FEU Special Topic: The outlook for the current account

Special Topic: The outlook for the current account

New Zealand's current account deficit has widened considerably, owing to many factors including the disruption caused by the pandemic, poor agricultural production, and higher global interest rates. These factors have given rise to a large deficit in the trade balance (the combined goods and services balances) which helped drive the current account deficit from 1.6% of GDP in June 2020 to 9.0% of GDP in December 2022.

The current account deficit began to narrow in the March quarter, falling to 8.5% of GDP, a trend that we expect to continue. In our Budget forecast, the deficit declines to 3.8% of GDP by June 2027, as tourism continues to recover, transport costs fall, and macroeconomic policy tightening weighs on import demand.

The current account of the Balance of Payments can be analysed from three perspectives: the flows from a country’s trade in goods and services and net investment income; the difference between national saving and investment; and the flows of financial transactions between New Zealand residents and non-residents. This Special Topic discusses the drivers of the deficit from each of these perspectives and assesses the prospects for a return to lower deficits.

The widening of the current account deficit…

The three primary components of New Zealand’s current account are the goods balance (goods exports minus imports), services balance (services exports minus imports), and the income balance (income paid to New Zealanders from overseas minus income paid to foreigners)[1]. When the sum of these balances is in deficit, New Zealand is spending more on imports and servicing overseas obligations than it is earning through exports and returns on overseas assets, meaning that a portion of the deficit must be funded through foreign obligations. Reliance on overseas borrowing adds to New Zealand’s stock of foreign liabilities.

Figure 1 shows that New Zealand’s current account has been in deficit continuously since 1974. It also shows that most of the increase since 2019 has been driven by the trade deficit, although the services surplus was trending down before then. In contrast to past chronically large deficits, the income deficit has remained relatively low and stable.

Figure 1: Annual current account balances (March years)

Source: Stats NZ

However, there are similarities between today’s deficit and the earlier peak in 1975. The oil shocks of 1973-74, severe drought, and the UK’s accession to the European Economic Community in 1973 all conspired to drive the goods balance sharply into deficit. The trade balance remained in deficit until 1986 (except for 1979), implying that consumption and investment spending by NZ residents exceeded their earnings from domestic production. This shortfall in income was reflected in large fiscal deficits and rising foreign debt. Subsequently, the trade balance was in surplus for all but four years prior to the pandemic, with an average surplus of around 0.8% of GDP. That is, the costs of servicing the stock of foreign debt accumulated in the earlier period have been the main driver of current account deficits since 1987.

Figure 1 also illustrates changes in New Zealand’s industrial structure arising from the expansion of the services economy. From 1995 onwards, exports of services and tourism have been the dominant driver of trade surpluses. More recently, the dislocation in international travel caused by the pandemic has been the main contributor to the wider current account deficit. Consequently, it’s recovery will be critical to the adjustment towards more sustainable deficits over the years ahead.

…has been driven by disruption in goods….

The goods deficit deteriorated steadily throughout 2021 as uncertainty around the path of the pandemic began to retreat, but restrictions on activity remained. Demand for imports of capital and consumer goods surged, not just in New Zealand but globally. With the pandemic continuing to disrupt supply chains the surge in demand led to widespread shortages and higher prices. This was exacerbated by the dramatic rise in commodity prices that resulted from Russia’s war on Ukraine. On the export side, volume growth has been subdued, especially in the dairy industry.

…and services trade

The onset of COVID-19 and related border restrictions led to a sharp decline in services exports and imports. The removal of border restrictions from June 2022 has seen New Zealand travel services exports recover strongly over the past year, with monthly visitor arrivals rising from 1% of 2019 levels in January 2022 to 69% in December. However, outbound travel has recovered even more quickly and freight costs have remained high, limiting falls in the services deficit.

The deficit is expected to narrow…

The current account deficit is forecast to materially improve in the medium-term as both the goods and services deficits narrow. The goods deficit is expected to narrow as high interest rates and high inflation reduce private sector demand for imports. The effects of falls in global goods prices (such as petrol) on overall import values is expected to broadly offset the impact of lower commodity prices on exports.

…driven by a continued recovery in tourism…

Continued recovery in tourism will play a key role in the improvement in the services balance and the overall current account deficit. Factors driving the recovery include the return of Chinese tourists, New Zealand’s second largest pre-COVID tourist market. The steady increase in New Zealand’s international flight connectivity will also support greater visitor numbers.

The outlook for services imports is more subdued. Transport services imports, which includes shipping costs, increased by $3.0bn over the past year and accounted for over one-third of the increase in import values (Figure 2).

Figure 2 also shows that transport prices more than tripled in the past three years. Anecdotes from the business sector and large falls in global shipping prices over the past year suggest that prices have already fallen substantially, although the extent of these falls is not yet apparent in the official data. In addition, outbound travel has regained much of its pre-COVID level and, in conjunction with higher domestic interest rates and cost of living pressures, growth is expected to slow. 

Figure 2: Travel services imports

Source: Stats NZ

…and a lower goods deficit…

The goods deficit is expected to fall as slowing domestic demand reins in import growth and falling global inflation is reflected in weaker import prices. Goods imports are expected to fall 2.5% in the year ending June 2024 before recovering 3.0% the following year. 

The outlook for goods exports is mixed. Primary production is under pressure from rising input costs and poor weather, but production is expected to recover over the year ahead.  Commodity export prices have weakened in recent months in anticipation of slower global growth, and China’s post-COVID rebound has faltered. Overall, goods exports are forecast to rise 1.6% in the year ending June 2024 with growth picking up to 6.1% the following year as global demand recovers and lifts commodity prices.

