Mr. Brash addresses the concern about New Zealand's balance-of-payments
Address by the Governor of the Reserve Bank of New Zealand, Dr. Donald T. Brash, to the
deficit
Canterbury Employers' Chamber of Commerce in Christchurch on 30/1/98.
Introduction
I am delighted to be addressing you once again, on the last Friday of January. If my
memory is correct, this is the fifth year in which I have done this, and I appreciate your tolerance in
inviting me back each year. On previous occasions, I have addressed a range of issues, often relating
to the exchange rate and to the question of whether monetary policy was too tight or too loose.
Today, I want to focus on one particular subject. Over the last few weeks, there has
been heightened public concern about New Zealand's balance-of-payments deficit, triggered at least
in part by media reports of comments made by the International Monetary Fund in the context of their
recent review of the New Zealand economy. And this public concern is hardly surprising: at 6.4 per
cent of GDP in the year to September 1997, New Zealand's current account deficit is already one of
the highest in the world. The Reserve Bank's latest projections have that deficit increasing further to
nearly 8 per cent of GDP in the year to March 1998, a level comparable with that in the crisis year of
1984, and closely similar to the deficit in Thailand's balance of payments before its mid-1997
difficulties. Moreover, our current account deficit is adding to a net stock of external liabilities which,
at some 80 per cent of GDP, is already probably the highest of any developed country.
So the questions I want to address today are, first, do large current account deficits
matter? And secondly, if they do matter, what should policy-makers seek to do about them?
Do large current account deficits really matter?
There are a number of well-respected economists who argue that large
balance-of-payments deficits are not something for policy-makers to be concerned about. They argue
that a current account deficit is simply an indication that investment being undertaken in New
Zealand exceeds the savings of New Zealanders and that, since the public sector is running a surplus,
this excess of investment over savings simply reflects the decisions of countless individual New
Zealanders in the private sector to borrow (or raise equity capital) to finance investment. In the longer
term, this process will be self-correcting as either New Zealanders decide not to take on additional
debt or foreigners decide not to extend additional credit. This view, in which the balance of payments
is expected to adjust relatively smoothly, without the involvement of governments or central banks, is
taken by such eminent economists as Max Corden and John Pitchford in Australia and Milton
Friedman in the United States.
Even economists who do not take quite such a sanguine view of current account
deficits as that concede that deficits are of much less concern today, with a floating exchange rate and
the virtually complete abolition of the distortions which previously affected the allocation of
investment, than was the case, say, prior to 1984. At that time, deficits were often the result of
substantial fiscal deficits and had to be covered by government borrowing overseas in foreign
currency. Today, of course, the government's accounts are in surplus. So what causes the sort of
current account deficits that have recently provoked so much comment?
It is probably fair to say that today's deficit is in part the result of the enthusiasm
which foreigners have had for investing in New Zealand. Not, I should stress, because foreign
investment creates a current account deficit over the full life of the investment. On the contrary, I
believe it can be shown that, after taking all the direct and indirect effects into account, most foreign
investment in New Zealand actually tends to have a beneficial effect on the balance of payments.
Rather what I am saying is that, as foreign capital flows into New Zealand, it is matched by a current
account deficit.
In other words, if there is a net inflow of capital, there must of necessity be a current
account deficit. Because that is what a current account deficit actually means - it means there is a net
inflow of capital. If the current account were in balance, there would be no net capital inflow. If the
current account was in surplus, it would mean that there would be a net capital outflow. (Those who
say, and many do, that New Zealand needs an inflow of capital to finance its future development are
in effect saying that New Zealand must continue to have a current account deficit.) So in that sense,
part of the reason for our current account deficit is simply a reflection of the enthusiasm which
foreign institutions, companies, and indeed individuals have had for investing in New Zealand in
recent years.
Some of this foreign investment has been in the form of so-called direct investment,
involving a foreign company establishing a controlling interest in a New Zealand operation. As you
know, there has been a very large amount of investment of this kind going back over many years - in
banks, insurance companies, and manufacturing - while in recent years the rate of foreign direct
investment has, if anything, increased - in telecommunications, food processing, hotels, forestry,
commercial property, and transport.
