Play the Wrong Key, Ruin the Song

currency / b. of payments - 20 October 2005 - 6705 views

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Now that the Governor of the Reserve Bank is free to speak, the group is at least two and yet Key is strangely silent in condemning Alan Bollard for his view. In fact Key’s probably quietly cheering the Governor on hoping that Labour’s post-election party will be spoiled. Funny what difference a few weeks in politics makes.

What does this remind ordinary Kiwis about politicians? When it comes to vote-catching they’ll cheerily mislead in order to promote themselves. In Key’s case it was simple – he wanted the public to vote for his tax-cut package so he was happy to promulgate the myth that there would be no adverse interest rate effects from reducing the fiscal surplus. Straight-faced he told the public so.

Alan Bollard’s argument is simple and the same as mine. So long as Kiwis are happy to borrow money from the oil-producers and the Asian surplus countries in order to expand spending faster than incomes, then New Zealand is heading towards a hard landing. The fiscal surplus is a very important element of reducing that risk. If the disjoint (the balance of payments deficit) is allowed to expand unchecked from its already-high levels, then a sudden correction becomes certain. That could take one of two forms. Either a significant fall in the currency unleashes an inflationary explosion or to contain that outcome interest rates have to be yanked skywards to stabilise the currency but at the cost of a recession. It becomes very difficult for policy to engineer a soft landing once the horse of international confidence has bolted.

These arguments are always about risks rather than certainties but the fact our economy is at capacity and inflation is moving merrily up through the ceiling of the band signals a reduction in the headroom in which to avoid a hard landing. What makes the case for this harsh reality even more probable is that New Zealand’s productivity performance continues to be lacklustre. There is little if any, sign of an escape route being proffered by significant industries emerging that can squeeze more production from our fully utilised labour and capital resources.

It gets worse. The terms of trade (ratio of export to import prices) are the highest they’ve been for 17 years. Yet growth in export volumes is negligible while imports are more and more popular. The former can only be stagnant because we are at production capacity, while more and more imports is hardly surprising given the fall in their price. The economic adjustment we might expect is that imports continue to knock over New Zealand manufacturers trying to compete with them and the resources then freed up move into the more-rewarding export activities – those getting record prices. The extent of this shift however will be limited given our most robust export activities involve producing protein while the capital knocked out of business by imports is general manufacturing. The potential for switching is limited, its economic cost in terms of write-offs on investment, high.

This suggests New Zealand is destined to produce a far worse current account deficit until finally the demand for imports is knocked off via a domestic recession. But for that outcome much water has to flow under the bridge yet. Foreigner lenders have to get concerned about our ability to service our debts. As I illustrated in this column a couple of weeks ago our debt servicing ratio (ratio of interest payments to export receipts) has fallen over recent years thanks to the drop in global interest rates. So our creditors have few concerns as yet. Indeed the balance of payments deficit would have to be sustained at around 13% of GDP at current global interest rates before they might be.

Alternatively however, global interest rates might rise and pre-empt that. If they were to rise from the current average of 4% to 6%, our debt-servicing ratio would be blown out as far as it’s ever been. This – rather than rates staying at present levels and us running our current account deficit to 13% – is most likely. Why? Because another large borrower, the US, is finding that its inflation is on the rise at last, that while it isn’t back operating at full capacity yet, the unused productive capacity lying around isn’t of much economic benefit and should really just be written off. So its closer to full capacity than appears at first sight.

If we postulate then that global interest rates have a further 2% upward in them yet, it is difficult to argue that New Zealand’s won’t follow suit. After all, we like borrowing too and have to compete for those funds. As always in the world of economics however, there’s another possible escape route from this hard landing outcome. The surplus countries of Asia and OPEC could decide the weakening US demand for their products (from the higher interest rates there) isn’t acceptable and simply lend more to US debtors than they have over recent years. The US Fed would be frustrated once more – raising rates to curb inflation only to find resultant capital inflows from abroad drive bond rates down.

Where does all this leave the New Zealand Minister of Finance? More helpless than normal. Our Reserve Bank’s campaign to cap inflation is hostage to the willingness of capital flows from abroad to fund our borrowing for consumption. If the lenders stay willing then our dollar will stay high. If they get discouraged then inflation threatens and our Reserve Bank has to rekindle their enthusiasm via higher interest rates. The Minister of Finance controls the government’s net savings position. If he decides politics dictates he must reduce it, then expect a reaction from the Reserve Bank as Alan Bollard has forewarned. The Reserve Bank will effectively offset any government spend-up by engineering a private sector shrink. Offshore creditors will decide (via the exchange rate) whether that is exporters who get buried, or our consumers.

In conclusion its odds-on that exporters have a lot more pain in front of them (I see very little sign of the global savings glut not providing us our share, nor is our debt servicing capacity stretched yet, and nor are our consumers surrendering on their borrowing-fuelled spending).

If exporters don’t like this they might think of taking John Key out the back and giving him a good talking to. His pre-election nonchalance about the impact of expansionary fiscal policy on interest rates, was at best misleading and more accurately irresponsible. That due its political hue, the Business Roundtable chose to cheer him on with correct but irrelevant claims that lower taxes ultimately aren’t inflationary, didn’t boost Key’s credibility. Roger Kerr has never cared about the transition cost of journeying to the small-government nirvana he preaches. But for businesses – exporters in particular – the journey matters. Timing of any tax cuts is all important therefore. No wonder the Hard Right has been marginalised.

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