4.2 Adjusting for inflation

In this section we address three separate adjustments to measured savings that arise as a result of inflation. Net lenders become relatively worse off in inflationary conditions, as inflation acts as a tax on their holdings. In contrast, net debtors tend to become better off, as inflation reduces their real debt. Each of the three adjustments we make reflects this impact of inflation. The distortionary effects of inflation on saving and other national statistics have also been recognised by previous authors in New Zealand (eg. White, 1980; Clements, 1984; Coleman; 2006).

4.2.1  New Zealand as a net foreign borrower

In the presence of inflation, real holding losses are incurred by lenders on financial assets. Lenders commonly demand higher nominal interest rates to compensate for inflation. As such, nominal interest rates can be decomposed into two components, real interest, and a component to offset the impact of inflation. This second component represents repayment of the real principal, rather than a real return. The consequence is that this amount should be recorded separately as a capital transfer, rather than as income for the lender or expense for the debtor.[20]

The national accounts and derived measures, however, are presented in nominal terms: Nominal interest receipts are entered as current income and nominal interest payments as current expenditure. Consequently, the income of lender is overstated, and the saving of borrowers is understated, as the nominal rate of interest includes an implicit capital repayment to the lender. The essence of the following adjustments lies in recognising the fact that inflation erodes the real value of financial assets.

The following clearly state the problem for measurement of savings in the presence of inflation:

As conceptually, the inflation component of the interest payments represents a repayment of capital in real terms, it should not be regarded as income when received or an expense when paid (The Australian Treasury, p.32).

It is well known that, in times of inflation, the nominal interest rate consists of two components - the real interest rate and an inflation component. From the viewpoint of borrowers, the inflation component of interest payments is, in effect, equivalent to the repayment of real principal because the real value of the principal outstanding falls by the same amount. In other words, the inflation component represents a flow of savings or an accumulation of wealth on the part of the borrower. Similarly, from the view point of the lenders, the inflation component of interest receipts is equivalent to receiving back part of the principal lent because the real value of the principal has declined by the same amount. In other words, the inflation component of interest receipts does not represent true economic income. (O'Mara and Walshaw, 1992, p. 51).

In an inflationary environment for a country with net external liabilities, the real value of the burden of these foreign obligations denominated in home currency falls at a rate equal to the domestic inflation rate and, consistent with the Fisher real interest rate effect, part of the annual interest payments effectively compensates lenders for the erosion in the value of their principal. Hence the inflation segment of interest received is not really additional income earned by creditors. Yet under existing external accounting procedures, all interest actually paid to foreigners appears in the current account when that part attributable to inflation should in fact be recorded in the capital account. (Makin, 1995, p.59).

The consequence for the measurement of savings is as follows: in the case of borrowers, interest expenses are overstated as the inflation component is in fact saving; reducing expenses for any given income level will lead to a higher estimate of saving. Likewise for lenders, their income will be overstated by the inflation component of their interest receipts, so that for any given level of expenses reducing income will lead to a lower estimate of saving.

In nations with a limited net foreign debt position, these effects offset each other in aggregate, and only the sectoral composition of income and savings is affected. However, New Zealand is a net borrower with the rest of the world, so the effects of inflation impact our position in aggregate. Our net external investment position represents claims on our economy by foreigners.[21]

Adjusting our net international investment position (excluding equity) (henceforth, net foreign liabilities) for inflation[22] results in a reduction in the level of net foreign liabilities and a commensurate increasein our net national savings rate. In making this adjustment we rely on the fact that the majority of overseas debt is either denominated in New Zealand dollars or hedged, and that the inflation rates in creditor countries have been broadly similar in the last two decades.

The following two figures summarise the results. Figure 13 shows the level of net foreign liabilities with and without the inflation adjustment. In 2012, the inflation adjusted level of liabilities is some 3.6 percentage points of GDP lower than the observed level.

This is an approximation, as the net international investment position is also affected by the currency in which debt is denominated as well as price levels, and hence exchange rate fluctuations, which are not taken into account here. A substantial part of New Zealand's foreign liabilities is denoted in New Zealand dollars, and of the remaining amount, much is hedged. This tends to minimise the problem of multiple currencies.

Based on the estimates of the inflation effect we can now adjust net national saving; the results are shown in Figure 14. The long run average (1989 to 2012) net national saving rate increases from 2.5% to 4.3% after incorporating the adjustment for inflation.

Figure 13 – Net foreign liabilities adjusted for effects of inflation: 1989-2012

Figure 14 – Net national saving adjusted for the effects of inflation on net foreign liabilities: 1989-2012

Source: Statistics New Zealand and author's estimates

The finding that on average the national saving rate is understated due to the impact of inflation by some 1.7 percentage points of GDP corresponds closely to a similar finding by the Reserve Bank (2010) which estimated the under estimation was up to 2 percentage points. The Bank noted that as a result of this correction for inflation, there are implications for international comparisons. Specifically debtor countries will have a higher adjusted saving rate, and by the same reasoning, the national saving rate of creditor countries would be reduced. This would have the effect of reducing the apparent gap between the national saving rate of New Zealand and the average of the OECD countries.

Inflation can distort the measurement and interpretation of national savings across time and across countries. A portion of any interest payment is simply compensation for the reduction in the purchasing power of the underlying financial instrument because of inflation. The full extent of nominal interest payments is recorded as an expense, but the inflation compensation component is better thought of as a repayment of principal. Although inflation rates among the countries we typically compare ourselves with are now quite similar over time, New Zealand's high net dependence on external debt means that this issue still affects the cross-country interpretation of our savings data. For a country with no net dependence on foreign debt, all the interest payments and receipts are (net) between residents, and net out for the purposes of national savings statistics. But New Zealand has net foreign debt of just over 80 per cent of GDP and survey measures of expected medium-term inflation are around 2.5 per cent. That combination means that the real national savings rate for New Zealand is understated by up to 2 percentage points. The inflation distortion works in the other direction for countries with large net foreign assets (such as Switzerland or Norway or Singapore). Correcting for this factor tends to narrow international differences in reported national savings rates a little. Reserve Bank (2010, p.4)