In addition, there has been an increasing flow of so-called portfolio investment from
overseas - non-controlling investment in New Zealand equities, a huge investment in New Zealand
dollar government securities, and most recently a very large investment in New Zealand dollar
securities issued by overseas corporations and governments, the Eurokiwi and Samurai bond issues.
These Eurokiwi and Samurai issues have, through the swap market, provided New Zealand banks
with attractively priced fixed-term funding, keeping longer-term interest rates lower than they would
otherwise have been and making possible the recent rapid growth in the fixed interest rate home
mortgage market.
New Zealanders' enthusiasm for borrowing
But if this desire to invest in New Zealand on the part of foreigners had been the
whole story, we might have expected to see interest rates in New Zealand at levels equal to or even
below interest rates abroad, and asset prices - share prices in particular - at high levels by world
standards as the impact of the abundant overseas capital swamped our small economy and readily met
New Zealanders' demand for funds. Instead, while New Zealand interest rates have been very much
lower in recent years than would have been the case had there been no capital inflow, they have
tended to be higher than those in major capital markets, whether measured in nominal terms or in
inflation-adjusted terms. The prices of shares and commercial property have tended to increase more
slowly than those in many overseas countries. This suggests that, while foreign investors have been
happy to provide capital, many have done so because New Zealand has offered unusually attractive
yields. What is striking is the willingness of New Zealanders to pay those yields. At least part of the
reason must lie in a strong demand for additional funds within New Zealand.
To some extent this demand has reflected strong investment activity in the corporate
sector, as recent reforms have opened up profitable investment opportunities or have obliged
companies to invest in cost-reducing facilities to improve their competitiveness. There has also been a
strong cyclical recovery in investment spending after the 1991 recession. Strong investment spending
widens the current account deficit in the short-term, but as long as that investment turns out to be
profitable, any foreign capital tapped to finance it - whether in the form of debt, new equity, or
retained earnings - will create no problems. In fact, corporate balance sheets in New Zealand have
generally remained healthy after the stresses of the late 1980s and early 1990s.
But much of the demand for borrowed funds in recent years has come from the
household sector, and has been secured by that favourite New Zealand financial instrument, the house
mortgage. This borrowing has taken the ratio of household debt to household disposable income from
a relatively low 42 per cent as recently as mid-1990 to almost 90 per cent currently (Graph 1) - from
a level which was relatively low by international standards to around the levels of indebtedness seen
in places like the United States. It has also taken the share of loans extended to the household sector
from 31 per cent of total bank loans to 52 per cent of the total over the same period, an increase in the
dollar amount from $16 billion to $50 billion in just seven years. As Graph 2 illustrates, lending by
major financial institutions to the household sector has been growing markedly more quickly than
nominal GDP throughout most of this decade.
Some of the borrowing by the household sector has been undertaken as a relatively
cheap and efficient way of funding small businesses owned by the household sector, and to that
degree is 'mislabelled' as household sector borrowing. But for the most part, the rapid growth in
household indebtedness appears to have helped make possible the rapid rise in house prices seen in
much of the country in recent years and, as employment, incomes, and wealth have risen, strong
consumption growth.
Obviously, this sort of strong growth in lending to households cannot continue
indefinitely, but while it does there is likely to be pressure on our external accounts. Credit, after all,
is designed to allow us to increase our investment without sacrificing current consumption, or
alternatively to increase consumption now in the expectation of higher income in the future. Both of
these mean enjoying now a level of consumption beyond what is produced locally: and in simplified
terms, that is what a current account deficit is.
Other things being equal, a strong demand to borrow tends to push up interest rates. It
is those pressures which then draw in foreign capital. The capital inflow in turn tends to check the
extent to which interest rates rise in response to the strong borrowing demand.
The willingness of foreign investors to provide capital allows us, as a nation, much
greater flexibility in making our own spending and investment decisions. But of course, the foreign
investors expect to earn a return on the funds that they invest in New Zealand, and by using those
foreign funds we are taking on an obligation to pay interest or dividends on the capital used, just as
we do when we use funds from a domestic source. If we use the capital unwisely, then we
compromise our future prospects, and that is no different when talking about four million people as a
group than it is when we talk about people individually.
