Liberalization Sequencing: the New Zealand Case

Journal of Economic Growth Volume 4, No 1, Winter 1989-90, p.14-18.

Keywords: Growth & Innovation; Macroeconomics & Money;

The economy of New Zealand first .surged forward under the Labour government, with registered unemployment falling from around 64 thousand at the time the new government took office in July 1984 to about 50 thousand a year later. As the restructuring took effect and firms dependent upon subsidies closed down, unemployment began to increase. By the end of 1989 it was close to 150 thousand with little prospect of significant reductions.

In fact, despite the glowing reports from those on flying visits who are impressed by the record of market liberalization, New Zealand’s economic performance has been disastrous in the latter half of the 1980s, with an average annual growth rate of one percent between 1984 and 1989. This is less than the population growth, itself depleted by migration of New Zealand workers to the more prosperous Australia. This weak performance has occurred while New Zealand’s markets have been expanding and there has been a strong world demand for most of New Zealand’s exports.

The violence and rapidity of restructuring was such that there ought to have been a sharp contraction as the measures took effect. A substantial dumping of labor from low-productivity, high-protection industries was inevitable. But that phase should have been followed by a growth recovery, as high-productivity firms, liberated from the shackles of intervention, took on the redundant labor as they exploited market opportunities. There is no indication that such a recovery will take place, and the most favorable forecasts project a long-term growth rate not unlike that of he past, although it would be from a lower base due to the stagnation of the 1980s.

It would be easy to argue that the market liberalization of the New Zealand economy has been a disaster and to advise other countries against pursuing such policies. In the near future, no doubt, New Zealand will receive visitors who will look at the record of unemployment and stagnation and will draw such a conclusion. In my view, it is premature to adopt this diagnosis for two reasons.

First, case studies of individual market liberalization at the microeconomic level are quite consistent with the results claimed by the more moderate advocates of these policies. Even in New Zealand in terms of entrepreneurial initiative, new products, technological innovation and better consumer quality and choice, the liberalized market has far exceeded anything the controlled market could ever have achieved. Second, there are more plausible alternative explanations as to what went wrong.

The Exchange Rate

The exchange rate has played a significant role in the recent poor economic performance. The strategy of market liberalization centered on growth through the tradeable sector, by promoting exports and competing against imports. The stripping away of protection removed the cost burden of protected but low-productivity industries and released resources for the growth of progressive firms.

But growth in the tradeable sector requires favorable prices. While firms may enhance their productivity, if the price signals are not profitable there is no incentive to produce, let alone to invest and expand. Since a small economy like New Zealand’s has very little influence on international prices, the profitability of the export sector is dependent on the exchange rate.

It was generally recognized in July 1984 that New Zealand’s exchange rate was substantially overvalued and would be even more so if border protection and export assistance were removed. The incoming government was advised by the Reserve Bank of New Zealand that a sizeable devaluation was required. Events overtook this advice when a run on the currency forced a devaluation of 20 percent in July 1984. New Zealand had a fixed exchange rate at that time, and the run depleted official reserves.

In March 1985 the government of New Zealand moved to a floating exchange rate, following the abandonment of capital controls in December 1984. Many countries have floating exchange rates, but usually an official agency, such as the Reserve Bank, regularly enters the exchange market to buy and sell currency in order to push the rate in some preferred direction. The New Zealand government does not; it confines foreign exchange purchases to its currency needs. Thus the float is of a very pure form, with a minimum of government intervention.

As predicted in the theoretical literature and by experience gained elsewhere, the exchange rate moved up shortly after the float was introduced. The technical term is “overshooting,” and the exchange rate has remained overvalued ever since that time. Between 1984 and 1989, producer prices rose by 51.2 percent, compared to 18.7 percent within the Organization for Economic Cooperation and Development (OECD). New Zealand’s exchange rate should have fallen 21.5 percent {the difference between the two increases) against its trading partners, to compensate for the loss of competitiveness. In fact, the trade-weighted exchange index fell 19.5 percent, roughly the same amount as the inflation differential.

It should be recalled that in June 1984, the exchange rate was considered by all informed observers to be substantially overvalued. Since that time, all export assistance and many border protection measures have been removed. The exchange rate remains highly overvalued, as it has been for the past four years. In practical terms, this means that firms in the tradeable sector face an enormous profitability hurdle, particularly because gains from increased productivity and reduced costs from the elimination of protection are already incorporated in the price index.

In the past five years, there appears to have been a significant reduction in the government deficit, although not as much as the crude indicators suggest. Similarly, there appears to be much tighter monetary control as market interest rates have risen in real terms. This has made the control of government spending more difficult.

Monetary policy has been credited with reducing the rate of inflation. Again the indicators are difficult to interpret, but there can be no doubt that in the past two years consumer inflation has fallen from the double-digit rates of the 19705 to a level close to the OECD average.

