The current account deficit has reached an estimated 8 per cent of GDP, and a further deterioration to an astonishing 10 per cent of GDP is possible in the coming year.
So far, offshore investors have been relatively unconcerned - our high interest rates are too enticing and more than compensate for any concerns about our appalling deficit.
How bad does it need to get before they finally take notice and we see the currency head significantly lower? Can anything be done to force an adjustment, or will time take care of things naturally?
To answer these questions, we need to determine how much of the deficit is cyclical and how much is structural or more permanent. The $11.9 billion deficit can be split into several key components.
* The trade and services balances have traditionally been either a small deficit or small surplus. The trade balance has deteriorated into a $3 billion deficit, and recent trends in trade data suggest that a further deterioration lies ahead. Fortunately, New Zealand's popularity as a tourist destination enables the services account to run a small surplus of around $900 million.
* The largest contributor to the current account deficit is the $10.3 billion investment income deficit. A couple of years ago, it was closer to $7 billion.
* A small contribution from transfers.
The deterioration in the trade balance has been largely cyclical. On the trade side, strong domestic demand and a high currency have encouraged import growth and left the export sector struggling to keep up.
Growth in commodity exports has been disappointing, despite record highs in commodity prices, but non-commodity manufactured exports have recorded robust growth.
The growing import bill is made up of several components. Imports of capital equipment have been strong. This is a positive trend - many businesses are facing capacity constraints; new investment should have a positive impact on future economic growth and productivity; and the cheapest time to invest is when the currency is high.
Also, some of our growing import bill is inevitable and largely outside of our control, for example rising oil imports.
More concerning is the 14 per cent growth in import volumes of durable consumer goods in the year to June. Plasma TVs and SUVs make up a significant proportion of the debt-funded consumer spending spree.
New Zealand's other problem is the growing investment income deficit - although a significant portion of this deficit is structural, its deterioration has been cyclical.
Some of the deficit is attributable to the profits earned by the large number of New Zealand companies that are owned offshore.
The fact that an investment income deficit has existed for some time reflects the strong interest shown by offshore investors in owning local companies and our need to access their capital.
It is also cyclical - when the New Zealand economy is performing well, the profits earned by those offshore-owned companies increase.
Another growing portion of the deficit is payment on debt, largely reflecting overseas borrowing by banks to fund households' insatiable demand for borrowing. Once again, this is partly structural - New Zealanders have been spending more than they earn for well over a decade - and partly cyclical, for example, the booming housing market.
The size of the banking sector's offshore debt is astounding - it accounts for 63 per cent of New Zealand's net foreign debt.
In 1998, the Reserve Bank Governor at the time, Dr Don Brash, said "a significant part of those foreign savings is being used not to generate faster economic growth but simply to buy ourselves larger houses". Nothing has changed.
The ongoing willingness of foreigners to invest or lend makes the risk of a currency crisis small. Currency crises are most likely to occur in countries with fixed currencies that are not allowed to freely adjust. Furthermore, unless the Australian banking sector faces a crisis it is unlikely to deny our banks access to their capital.
Nevertheless, New Zealand has a growing problem which cannot continue indefinitely.
The most likely scenario is that the currency will fall and domestic spending will slow in response to higher interest rates and sharply lower levels of net migration. The currency is well overvalued, and a decline is just a matter of time.
Herein lies the dilemma - our interest rates have not yet reached the level where they are a disincentive for borrowers but are high enough to encourage ongoing inflows of foreign capital.
Can something be done to give the currency a push? Given the inflation outlook, cutting the Official Cash Rate on the off-chance that the currency will fall is not an option. This would only ignite domestic spending and the housing market, which will already be underpinned by tax rebates during the next few years.
A downgrade by international credit rating agencies would certainly grab the attention of offshore investors, but the Government's fiscal prudence makes this unlikely.
It is most likely that the currency will gradually decline as offshore investors finally notice that maybe New Zealand isn't such a great place to invest for now.
The dilemma for policymakers is that it may take a recession to bring the current account deficit back to the comfort zone.
* Rozanna Wozniak is chief economic adviser to Spicers Wealth Management
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Rozanna Wozniak
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