Our glut of overseas borrowing is like a disease eating away at the economy.
Listener: 24 October, 2009.
Keywords: Growth & Innovation; Macroeconomics & Money;
If a large highly productive foreign-exchange-earning sector emerged, it would squeeze the existing tradeable sector: exporters, and industries that compete with imports. Not only would it earn foreign exchange more efficiently but it would compete with the existing sector for labour and materials to fuel its expansion. Ultimately, the squeeze would operate by lifting the exchange rate; the increased supply of overseas currency would drive up the New Zealand dollar, making the existing businesses earning or conserving foreign exchange less profitable.
That’s what happened about 100 years ago. Refrigeration unleashed the pastoral sector, enabling it to export meat and dairy products. Manufacturing was squeezed, falling from about 25% to 15% of the labour force. (If we exclude the freezing and dairy industries, the fall was even more dramatic.) The new growth industry was more productive than those it displaced, so the economy was better off. The only grumbles came from those in the displaced industries.
The scenario also applies when the emerging industry is mining. The exploitation of the North Sea gas fields reduced Holland’s manufacturing industry. A similar thing happened in Australia with its mineral boom.
The phenomenon is sometimes called the “Dutch disease” or the “Gregory effect” (after Australian economist Bob Gregory). It’s called a disease because when the gas or minerals run out, the country needs to expand its manufacturing industry to replace the lost earnings. But that is difficult, because of the enfeebled state of the displaced industry.
We can simplify the analysis by imagining the mine is a vault containing bars of gold, which are exchanged for US dollars to buy imports. Same conclusion: up goes the exchange rate at the expense of tradeable production; exporting and import-substituting production diminishes.
Or suppose the vault contained IOUs that could be converted into US dollars. It is another source of foreign exchange, so the analysis is much the same. The exchange rate would rise and the tradeable sector would suffer because borrowing is an easier way to get foreign exchange.
But when this vault runs out, the situation is worse. Not only has the sustainable tradeable sector been damaged, as in the Dutch disease case, but the borrowings have to be serviced (and perhaps repaid), so there is an even greater need for foreign exchange.
This lengthy introduction is to give general readers the sense of the well-established economic proposition that capital inflows (which include borrowing) lift the exchange rate at the expense of the ability of the economy to earn and conserve foreign exchange by production and sales.
That is exactly what has happened to the New Zealand economy since 2002, when we embarked on a great splurge of foreign borrowing. Not surprisingly, the tradeable sector stagnated while the internal sector expanded rapidly, its expenditure fuelled by the borrowing.
That’s not to say all offshore borrowing is necessarily bad. If the funds are invested in strengthening the tradeable sector, the foreign-exchange-earning and -conserving production is enhanced, so when the borrowing splurge is over, the strengthened industry can take over again (as well as service and pay off debt).
But this did not happen here. We spent most of our borrowing on housing, property speculation and consumption. The part that was invested went into the non-tradeable sector.
The borrowing boom is largely over, and we live with the aftermath of a weakened tradeable sector and a shortage of foreign exchange. However, “largely” may be an exaggeration; we are still borrowing offshore. Whether we can continue to do so remains to be seen (and it may get more expensive). But if we can, the rising exchange rate will once again undermine the tradeable sector – exactly as has been happening.
It is absurd to expect the Reserve Bank to hold down the New Zealand dollar while we continue to borrow heavily offshore. Admittedly, some short-term measures can influence the exchange rate, but in the medium term the Reserve Bank cannot keep the dollar low when we are over-borrowing. This conclusion involves a very different view of the monetary regime from that of the past two decades. I wonder how long it will take for those who got us into the mess by over-borrowing to admit to their errors.