This Note was written in early December 2005, to clarify some issues in my mind about exchange rate policy
Keywords: Macroeconomics & Money;
Why is the exchange rate high. The short answer is that the New Zealand economy is badly imbalanced, and the imbalance vents through the foreign exchange market into a higher exchange rate.
There are two sorts of responses. We could try to vent it another way (inflation might be an option), or we could try to reduce the imbalances.
In my view the priority has to be reducing the endemic imbalances. The world economy is also badly imbalanced, the most obvious cause being the US fiscal deficit. Whatever the state of the New Zealand economy, it will be affected when the world economy adjusts, but the damage will be very much greater if the New Zealand economy is also imbalanced. So we need to address our imbalances before the world economy does (although I dont know how it will happen, nor when).
At the heart of the domestic imbalance is that we are spending too much and saving too little. We are forced to finance the deficit by borrowing offshore. That drives up interest rates to attract foreign capital, and the exchange rate. the focus has to be on the savings deficit.
The implication here is that what the Reserve Bank does, is not nearly as important as in the public rhetoric which is about quick fixes, rather than addressing the savings deficit. As it happens, I think that the Reserve Bank policy framework is flawed, and said so when it was introduced in the 1980s, persistently criticising it through the 1990s. One day we will get a better framework, but that will take time.
(My concerns are that monetary policy cannot regulate the economy by itself, and in any case given the limited range of policy instruments it has – one, the OCR, plus rhetoric – it has only a limited capacity to attack complicated macroeconomic issues.)
I do favour the operational transparency provisions in the Reserve Bank Act, and would not want to see them revoked. Rather, when they were introduced in the late 1980s a number of monetarist assumptions were slipped in, which need to be reviewed. There is some good news here. One assumption was that monetary policy could operate independently of fiscal policy, overriding its failures. It cant. Today, there is much greater cooperation between the Reserve Bank and the Treasury. The Labour government deserves credit for this.
What about fiscal policy? A coherent macroeconomic policy requires that if private savings are insufficient, the government’s income and spending plans have to offset them by extra public saving. (There is also a strategic reason. When the economy fractures because of the imbalances – international or local – the public will demand that the government steps in and helps it get over its earlier foolish decisions, a demand which will be partly politically irresistible. So the sensible thing is for the public sector to have an especially strong balance sheet in preparedness.)
The New Zealand public balance sheet is one of the strongest in the world: long may it remain so. However, it took on water during the election, as irresponsible National tax and spending proposals were countered by Labour, while the coalition agreements seem to have added a little more to the water logging.
What the government has to do now is to restrain its spending (even if it had no plans for future income tax cuts). This is going to be harder than it might seem because not only are there political pressures, but also because there has to be major outlays on public infrastructure over the next few years. The public expenditure review is a part of this strategy (although it wont cut that much), certainly not as much as was promised by the National Party during the election campaign.
So the short answer on fiscal policy is to restrain everyone’s natural desire to spend more and tax less. We are lucky that we have a Prime Minister and a Minister of Finance who are fiscal conservatives. They need all the support they can get.
What else can be done? The household sector needs to be encouraged to increase its savings. So any incentive measures the government has in train might be accelerated.
There appears to be two specific, but connected, problem areas. The first is housing, where outlays seem excessive, driving a housing construction boom and driving up housing prices. The Reserve Bank and the government are trying to reduce expectations of house price increases. My impression is that housing prices are peaking, so their cautions may have some effect.
Additionally, I’d be looking at taxation on housing. I was surprised last week to hear a couple of respected business leaders privately regretting the way household savings are going into houses rather than businesses: both advocated capital gains taxes on second homes. They are not advocating publicly (yet) and (yet) it is easier for them to say so than the politicians. Even so it would be sensible to check tax law on housing, to see if any tightening, including removal of those which encourage commercial exploitation of loopholes. even if only on the margin. Small changes may contribute out of proportion to restraining the boom.
The other problem area is the consumer spending funded by debt, sometimes secured on housing. The debt finance (for mortgages and general consumer spending) is generally funded from overseas, through a conduit provided by banks and other financial institutions.
The banks are not behaving irresponsibly, for they make money from this conduit. However, the outcome of increasing consumer debt is irresponsible household balance sheets. Hence, the arm wrestling between the trading banks and the Reserve Bank. There may be some financial measures which would restrain this consumer lending, although I doubt we would (or could) go back to hire purchase.
Meanwhile, the cost of consumer finance is rising, not only as the Reserve Bank pushes up short term interest rates, but also as foreign investors allow for the downside risk of a fall in the exchange rate. I must say I am pessimistic about finance costs restraining consumer debt although it will restrain the housing market.
The other potential domestic saver is the business sector. The government is reviewing business taxation. I would place a priority in a regime which encourages business to retain profits.
Second, some local investors are portfolio investing overseas because of the limited opportunities in New Zealand. Such investments add to the amount of cash which flows through the foreign exchange market, which has to be offset by borrowing from overseas sources, increasing gross foreign borrowing, and pushing up the exchange rate. (Note I am discussing here portfolio investment, not foreign direct investment.) Can we increase portfolio investment opportunities in New Zealand, thereby encouraging New Zealand savings to stay home and reducing gross overseas borrowing?
Why not let private investors in state owned enterprises. This is how to do it.
1. The government makes a clear statement why public ownership of SOEs is appropriate.
2. It identifies those SOEs where cornerstone ownership is appropriate – that is where it is the largest, usually majority owner – but where total ownership is not necessary.
3. It offers to sell down its shares to the cornerstone level, to long term investors – such as pension funds, the Cullen Fund, GSF, ACC – who thereby switch some of their investments from offshore to onshore, reducing the need for gross foreign borrowing.
4. It will have to make some other concessions such as minority representation on the board, registration of shares on the share market, and some access to CCMAU.
The sort of SOEs I have in mind are like Air New Zealand, Railtrack, Transpower. I would not included those SOEs which have social objectives (or a primarily funded by the government) but are held in a corporate form for convenience (including TVNZ, RNZ, DHBs CRIs, …). I would not include the electricity generation companies, until the sector is sorted out. (My definition of SOEs is wider here than the legal one. A longer paper would have to be more precise, but for political purposes it has to be clear there are no go areas.)
The advantage to the investors, are they are substantial companies, with a solid effective owner, likely to make good returns over the years.
In summary there are no quick fixes,. Addressing the imbalances requires a spectrum of measures, some of which are being implemented and others which could be introduced without too great difficulty.