Brian Fallow: Heading for the danger zone

No need to worry about New Zealand's yawning chasm of a current account deficit - unless you pay interest or pay tax.

We learned last week that in the year to June what New Zealand earned from the rest of the world through trade, tourism and investment overseas fell more than $15 billion short of what the rest of the world earned from us. At 9.7 per cent of GDP it is the widest deficit, relative to the size of the economy, since the oil shock days of 1975.

And it looks as if it may get worse before it gets better. Last month's trade deficit was nearly $1 billion. So the arresting figure of 10 per cent of GDP is a real risk.

Just like an individual who spends more than she or he earns, the country has to fund the shortfall by selling assets or running up debt.

The cumulative effect of decades of deficits is that the stock of foreign claims on the economy, net of New Zealand investment abroad, is $130 billion, equivalent to 83 per cent of GDP.

The cost of servicing that debt and providing a return on that equity investment equated to 7.6 per cent of GDP. In effect, the economy's entire output every February belongs not to us but to the overseas suppliers of the capital and credit we rely on.

One consequence is that we pay higher interest rates than we otherwise would, a bit over 1 per cent, more according to some research at the Reserve Bank.

That figure could jump if international financial markets' view of our collective creditworthiness were to deteriorate.

The rating agency Standard & Poor's said this month that the current account deficit "continued to weigh" on New Zealand's sovereign rating of AA+.

But the Government's solid fiscal profile and use of adequate hedging practices sufficiently offset the risks in the external position. And going forward an expected easing of the New Zealand dollar was likely to reduce the current account deficit, S&P said.

The message from it and its fellow rating agency Moody's has been similar for years.

In effect they are saying that we can get away with these hideously bad balance of payments and international investment position figures because the Government's accounts are so shiny and good. Years of operating surpluses and general fiscal restraint have whittled Government debt to very low levels by international standards.

The floating exchange rate, widespread use of hedging and the fact that all the big banks are owned by bigger banks offshore give them some comfort as well.

But there is an implicit warning: Don't even think about drifting into a Budget deficit while the external accounts are in such bad shape.

It is not that long ago that the mighty US dollar was hammered by a double (fiscal and external) deficit, even though the United States' external debt level was only up to its knees where ours is up to our chin.

In that context some reflections by ANZ National Bank's economists on the fiscal outlook make sobering reading.

In the May Budget, Treasury forecast an operating surplus of $5.7 billion or 3.6 per cent of GDP for the year to next June, to be followed by a $4.3 billon surplus or 2.6 per cent of GDP the next year.

These look like thick buffers.

But such forecasts are subject to substantial margins of error and the fact that the surprises in recent years have been positive should not lull us into expecting them always to be so.

The ANZ economists believe the tax-take forecasts are over-optimistic to the tune of about $500 million this year and $1 billion next year. In particular they think the corporate tax take (lately about 18 per cent of the total) will be weaker than expected as the squeeze on profits already evident flows though. But the bigger worry is the spending.

Wage inflation in the public sector is running at 5.7 per cent. And general inflation is stronger than the Budget forecasts assumed, which will push up the cost of those benefits which are inflation-indexed.

Crown expenses could easily exceed the Budget forecasts by $1 billion this year, they say.

If they are right and the fiscal bottom line for the current year turns out to be $1.5 billion lower than forecast, that would still leave a surplus of around 2.5 per cent of GDP. "Such a buffer should still provide the rating agencies with some comfort," says the ANZ.

But next year and the following years things could get much tighter.

"We suspect the rating agencies will be wary of operating surpluses below 1 per cent of GDP. History shows that such slippage is hard to arrest and such a level is within the margin of error when it comes to forecasting."

The Treasury projects surpluses of 2.6 per cent of GDP in 2008 and 2 per cent in 2009, but there is enough pressure coming on both the tax and expenditure sides to reduce them by 1.5 and 1 per cent of GDP respectively, the ANZ economists say.

Oh dear.

What then are we to make of the recent behaviour of Finance Minister Michael Cullen, for so long the stern steward of the public purse, the very model of fiscal prudence?

Just in the past couple of months he has agreed to tax sweeteners for employers' contributions to the KiwiSaver workplace savings regime at an estimated revenue cost of $160 million a year.

The latest version of the investment tax regime has an estimated cost of $140 million a year.

And in speeches last week he has come close to promising a cut in the company tax rate, without abandoning his preference for more targeted measures.

A 3c in the dollar cut to a 30c would cost at a minimum $540 million. The cost would quickly expand if there were consequential changes to personal tax rates.

Overlay those structural cantos to the tax regime on top of the cyclical downturn effects on the fiscal position that ANZ National Bank forecasts and we could easily end up in the danger zone as far as credit ratings and the cost of capital are concerned.

The rating agencies and the markets are much more relaxed about external deficits and debt that arise from the private sector than from Government decisions.

"They have always taken the approach that governments distort economies but private individuals know what they are doing," says Deutsche Bank chief economist Darren Gibbs.

"Who is to say people are wrong to bring forward consumption from the future to the present? It may be the optimising thing to do, importing cars or machinery when the currency is high, for example."

This tolerance of private sector debt has served us well.

But it would be foolish to think that a current account deficit approaching 10 per cent of GDP, and a net external debt level of 83 per cent of GDP, place no constraints on what the Government can do by way of tax relief.

You can't sell the farm and lease it back, and imagine you are in the same position.