3 Implications of New Zealand's national saving position
3.1 Vulnerability
New Zealand's high level of NFL, at around 85% of GDP, is cause for concern:
- It makes New Zealand vulnerable to sudden shifts in international market sentiment, which can cause financial shocks and serious economic and social disruption.
- It limits the country’s capacity for additional borrowing and options for dealing with unexpected problems (a foot-and-mouth outbreak, earthquakes, etc.) and emerging problems (an ageing population, climate change, energy and water shortages, technology change, low productivity, slow growth, increasing trade competition).
- The burden of servicing the liabilities lowers income available for other uses.
As a country's debts grow, markets become more cautious, credit ratings are downgraded and the cost of debt, including the cost of rolling over existing debt, rises. A tipping point in sentiment can be sudden, giving a country little time to adjust and can cause a “sudden stop,” which means a sharp reduction in capital inflows and a painful economic slowdown. Borrowing costs rise and the currency weakens. Slower growth erodes the tax base, causing concern about fiscal sustainability.
Is a sudden stop inevitable? No. However, the SWG's view is that New Zealand's current position increases the risk of such an outcome. Recent history is a stark reminder that adverse events, in a wide variety of forms, are not uncommon and withstanding them requires financial resources.
Box 2: What a sudden stop could look like
New Zealand's continuing ability to sustain its foreign debt position is strongly influenced by investor confidence and economic performance. Given the importance of agricultural exports to the economy, one possible trigger for a sudden stop could be a negative terms of trade shock. Another could be a sudden shift in market sentiment, triggered by concern about European debt.
A sharp drop in dairy prices could cause New Zealand's trade balance to deteriorate and growth expectations to weaken. Farmers' and exporters' ability to service their debts would be impaired. Higher non-performing loans would cause credit conditions to tighten. Weakening sentiment would reduce the exchange rate, raising the cost of imported inputs. Investment would probably fall sharply.
A vicious feedback loop would emerge as the economy moved closer to its debt threshold. Weaker perceived creditworthiness would increase interest rates on foreign debt and reduce the availability of financing, making servicing debt even more difficult and causing rising bankruptcies and falling consumption. Declining demand, higher unemployment and lower expected income streams would cause the prices of domestic assets to fall. This would lower collateral values, further tightening borrowing constraints. Currency depreciation would amplify the impact on balance sheets by raising the local currency value of foreign liabilities that are denominated in foreign currency. A critical issue would be the government’s fiscal position and ability to sustain its levels of activity.
As the outlook for the economy deteriorates, speculation over the sustainability of debt levels would grow, until external borrowing freezes up. Because New Zealand's foreign debt is largely denominated in New Zealand dollars, the country does not have large foreign currency debts. It also has a flexible exchange rate and so most of the current account adjustment may be expected to come through a substantially weaker exchange rate and a rapid reversal in the current account deficit, which would not be all bad news.
But the adjustment that a sudden stop imposes is very painful. The decline in domestic credit and output is severe as the economy is forced to deleverage over a very short period. The government and banks may also be required to repay short-term debt at short notice. Because it takes time for the export sector to respond to the weaker currency, much of the improvement in the current account balance over the short-term is likely to come through a substantial fall in imports and domestic investment. The resultant fall in output and reallocation of resources from the non-traded to the traded sector may well cause a large and persistent unemployment shock.
Tax revenues also fall, the capacity for the government to borrow falls and pressure on government services rises. Ultimately, these effects mean the government is constrained from paying income support and other programmes at a time when demand is likely to be higher.
If the stress on business and household balance sheets is sufficiently severe or domestic banks have problems refinancing maturing loans, the sudden stop could produce a bank crisis. In this case, the contraction in output would be even larger as financial disruption results in an even sharper decrease in credit extension. This would also threaten the government's balance sheet if the government is forced to bail-out systemically important financial institutions.
Research by Reinhart and Rogoff (2009) suggests that financial crises result in severe and protracted recessions that generate large increases in unemployment. Unemployment increases, on average, by 7 percentage points and lasts for four years on average. Output declines by over 9% but tends to recover faster than employment, with a duration of about two years. The real value of public debt tends to balloon, rising by 86% on average during post World War II financial crises.
Country experiences suggest the availability of fiscal and monetary buffers, along with a flexible currency and openness to trade, play an important role in preventing shocks from causing full blown sudden stops (Bordo 2006). Sound prudential management of the banking sector also protects against an abrupt rebalancing exploding into a banking crisis.
Section 9.2 contains more material on the probability of a sudden stop happening in New Zealand, while Section 9.3 has three examples of how financial and economic crises came out of the blue. This includes the example of New Zealand's experience after the 1987 share market crash.
3.1.1 Macroeconomic vulnerabilities are of concern in New Zealand
New Zealand relies heavily on short-term offshore borrowing – about 40% of debt matures within one year (Figure 3.1), which increases vulnerability to sudden changes in sentiment because of “rollover risk.” In the wake of a shock, this risk could cause domestic banks to restrict loans to households and businesses, reducing growth and investment, as occurred during the GFC.
- Figure 3.1: Maturity of overseas debt
- Source: Statistics NZ
Note: 2000 to 2009 are December years; 2010 is a September year.
New Zealand's vulnerability has some mitigating factors:
- Most (93%) of the country’s foreign debt is hedged back to New Zealand dollars, limiting the impact of a weaker currency on the cost of servicing foreign currency denominated debt.
- A flexible currency also helps external rebalancing, as happened in the Asian crisis in 1998 when currency depreciation reduced the current account deficit by increasing export competitiveness and reducing demand for imports.
- Space for fiscal and monetary policy gives policymakers the flexibility to respond to unexpected shocks – by cutting interest rates and providing fiscal stimulus to buffer the economy – although the recent deterioration in New Zealand’s fiscal position has reduced the government’s ability to respond to any shocks in the near term.
- The relationships between main local banks and their parents in Australia, as well as the Reserve Bank’s new liquidity policy, have helped ensure that the funding lines of domestic banks have remained open in spite of problems in credit markets.
These institutional factors help to reduce the immediate risk of a crisis for New Zealand, but the risk is still high and increasing.
The Treasury (2010b) estimates that stabilising NFL requires an increase in national saving equivalent to about 2% of GDP, but to reduce NFL to a safer level requires an increase in national saving of about 4% of GDP.
The IMF (2010a) also estimates that stabilising NFL would require the real effective exchange rate to depreciate by 20%, and a reduction of NFL to 75% of GDP over 15 years would require the real effective exchange rate to depreciate by 25%.
These are potentially very challenging adjustments for the New Zealand economy and community, and delay will increase, not reduce, the challenge.
The recent experiences of Iceland, Ireland and southern European economies highlight the vulnerability of debtor nations to tightening credit conditions. New Zealand’s resilience in the face of the GFC reflected a low level of public debt and the soundness of the country’s macro-financial institutional arrangements.
Withstanding future shocks requires the rebuilding of the country's unused borrowing capacity, particularly its fiscal buffer by returning the government's net debt-to-GDP ratio to where it was before the GFC. Over the longer term, the focus of policymakers should be on developing a more robust and sustainable economy, and the creation and maintenance of incentive structures that support preferences for investment and saving over debt-financed consumption and ensure prudent risk management.
