1  Introduction

The size and persistence of New Zealand’s current account deficit (CAD) and associated foreign debt remain at the centre of ongoing economic debates about the economy’s international economic performance. Much of the commentary views the foreign inflows as a cause of concern. The external deficit has averaged over 4.8 per cent of gross domestic product (GDP), since the float of the exchange rate in 1985. Relative to GDP, the associated foreign borrowing and net stock of foreign liabilities reached over 90 per cent by end 2006 making New Zealand, like Australia, one of the largest international borrowers for its size within the OECD group of economies.

The CAD had risen from 2.8 per cent of GDP in 2001 to 9.7 per cent in 2006. Media commentary routinely assesses CAD outcomes as “improving” if imbalances narrow and “worsening” if they widen. More serious assessments of the economy’s external position portray the CADs and associated foreign debt as a source of macroeconomic risk and cause for policy concern[1]. Bollard (2005) argues that ”currently standing at 8 per cent of GDP, New Zealand’s current account deficit is at levels that cannot be sustained indefinitely” and “that the eventual adjustment of the high current account deficit could make the job of maintaining price stability more difficult”. Edwards (2007) estimates that the increase in the current account deficit has raised the probability of an adjustment of 3 per cent of GDP to 20 per cent, although for a 5 per cent adjustment in GDP the probability was only 5 per cent. However he concluded that “the current external imbalances should not be a cause for great concern”.[2]

Current account deficits are also often perceived as a problem of trade competitiveness which unfortunately can trigger direct policy “solutions” that are inevitably distorting, such as export subsidies or higher tariffs on imports. However, what these trade-oriented perspectives generally ignore is that deficits on the current account side of the balance of payments are directly related to domestic saving and investment flows and matched by surpluses on the financial and capital account side.

These financial account surpluses reflect the growth of international capital mobility which has expanded substantially since the worldwide liberalisation of financial markets in the early 1980s. Accordingly, domestic saving and investment rates for individual economies have become more independent, or less correlated, so that capital mobility in the Feldstein-Horioka (1980) sense has increased.

Contrary to popular perception, several theoretical approaches that focus on financial and capital flows rather than trade transactions yield the result that international borrowing confers net macroeconomic welfare gains. For instance, neoclassical foreign investment theory (MacDougall 1960, Grubel 1987) proposes that both creditor and debtor nations reap income gains from international trade in real capital, whenever the marginal product of capital differs across national borders. Viewed in this light, external imbalances reflect differences in investment opportunities rather than necessarily, poor trade competitiveness.

Alternatively, the inter-temporal approach to the external accounts (Sachs 1981, 1982, Frenkel and Razin 1996, Obstfeld and Rogoff 1996, and Makin 2003), based on saving-investment behaviour and well founded expectations about future returns on capital, concludes that capital inflow in the form of borrowing unambiguously raises consumption possibilities and national income if that borrowing facilitates additional domestic capital accumulation. As in the neoclassical foreign investment approach, this macroeconomic welfare improvement results from the tendency of expected rates of return on capital to equalize across borders.

The inter-temporal approach has been applied to New Zealand by Kim, Hall and Buckle (2004 and 2006). Using data from 1982 to 1999 their 2006 paper concluded that there was no evidence that the conditions for solvency had been violated and large deficits were not a cause for concern. Rather these deficits were the result of optimal decisions by economic actors. This finding is consistent with results for New Zealand reported by Makin (2005) using an alternative approach to assess the sustainability of the current account deficits. He shows that it is the quantum of productive domestic investment that sets the feasible limit to the CAD. He finds that between 1990 and 2003 (with the exception of 1991-92), the actual deficit was always less than the maximum feasible deficit consistent with long-run sustainability.

The study by Kim, Hall and Buckle (2006) paper did not cover the period since 2000 when the deficits have grown appreciably. Munro and Sethi (2006) revisit this question using an extended data set, and their results concur with Kim, Hall and Buckle (2004). However they note that worsening of the trade account may threaten long term solvency. In subsequent work (Munro and Sethi 2007) they develop a richer model of the current account and find again that the movements in the current account can be explained by the response of economic agents making optimal decisions given the costs of borrowing and the expected returns to investment.[3]

Numerous studies have examined the links between international capital flows, investment and economic growth. Yet, this body of work focuses mainly on emerging economies and yields mixed results. While numerous studies (Bailliu 2000, Haveman, Lei and Netz 2001, Chandra 2005, Klein and Olivei 2006) find that capital inflow does positively influence national income, especially through the foreign direct investment channel, others (Rodrik 1998, Edison, Levine, Ricci and Slok 2002, and Carkovic and Levine 2005) find either a minimal or nil effect. This remains an empirical puzzle. In light of the strong case for increased international trade in saving on theoretical grounds.

When foreigners finance expansion of New Zealand’s capital stock, the rise in external liabilities is also matched by an increase in the nation’s real assets. In short, foreign investment supplements domestic saving, allowing the economy to accumulate real capital more quickly than it would have otherwise. Without that capital inflow over past decades, the combined saving of the private and public sectors would have implied less investment and hence lower real output growth.[4]

The economic policy significance of CADs which necessarily match net capital inflow, critically depends on whether the extra real output made possible by foreign funds exceeds the real servicing cost on that source of finance. As the Reserve Bank notes:

“New Zealand’s level of foreign debt has developed an increasing trend, repeatedly recording new highs and becoming a greater source of risk. Increased foreign debt puts pressure on New Zealand to grow fast enough to meet increased debt servicing obligations – otherwise the debt will not be sustainable” (2007, p.10).

Generating additional income sufficient to meet the debt servicing costs on foreign liabilities is crucial; but it is a necessary, not sufficient, condition to ensure long run sustainability. Since economic theory suggests that net gains from capital inflow should unambiguously be positive, the central question is: To what extent has New Zealand actually benefited, in terms of income and wealth, as a result of capital inflows that have enabled the NZ capital stock to grow faster than otherwise?

This paper estimates the contribution of foreign capital to New Zealand’s income growth by deriving rates of return on foreign funded capital and their implications for national income for the period 1988 to 2006. Using national balance sheet analysis it also evaluates New Zealand’s foreign debt with reference to counterpart national assets. The paper provides evidence that in fact, the necessary condition for the long-run sustainability of the current account does appear to have been met; ie, that the use of foreign savings has augmented the capital stock and generated additional income more than sufficient to meet the obligations on the foreign liabilities.

This conclusion is consistent with modelling by Makin (2004) in which current account imbalances and national income are determined simultaneously and which shows how the large current account deficits experienced over recent decades by Australia, the United States and New Zealand can coincide with periods of strong economic growth and low saving in those economies.

The remainder of this paper is structured as follows. Section 2 briefly analyses trends in domestic saving and investment and their implication for the external account. Section 3 proposes a straightforward theoretical framework for interpreting the direct links between saving, investment, capital inflow and national income. Section 4 applies growth accounting principles to data from New Zealand’s national and external accounts to estimate the contribution of foreign capital to New Zealand’s national income. Section 5 then shifts attention to macroeconomic stock values by presenting a prototypical national balance sheet that offsets New Zealand’s foreign liabilities against its national assets to derive a national wealth series. Section 6 concludes the paper by summarising the main findings and highlighting their implications for economic policy.