Mr. Brash points out some positive aspects of New Zealand's situation in the world economy  (Central Bank Articles and Speeches, 26 Jun 98)
Central bank: rbnz | Type: speech | Date: 1998-06-26

## Mr. Brash points out some positive aspects of New Zealand's situation in tAddress by the Governor of the Reserve Bank of New Zealand, Dr. Dona world economy Brash, to the Construction Liaison Group in Wellington on 26/6/98.

## IntroductionOver recent months, there has been a great deal of negative economic news countries

as diverse as Italy and Japan, GDP data for the March quarter have been suggesting economic activity is slowing down.

Growth in industrial production in countries which we monitor most closely in preparing our own economic forecasts was pro to be just 0.1 per cent in 1998 in the June Consensus Forecasts, a significant fal increase of 3.8 per cent expected last November, and even a fall from the 1.0 per cen expected as recently as last month.

Financial markets have been extremely turbulen particularly volatile trading in the foreign exchange market and some equity markets. the world economy going, and how will New Zealand be affected?It is always risky being too definitive in answer to questions of this kind in reality nobody can know the answers with any confidence.

But it is particularly dan give answers at this time.

If one suggests that the world economy is in for a very roug New Zealand with it, one is accused of undermining confidence and making the situation If one points out some of the positive aspects of New Zealand's situation, one is accus hopelessly unrealistic.Today I will try to be totally realistic.

You may not agree with me, but I gild the lily.

## The implications of the situation in Asia are serious for New ZealandIn our December 1997 Monetary Policy Statement, we estimated that growth our trading partners would average 1 per cent less than otherwise over 1998/99 due to t in Asia, and in releasing that document I commented that the most obvious risk to our projection

was that the difficulties in Asia would turn out to be even more seriou assumed at that time.In the intervening six months, the situation has indeed become markedly w Whereas in November 1997, the Consensus Forecasts projected Japan's industrial product grow by 1.6 per cent in 1998, the comparable estimate in June 1998 is minus 4.0 pe Whereas in November 1997, the Consensus Forecasts projected Korea's industrial producti grow by 8.2 percent in 1998, the comparable estimate in June 1998 is minus 7.8 pe Whereas in November 1997, the Consensus Forecasts projected Indonesia's industrial prod to grow by 6.9 per cent in 1998, the comparable estimate in June 1998 is minus 13.3 p Japan's banking system is under severe strain, and this is hampering the recovery economy.

The same is true in many of the other countries of Asia.

A number - potentiall number - of banks will fail unless the governments of the countries concerned are wi able to support them.

Even those countries which have strong banking systems, such a Kong and Singapore, face very sharp slowdowns in economic activity and possibly recess 1998.

So the economic situation in Asia has deteriorated significantly in recent months get much worse yet.With the exception of Japan, Korea and Australia, New Zealand has a big exposure to Asian markets than does any other OECD country.

In 1997, some 36 per cent o total exports went to the countries of East Asia.

In that year, Japan was our second la market, and Korea our fifth largest market.

Of our 10 largest export markets, six were Asian area last year, or seven if Australia is included.

And Australia itself has a hug the markets of Asia, which means that we have a further indirect exposure to those through that country, now easily our largest single market.

Of the tourists who vis Zealand in 1997, over 30 per cent came from East Asia.This substantial involvement in the markets of Asia has been of great ben New Zealand in the past, and will be of great benefit to us in the future.

But right no is also our headache.

In the three months to April, for example, our exports to Korea 48 per cent compared with the same three months in 1997, while exports to Indonesia wer 69 per cent.

Some commodity exports, such as logs and deer velvet, have been particula hit.

This has had a severe impact on some industries and some regions.Moreover, there are other risks.

If the Japanese economy moves deeper recession, and the Japanese yen resumes its fall, there could be further downward pr other currencies in the region, as well as political pressures to build protectionist b other markets.

Or, because of Asian difficulties or for some other reason, the US equ could turn down sharply, triggering an abrupt slowdown in the United States economy.

As in releasing our May Monetary Policy Statement, it is not at all difficult to circumstances where the New Zealand economy grows more slowly than projected.

Indeed, possible to imagine scenarios where the world economy at least is quite weak.

The environment is not good, and could get markedly worse.To complicate matters still further, New Zealand enters this period of inter turbulence with a balance of payments deficit exceeding 7 per cent of GDP, and a nega international investment position (overseas assets less liabilities to foreigners) of cent of GDP, both high figures by international standards.

