1 Introduction

New Zealand real interest rates have on average over the past two decades been high relative to most other Organisation for Economic Co-operation and Development (OECD) countries. The purpose of this paper is to ask, and answer, why that is. One explanation often cited for this interest-rate premium is that the premium is necessary to attract foreign funds to New Zealand to finance the domestic saving shortfall. That is, investors will lend to New Zealand only at those higher rates as compensation for the risk borne when investing in New Zealand.The types of risk being compensated for could include currency risk (the risk associated with currency volatility), default risk (the risk of default associated with New Zealand's high level of indebtedness), inflation risk (the risk associated with inflation volatility) and liquidity risk (associated with the lower liquidity of the New Zealand market).

This “risk-premia” explanation of New Zealand's higher real interest rates treats New Zealand as a “price-taker” on the world market. That is, as a small, open economy, New Zealand can not affect the “world” real interest rate. If country risk premia are zero and capital markets are fully integrated, then any deviation in New Zealand's long-term interest rates from the “world” rate could not be permanent because capital is assumed to flow from low-yield currencies to high yield currencies until the gap in country rates is eliminated. In this standard neoclassical model, domestic saving and investment imbalances can not drive the level of domestic real interest rates.

This paper will argue that even if capital markets are fully integrated and capital is highly mobile, that it is possible for New Zealand real interest rates to deviate from the “world” rate for many years even in the absence of externally-imposed country risk premia.

The framework presented in this paper uses the theory of Uncovered Interest Parity (UIP) together with evidence on the carry trade to show how New Zealand interest rates can deviate from the “world” rate for many years. Under this explanation for New Zealand’s relatively high interest rates, New Zealand’s low rate of saving relative to investment make higher real interest rates necessary to maintain inflation within the official target range compared to the situation where households and government saved more. The interest-rate premium is not exogenously imposed by foreign investors. Instead, foreign inflows seek out (rather than demand) the interest rate premium. Seeking out the higher yield, foreign capital flows into New Zealand and this puts upward pressure on the exchange rate until the dollar appreciation “forces” a change in expectations that eliminates arbitrage opportunities. At this point, capital inflows that are seeking out the higher yield will cease, preventing the gap between New Zealand real interest rates and the “world” rate from being eliminated.

Overall, this combination of higher interest rates and an exchange rate above its long-run equilibrium in New Zealand has hindered the tradeable sector's (including exports) performance relative to the non-tradeable sector.[2] To put it another way, domestic resources have shifted from exporting and the production of import-competing goods to supplying non-tradeable output to satisfy government and household consumption. Higher imports have also been necessary to meet this demand.

A permanent increase in national saving, all else equal, would reduce domestic imbalances and take pressure off domestic resources, which would permit the inflation target to be achieved with lower average domestic interest rates ex ante. As the premium on New Zealand interest rates relative to interest rates elsewhere would be smaller, it would be expected that the exchange rate would also be lower on average too - at least for a few years.

Lower real interest rates would be beneficial for investment. Investment not only adds to the capital stock (which is an important influence on labour productivity) but investment itself can help to drive additional productivity growth through improvements in technology and business practices that enable labour and capital to be combined more effectively.

Lower real interest rates could also indirectly benefit the export sector through a lower exchange rate. Whether a sustained increase in exports will itself enhance productivity depends on a number of micro-economic factors, but the evidence suggests that a lower exchange rate creates opportunities for high productivity firms to grow and achieve scale through exporting.

The remainder of this paper is organised as follows. Section 2 introduces the interest rate concepts used in this paper. Section 3 provides some evidence as to the premium on New Zealand real interest rates. In Section 4 the basic framework is introduced and we ask whether New Zealand's low saving rate relative to investment could be driving the interest rate premium. The role of country risk premia is also explored. Section 5 briefly discusses the implications of the interest rate premium for the costs of capital and labour productivity. Section 6 concludes.