$8.2bn deficit tipped to slow growth

New Zealand's gaping current account deficit is likely to get worse before it gets better, economists say.

But they say an ever-growing deficit is not sustainable and foreshadows an economic slowdown and a weaker dollar to correct it.

In the September quarter, the deficit hit $4.2 billion, a record, pushing the annual deficit to $8.2 billion, up from $6.7 billion three months earlier.

The deficit was largely funded by overseas borrowing by the banks, who lent it on to mortgage borrowers.

Westpac chief economist Brendan O'Donovan said with so much of the inflow of capital being used to fund the housing boom, rather than more productive assets, the financial markets would eventually question the sustainability of a current account deficit that was heading towards 7 per cent of GDP.

National Bank chief economist John McDermott agreed. "It is going into the housing market. It is not the kind of investment that generates a cash stream for an economy to repay that debt."

Exports were weaker, but that was largely offset by lower imports and increased tourist spending.

The main "problem" was that a buoyant economy has boosted the profits of foreign-owned companies, which count as debits in the current account.

The gap between what foreign investors earned in New Zealand and what local investors earned abroad was $2.7 billion in the September quarter, $1 billion more than it had been in the March quarter.

Most of that money does not leave the country, however. Statistics New Zealand said that of the profits earned to foreign direct investors 77 per cent was reinvested in the September quarter and 68 per cent in the June quarter.

The annual deficit of $8.25 billion equated to 5.8 per cent of gross domestic product.

Westpac expects the deficit to push out towards 6.5 per cent or 7 per cent of GDP by the middle of next year. Deficits above 5 per cent of GDP tend to raise a red flag in foreign exchange markets, fuelling doubts about their sustainability.

Corrections to excessive deficits typically require slower economic growth and a weaker currency. The kiwi fell half-a-cent against the US dollar on the news and is now trading around 71.12USc.

The September result puts New Zealand's deficit, relative to the size of the economy, in the same league as the United States. Its external deficit is one of the reasons the greenback has been falling.

But the US deficit is largely a reflection of the fiscal deficit being run by the Government. In New Zealand's case, the Government is in surplus and the deficit reflects households spending more than they earn.

Deutsche Bank chief economist Ulf Schoefisch expects the deficit to widen to about 6.5 per cent of GDP by the middle of next year and then to moderate to 6 per cent by the end of 2006 as a slowing economy causes import growth to weaken and investment income deficit to improve.

He expects the combined effect of the current account deficit and falling interest rates in the second half to cause the kiwi to struggle next year, despite continued weakness in the greenback.