## But we have many strengthsSo we face serious challenges.

But having established that I am fully aware fact, allow me also to note some of the advantages we have in dealing with those challeFirst, while a little over one-third of our exports go to East Asia, almost do not.

And many of those other markets continue to grow strongly at this stage.

In months to April, New Zealand's exports increased by nearly 30 per cent to the United St third largest market) as compared with the same three months in 1997, while those to and Italy increased by more than 50 per cent.

Even exports to some parts of East Asia during that period - to Hong Kong by 29 per cent and to Singapore by 27 per cent.

Whil arrivals from Korea in the month of May were down 89 per cent as compared with the earlier level, and from Thailand by 64 per cent, overall visitor numbers were down on cent as a result of increases in tourists from the US, Britain and Australia.

Our ex tourist operators are showing considerable ability to switch from weak markets to more markets.The decline in the New Zealand dollar against the currencies of the United and Europe has greatly helped in this re-orientation of our markets.Secondly, we go into this period of international turbulence without the over-inflated asset prices which have been such a serious problem in many of the coun Asia, and which were such a serious problem in Japan in the late eighties and early nin the pricking of these asset price bubbles which has often done so much damage to b sectors and, as a consequence, to the real economies of the countries affected.

Yes, times lamented the high prices paid for both houses and rural land in New Zealand. convinced that some of these prices reflected unrealistic expectations of future inco But the extent to which these prices got out of line with long-term trends was relati compared with the inflation in asset prices in some of the countries of Asia.

We unlikely to see the 60 to 80 per cent fall in such prices which have been common else the Asian region.

And we have not (in the last few years) seen 'price bubbles' commercial property or equities.Of course, in part, the absence of significant asset price bubbles in New Ze a direct result of the fact that monetary policy here was leaning hard against i pressures throughout the middle part of the decade.

While that attracted a great deal at the time, it now means that we don't face the painful adjustments which inevitab when asset price bubbles burst.Thirdly, and related in part to the substantial absence of asset price bu have a banking sector which is arguably as strong and as competitive as at any time Zealand's history.

This is in marked contrast to the situation in all of the troubled Asia.

Indeed, the troubled countries of Asia are in an important sense defined as those banking sectors are in serious trouble.Fourthly, we go into this period of turbulence with a ratio of net public s to GDP of only some 25 per cent, less than half the level as recently as 1992.

This rat the lowest in the OECD.

While the Government does owe some of this debt to foreigner foreign currency component of the public sector debt is exactly matched by foreign assets, so that the Crown has no net foreign currency debt at all.

As everybody Government has been running fiscal surpluses for the last five financial years, and is b continue doing so for the next three years.

This clearly gives the country considerably to manoeuvre than if we were already running substantial fiscal deficits.And perhaps most important of all, New Zealand has a floating exchange regime, and has had since March 1985.

This has two hugely important implications.

F means that the value of the New Zealand dollar adjusts day by day and month by mon supply and demand change.

This in turn means that, if there is a perception that New Z in a difficult period, for whatever reason, the New Zealand dollar tends to fall in va versa).

This tends to offset some of the impact of a weaker international environment. precisely what has happened over the last year or so, with the New Zealand dollar down peak by some 28 per cent against the US dollar and by 17 per cent against the Trade-W Index (TWI).

As a result, though the average world price of the commodities that New Z exporters sell declined by 10.8 per cent over the last year, the New Zealand price of t actually rose by 9.3 per cent over the same period.Furthermore, having a floating exchange rate regime - one where everyb understands that neither the Government nor the central bank will interfere in th exchange market to prop up the value of the dollar - strongly discourages banks and cfrom taking on unhedged foreign exchange liabilities.

This means that when the New Ze dollar moves substantially, as it has done over the last year or so, neither banks no incur the huge losses which have been commonplace in countries which have been force abandon fixed exchange rate regimes. 1 To the best of my knowledge, there has been nothing which could be called a foreign exchange crisis in any country with a floating exch regime since 1945.In a recent editorial, the Christchurch Press suggested that 'New Zealand is out in the economic storm this week - out in the storm without a hat or coat and with leaking'. 2 Certainly, the weather is getting rough, and may get rougher.

But in my own vi have good wet-weather gear and a sturdy four-wheel-drive vehicle.

