5 The interest rate premium and economic performance
The previous section has argued that the premium on New Zealand real interest rates is likely to have been primarily driven by low domestic saving relative to investment rates. That is, the interest rate premium can be seen as a symptom of New Zealand imbalances. This section provides indicative evidence of the impact of the premium, which is expected to be important, but moderate.
The decision to invest in capital depends on the return the investment is expected to generate relative to its cost of capital. The cost of capital (C) can be thought of as a pre-tax, real gross rate of return on an investment that is required to earn a given rate of return after tax and depreciation. If the investment is fully debt-financed:
where r is the pre-tax actual real return that will need to be paid to lenders/investors that demand an after-tax real return R and δ is depreciation (and is tax-deductible, where t is the tax rate).[7]
Modelling by the Treasury (Szeto and Ryan, 2009), based on the New Zealand Treasury model (NZTM) production block estimations, indicate that a 1 percent decrease in the cost of capital would lead to a 0.8 percent increase in the capital stock.[8] In NZTM, the capital stock refers to the private business sector capital stock. What would this mean in terms of labour productivity and growth?
Assume the following:
δ= 10%
r = 6%
We can not say exactly how elastic R would be to a change in net national saving, but assume that r drops from 6 percent to 5 percent. The 1 percentage point drop in the costs of capital lifts the business capital stock by 5 percent. GDP is expected to increase moderately by around 1.1 percent in the long-run. These results do not allow for a positive spillover from higher capital stocks into multi-factor productivity (MFP) which may be one reason for the moderate impact.[9]
Although the results from NZTM are not directly comparable with the international growth literature, the latter would similarly suggest that the growth impact from a reduction in the costs of capital are likely to be moderate. There is some controversy in the international literature about how much the costs of capital actually matter for investment and growth however, with the range of elasticities of investment to costs of capital ranging from very high to very low (Chirinko et al, 2002). From the OECD literature, the GDP impact of a 1 percentage point increase in the investment-GDP-ratio, could increase GDP per capita in the long-run by between 1.3 percent and 1.5 percent (Bassanini, Scarpetta and Hemmings, 2001).
Notes
- [7]For ease of exposition, we assume inflation is zero, but this does not alter the conclusions of this section.
- [8]The functional form of the production function in the NZTM is a CES (constant elasticity of substitution) equation.
- [9]The NZTM results suggest a more moderate GDP impact from a reduction in the costs of capital than those estimated by the NZIER (2010) using a dynamic CGE model.
