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Comparisons of market interest rates offer another perspective on New Zealand’s cost of capital

Comparisons of market interest rates are the second source of evidence regarding New Zealand’s relative cost of capital and the possibility of an impediment to capital accumulation.

One approach calls for comparing interest rates on similar assets – typically government bonds. Long-term rates are the most relevant for the kind of “long-run” equilibrium considerations embodied in our discussion so far. Using the terminology developed in this paper, we can think of any gap between two country’s nominal rates as comprising two components: 1) expected changes in the exchange rate and 2) a premium associated with any impediment. In a ‘long-run’ context we can make an approximate estimate of the second component by using the difference between real interest rates across countries.

While there has been some convergence in real interest rates over the past 10 years, New Zealand’s cost of capital has been high relative to other OECD countries for quite a while

In its 2007 Economic Survey, the OECD looked at real interest rate differentials between New Zealand and other OECD countries. Figure 9 compares New Zealand’s real long term interest rates (10-year government bond rate) with Australia, the United States and the OECD average. While New Zealand’s real interest rates have tended to converge with those of other economies, there has been a persistent premium for some time. New Zealand maintains an interest rate premium over the United States and OECD average.

Figure 9: Real long term interest rates
Figure 9: Real long term interest rates.
Source: OECD 2007

New Zealand’s real short-term interest rates have averaged around 1 percent higher than those in Australia this decade. The Reserve Bank (2007) notes that, while different approaches to measuring the interest rate deliver slightly different results, there is a clear finding that real interest rates in New Zealand have remained persistently above those in Australia. They also note that Australian rates are higher than in many other developed countries.

Other authors have also examined New Zealand interest rate performance. Hawkesby et al (2000) compare nominal interest rates on ten-year New Zealand bonds with corresponding Australian and US rates and estimate the two gap components discussed above.[15] For the period of 1990Q1 through 2000Q2, they find a substantial impediment premium relative to the US (2.1 to 2.4 percentage points),[16] but no significant premium relative to Australia.

Björksten and Karagedikli (2003) offer another piece of evidence based on interest rate comparisons. Specifically, they explore various estimates for the “neutral real interest rate” (NRIR). Archibald and Hunter (2001) define the NRIR as “a broad indication of the level of real interest rates where monetary policy is neither contractionary nor expansionary.” In other words, we can think of the NRIR as filtering out the “short-term” fluctuations in interest rates associated with the business cycle. In this way, NRIR comparisons are conceptually similar to the other cost of capital comparisons discussed in this section. Björksten and Karagedikli estimate that New Zealand’s 2003 NRIR was significantly higher than that of Australia, the US and the other OECD countries in their sample: New Zealand’s NIRR is more than 3.5%, compared to about 2.3% for Australia and about 1% for the US, Canada and Switzerland.

To sum up, a number of studies have examined whether New Zealand has a high cost of capital relative to other OECD countries. While some of the evidence is mixed, it is reasonably clear that New Zealand faces a higher cost of capital than most OECD countries, including the United States. Over the past decade the weight of evidence suggests that there has been some premium relative to Australia, although this looks to have narrowed over recent years. The Reserve Bank (2007) recently reached a similar conclusion: “a high domestic cost of capital is almost certain to be holding back the total level of real business investment in New Zealand” (p. 79).

Notes

  • [15]Hawkesby et al use somewhat different terminology. Our “expected currency movement” component of course corresponds to their component of the same name; our “impediment” component corresponds to their “default and liquidity risk” component plus their residual (which they term “currency risk” but acknowledge that, as a residual, it includes the effect of all other factors). Note that, in their favoured estimate of gaps in long-term rates, “expected exchange rate changes” are driven entirely by relative purchasing power parity – ie, differences in inflation expectations.
  • [16]See Hawkesby et al, Box 1.
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