6 Conclusion
This paper has presented a framework that leads us to the following conclusions.
“World” convergence factors drive the direction of New Zealand interest rates. That is, if foreign real interest rates drop, this will apply downward pressure to interest rates in New Zealand, all else equal.
Domestic demand conditions in New Zealand determine the extent to which these world forces matter. That is, the achievement of internal balance could drive a wedge between New Zealand actual interest rates and the “world” rate. The relationship between the interest rate differential, the actual real exchange rate and exchange rate expectations can sustain the interest rate differential even with open capital markets and perfect capital mobility.
Country risk premia (in particular, default risk premia), could potentially drive a wedge between New Zealand actual interest rates and the “world” rate. However, the evidence for New Zealand suggests that this has not been a material driver of the interest rate premium over the past two decades. The overvalued New Zealand dollar is consistent with foreign inflows seeking out a higher yield currency, rather than foreign investors reluctantly lending to a risky debtor.
Even if country risk premia are responsible for driving the interest rate premium, the size of this wedge depends on domestic saving rates relative to investment both directly (in terms of debt and perceived riskiness) and indirectly via the operation of monetary policy to maintain internal balance.
Overall, it is hard to escape the conclusion that low national saving rates relative to investment are an important driver of New Zealand's interest rate premia.
