The focus on COVID-19 and the associated inflation forces have crowded out consideration of strategic issues that are fundamental to the New Zealand economy
If Treasury forecasts are correct, then New Zealand will have short term economic growth as a rebound from COVID-19. However, it could be a very short rebound.
The first skiff of bad weather will come from the higher interest rates that are now upon us. A lot will depend on how the Reserve Bank plays the game going forward.
House price stabilisation is essential, and some decline would also be considered a good thing by many people. However, the higher interest rates will also lead to less circulatory spending in the local economy. That will be problematic for employment.
This will first show up in the hospitality sector and flow on from there. It may already be showing in the hospitality sector, but the signs are confused by the direct effects of COVID-19. In time it will also show up in the building construction industry, and potentially also more broadly in the economy.
These effects are economic-cycle effects. There are no painless solutions. We are in an inflationary cycle that will have to be reined in. However, I have already written about that inflationary cycle, both with foresight and frustration more than 18 months ago when the signs were not being read, then again a year ago, and then again in recent weeks.
Accordingly, I have no wish right now to focus any further on the wicked problem that lies within the current short-term economic cycle. Instead, my focus here is on some longer-term strategic issues that will extend out further. The strategic issues will have even more profound effects than the economic cycle effects. These strategic issues are not addressed within Treasury forecasts.
New Zealand’s strategic problem
The strategic problem for New Zealand is how can it pay its way long-term within the global economy. This problem lies within a framework where the fundamentals of New Zealand’s international economy are resource-constrained exports of primary products, which fund the import of technology-based items. The latest figures from MPI are that 82.4% of exports come from primary industry products.
Unfortunately, there are very big storm clouds that are now coming over the horizon. The storm forces are created by large and increasing deficits on New Zealand’s current account. A current account deficit means that New Zealand is not paying its way with the rest of the world.
These growing deficits are not sustainable. The problem is that in an open economy, current-account deficits have to be balanced by inflows of capital. These current account deficits with the rest of the world are very different to internal deficits that can be funded through money creation.
To understand what is happening and what will happen, it is necessary to understand something about both the components of the cross-border current account and the balancing cross-border capital flows. The data that I use here come from various RBNZ series, in particular the spreadsheets that underpin the online M6, M7 and M8 series.
The starting point is recognition that in an open economy, the current and capital accounts must balance. It is an identity relationship. So, the big current account deficits, which were $15.9 billion in the latest 12 months ending September 2021, have to be balanced by equally massive capital inflows.
Something on capital flows
New Zealand always runs deficits on its current account. Accordingly, one way or another, New Zealand always has to attract more capital into the country. This can be either as debt supplied to New Zealand entities by foreigners, or as foreign-owned equity. Debt flows can be either short-term or long-term capital, whereas equity is essentially long-term. These flows may also include the Government remitting reserves that it holds overseas, but that is essentially just a crisis band-aid and cannot be strategic.
The short-term financial flows intermediated by currency traders are largely speculative in nature. They relate to opportunistic behaviours linked to interest rates in New Zealand relative to the rest of the world, together with the perceived sustainability of the exchange rate.
Once the current account deficit is perceived by speculators as non-sustainable, then the inward flows of speculative capital go into reverse. At that point, the exchange rate declines to a level where foreign currency demand and supply are back in balance.
Although essentially speculative, these short-term flows do serve a key purpose in reducing day-to-day volatility in exchange rates and providing liquidity to the foreign exchange market. But this is not the way to build or even maintain an economy.
In contrast, long-term flows are capital inflows by investors who are either purchasing New Zealand-based assets or lending money for the ‘long-term’. This is the pathway by which the rest of the world invests in New Zealand to generate long-term wealth for itself.
The returns to overseas investors come largely from remitted profits and dividends which are recorded in the current account. However, they also include remittance of capital gains (or losses) when long-term assets are sold, with these being recorded in the capital account.
Long-term inflows of foreign capital have always been a characteristic of the New Zealand economy. One way or another, be it by equity or debt, the rest of the world has found that investing in New has in general been a great way to generate wealth for itself, using New Zealand’s labour plus natural resources. Of course, New Zealanders also invest off shore, so it is not all one-way. However, the overall flow is strongly inward.