The lessons of Asia
The key issue at the moment is whether a current account deficit approaching 8 per
cent of GDP, well above the 5 percent of GDP sometimes regarded as being dangerous, should be of
concern. And the answer appears to be 'not necessarily'. Singapore ran a current account deficit
averaging 10 per cent of GDP for 20 years from 1965 to 1985, while Canada ran a deficit which
exceeded 5 per cent of GDP for most of the 43 years from 1870 to 1913.
But what about the recent lessons of Asia? What about the risk that foreign capital
might suddenly flow out again, with disastrous consequences for New Zealand banks, New Zealand
corporates, and the New Zealand dollar? Indeed, hasn't the New Zealand dollar already been dragged
down because of foreign concerns about our links with Asia?
Let me correct one misapprehension at once. Yes, as of the middle of this week, the
New Zealand dollar had declined by some 17 per cent against the US dollar since 1 January 1997, but
this is closely similar to the extent to which the Australian dollar had declined against the US dollar
over the same period (15 per cent), and was from levels at which the New Zealand dollar was widely
regarded as being significantly over-valued. In fact, virtually all currencies have depreciated against
the US dollar over the last year or so. This is simply another way of saying that the US dollar has
itself appreciated against virtually all currencies. By comparison to the 10 to 20 per cent depreciation
of most currencies, including the New Zealand dollar, against the US dollar, the currencies of many
East Asian countries have fallen very much more sharply - by 44 per cent in the case of Malaysia, by
50 per cent in the case of South Korea, by 52 per cent in the case of Thailand, and by 84 per cent in
the case of Indonesia. Neither New Zealand nor Australia has had an experience even remotely
similar.
It is worth looking briefly at some of the factors which have provoked recent
problems in Asia because understanding these factors helps in understanding why the sorts of vicious
corrections we have witnessed in Asia are not likely to happen here.
There appear to have been three factors in particular which caused what seemed
initially like a localised currency crisis in Thailand to spread so quickly to embrace many parts of
Asia:
* First, a serious lack of transparency in many Asian countries and markets,
which made it difficult for investors to assess and understand the risks they
were assuming, and which contributed to the speed at which confidence
collapsed as soon as bad news began to appear.
* Second, fairly widespread evidence of poor credit evaluation by banks and
other intermediaries, perhaps in part a result of the often-close connections
between governments, banks, and big business, and in part a result of
over-confidence and carelessness borne of decades of strong economic
growth. (Paul Krugman has suggested that the willingness of banks to take on
high credit risks was in large part the result of the perception that the
liabilities of banks were effectively government-guaranteed, and that the
moral hazard created by this perception was itself the cause of grossly
inadequate credit evaluation.)
* Third, the widespread maintenance of pegged exchange rates, which
compromised the ability of the countries concerned to maintain adequate
monetary control when faced with very large capital inflows, and which
seriously complicated financial management when problems began to emerge.
New Zealand different from Asia in several crucial respects
Of course, capital could flow out of New Zealand, and it would be a brave (or
foolhardy) central banker these days who would claim 'it can't happen here'. Foreign investors could
decide to sell-up and leave New Zealand, and indeed New Zealand investors could do likewise, in the
absence of any controls preventing them from doing so. But I don't think we are afflicted by any of
the particular Asian problems I have just mentioned.
To begin with, a rapid outflow of capital is very unlikely if the policy framework
remains sound and transparent and if those who are the recipients of the foreign capital inflow remain
creditworthy.
In that regard, there is no sign of the policy framework here being changed. Almost
all political parties are committed to the retention of the current transparent and independent
monetary policy framework, established without dissentient vote in Parliament in 1989. Almost all
political parties recognise the importance of continuing to run fiscal surpluses at this stage of the
demographic cycle, and the high level of fiscal transparency is simply not a political issue at all.
Almost all political parties are committed to an internationally open and competitive economy.