## Should policies be changed?Are there things which Government should be doing to further assist the co weather the storm?

Clearly, one of the issues being focused on currently is the desi Government's cutting back on some of its planned increase in expenditure because of t that, with slower economic growth a possibility, the projected operating surplus may t deficit.To the economist, cutting government expenditure in a growth slowdown seem counter-intuitive.

Better, surely, to allow the 'automatic stabilisers' to work Government's operating position moving into a small deficit when the economy is in the of the cycle and into a surplus at the peak.

Moreover, there is quite a strong case longer-term considerations to determine fiscal decisions, in the light of considered about the appropriate size of the public sector in the context of Government's econ social objectives.On the other hand, it must be acknowledged that the Government's determinat to run fiscal surpluses throughout the cycle, and to achieve further reductions in net debt, has been one of the important reasons why foreign investors have been willing t New Zealanders' insatiable appetite for borrowing in recent years.

Should there Government fiscal response to the present situation, and should a fiscal deficit su emerge, the confidence of foreign investors could be somewhat undermined - with res upward pressure on interest rates and downward pressure on the exchange rate.1 Last week, the Government Statistician announced that the gross overseas debt of New Zealand bank corporates had risen by $20.1 billion during the year to 31 March 1998, to reach a total of $79.0 this increase, it was stated that $6.2 billion was on account of the increase in the New Zealand of foreign currency debt.

It was also noted, however, that the figures took no account of 'hedgi financial derivatives used by companies to offset potential foreign currency risk.' The signific note has almost certainly been missed by many commentators, because it is quite clear that all ba suspect most corporates, hedge their foreign-currency denominated liabilities in full or in subs Certainly at 31 March 1998, the four largest banks, which have been heavy borrowers of foreign f recent years, carried almost no foreign exchange risk on that borrowing.

This means that the incr New Zealand dollar equivalent of the gross overseas liabilities of the banking system as a res depreciation in the New Zealand dollar, included in the debt figures published by the Gove Statistician, will have been almost exactly matched by gains on the banks' currency hedges.2 The Press, 23 June 1998.Moreover, in recent years it has been possible to argue that New Zeal balance of payments deficit has been a result of investment exceeding saving in th sector; the public sector was more than funding its own investment activities th operating surplus.

In 1998/99, the budgeted operating surplus looks likely to be broad to public sector investment.

If the operating surplus turns out to be less than now perhaps because economic growth turns out to be slower than projected, it is possible t sector investment will exceed the operating surplus.

In other words, if the operating s out to be less than now budgeted, the public sector will be contributing to the payments deficit in 1998/99 for the first time in several years.If Government were to cut back on its own spending, this would further dam demand in the domestic (non-tradeable) part of the economy.

This would in turn permi further easing in monetary conditions without putting price stability at risk, leadin investment in export and import-competing sectors of the economy.

The economic benefit be faster reduction in the balance of payments deficit.

The economic cost would be growth in the domestic (non-tradeable) part of the economy.To the best of my knowledge, all commentators project a gradual reduction i balance of payments deficit over the next few years on present policy.

My own hunch is deficit will in fact reduce somewhat more quickly than any of the official projections that of the Reserve Bank) now suggest, as a result of the substantial fall in the real over the last 12 months and a decline in imports which may follow an increase in ho sector saving, in turn a result of a decline in house prices.

It is already evident bank lending to the household sector has slowed markedly in recent months.

Offsetting course, is the risk of further reductions in export volumes as a result of the prolon and the weakness in some of our export markets.At the end of the day, this decision about the trade-off between the s balance of payments adjustment and the strength of the domestic part of the economy m course, be a political judgement.Whatever Government chooses to do with fiscal policy, it is obviously impo to continue with the programme of microeconomic reform, which can play such an impor role in building on the competitiveness of New Zealand producers in world markets.

## What about monetary policy?It is my absolute conviction that monetary policy targeted at maintainin stability has a crucial role to play in the uncertain environment in which we now findJust

as policy aimed at price stability must tighten monetary conditi inflationary pressures increase, so policy aimed at price stability must ease monetary as inflationary pressures abate.And that is what the Reserve Bank has been doing for the last 18 months. much of 1997, before the Asian crisis became a present reality, we eased gradually fro of 1000 on our Monetary Conditions Index (MCI) in the December quarter of 1996 to ar 650 in the December quarter of 1997.