…but higher debt servicing costs will be a drag

Globally, surging inflation has led central banks to raise interest rates and increased the cost of servicing the net liability position. The net cost of interest paid to foreigners rose to $3.6bn in the year ended March 2023, the highest since 2009, up from $2.3bn in the March 2020 year. Higher interest costs are the main driver of the rise in the income deficit from a low of 2% of GDP in 2020 to 3% of GDP in 2023. We project the income deficit to widen to 4.0% of GDP in 2024 as the effects of higher interest rates continue to flow through.

The gap between saving and investment has widened…

The connection to international capital markets that is captured by the Balance of Payments also reflects the consumption smoothing, or longer-term term elements of the current account. By borrowing offshore, the effects of a fall in national income can be smoothed but with little change in consumption spending. Over the longer-term, a sustained fall in income will need to be reflected in some combination of lower consumption and lower investment to ensure that the current account deficit and its financing remain sustainable.

The government responded to the pandemic by borrowing to support household and business incomes, especially though the wage subsidy scheme. Initially, pandemic restrictions limited the ability of households and businesses to spend this income, and their preferences for saving and investing shifted with the increased uncertainty. As a result, the gap between government saving and investment (net lending) widened sharply. In contrast, household and business saving exceeded their investment spending (Figure 3).

Figure 3: Net lending by sector (March years)

Source: Stats NZ. Notes: Household data includes Canterbury and Kaikōura earthquake insurance payouts. For 2023, data is for the year ended December 2022. The sector contributions are from the experimental National accounts, and the current account data is from December’s Balance of Payments release.

Subsequently, easing pandemic restrictions, pent-up demand and supportive macroeconomic policies led to higher household and business spending. As a result, the gap between national saving and investment widened to 9% of GDP in the year ending December 2022.

…but tighter macroeconomic policies will help to narrow the gap

While the increase in government borrowing helped to mitigate the immediate effects of the pandemic on household incomes, the deterioration in the current account deficit has reflected falls in net lending by each of the three main sectors (Figure 3). Returning to more sustainable levels will require adjustment in each of these sectors.

The government’s plans to return the budget to surplus is a key part of that rebalancing. Tighter monetary policy is also contributing to rebalancing by inducing the private sector to save more, which will take some pressure off imports. In the longer-term, the Treasury forecasts interest rates to return to more neutral levels as government and household spending slows, which is reflected in the narrowing of the current account deficit to a more sustainable level of around 4% of GDP.

Net foreign liabilities have increased 

The counterpart of a current account deficit is a capital inflow and a surplus on the financial account. Over the four years ended March 2023, the financial account has recorded net inflows of nearly $52bn, with near equal contributions from increased foreign investment in NZ and reduced NZ investment abroad. Most of the capital inflows have been driven by government borrowing, while the outflows mostly reflect the rundown of government funds held offshore.

The net inflow of capital is reflected in an increase in New Zealand’s net foreign liabilities in dollar terms – what households and business resident in New Zealand owe the rest of the world. For the most part, the net liability position is made up of debt (Figure 4).

Figure 4: Net international investment position and net external debt

Source: Milesi-Ferretti[2] for data prior to 1988, Stats NZ

Net external debt was $28bn higher in March 2023 than March 2019, led by a $22bn increase in government and central bank debt, but despite this increase, net external debt has fallen to 46% of GDP (Figure 4). The implication is that the financing requirement is less of a burden than it has been, as reflected in the downward trend of the investment income deficit. In addition, because banks facilitate most of the financial flows between New Zealand and the rest of the world, the reduction in the external debt ratio implies that bank decisions regarding loan availability and how they fund lending has reduced systemic financial risk. Equally, reduced household demand for credit and relatively strong growth in deposits has reduced the need for banks to borrow offshore.

The vulnerability associated with the debt position is also influenced by the maturity and currency composition of the debt. The floating exchange rate provides a further layer of protection against a weakening in market sentiment.

The reduction in perceived risk has been reflected in New Zealand’s foreign currency credit ratings, which were upgraded to AA+ by S&P in 2021 and by Fitch in 2022 (AAA is the strongest level of creditworthiness). However, these ratings could come under pressure if the current account deficit and the associated higher borrowing requirement were not to show the expected improvement over time.

A feature of the decline in New Zealand’s net liability position since 2009 has been a relatively high exchange rate compared to the past (Figure 5). Typically, a higher exchange rate would contribute to a widening of the current account deficit, as exports become less competitive and lower import prices encourage substitution away from domestically produced goods and services. However, the strength of the exchange rate since 2010 is partly related to the increase in the terms of trade over this period, which helped offset the dynamics noted above.  

Figure 5: The terms of trade and the exchange rate

Source: The Treasury

The Treasury is forecasting the terms of trade to gradually rise over the years ahead and the exchange rate to gradually decline. Both these assumptions are highly uncertain and there are risks in both directions. A higher exchange rate may slow the pace of improvement in the current account deficit, while a lower terms of trade could place downward pressure on the exchange, which could add to inflation, and increase pressure on household consumption spending to slow.

There are several other factors that could see the deficit remain wider for longer than expected: the scale and timing of the rebuild stemming from the severe weather events earlier in the year is uncertain, and the associated import demand may be larger than assumed; and the high probability of a severe El Niño climate pattern developing could further disrupt exports. The strength and timing of the recovery in tourism is a further source of uncertainty. However, the reduction in the net liability position achieved over the past decade of so means that our financial system is better placed to manage these risks than in the past.