The overall net inflows of capital have been running at around $8 billion in recent years (RBNZ M7 series) but with considerable fluctuation from year to year. However, these inflows have increased considerably to $15.9 billion for the 12 months to 30 September 2021 and $8.3 billion for the September quarter alone, as evidenced by the equivalent deficit in the current account. I reinforce the point that although the capital accounts are not updated on a quarterly basis, by definition there have to be inflows of capital to balance the current-account outflow, and these current account data are published on a quarterly basis.
The current account
At this point we need to look in more detail at what has been going on in the current account.
Essentially, there are three components to the current account. First, there is the trade component comprising merchandise exports and imports. Then there is the services component with tourism and education services being particularly important elements. Then there are all the financial flows arising from profits, dividends and any other financial transfers not classified as capital items.
Exports and imports
The last two decades have been excellent for exports, with prices for primary-industry exports rising considerably faster than the prices of imports. Dairy, meat, and kiwifruit have been great industries for New Zealand.
Right now, the trade-weighted price index stands at 1536, the highest it has ever been. Back in June 2000, it stood at 1000, and for much of the 1980s and 1990s it was in the 900s.
Put simply, this means that a merchandise unit of New Zealand exports currently purchases in the order of 50 percent greater volume of imports than was the situation 20 years ago. So, let there be no doubt that New Zealand has been greatly advantaged in the last two decades by its particular exports, based largely on primary products which the rest of the world wanted and was prepared to pay excellent prices for.
For much of these two decades, New Zealand was also investing heavily in these primary industries. Accordingly, New Zealand’s volumes of exports increased by a factor of approximately three. Put the combination of volumes and prices together, and New Zealand has recently had enough export income to fund 4.5 times as many imports as it did 20 years ago.
So how did New Zealand respond in terms imports? Well, until about 2015, it typically spent less on imports than exports, but since then the trend has been to spend increasingly more on imports than has been earned from exports. This is recorded in national statistics as a negative balance of payments on goods.
In the latest quarter to Sept 2021, this negative balance was an exceptional $4.5 billion. This has been driven by record imports (both volume and value), but with export volumes no longer growing. The September quarter is typically a bad one for exports, given the seasonality of primary industry exports, but that explanation is far from adequate to explain away the current situation.
Services income has crashed
The second component of the current account is services. The big income items are tourism and related travel, plus income from export-education services. The big expenditure item is outward tourism, including the traditional ‘OE’ rite of passage of young adventuring Kiwis.
In recent years, the services sector has typically run at a considerable surplus of between $3 billion and $5 billion per annum, linked to buoyant tourism and export education sectors. However, that all turned to custard in the June 2020 quarter and has now deteriorated even further as more foreign students return home.
For the 12 months to Sept 2021, the balance of payment for services was a deficit of $4.3 billion, and negative $1.7 billion for the September 2021 quarter alone. Remember that these are not just funny-money New Zealand dollars which the Reserve Bank can create at will. These are international cross-border outflows that have to be balanced by cross-border international currency inflows.
Accordingly, there seems little prospect of the services balance of payments turning around quickly. Education services will depend to a large extent on whether Chinese students return. Also, once the borders do open, it is unclear as to how long it will be before inward tourism balances the outflows of Kiwis heading overseas.
Financial transfers are the third component of the current account. In New Zealand, these are always negative, reflecting the ever-present flow of profits and interest payments back to overseas owners. This is a consequence of the long history of imported capital.
For the last 12 months through to September 2021, the net financial transfers were an outflow of $7.8 billion. This is not in itself exceptional. This is considerably less than throughout much of the last fifteen years when the net annual payments were typically between $10 and 14 billion.
The key reason why these payments have recently been somewhat more modest is that interest rates have been low and this has been reflected in the amounts paid to the overseas owners of debt capital. Of course, that is now about to change with rising interest rates. Also, the big Australian-owned banks have recently been remitting less profits back to their Australian parents, although that too appears to have only been a short-term aberration, with these banks currently earning huge profits again.
Bringing the current-account components together
The big message is that all three components of the current account are now running very large deficits. Export income has been outpaced by imports. Services income from tourism and foreign students has crashed. Financial service payments have essentially continued on their merry way of always being negative, albeit with those deficits having being moderated recently by the low global interest rates.
It is a direct consequence of these factors in combination that has led to the current account deficit for the year to 30 September 2021 ballooning out to $15.9 billion, with $8.3 billion coming in the last quarter. Both of these numbers are a record.
