4.4 The role of a default risk premium

Most of the literature on New Zealand's interest rate premium has attempted to measure the different types of country risk premia (see for example Lally, 2000; Hawkesby, Smith and Tether, 2000).Country-specific risk premia (CRP) include:

• currency risk premia, that compensate for currency volatility;
• inflation risk premia, that compensate for inflation volatility;
• default risk premia imposed by creditors to compensate for the higher default risk implied by New Zealand's high net indebtedness; and,
• liquidity premia to compensate for the lower liquidity of small markets such as New Zealand.

There is little evidence to support the view of inflation or liquidity risk premia. Actual and expected inflation is quite similar across OECD countries. New Zealand inflation and inflation variability has (since 2000 at least) been within the median of comparator countries and is not a significant outlier. It is also not obvious that liquidity premia could explain the (around 100 basis points on average) divergence between Australian and New Zealand rates.

Hawkesby, Tether and Smith (2000), in evaluating the New Zealand interest rate premium relative to Australia and the United States, assume no significant difference in liquidity risk between New Zealand and Australia. This assumption is based on the predominance of Australian banks in the New Zealand financial market. For the United States, they assume that the liquidity premium is relevant only in the long-run (10-year rates) and is around 50 basis points. The remainder (the residual) of the premium is then assumed to be explained by currency risk premia. Relative to Australia, the premium is estimated to be around 150 basis points (but only for short-term interest rates, not long-term). Relative to the United States, the premium is estimated to be between 100 and 400 basis points.

However, over the last decade at least, it is not obvious that currency risk premia can explain the premium on New Zealand interest rates. Mabin (forthcoming) concludes that while New Zealand dollar short-term volatility is high, it is also high for countries like Australia and the United States. A similar story can be told in terms of medium-term exchange rate variability.

Accepting that premia for liquidity, inflation volatility or currency risk are not especially relevant here, the remainder of this section focuses on the role that a default premium could play in New Zealand's interest rate premium.

Consider the basic framework as in Figure 3. At r^NZ = r₀^w, the actual real exchange rate, e₀ determined along the UIP schedule, is consistent with internal balance along ē. Assume now that because of New Zealand's high stock of country debt (New Zealand's NIIP is currently around negative 86%), that foreign investors demand a higher return for lending to New Zealand. This would imply a new aggregate supply of funds schedule such as the bolded (red) line in Figure 7 kinked at r₀^w. Assume that this foreign supply of funds schedule is more elastic to interest rates than the domestic saving curve. If this were not the case, New Zealand would rely solely on domestic funds - there would be no international capital market which would be the extreme “sudden-stop” case.

From the perspective of the New Zealand borrower, the “world rate” has increased and so the UIP schedule shifts left. That is, at every level of the exchange rate, the interest rate must be higher, because foreign investors now demand to be paid a premium to invest in New Zealand. The domestic interest rate will increase to reflect the new conditions on world markets. The new combination will have a lower exchange rate level and a higher interest rate (r^crp).

Note that in this scenario, the RBNZ has not adjusted the OCR to maintain internal balance. The imposition of the risk premium implies that the gap between the OCR and long-rates has widened. In the previous sections, a widening gap between the OCR and actual rates resulted in pressures on internal balance that had to be managed by changing the OCR. In this case, the exchange rate and interest rate both move in the right (opposite) directions to maintain internal balance without the RBNZ necessarily having to react.

Figure 7 - The role of a default risk premium

This scenario illustrates that a default premium could be a driver of the New Zealand interest rate premium. However, the following two stylised facts would seem to suggest that default risk is not currently the primary driver of New Zealand's interest rate premium, but that the conditions for internal balance matter more:

First, a default premium would likely see a New Zealand exchange rate closer to its long-run equilibrium level or below it. Instead, the New Zealand dollar appears to be overvalued and has been for some time. This is consistent with the carry trade story where foreign investors are seeking out a higher yield currency, rather than reluctantly lending to a country perceived to be overly risky.

Second, the imposition of a default premium would likely over time see New Zealand households and business deleveraging (as costs of borrowing increase). Instead households have tended to leverage more which suggests that domestic conditions are more relevant to driving interest rates up. Of course, global conditions have been important in driving interest rates down across many OECD countries over the past two decades, including in New Zealand despite the on-going premium, which would encourage further leveraging by New Zealand households and businesses.

Furthermore, from Figure 7 it is worth noting that the extent to which default risk premia would “bite” still depends on the saving rate. That is, increased saving at the national level would lower the premium through two channels. First, higher saving would eventually translate into lower foreign debt levels (other things equal), and as a result, the default premium (perceived riskiness) would decrease. Second, given a perceived level of riskiness, a higher level of national saving would lower the demand for foreign capital and would therefore indirectly lower the default premium. That is, e( r^crp) would sit somewhere to the right of where it is sitting in Figure 7. To put it another way, for the same level of capital inflows and the exchange rate, foreign investors can be compensated at a lower premium.

To conclude this section, while the stylised facts and framework are not inconsistent with the existence of default risk premia, the framework does highlight the importance of low domestic saving rates relative to investment as a driver of the real interest rate premium in New Zealand over the past two decades. Furthermore, should perceived risk increase, country risk premia could matter more in the future.