Only two months ago I was writing that New Zealand bank deposits do not come with a money-back guarantee. Today they do, says Anthony Byett of fxmatters.

The guarantee provided by the government, which has the ability to print NZ dollars if need be, promises “due and punctual” payment to depositors of the major NZ deposit-taking registered banks and many other financial institutions as well, applying to principal and interest. But there are limits: the guarantee only applies to the first $1 million per person per institution, it excludes deposits of other financial institutions (wholesale deposits are treated separately) and the guarantee does not apply to any deposits after 12 October 2010 (irrespective of when the money was deposited).

The guarantee has not come cheaply for the four major banks. A crude estimate would put their collective fee to the government for the guarantee at more than $200 million over the next two years. The smaller banks (eg Kiwibank), building societies (eg Nelson Building Society), credit unions (eg United Credit Union) and finance companies (eg MARAC Finance) who have applied and been granted the guarantee do not pay this fee: except, that is, should they grow. Then they will be hit with a 0.1% to 3.0% per annum fee, depending on their credit rating, of net deposit growth.

Undoubtedly the scheme creates distortions, particularly around the start and the end of the guarantee period. All of a sudden the non-bank sector takes on more appeal to depositors, especially at present when the return for effectively a loan to government is higher through approved non-banks than money on deposit with a bank or money invested in government stock. But these excess returns are likely to disappear quickly once the non-banks start to actually grow. The most likely outcome is that very soon all approved institutions will be offering very low interest rates, the combination of current credit spreads disappearing and the rapid reduction of the benchmark cash rate by the Reserve Bank of New Zealand.

There is likely to be another knee-jerk reaction near October 2010 when funds leave the riskier non-bank institutions, thereby forcing their deposit rates to increase again. It would not be surprising to see any longer-term bonds issued by the riskier institutions falling in value at that time.

In the meantime, if you want higher returns then you cannot get away from putting your money at risk. This will still be possible with corporate bonds. It will be possible with deposits, debentures and bonds maturing beyond October 2010 amongst the non-bank sector. Then, of course, there are the wider asset markets.

The scheme will have spin-offs for the wider public, other than the obvious safer savings for many. It does create the opportunity for smaller financial institutions to prove themselves and hence, hopefully, create a more competitive investment sector long-term. It will also encourage banks to issue more bonds, with the potential to bring savings back onshore to the extent that investors who have invested in offshore fixed interest funds, having been fed up with the penalty fees associated with breaking term deposits, repatriate their funds.

There are risks to the scheme. For depositors there will probably still be isolated cases of delayed payment should default amongst small (or big) approved institutions come as a surprise. The scheme does not, by the way, prevent delayed payment because of  administration error. For the NZ public in general, there is the small but not insignificant risk that the government may have to meet its guarantee on billions of dollars. It would seem that the New Zealand government does see this as a great risk judging by Dr Cullen’s pre-election talk of putting accumulated fees into NZ Super come October 2010.