NZ Dollar- deficit not all gloom?

This is an article by Gareth Morgan.


The Imminent Crash of the Kiwi Dollar
28 September 2005

With last week’s announcement that our balance of payments current account has ballooned out to 8% of GDP, and this week’s news that the trade deficit is really ramping thanks to oil, it’s reasonable to forecast that the deficit’s on the way to a record 11% of GDP and that a crash of the NZ dollar is threatening. It was in 1984 when we had our “constitutional crisis” and enforced devaluation that our balance of payments deficit was last out near these levels.
But things have changed. With a floating currency and a significant government surplus there are grounds to conclude that markets are already freely and continually adjusting to developments in our current account. Given the deterioration is coming from the private sector rather than as it was in the 1980’s – from a government running large deficits as well as trying to fix the currency by borrowing overseas reserves – we could even be so blasé as to assert that there is nothing out of order, nothing to worry about.
Over the last week the Kiwi dollar has eased back somewhat, being down 2.5% since election night (trade-weighted measure). Given the close timing of the three events – the election on the 17th, the June quarter current account announcement on the 21st, and the August month trade deficit on the 27th, it’s not possible to unravel which is the main driver of the weakening dollar. The currency dropped 0.5% between the first two announcements, 1.5% between the second and third, and so far has dropped another 0.5% since the trade announcement. Prima facie it looks like the external accounts were the final straw. Interest rates – both short and long have moved up across the whole two weeks.
Given rising inflation, full capacity and a promise of fiscal stimulus, the market is pre-empting a Reserve Bank action. It’s unlikely however market action alone will be sufficient to enable the Bank to avoid a further rate hike, the market is clearly anticipating that. The rise in interest rates will put a brake on how far the Kiwi will fall. This ying and yang between the level of the dollar and the level of interest rates, is of course how the financial market searches for the right mix to accommodate economic growth in a sustainable, non-inflationary manner.
But how bad is the current account deficit? We’ve covered above how it is a very different animal than when it ballooned out under a fixed exchange rate regime and the government had to fund the cost of maintaining a currency at an unsustainable height. Nowadays the expansion is a private sector phenomenon and reflects a number of contrary influences;
(a) despite very high commodity prices, and a terms of trade at its highest for 15 years, we have managed to blow the trade surplus well away. It’s the ballooning deficit on goods that has been the biggest contributor to the current account deterioration
(b) all’s not well on the investment income balance either however. The net outflow of dividends and interest has gushed with the good profit performance of New Zealand businesses and our relatively higher interest rates. This balance stands to get a lot worse if Michael Cullen manages to “deter” Kiwis investing abroad by imposing a punitive and selective capital gains tax on Kiwis investing outside New Zealand. Such “Fortress New Zealand” type policies have always caused damage.
(c) export volumes are now falling while our import volumes continue to grow at about 10% per annum. This suggests that monetary conditions, at least as far as the domestic sector is concerned, are ineffective. With an economy at full capacity, the excess demand is simply spilling abroad. It may need higher interest rates yet to stunt that.
But it’s not all bad. There are ameliorating factors that portend a prolonged period of current account deficit.
(a) the world’s savings surplus. It has been argued that the emerging economies of Eastern Europe and Asia, while benefiting enormously under globalisation, have yet to “free” their consumers at home, who maintain very high savings rates. As a consequence these economies have amassed burgeoning current account surpluses. As the balance of payments across the world must be zero, this means that another set of countries – including New Zealand – have amassed larger current account deficits. These deficits arise due to cheap world interest rates which make it painless for deficit countries to borrow and fund higher consumption levels.
(b) debt servicing cost. Despite persistently high external debt – still around 80% of GDP as it was at the beginning of the 1990’s – our debt servicing burden (ratio of interest to exports) has dropped markedly. In an analogous fashion to the “new paradigm” of low interest rates discovered by households, debtor countries have found this era of lower rates has enabled them too to sustain far higher debt. Households have taken advantage of lower interest rates to expand their mortgages, New Zealand has done similar and expanded overseas debt in line with GDP – and even then found the debt servicing burden lower. The graph illustrates, the fall in the debt service burden coinciding with the fall in international interest rates that the sharemarket crash of 1999 precipitated.
So what do we conclude? It’s analogous to discussion in last week’s column on inadvertent presumptions about constraints on our government spend. In that column the conclusion was that as far as government expansion is concerned there is little constraint – our government spend ratios aren’t high compared to the egalitarian, welfare-spending countries New Zealanders aspire to emulate. European countries tax and maintain government spends 50% higher than our own.

Similarly when it comes to our external borrowing situation what matters in terms of sustainability is the debt servicing ratio, and that has fallen over the last decade – despite a larger current account deficit. This suggests that New Zealand can maintain at least its present degree of external debt and even expand it some – as it has over the last year.
These arguments suggest that the conventional wisdom of a “crisis” in our current account is rather a tenuous assertion and predictions of a concomitant collapse in our dollar should that deficit keep rising, somewhat fanciful as well. What is more likely is that the external deficit does keep growing and that a dual of rising interest rates and an easing currency – the trend of the 2005 – continues – eventually capping the deficit.
Where’s the greatest risk to this rather sanguine prognosis? That global interest rates leap for some reason and the indebted – countries and households – suddenly find their “new world” has gone. If it becomes a creditors’ market again, then currency shocks would be in store, as would be shocks to house values.
That scenario though isn’t obvious.