Executive Summary
Like many other countries, New Zealand has seen a significant build up in its offshore and private debts over a long time period. At the same time, farm and house prices have substantially moved away from long-term norms, both historically and internationally. These observed long-term trends are the focus of this Working Paper. In particular, they represent imbalances that may not be sustainable. The recent global financial crisis shows how imbalances can magnify economic shocks and threaten living standards, which is a key concern for the Treasury.
This Working Paper investigates whether the resilience the New Zealand economy has shown to date can endure. It examines the need and possible means for policy to address imbalances. The Working Paper builds on considerable previous Treasury work regarding the link between national savings and imbalances, and adds to other recent publications about New Zealand's contemporary macroeconomic challenges.
Structural imbalances create the risk of a sudden financial crisis when creditors lose confidence in the solvency of the financial system. This would have severe spill-over effects into the domestic economy through disruptions to the credit and exchange rate markets. Alternatively, if collectively debtors become concerned about the sustainability of their financial position, absent other changes in the economy, sharp falls in private consumption and investment growth can slow economic growth for a prolonged period. However, not all imbalances are problematic; it depends on the causes and circumstances. The key issue is the perceived on-going systemic ability of debtors to service liabilities, which depends on enduring inter-related factors such as risk appetite and savings behaviours, as well as economic performance.
Persistently high household and farm debts have reflected a long-term willingness to take on significant debts for property purchases because of an expectation of continuing appreciating prices. In turn, high offshore debt reflects persistently higher investment than saving (income less consumption) at a national level, or a current account deficit. These debts are related through reduced saving from wealth effects, as a result of property price increases leading to higher consumption. Therefore, ultimately offshore creditors are taking a view about the soundness of the domestic property market through their bank-intermediated investments. Higher consumption in a resource constrained economy has another key economic impact, it tends to raise interest rates higher than would otherwise be required to maintain price stability. This elevates the average real exchange rate to the detriment of tradables.
The extent to which higher consumption and debt and a worse performance of tradables represent a problem depends on three key judgements: the degree of rationality of individual decisions and the degree of influence of government policy that inadvertently may lead to later regrets should a shock occur; the degree of capability of the economy to manage the risk created; and the degree to which resources are being skewed to potentially lower productivity activities.
On the first judgement, it is not clear how much government policy is impacting on private decisions, or if changed how that would affect behaviours. Given the general prudency of the government and business sectors, there is no obvious explanation why New Zealand national saving is so low and household and farm debt so high, but it is unlikely that policy settings play no part in this outcome.
On the second judgement, New Zealand's strong institutions provide considerable resilience and capacity to manage the impact of shocks on high levels of debt that could otherwise cause crisis, or the risk of slow growth. These include relatively strong and transparent fiscal policy, independent monetary policy with a floating exchange rate, and relatively prudent intermediation. However, there are a number of New Zealand-specific factors that detract from resilience. These include reduced fiscal headroom associated with the recent emergence of a structural fiscal deficit (albeit projected to diminish), a current account deficit that is driven by the servicing of prior borrowing rather than high investment that can be expected to generate returns to service the borrowing, and a significant proportion of offshore debt is still in the form of relatively risky short-term wholesale debt. In addition, several studies show that this debt is secured against property prices that are significantly overvalued, and so a substantial fall in price to fair value would cause significant interrelated financial and economic stresses.
On the third judgement, there is some evidence to suggest that exports are associated with greater productivity due to exposure to international competition, so skewing the production mix in the economy towards non-tradables is contributing to a slowdown in long-term economic growth.
Overall, on balance, the judgement of this Working Paper is that the economy does not appear to be in imminent danger of a sudden financial crisis. New Zealand debtors have maintained the confidence of creditors despite the risks associated with large economic imbalances. Moreover, going forward, increased saving further reduces the risk, but does increase the risk of slow growth.
However, high structural debts elevate threats to living standards, especially if New Zealand households and farms were to recommence significant borrowing from current high levels in connection with a resurgent property market, or face a new significant shock. This view is generally consistent with those held by a range of commentators, including credit rating agencies.
Bearing in mind recent overseas experiences about how quickly investor sentiment can change, it does suggest a pro-active policy response would be desirable to reduce the risk of costly adjustment. A “do nothing” approach risks several less benign paths for the economy, including some possible combination of a very costly banking crisis, or “sudden stop”. In particular, the government should look at policy settings to remove impediments to saving but also encourage growth. This includes reassessing taxes and transfer settings, the pros and cons of regulatory settings in the housing market, as well as better use of cyclical management tools.
These policy responses have the potential of raising both private and government sector saving. Higher national saving should increase New Zealand's resilience. It would also improve tradables performance through lower interest rates than would otherwise be the case, which in turn should lead to a durable and deep depreciation in the exchange rate. Overall, this should have the impact of raising sustainable per capita growth rates at less risk.
