Demand for capital

Possible lack of demand for finance amongst small to medium sized firms

Regardless of the availability of capital, there could be a lack of demand for finance of any kind among many of New Zealand’s small to medium sized firms (Hamilton & Fox, 1999)[9] and this could be affecting firm performance. A survey indicated that 93% of respondents (especially long established firms) had no intention of growing their business. This has implications for financial sector development and more importantly for productivity and economic growth.

A range of factors could be influencing firms’ demand for finance including:

• Few profitable opportunities – New Zealand firms have dividend payout ratios that are significantly higher than other countries, which could signal a lack of investment opportunities (CRA, 2003). It is plausible, however, that other factors could be contributing to high dividend yields such as widely held ownership and New Zealand’s dividend imputation system, which provides little tax advantage for companies to retain earnings unlike the case in many other countries[10].
• Entrepreneurs fear the loss of control associated with diluting their equity, even if the new investment is expected to lead to significant growth (Austin, Fox & Hamilton, 1996).
• The quite common use of private homes as collateral for business borrowing gives rise to the risk of double jeopardy (loss of home and job) for business owners, which may make them less inclined to take on additional risk in their business ventures (Hamilton & Fox, 1999; Cameron & Massey, 1999).
• The cost of capital is also high relative to most other OECD countries. This is discussed in the next section, although evidence is unclear on how responsive investment would be to a fall in the cost of capital.

Cost of capital

The cost of capital in New Zealand is high relative to other countries

Long-term real interest rates have declined in New Zealand since 1996. While international differentials in real interest rates have narrowed, partly due to lower government debt levels, New Zealand’s long-term real interest rates are high compared to a broad cross-section of OECD countries. In particular, there remains a significant currency and liquidity premium vis-à-vis the United States and some other OECD economies. Hawkesby, Smith and Tether (2000) estimate the liquidity premium to be around 50 basis points relative to the United States, although it is questionable whether the United States is the most appropriate comparator[11]. New Zealand’s long-term real interest rates are similar to those in Australia. However, both Australia and New Zealand have high net external liabilities, which may partly explain their high costs of capital relative to other countries.

New Zealand’s high foreign indebtedness could be a driving factor behind the country’s persistently high interest rates

A country’s net foreign asset position features prominently in most stories of interest differentials reflecting a premium imposed by foreign investors (figure 5 plots a simple graph between the two variables across countries). Plantier (2003) has tested whether New Zealand’s relatively high foreign indebtedness, as measured by net foreign asset positions as a percentage of GDP, might in fact be a driving factor of the country’s persistently high real interest rates. His main result confirms that OECD countries’ net foreign asset positions correlate well with the gap between domestic-currency real interest rates and those in the rest of the world. Further, this work suggests that not only does the size of a country’s net foreign asset position relative to GDP matter for interest rate differentials, the composition of this position matters as well. In particular, government indebtedness appears to have a larger effect on the interest rate differential than private indebtedness. In the case of New Zealand, Plantier’s results suggest that reductions in the net indebtedness of the New Zealand government since 1994 have lowered real interest rates by almost 1 ½ percentage points, though this has at least partly been offset by increases in household indebtedness.

Figure 5 – Net liabilities and interest rates

Source: Net foreign assets from 2004 - Milesi-Ferretti & Lane (2006), Long term average interest rates over last 10 years – OECD Economic 80 Outlook database

The cost of capital appears to be more sensitive to changes in government debt than private sector debt

If investors’ perceptions of NZ dollar risk have been influenced by the high level of external debt, the resultant currency risk premium attached to New Zealand investments will have adverse consequences for the cost of borrowing for New Zealand firms. Lowering household debt levels (by increased saving) may help to reduce the currency risk premium paid by New Zealand companies. However, since the cost of capital appears to be more sensitive to changes in government debt than private sector debt, the dollar-for-dollar gains of a lower level of private external obligations are expected to be smaller than those reaped from lowering public sector debt in the 1990s.

Estimates indicate that interest rates have a moderate effect on investment 

There is also some controversy about how much the real cost of capital matters for investment and, therefore, GDP growth. International evidence suggests a wide range of estimates of the elasticity of business capital formation to its user cost. Most recent estimates, using large firm-level data sets, tend to find relatively low elasticities (e.g. Chirinko et al (2002) estimate the user cost elasticity at -0.40), suggesting a moderate effect of interest rates on investment.

Taxation and regulatory structure

New Zealand’s current financial sector development may have been influenced by the regulatory structure and past tax settings.

Past tax settings may have limited New Zealand’s current financial sector development 

With regard to taxation for example, housing is less taxed than some financial investments, contributing to unbalanced household portfolios. In addition, the taxation of savings used to be applied on a Taxed-Taxed-Exempt (TTE) basis. This was unusual compared with practice in other OECD countries. The introduction of KiwiSaver and the recent tax reductions for collective investment vehicles have moved New Zealand closer to standard OECD practice for taxation of savings.

Another tax issue is the use by banks and others of offshore branches to issue debt in order to avoid the approved issuer levy (AIL). This appears to have inhibited the development of a domestic debt market. AIL is currently being reviewed through the international tax review. Furthermore, New Zealand’s unusual method of taxing offshore subsidiaries could be affecting firm location choices. Budget 2007 announced changes to the tax treatment of offshore subsidiaries to bring it into line with international practice.

Overall, New Zealand’s investor protection and financial-system regulation are good by OECD standards, although there is scope to enhance the regulatory framework 

Overall, New Zealand’s investor protection and financial-system regulation are regarded as comparatively good by OECD standards (de Serres et al, 2006). In addition, a recent study by Cameron (2007) has shown that New Zealand rates well in terms of private protection measures that seem to matter for stock market development[12]. As a result of the current Review of Financial Products and Providers (RFPP) an enhanced regulatory framework is being developed that will increase investor confidence in areas including collective investment schemes, non-bank deposit takers and the advice available from financial advisors.

There is a need to further explore whether the regulatory environment is contributing to New Zealand’s poor saving performance and lack of development in certain parts of the financial system. Financial liberalisation has been beneficial in terms of increasing access to finance, but a negative consequence has been higher household debt levels and lower saving rates.