And as far as creditworthiness is concerned, one of the major 'borrowers' - to the
extent that foreign investors have bought New Zealand dollar government securities on the New
Zealand market - is the government itself. The government has become markedly more creditworthy
in recent years, as the ratio of net public sector debt has declined from around 52 per cent of GDP in
the early 1990s to some 27 per cent currently. In the private sector, banks have on average
strengthened their total capital position since the beginning of the decade, and all registered banks
comfortably exceeded both the tier 1 and total capital ratios prescribed by international agreement as
at the last date for which we have complete data (30 September 1997). All but two of the banks are
rated by one or more of the international credit rating agencies, with the four largest banks all
enjoying an S&P rating of AA- or better. In addition, of course, almost all the banks operating in
New Zealand have the backing of financially strong overseas parent banks. Among corporates,
balance sheets are probably as strong as they have been at any time in the last two decades. It is in the
household sector that balance sheets are probably becoming most extended, after seven or eight years
of strong borrowing, but international creditors are protected from potential bad debt problems in that
sector by the fact that the foreign capital which has, in effect, been lent to ordinary household
borrowers has been channelled through the banking system, and, as indicated, our banks are in robust
condition.
So there seems little reason for any sudden loss of confidence leading to capital flight.
Secondly, even if there were to be a sudden flight, leading to a sharp depreciation in
the New Zealand dollar, the result would be very different in one important respect from what we
have seen in some Asian countries in recent months. In those Asian countries currency weakness led
to very serious problems because, previously, as I have noted, currencies had been actually or
virtually pegged to the US dollar. This led borrowers to take on large unhedged US dollar liabilities
these looked very cheap at the time and, with the explicit or implicit guarantee that there would be no
currency depreciation, devoid of currency risk. When as so often happens the countries concerned
were forced to abandon their peg to the US dollar and the currencies fell sharply as a consequence,
the losses which both banks and corporates sustained were often huge, threatening many of them
with insolvency and collapse. (Indeed, the losses were magnified because, with sharply increased
liabilities expressed in local currencies, borrowers rushed to sell assets, which tended to push down
asset prices sharply as well.) These large losses in turn tended to further reduce investor confidence,
and accelerate the capital outflow.
By contrast, much of the foreign capital inflow into New Zealand has been either in
the form of equity investments, with no currency risk borne by the company receiving the capital, or
in the form of New Zealand dollar borrowings, by government and banks. The quarterly disclosure
statements published by New Zealand banks show that they have little in the way of unhedged
foreign exchange positions and, although I do not have detailed information on which to make a
dogmatic assertion, I would be fairly confident that the unhedged foreign exchange liabilities of New
Zealand corporates are very small. They have been operating for too long in a freely floating
exchange rate environment to be unaware of the risks, and indeed some still recall the losses they
sustained by borrowing in low interest foreign currencies in the 1970s and 1980s when the New
Zealand dollar itself was pegged.
A third point to note is that, if a capital outflow did occur, interest rates would rise
sharply as a result and it is very likely that the combination of sharply lower exchange rate and
markedly higher interest rates would quite quickly reduce the current account deficit. The Reserve
Bank might well be blamed for the sharp rise in interest rates, and to be sure we would not be at all
opposed to such an increase since if the exchange rate fell sharply a marked increase in interest rates
would be needed to keep inflation under control. But it is also true that, unless the Bank moved to
pump money into the economy aggressively, any sharp outflow of capital, whether owned by
foreigners or owned by New Zealanders, would necessarily result in a sharp increase in interest rates,
since those selling New Zealand securities and other assets would be forced to increase the yields
offered on those assets in order to encourage others to buy them.
In other words, with a floating exchange rate, investors (whether foreign or local)
wishing to sell out of New Zealand assets or the New Zealand dollar need to find private sector
buyers to sell to. The central bank is not going to be supporting the price of the New Zealand dollar,
or of New Zealand bonds, or of New Zealand shares.
And of course, although capital outflow can alter the price of assets, foreign corporate
owners can not take the land and buildings which they own with them. Those assets would remain in
New Zealand, with their ownership changing from foreign to local.
Whether or not an outflow of capital was 'painful' and disruptive would depend very
much on the magnitude and speed of the outflow. If, as seems quite unlikely, it happened on a large
scale and over a short period, the adjustment could involve markedly higher interest rates. Companies
exposed to interest rates and not benefiting from the fall in the exchange rate would be put under
pressure, and some might well collapse, notwithstanding their currently-strong balance sheets. This
would be part of the process of reducing the current account deficit, as resources were displaced from
domestic or non-tradeable parts of the economy and enticed back into exporting and
import-replacement industries. Household borrowers, especially those with variable rate mortgages,
could also face some very sharp adjustments to their spending patterns.