The main mechanism for reducing the inflation rate has been low import prices, resulting from the overvalued exchange rate. By keeping interest rates high, monetary authorities have attracted overseas capital, which in turn hiked the exchange rate. Overvaluing exchange rates to hold down the rate of inflation is a well-known strategy in the Third World , particularly as cheaper consumer imports favor the restless urban masses and those with secure jobs in the non-tradeable sector. The cost is unprofitability in the tradeable sector.

The lesson to be learned is that successful market liberalization aimed at growth through an expanded tradeable sector requires a realistic exchange rate. Leaving the foreign exchange market to itself during a transition, when there is so much turbulence in other markets, is unlikely to succeed. The resulting overshot and overvalued exchange rate can destroy all the gains achieved by the market liberalization program.

The Sequencing Issue

The problems that New Zealand has faced concerning its exchange rate policy reflect a general issue in market liberalization strategy known as “sequencing.” Since all liberalization changes cannot be made overnight, and since the speed of response to the measures will vary in different parts of the economy, what is the best order, or sequence, in which to carry out liberalization?

The literature discusses the sequencing issue most fully with respect to the foreign exchange markets, particularly using the Latin American experience. In simple terms, the question is the following: when should the capital account be liberalized relative to the current account? In other words, in what sequence should capital controls and border protection be removed? In New Zealand, capital controls were eliminated overnight while protection was gradually phased out. This sequence does not seem to have been successful, partly because product markets respond much more slowly than financial markets.

But the sequencing issue is not confined to the external account. Notable in the New Zealand case has been the sequencing of regulations concerning financial and corporate markets. The strategy was to abandon the traditional controls on financial activity as quickly as possible, but that meant that a new framework, including the development of revised accounting standards and shareholder information and control, could not be put into place in time.

In addition, the one failure of the tax reform has been the biased taxation of investor income. New Zealand still has no capital-gains tax, but the taxation of other investment is at a relatively high rate because there is no exemption for the inflation component of interest payments. Different tax treatment for different types of investment income encourages investors to invest for capital gains in financial speculation and property.

The result was a wild speculation boom which ended with a shattering bust in October 1987, when the New Zealand stock market collapsed further than any other in the West. Two years later, the indices are at half the level of their 1987 peak. Some of New Zealand’s largest investment and property companies have disappeared and billions of investor dollars have been lost.

Once again, the international literature and experience would warn that foreign exchange overshooting would be accompanied by a financial and construction boom, but little notice of the warning was taken during the liberalization process. The result may be a setback of more than a decade for investor confidence in the integrity of New Zealand’s financial system with a corresponding disastrous result for investment and economic growth.

The justification for the rapid market liberalization with little regard to the sequence was that attempts at orderly liberalization in the late 1970s and early 1980s had been thwarted by the political pressures of affected interest groups. They were put off course by the need to institute compensating interventions or to address some economic crisis where intervention seemed to be the easy solution. The notion of a “temporary intervention ” is practically an oxymoron.


Most New Zealand economists would still support the direction of market liberalization of the late 1980s and applaud the courage of the government that undertook the program. However, they would add one or two major caveats.

The first lesson is that if the strategy involves a greater role for the tradeable sector, the exchange rate must be favorable. No government can achieve perfection in adjusting the exchange rate, but that is no excuse to leave it to market forces when markets are in turmoil as the result of decreased intervention.

The balance between the methods of maintaining a favorable exchange rate, such as direct purchases and sales of foreign currency, relaxing foreign exchange controls and trade protection or the use of fiscal and monetary policy) will depend upon the circumstances of the country and the stage of liberalization it has reached. But the method must be subservient to the objective. If there is uncertainty concerning the correct exchange rate, the sensible strategy is to err on the side of underevaluation, since the aim is for the tradeable sector to absorb resources and expand.

Unfortunately, such a strategy may prolong the process of disinflation. There is no doubt that erratic high inflation is a serious handicap to the effectiveness of the market, but if the New Zealand experience is any guide, it is better to have double-digit inflation than double-digit overvaluation of the exchange rate.

The second lesson is to pay attention to sequencing, particularly in terms of the legal framework. The old legal system may have been quite adequate when government intervention was rife) but its inadequacies will be exposed as the government withdraws. We can learn much from New Zealand’s experience. The details of how to go about removing protection, regulating markets, reforming the tax system and improving the quality of government expenditure will be invaluable to others embarking on the same path. And the successes at the microeconomic level will encourage them to do so.

There is a danger that this experience will be used to point out the failure of market regulation, particularly as the evidence of the poor macroeconomic performance and the disaster in corporate markets become more widely known. But that is to miss the point. Few advocates of free markets would expect them to work well in the context of poor economic management and an unsatisfactory legal framework. The New Zealand experience supports the judgment of the majority.

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