When expressed as a proportion of GDP, the current account deficit is 4.6 percent and growing. This is the highest it has been since 2009. That was a time when interest rates and hence interests-rate transfers across the border were much higher. It was also a time, unlike now, when there was considerable export-earning productive investment occurring in the New Zealand economy.
Where is the new capital going?
The simple answer is that we do not know the details of where the incoming capital has gone. All we know is that there has been $15.9 billion in total, with $8.3 billon of that occurring in the most recent quarter through to 30 September. However, we can be confident from looking around the country that not much of it has gone into new export-focused investment that might reduce the huge $15.9 billion current account deficit.
At least some of the capital inflow has come from the sale of a range of software and intellectual property companies such as Seequent, Vend, Education Perfect, and many others that will now operate from overseas. However, some of those companies were already largely owned by overseas venture-capital investors, and so how much of the net sales have been remitted into New Zealand remains unclear.
RocketLab is an example of a former New Zealand company that is now headquartered in California and largely owned by American investors, but still has operations in New Zealand.
Xero is an example of a company still headquartered in New Zealand but with both the Chair and Chief executive residing in Australia, and with the company no longer even listed on the NZX.
The biggest sale of 2021 appears to be Weta Digital’s intellectual property sale to US company Unity Software for $2.3b.
There have also been significant capital inflows by overseas forestry investors. These investors will now earn profits from carbon farming which will be transferred back overseas. So, not only will we earn no future overseas exchange from these investments, at least until or if these forests are harvested in 30 years time, but there will also be a drain on overseas funds as the carbon-farming profits are remitted.
Perhaps one of the most remarkable sales of recent times has been Metlifecare, sold for $1.3 billion to a Swedish investor in November 2020. It is challenging to see what special expertise this investor brought to the New Zealand retirement-village industry.
Indeed, from an overarching perspective, it is very challenging to identify recent or potentially forthcoming investments that actually create new potential for earning overseas funds. This is one of the key differences from much of the last two decades, when there was major investment occurring, particularly in primary industries, but also in tourism, such that export volumes increased by a factor of three. Those days are well behind us.
Is the current situation sustainable?
The simple answer is that the current situation is not sustainable. New Zealand is now in an economic environment where there are no easy options for stimulating exports.
Accordingly, if New Zealand continues to finance imports by selling off existing businesses, then New Zealanders will increasingly become the wage-slaves to overseas-owned companies. Key sectors of the New Zealand economy that are already owned by overseas investors include financial services (banks and insurance), forestry, wine, aluminium and steel.
In recent years, New Zealand’s leaders and hence also the New Zealand public have lost sight of a simple reality that exports are the engine room of the economy. The way that things work has meant that the New Zealand economy has been able to freewheel for quite some time, relying on exceptional returns from its primary industries, but with very little productive investment.
This freewheeling, together with exceptional export prices, has also helped hide the fact that exports have been declining as a component of the overall economy. In the ten years through to 2012, exports of goods and services averaged 30 percent of GDP (data sourced from national accounts). Since then, they have always been less than 30 percent of GDP, first slipping down inexorably through the ‘high twenties’ and then dropping alarmingly in the March 2021 year to 21.9 percent.
As long as overseas investors have been willing to provide an ongoing flow of capital, then this decline has not been readily apparent except to those who searched in some depth. But at some stage there has to be a day of reckoning.
If and when that day of reckoning comes, then it will show up via on-market devaluation of the New Zealand dollar. Market forces will be saying that New Zealand has to start paying its way. That will mean less importation of energy, cars, machinery, computers, pharmaceuticals and medical equipment.
As to when that day might be, I cannot tell. It will depend in large part on when the fickle speculative money-trading community, acting in normal fashion as a herd, decides that the New Zealand dollar is not worthy of their speculation. This will also be influenced by when the international long-term investment community decides there is a lack of good New Zealand investments to buy.
So, is there a solution?
One thing for sure is there is no easy solution. But there are some things we can do to lessen the problem, and the starting point has to be to recognise the problem.
My own key professional interests relate to the primary industries that underpin our economy, and how we can make them more sustainable, both environmentally and also from a productive perspective. I believe we can do a lot on both counts. Those are the issues on which I spend much of my time. However, it does seem to me that a lot of the public debate is off-key and distracted by misinformation.
Without considerable change of thinking and perspective, it cannot be a good future for New Zealand.