rankinfile.co.nz/rfile041222BalancePaymentsBlowout.html

On Tuesday (21 Dec) balance of payments data revealed that New Zealand had a near-record "monster" $3.09 billion current account deficit for the September quarter (ref. NZ Herald article). The Herald news cartoon on the following day showed a bloated Christmas turkey, labelled "the consumer".

Indeed the standard explanation for such a deficit is consumer over-spending. It is however grossly misleading to blame ordinary New Zealanders for our nation spending much more (including debt service) than it earns.

We need to understand that there are important relationships between a country's exchange rate and its balance of payments. We also need to understand that, in a global context, if some countries have balance of payments surpluses, then others must have deficits. Likewise, if some countries have undervalued currencies, then some others must have overvalued currencies.

The economic relationship between China and the United States has created a number of significant imbalances in the world economy in 2004. China's currency is fixed against the US greenback, much as New Zealand's currency was in the 1960s (when seven US dollars equalled five NZ dollars!).

This arrangement worked all right in the 1990s when the United States economy was very strong. But, since 2000, the US economy (and the $US with it) has been in crisis while China is emerging as an economic super-power.

From 2000, if China's currency was floating as ours is, the Yuan would have risen markedly against most of the world's currencies. Instead it fell with the US dollar. The result is one huge economy with a substantially undervalued currency and a large balance of payments surplus. Therefore, by definition, the rest of the world has a balance of payments deficit, and almost all countries whose currencies not fixed to the $US have overvalued currencies.

There are some special circumstances, however, which make our balance of payments deficit and currency overvaluation unusually large.

Why is the kiwi dollar so high? More particularly, why did the $NZ rise in value so much in the July-September quarter, which is typically our worst time of the year for exports?

One driving factor is the demand from savers in the rest of the world for safe fixed-interest returns that are higher than what is available in their own countries. The huge inflow of foreign capital arising from that demand is a direct consequence of our high Official Cash Rate (6.5%), set by the Reserve Bank.

The second reason why the New Zealand dollar is so highly valued is that world commodity prices are high, and the kiwi dollar (like its Aussie counterpart) is seen in world financial communities as a commodity currency.

In other words, foreign savers buy $NZ denominated financial assets (including mortgages and government stock) because they believe that, in the current global financial environment, the New Zealand dollar can only continue to rise. They are using the $NZ as a means to a tax-free capital gain.

If our balance of payments situation conformed to the stereotype of greedy consumers demanding more goods and services than domestic producers can supply, then we would be selling more kiwi dollars in order to pay for a cornucopia of imports. If that was the case, our exchange rate would be falling not rising, as per the United States' experience.

So why does a large inflow of foreigners' savings cause us to spend more on imports? It's simple. The inflow of foreign money causes our exchange rate to rise, making imports cheaper. In the meantime, New Zealand workers continue to be employed satisfying high world demand for our commodities and building houses financed by foreign savings.

There is an orthodox macroeconomic solution to an exchange-rate driven balance of payments blow-out: ease monetary policy (ie reduce interest rates) while, to prevent inflation, tighten fiscal policy (ie raise taxes). Raising taxes may be a hard sell politically, given our government's substantial budget surpluses. Further, a large fall in interest rates would be required, given that interest rates are not the only reason why so many foreign savers are attracted to New Zealand.

The better policy option is probably to ride the wave and to enjoy the ride. Our economy looks as if it will continue to grow at annual rates significantly higher than the averages for the last 30 years. Our balance of payments, while high in dollar values, is less of a burden to service than it has been in the past.

The more interesting question for us is: what will happen when China finally does get around to floating or revaluing its currency? If we are poised to satisfy even a small fraction of that unleashed spending power, we will receive a bigger export-led boost than we ever received from British demand for our goods in the 1900s, 1950s and 1960s.
 

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