formation.
Given the rapidly changing housing market in Australia and the change beginning to be seen in ours, we need to seriously ask ourselves, are these outcomes the anticipated effects of the Reserve Bank’s proposal? Particularly in what could be a tough decade ahead, are we creating unnecessary pain for the economy by trying to do what we thought was the right thing in a previous cycle?
Perhaps the right thing to do now, instead of pushing ahead, is to retest the assumptions that led to the proposal in the first place.
If this kind of structural change proposed by the Reserve Bank was to happen in isolation, we would likely see people gradually shifting from debt to equity for funding.
But at the same time, on that side of the market, the Tax Working Group’s suggestions are set to have a direct impact on the suppliers of equity capital.
By taxing small business owners, KiwiSaver providers, farmers and start-up investors on capital gains, it will lower the availability of capital and increase the return requirements of investor. This directly increases the cost of equity capital – at exactly the same time the cost of debt capital is increasing.
For a business today, the combined impact of these two changes are that debt will be harder and more expensive to source domestically, and equity capital is going to get more expensive domestically. Invariably this lowers capital formation and the cost of capital, which lowers growth within our country.
If the ultimate goal in our economic system is safety and fairness, we need to ask, on a global basis, how unsafe is our capital market, and we need to think seriously how these two proposals will impact the economy.
We believe strongly our country should be a fair and financially secure place to do business to help provide for this and future generations of New Zealanders. We would argue the best way to do that, is to grow the economy towards a common vision with clear rules of engagement. After all – no one has ever shrunk their way to greatness.
Looking at face value today, we believe the combined impact of these proposals has the potential to reduce capital formation at the exact time we are seeing the market they are aimed at impacting, already slowing.