3 Imbalances described
The following sections describe the nature of imbalances, and applies the concept to the New Zealand context.
3.1 Concepts
As discussed earlier in Section 1, economic imbalances generally refer to significant movements of factors in the economy away from historical long-term average levels or trends. Accordingly, there is the connotation of instability, or something that builds up and ultimately cannot be sustained. This could either be because of some sort of externally-imposed financing constraint, or an internal adjustment as a result of expectations of future states of the world turning out to be incorrect.
The focus of this paper is on structural imbalances rather than temporary imbalances. Temporary imbalances by definition will self-rectify through a smooth transition, with little likely long-term detrimental economic effects. While eventually even structural imbalances are rectified, the difference is that absent mitigating policy change, the structural economic changes involved tend to be very disruptive and therefore costly. However, this does not mean structural imbalances cannot intensify and wane over the course of an economic cycle. The key issue is persistence through cycles.
Of particular interest are imbalances that ultimately manifest through growing indebtedness, either offshore or for particular sectors of the domestic economy. Debt levels reflect the saving and investing behaviours of households, businesses, and the government. High levels of debt can be a problem because debt is more reliant on the matching of short-term cash flows, and so default risk to unexpected events can be high.[4] In particular, high debt can be a problem if co-incident with assets being mispriced relative to fundamental value drivers. This mispricing produces so-called asset bubbles. Bubbles can be due to market euphoria phenomena arising from market momentum.
Accordingly, the imbalances idea is both a stock and flow concept. They build up from flows (new borrowing) and accumulate to what can be an unsustainable stock level (debt ratio). Therefore, it is the flow that creates the issue. This view is consistent with research regarding financial crises across the globe over 140 years, which showed that credit growth is a key indicator of financial instability (Jordà et al, 2010). However, it is the stock that ultimately determines if there is a problem, since high levels of new borrowing in any given year may not be problematic if initial debt ratios are at a low level.
The recent devastating Canterbury earthquakes have had a significant medium-term impact on the economy, weakening the financial positions of both the private and public sectors. But overall, the earthquakes are not expected to add materially to the long-term structural debt issues facing the country, and so is not a key focus for this paper (Box 1).
Box 1: The impact of the Canterbury earthquakes
The immediate financial cost of the earthquakes to New Zealand sums to around $15 billion (Treasury, 2011). The government's share of property-replacement costs, and higher expenses associated with various earthquake-related support and assistance packages is around $8.8 billion, much of which will have to be borrowed (Treasury, 2011). This is a large one-off impact on the Crown's financial position (equivalent to around 4.5% of GDP (Treasury, 2011)). However, actions taken by the government in Budget 2011 to hasten the return to fiscal surpluses should see that this debt increase is not sustained over the long term.
In addition, as a result of the earthquakes' impacts, the economy is expected to slow in the short term, but in the medium term, reconstruction activity is expected to lift economic activity considerably. In the long term, economic activity is expected to revert back to towards trend with little long-lasting impacts from the earthquakes.
Because of New Zealand's high level of earthquake reinsurance, the other impact that the earthquakes have had is to reduce temporarily the current account deficit and associated net offshore liabilities, as reinsurance money is treated as income and/or offshore assets (Section 3.2.2). Over the medium-term, the earthquake rebuild will increase the current account deficit as higher investment leads to increased imports. This will be partially offset by higher private saving over the medium-term so deficits do not reach levels attained prior to the GFC.
It is possible long-term consumer behaviour will change as result of the earthquakes, raising precautionary saving. However, it is expected that a return to trend economic growth will see private sector saving likely returning back closer to trend, especially as households more generally regain confidence in their financial positions. This means that the current account impacts from private activity may also return closer to trend over the long term.
Notes
- [4]This is distinct from equity, which is not as dependent on short-term cash flow matching and therefore fluctuations in financial returns do not create the same financial risks.