As it became obvious that the international envi was deteriorating, we allowed conditions to ease substantially faster, to around 250 o month.The MCI seeks to measure the effect of both interest rates and the exchang on the real economy, and so on inflation.

Perhaps not surprisingly, given New Zealand's of payments deficit and the uncertain international environment, the easing in conditions over the last year or so has been entirely in the form of a fall in the e Indeed, 90-day interest rates have actually risen somewhat over that period.

But ov easing which has taken place over the last 18 months is equivalent to a fall in 90 d rates of over 7 per cent with unchanged exchange rate, a substantial easing in any lan as it was the export sector which bore much of the brunt of policy tightening between e and late 1996, so it has been the export sector which has received all of the benefit, easing.Ten days ago I attended an interesting conference in Stockholm on the best of conducting monetary policy.

One of the papers at that conference 3 argued that, when the Swedish central bank became the first central bank to use monetary policy to try to m stable price level in Sweden in the 'thirties, it had the important benefit that Swedi employment were also maintained at markedly higher levels than was the case in other co at that time.We in New Zealand do not target a price level but we have been charged with responsibility of keeping inflation tightly constrained below 3 per cent and above 0 pe does not imply that we can eliminate the economic cycle.

The world is far too uncertain and the lags between taking a monetary policy action and the effects of that action a long and too variable. (This means, incidentally, that there is nothing which monetary do at this stage to affect the growth in GDP in the June quarter, which indeed is vir There is virtually nothing which monetary policy can do at this stage to affect the gro in the September and December quarters.

As far as monetary policy is concerned, those are already substantially beyond influence.

Whether they are quarters of strong grow weak growth will be determined by a range of domestic and international factors, one of monetary policy in 1997.)But, provided we take our responsibility to keep inflation above zero as s as we take our responsibility to keep it below 3 per cent, monetary policy should b protect the economy from any prolonged deflation and the loss of output and employment that would entail.

We have spent much of this decade fighting to keep inflation below the target agreed with Government.

It is at least possible that, over the next year or be working to prevent it from going through the bottom of that target.

We will be a minded in that objective as we were in the earlier challenge.

Indeed, we have bee monetary conditions for more than a year with exactly that objective in view.Having said that, we also need to be mindful of the risks in ignoring the l with which monetary policy works.

If we ignore those lags, we run the risk of making e cycles worse.Alan Blinder, former vice-chairman of the Federal Reserve Board, sometimes u the analogy of the thermostat.

Who has not checked into a hotel room and turned up the because the room is too cold?

Then, after having a shower, turned the heating up som3'Pioneering price level targeting:

the Swedish experience 1931-1937', by Claes Berg and Lars Jo nung.because the room is still cold.

And finally woken up two hours later in a sweat, with like an oven.

It takes time for central heating to warm up a room.

It takes time for monetary policy to offset a sharp increase in deflationary pressures.

If we keep ea activity actually starts picking up strongly, we run the risk that in a year or two we w slamming on the brakes.

As we have sanctioned very substantial easing over the last have been conscious of this risk.

We have been conscious also that, with the sharp f exchange rate which has taken place, import prices may be pushed up, with a risk that t spill over into more generalised inflationary pressures.

We recognise that, even n confidence quite low among both businesses and households, there is a strong increase i in some parts of the economy, particularly in those parts of the manufacturing sector w benefited most from the fall in the exchange rate.In short, while we can not eliminate cycles in economic activity, we belie monetary policy aimed at price stability can smooth economic cycles to some degree.

This that when inflationary pressures increase, we can be relied upon to tighten.

It means inflationary pressures fall away, perhaps because of a sharp deterioration in the i environment, we can be relied upon to ease.

It certainly does not mean, as some comme have asserted, that we operate in some kind of strait-jacket which requires us to economic activity at every opportunity.

Monetary policy aimed at delivering predicta inflation enables the economy to maximise sustainable growth and employment opportuniti

## ConclusionThe sharp downturn in many of our major export markets may well turn out to the most serious shock to hit the New Zealand economy since the oil shocks of the 'sev so, the benefits of recent economic reforms, in reducing public sector debt and impr flexibility and adaptability of the economy as a whole, will be evident for all to see policy aimed firmly at price stability is of enormous benefit in weathering the storm.*

* *NB This BIS Review is available on the BIS World Wide Web site ().\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_