Brian Fallow: Debt tide nearing our noses

We get an update today on how far our trade and investment income has fallen short of what the rest of the world earns from us.

And the answer is likely to be something like $10 billion for the year ended March, if the consensus view of economists is accurate.

That would equate to 6.7 per cent of gross domestic product and represent an increase from the current account deficit of $9.4 billion, equivalent to 6.4 per cent of GDP, for calendar 2004.

The lion's share of the 2004 figure, $8.9 billion or 6 per cent of GDP, was the investment income balance. That is what we had to pay offshore lenders in interest plus the profit overseas investors earned on their stakes in the New Zealand economy after allowing for what we earned from investment offshore.

It means about three weeks' worth of the annual output of the economy does not belong to us, but to the overseas providers of the capital we have used to fund the gap between investment and domestic savings.

As at the end of last year, the net investment position relative to the rest of the world was $123 billion in the red.

All of which raises the questions: how big a current account deficit is sustainable and what constraints arise from the state of our external accounts?

It depends, of course, what you mean by sustainable.

Let's take that to mean the level of annual deficit that would stabilise net foreign liabilities relative to the size of the economy.

Currently that stands at 84 per cent, a very high ratio internationally to which only Australia (at 66 per cent) comes close.

It is one reason New Zealand interest rates are consistently higher than other comparable countries'.

So how much of a deficit can we sustain without seeing those waters keep rising from our necks to our chins, then our nostrils?

HSBC chief economist John Edwards has done the sums.

If nominal GDP is increasing at, say, 5 per cent a year the maximum current account deficit consistent with holding those liabilities at no more than the current 84 per cent of GDP is 4.2 per cent of GDP.

If the dividend and interest rate across foreign liabilities is, say, 6 per cent, then the costs of servicing that debt (the net investment income deficit) is 5 per cent of GDP.

Edwards says it follows that net foreign liabilities can only be stabilised by running a trade surplus equal to 0.8 per cent of GDP.

New Zealand has averaged a "very small" trade surplus over the last 14 years, insufficient to stop the net liabilities ratio creeping higher.

The trade balance swings around with the business cycle. Last year, the balance on goods was a deficit of $2.1 billion, as a booming domestic economy sucked in imports, but that was largely offset by a $1.5 billion surplus on services like tourism. Combining the two, the trade balance was a deficit of 0.4 per cent of GDP.

In this respect, Australia is in an even worse position. It is running a trade deficit (on a balance of payments basis) of about 3 per cent of GDP and has averaged over the past 45 years a trade deficit of 1 per cent of GDP.

"At some point, we both need to be running trade surpluses and we will both see a sharp correction in the exchange rate," Edwards said.

While it is desirable to be able to access international capital so that investment can grow faster than domestic savings alone would allow, you can have too much of a good thing.

New Zealand and Australia are susceptible to market mood swings because of the way the current account deficits are funded.

Net foreign debt has been rising much faster than equity and now represents about 75 per cent of net foreign claims on both economies.

Debt through banks is a large part of that and their ability to raise debt in their own currency depends on the willingness of foreign investors to carry the currency risk, in return for attractive interest rates.

Which is where the Reserve Bank comes in. Appearing before Parliament's finance select committee two weeks ago, Governor Alan Bollard said New Zealand was capable of going on with a current account deficit of something like 4 per cent of GDP for a long time.

But the bank was aware of the links between interest rates, the exchange rate and the current account, he said.

"It is a bit of limitation on how far we can go on interest rates."

Bollard did not elaborate, but the constraint would presumably be that pushing up interest rates makes New Zealand a more attractive place to park short-term money, pushing up the exchange rate.

That, in turn, makes life harder for exporters and makes imports cheaper, widening the trade gap.

The current account may also provide - it is hard to be dogmatic about this - a constraint on a New Zealand Government's fiscal policy.

Whenever the credit ratings agencies reaffirm our relatively good sovereign debt ratings, they contrast the shiny state of the Government accounts (10 years of surpluses, low levels of debt and so on) with the state of the external accounts.

The implication is that we can only expect to get away with the latter because of the former.

The mighty United States dollar has been dumped because the US is in a double-deficit position, running significant fiscal and current account deficits, even though its level of net international debt (relative to the size of the economy) is much lower than New Zealand's or Australia's.

The implication would appear to be a significant deterioration in New Zealand's fiscal position, especially if it appeared to be structural rather than cyclical, which could prompt an unpleasant reaction from the markets.

Edwards said: "What it really means is that if you have an expansionary fiscal policy, it has to take the form of moving from a large surplus to a slightly less large surplus."

Or if you are up to your neck in debt, don't make waves.