So the deficit is not a matter for alarm, but we should not be complacent.
So in answer to my first question, namely, whether our large current account deficit
matters, my answer is that it isn't a matter for great alarm at present. The deficit in part reflects
international enthusiasm for investing in New Zealand, and in part a judgement by many thousands of
New Zealanders that there are attractive investment opportunities in New Zealand which are worth
pursuing with borrowed funds (especially in the housing sector) and perhaps a judgement that future
incomes will rise sufficiently rapidly to support a higher level of consumption spending now. There
are market mechanisms which generally succeed in reconciling the intentions of individual
households and firms with the interests of the nation as a whole. Some other countries have
experienced similarly large deficits for years on end without ill effect, although it is not common to
sustain for too many years a large current account deficit, in a floating exchange rate regime, without
particularly high GDP growth rates.
Moreover, we are well placed to weather any capital outflow which might eventuate.
While a current account deficit of about the present size was associated with a foreign exchange crisis
in 1984, that situation was one where the Government was trying to maintain a fixed exchange rate
against a widespread belief that the exchange rate was over-valued. Today, with the exchange rate
freely floating and able to adjust, month to month and hour to hour, to reflect changes in demand and
supply, the situation is fundamentally different.
But we should not be complacent. The size of our accumulated external liabilities
does, as the IMF has suggested, make us somewhat vulnerable to unpredictable external shocks, or to
a sudden loss of confidence for whatever reason. It puts a premium on maintaining the confidence of
markets that New Zealand remains a safe place in which to invest, and means that the quality and
transparency of economic and financial sector policies are crucial. In a situation where much of the
capital inflow has, in effect, found its way into financing consumption, higher house prices, and
residential investment, rather than into much higher investment in directly growth-enhancing sectors,
we would be unwise to assume that we can sustain a deficit at around current levels indefinitely.
Much will depend on the rates of economic growth we are able to sustain: the results in recent years
have been encouraging, but to adopt a cricketing analogy, the innings is really just getting underway.
If we want to reduce the deficit, what needs to be done?
If as a country we want to reduce our vulnerability to external shocks by reducing first
our current account deficit and then, over time, our high ratio of net external liabilities to GDP, how
could this be done?
The first point to reiterate perhaps is the one which the Corden/Pitchford/Friedman
school would probably make, and that is that, because the public sector is in surplus, our current
account deficit reflects decisions being made in the private sector to take on more liabilities. This will
not continue indefinitely, since at some point we are likely to find either borrowers deciding that they
have taken on enough debt or lenders making that decision for them! New Zealand has already seen a
very strong increase in the ratio of household debt to household disposable income, as already noted.
This has seemed prudent to thousands of New Zealanders, partly because house prices have increased
strongly in recent years. And while to some extent it does make sense to anticipate future income
growth, the ratio of house prices to incomes is currently at historically high levels - the sort of levels
reached in the mid-1970s, just before the very sharp fall in real house prices in the second half of that
decade, or in the United Kingdom before the savage correction in the late 1980s and early 1990s. If
New Zealand house prices were to falter, even more if they were to fall back somewhat over the next
year or two, as several commentators are now suggesting is very likely, we could quite quickly see a
rapid slow-down in the growth of household sector borrowing followed by a down-turn in investment
in housing and a rather broader slowdown in consumer spending. This would in turn quite quickly
produce a reasonably rapid reduction in the current account deficit, both as the demand for imports
fell away and as the profitability of foreign companies operating in New Zealand dropped. Any
policy issue would disappear.
But supposing this does not happen in the near future. Are there measures which
policy-makers should be considering to reduce the deficit?
We know from long and bitter past experience that imposing direct controls on
imports is no solution. Unless matched by measures to reduce domestic spending power, consumers
initially spend on items other than controlled imports in such a way that exports tend to be reduced
and other imports increased. The balance of payments is not helped. Moreover, in time New Zealand
producers invest in the production of the items subject to import controls, and since these items are
almost by the nature of the case expensive to make in New Zealand, productivity suffers and efficient
exporters are severely hindered. There is no solution in trying to license or control imports.
