Brian Fallow: Up to our necks in foreign debt

The blowout in the current account deficit and the prospect of uglier numbers to come might be the sort of ill wind that blows exporters some good.

It will be if it encourages foreign investors to notice the parlous state of our external accounts and start selling the dollar.

After all, the United States' widening current account deficit has been dragging the US dollar lower, with an unwelcome seesaw effect on floating currencies such as ours.

But the financial markets have shown scant sign of caring that this country has clearly been heading to an equally wide gap (relative to the size of the economy), if not worse. Our dollar has been positively buoyant, doing nasty things to exporters' profit margins.

The contrast between the markets' fretfulness about the US external deficit and its indifference to ours is stark.

True, the US dollar is the world's reserve currency and funding the US deficit sucks in the thick end of US$2 billion a day of other people's savings. Ours is hardly a global problem.

On the other hand, the stock of foreign claims on the US economy equates to about 25 per cent of its gross domestic product. But in our case the legacy of decades of running current account deficits is that the comparable ratio is about 80 per cent of GDP.

If they are up to their knees in debt to the rest of the world, we are up to our necks.

The cost, more than $8 billion in the latest year, of paying interest on that debt and providing a return on that equity investment is what keeps the current account permanently in the red.

But it is also testimony to 20 years of untrammelled openness to foreign investment and the ongoing profitability of that investment.

The US's current account deficit on the other hand is driven by its trade deficit and, for some reason, the markets worry more about that.

New Zealand's exports would have to increase by an eighth to get back in balance with imports. The US's exports would have to be half as large again to get close to balance.

But it is a matter of concern that the current account deficit has swollen from 2.9 to 5.8 per cent of gross domestic product during the past two years when the trade environment has been benign. The terms of trade (the ratio of export to import prices) have improved 10 per cent over that period.

The widening deficit is a sign of an overheated domestic economy, sucking in imports and throwing off lots of cash to the foreign owners of much of corporate New Zealand.

Bank of New Zealand's head of market economics, Stephen Toplis, expects the current account deficit to get even uglier and, possibly, quite quickly.

He said a quick drop in the terms of trade at a time when export growth slowed for climatic reasons but imports kept pouring in because of buoyant domestic demand could bring a "very nasty shift" in the current account balance.

"It must be of concern to the Reserve Bank. It is reflective of excess domestic demand, which they don't want. The more exaggerated the current account deficit gets, the greater the likelihood of an extreme currency movement, which is the volatility they are trying to avoid."

In hindsight, Toplis said, the gaping current account deficit indicated the Reserve Bank was too slow to act to dampen domestic demand.

To be fair, it tried.

But the trading banks' price wars in the fixed-rate mortgage market had, to some degree, frustrated the Reserve Bank's moves to cool the domestic economy down.

They have now called at least a Christmas armistice in that war. If it holds, the 150 basis points of tightening Alan Bollard has doled out this year should bite next year.

The classical prescription for treating an inflamed external deficit involves not only a slower domestic economy but a weaker exchange rate.

But such is the negative sentiment towards the US dollar that the kiwi could fly higher before gravity asserts itself. And, in the meantime, some of the edge has been taken off the kiwi's appreciation by historically high world prices for our export commodities.

The weakness of the US dollar is one of the reasons that world prices for those export commodities have, in many cases, been hitting historic highs. They are typically priced in US dollars.

However, when expressed in terms of a basket of global currencies, international commodity prices have been flat for three months, ANZ National Bank says: "The turning point for soft commodity prices may already have been reached."

The bank's chief economist, John McDermott, says that in previous currency cycles, the economy has stalled around 70USc or 65 on the trade-weighted index. (The kiwi dollar was trading around 71USc and 69 on the TWI yesterday).

Another way of looking at it is that the kiwi has typically overshot levels implied by commodity prices by 10 per cent before correcting. He said that on that basis it could go as high as 76USc.

The economic impact of the high dollar has been blunted by favourable terms of trade. The international purchasing power of a standard basket of exports has improved 10 per cent over the past two years, although the most recent reading suggested that effect is running out of steam.

"High international commodity prices also increase the serviceability of the debt through stronger growth," McDermott said.

The flipside of that is that if the currency keeps going up but commodity prices weaken the country faces a "losing quinella".

It would make the trade gap worse and undermine the ability to service the debt.

Westpac currency strategist Johnathan Bayley expects the dollar to be pulled lower next year. One reason is the expected drop in economic growth. Another is that the gap between interest rates here and those available elsewhere will become less temptingly wide.

Westpac is forecasting declines of 10 to 15 per cent against the Australian dollar, the euro and the pound, and an even sharper decline against the yen.