Brian Fallow: Why Dr No is holding to the cash

COMMENT

When he delivers his fiscal update next Thursday, Michael Cullen is likely to reprise his role as Dr No, or at least Dr Not Yet, the finance minister with deep pockets and short arms.

A month ago, Cullen told MPs on the finance and expenditure select committee that $500 million was still his best estimate of how much would be available in next year's Budget for extra spending aimed at low and middle income earners.

It does not seem much, when the Government ended the last fiscal year with a surplus of $5.6 billion - $1.5 billion more than it expected on Budget day - and when a third of the way through this fiscal year its tax income is more than $600 million (or nearly 5 per cent) ahead of forecasts.

With the economy slowing, it makes sense for the fiscal policy dial to be switched from slightly contractionary to mildly stimulatory.

By 2005, the delayed effects of the dollar's rapid rise on export incomes and of next year's interest rate rises will be felt, so a bit of a boost to household spending power though the Family Support system would be timely.

But Cullen is right to resist any clamour for a more radical permanent loosening of the purse strings.

It is not that a case can't be made for tax cuts or for increased spending on any number of things.

But our ability to afford them is not nearly as great as the surpluses suggest.

The problem is that we are up to our necks in debt to the rest of the world.

We already pay a price for that in higher interest rates than other comparable countries - about 2 percentage points higher by some estimates.

And that price would be even higher if the Government had not drastically reduced its indebtedness over the past 10 years.

In short a prudent, provident public sector running surpluses and reducing its net debt is part of the price we pay for a profligate household sector.

Any gains from more liberal Government spending or lower taxes would be likely to come at a cost of higher interest rates as international lenders sought greater returns for increased risk.

In its survey of New Zealand issued yesterday, the OECD links its lacklustre productivity performance to, among other things, low investment in equipment, research and development, and information and communication technology - "possibly because high foreign debt raises the cost of capital".

On Monday, credit rating agency Moody's, reaffirmed New Zealand's Aaa sovereign rating, citing the comparatively low level of Government debt.

But it warned about the level of New Zealand's overseas liabilities, mainly owed by the private sector. They are equivalent to around 80 per cent of GDP, the accumulated legacy of 30 years of spending more than we earn in our dealings with the rest of the world.

And they indicate in Moody's view "a fair degree of vulnerability to external shocks".

The Reserve Bank's monetary policy statement last week voiced similar concerns.

It expects New Zealand net debt, which was around 64 per cent of GDP in 1990, to continue climbing to 87 per cent of GDP by 2006.

It is a trend that cannot be sustained indefinitely, the bank warns.

"The greater the level of debt and debt service obligations the greater our exposure to changes in foreigners' willingness to lend to us."

It cites research by one of its economists, Christopher Plantier, on the risk premium built into New Zealand interest rates.

His results confirm an overseas study which found that countries with large net liabilities to the rest of the world can expect to pay higher real interest rates.

He found that the overall premium has shrunk somewhat since the mid-1980s and that the factors driving it have changed over that period.

In the mid-1980s, when major economic reforms were beginning, about 200 basis points of the difference between New Zealand and world real interest rates could be attributed to Governing indebtedness and 150 basis points to inflation variability.

But as inflation was tamed, its effect has diminished to about 30 basis points.

There was also a big pay-off in interest rates from the reduction of public debt.

The risk premium associated with that shrank from 200 basis points to less than 100 by the late 1990s.

Unhappily, though, that has been offset by a much increased risk premium associated with burgeoning private sector debt.

That effect has climbed from negligible levels in the mid-1980s to around 125 basis points now.

"The overall picture is that the macro-economic reforms that helped ensure price stability and fiscal prudence were very beneficial in reducing real long rates, but that the private sector offset some of these benefits by borrowing significantly more," Plantier writes.

Moody's says that despite New Zealand's large negative net investment position - in the red by $100 billion - several factors mitigate the vulnerability that implies.

One is that a large part of the external liabilities is denominated in New Zealand dollars.

Second, the part that is in foreign currency is hedged.

And third, a large part of the net liability position is accounted for by New Zealand banks' funding from their overseas parent and is accordingly less volatile.

In last week's monetary policy statement, the Reserve Bank says that the risk premium associated with New Zealand's external indebtedness "appears to have been increasing during a very stable period in our history characterised by high quality policy".

"Were New Zealand to be confronted with a substantial adverse event that substantially increased the perceived risk of lending to New Zealanders, especially in New Zealand dollars, the jump in the cost of retaining access to financing could represent a very substantial cost to our collective disposable income," the bank said.