The key challenge: how to increase national savings
Since at root a balance-of-payments deficit is an excess of investment over saving,
any attempt to reduce the deficit must either look to reduce investment or to increase saving. I will
assume that reducing investment is hardly an attractive policy option given the constant pressure for a
higher standard of living and more jobs, which leaves us with the question of how to increase savings
in New Zealand. And I can't stress too strongly that, fundamentally, reducing the current account
deficit is ultimately about how we might increase total national savings relative to national
investment.
For a great many years, the public sector was a net dis-saver in New Zealand, as
indeed it still is in most countries in the world. This was reflected in a considerable build-up in net
public sector debt, to a peak of some 52 per cent of GDP in the early 1990s, as I have already
mentioned. Partly as a result of the sale of government assets but mainly, since 1993/94, as a result of
running budget surpluses, debt has been roughly halved in relation to GDP and at the present time the
public sector is making a contribution of some 1.5 per cent of GDP to our total national saving effort.
This is a very much better performance than that of virtually any other developed country (the
exception, as to so much else, is Singapore), but it is a markedly smaller contribution to national
saving than the public sector was making in, say, 1995/96. In that year public sector saving amounted
to 3.7 per cent of GDP. So in the last couple of years the trend in public sector saving has been
unhelpful in terms of the balance-of-payments deficit, a reflection of a strong increase in public sector
spending over the last two years and a reduction in tax rates. One way of reducing the
balance-of-payments deficit might be to increase the public sector surplus again, although nobody
should under-estimate the difficulties of doing that in a country where pressure to increase
government expenditure is relentless.
New Zealand's record of household sector savings seems to have been relatively poor
for many years. There have doubtless been many reasons for this. In the high inflation 1970s and
early 1980s, when many interest rates were controlled at artificially low levels, the after-tax real
return on savings invested in fixed interest securities was strongly negative, creating a strong
disincentive to save. This situation changed markedly in the mid-1980s, with positive after-tax real
interest rates, but at about the same time financial sector liberalisation greatly increased the ability of
many households to borrow; this too almost certainly discouraged net saving. And of course for most
of the last half century New Zealanders have been encouraged to believe that the things for which
people save up in many other countries - education, medical care, and retirement - would largely be
taken care of by government. We were effectively told: you don't need to save and, by the way, if
you do, you're a fool, because government-sourced inflation will steal a large chunk of what you save
anyway.
I'm frankly not sure how this culture of low household-sector saving can be changed.
Clearly there is a significant section of the community that has no surplus income at all. To suggest
that a solo parent living on benefit has scope for increased saving is absurd, and would be
presumptuous in the extreme coming from me. But it is also true that too many New Zealanders on
higher incomes still have attitudes to their personal finances that only made sense in the high inflation
1970s and early-1980s. The mind-set was that only a fool had personal savings, and the quick and the
clever were in debt up to their eyeballs. Indeed, those attitudes were sensible from an individual's
point of view, with negative real interest rates and rising asset prices. Those attitudes no longer make
sense.
Part of the problem in recent years may have been the less-than-ideal mix of monetary
conditions, with interest rates too low to encourage saving or discourage borrowing and with the
exchange rate too high to allow the export and import-competing sectors to grow. This mix of
monetary conditions was particularly unhelpful when most of the inflation pressures were in the
domestic parts of the economy, especially the housing sector, and not in the export and
import-competing sectors. The Reserve Bank began to tighten monetary policy early in 1994 to head
off the inflationary pressures which we projected at that time. By the end of that year, 90 day interest
rates had risen from around 4.5 per cent in January to close to 10 per cent, while the exchange rate
had increased from 57 on the trade-weighted index (TWI) to 60. Through the next nine quarters, to
the end of March 1997, interest rates never went much above 10 per cent, but the exchange rate
continued to increase until the TWI reached 69. As a consequence, lending by major financial
institutions to the private sector continued growing at rates more than double that of nominal GDP
growth. In other words, although the exchange rate was putting great pressure on the exposed parts of
the economy, interest rates were not nearly high enough to restrain a huge surge in private sector
borrowing.
But hold on, you may be saying. Don't we have some of the highest inflation-adjusted
interest rates in the developed world? And so we do, if one compares interest rates with inflation in
the CPI. But of course few