4.2 Could a low saving rate be driving the premium?

This section shows that New Zealand's low saving rate (given current policy settings) could drive a wedge between New Zealand interest rates and the “world” rate, even without a country risk premium. This wedge could exist for many years.

Start with the basic framework above, where the New Zealand actual real interest rate (r₀^NZ) is assumed equal to the world interest rate (r₀^w) and the actual exchange rate, e₀, is consistent with internal balance_. Assume an ex ante decline in the New Zealand saving rate (either public or private) as in Figure 4.

Figure 4 - New Zealand imbalances and the interest-rate premium

The supply of domestic funds/saving schedule moves left. In a risk-free, frictionless world, the domestic rate would remain equal to r₀^w and the only impact would be a larger supply of foreign-sourced funds to make up for the decline in domestic funds, and the current account deficit would increase. However, a decline in saving means that there has been an increase in aggregate demand and as a result, the internal balance (ē) schedule shifts right - for every level of the real exchange rate, a higher real interest rate is necessary to maintain internal balance.

At r^NZ = r₀^w, the actual exchange rate e₀ is now too low for internal balance and inflation pressures would build. Domestic interest rates must increase. As real interest rates increase, aggregate demand will decrease (savings will increase, while investment will decrease).

However, as interest rates increase, the gap between New Zealand interest rates and the world rate, all else equal, implies an arbitrage opportunity. That is, investors will demand the higher yield New Zealand dollar. This pushes up the exchange rate, which is reflected as an upward shift along the UIP schedule. The new interest rate and exchange rate combination is (r₁^NZ, e₁). At the higher interest rate, the lower rate of investment could lead to a reduction in aggregate supply, which would shift the internal balance schedule even further to the right, necessitating an even higher interest rate and exchange rate combination to maintain internal balance.

Given the arbitrage opportunity associated with the interest differential, all else equal, capital should continue to flow into New Zealand until the interest differential is eliminated. So what prevents this from happening?

In order for the no-arbitrage UIP to hold, expectations about New Zealand dollar depreciation will have to change. That is, investors will seek out the higher yielding currency up until the point where the expected depreciation eliminates (expected) arbitrage opportunities. These exchange rate expectations allow the New Zealand real interest rate to deviate from the “world” rate and can be maintained for a significant number of years, without an actual depreciation occurring, which allows the wedge between New Zealand interest rates and “world” rates to also be maintained for many years. For example, since 2001, the New Zealand dollar appreciated on average relative to the United States dollar. However over this period, the New Zealand dollar was expected to depreciate. In Figure 5, estimates of exchange rate expectations since 1990 are presented.

Figure 5 - Expected change in the US/NZ exchange rate

Source: RBNZ, Bank of England

Although e₁ is consistent with internal balance, it may not be consistent with the equilibrium exchange rate, which is unaffected by the level of the interest rate and demands both internal and external balance (using the Macroeconomic Balance approach). As stated above, the long-run equilibrium real exchange rate for New Zealand is likely to be well below the average real exchange rate level for the past 20 years. This deviation of the actual exchange rate from the level suggested by economic fundamentals is likely to be known by sophisticated currency traders, supporting the view of an expected depreciation.

This relationship between actual interest rate differentials across countries, actual real exchange rates and exchange rate expectations are consistent with the empirical evidence on the carry trade. The carry trade is the name of the strategy where investors borrow a low-interest rate currency such as the Japanese yen, and simultaneously lend in a high-interest rate currency such as the New Zealand dollar so as to exploit the arbitrage opportunity (Frankel, 2007). A thorough exposition of the carry trade is beyond the scope of this paper, but Galati et al (2007) examine the extent to which carry trade positions can be traced in various sources of data, including for New Zealand and document the associated appreciation of the currencies that are targeted by carry traders, such as the New Zealand dollar, the Australian dollar, the South African rand and the Brazilian real. Burnside et al (2008) provide evidence of the gains from a diversified carry-trade strategy (that is, applied to a portfolio of currencies). Since 2002, the gains from a carry trade strategy applied only to the New Zealand dollar, have tracked the gains from the more profitable diversified strategy.

In conclusion, as real interest rates in New Zealand are driven up to maintain internal balance, the saving rate increases ex post. However, New Zealand's low saving rate ex ante relative to investment drives the wedge between New Zealand real interest rates and the world real interest rate even without the existence of country risk premia. This New Zealand interest rate premium could be sustained for many years (not arbitraged away via capital inflows) given an assumed UIP relationship where arbitrage opportunities are expected to be zero, even when those expectations are not fulfilled for many years.

Although the framework presented is not able to speak to the length of the period over which the real interest rate premium can be maintained, stylised facts as to the deviation of the real exchange rate from equilibrium levels provides some tentative support for the framework's conclusions.