Last week I illustrated how much higher our long-term interest rates have been (and are) than those in other advanced countries, and set out my argument that investor concerns about the large New Zealand negative NIIP position (loosely, “the large external debt”) don’t look to have been the culprit.
In this post, I’m going to show another couple of charts, and then briefly respond to a commenter’s question.
One possible reason why New Zealand’s interest rates might sensibly have been higher than those abroad would have been if New Zealand’s rate of productivity growth had been so strong that returns to large amounts of new investment in New Zealand were very high. Profitable business opportunities might have abounded, and businesses had been rushing to invest to take advantage of those opportunities, while households might have been rationally anticipating future much higher incomes.
That doesn’t sound like New Zealand over the last 25 years. In fact, our rate of business investment (as a share of GDP) has been one of the lower among OECD countries. In recent days, I’ve shown a couple of charts drawn from the Conference Board’s TFP data. Here is another. For the advanced countries for which the Conference Board has estimates all the way back, it shows total estimated growth in TFP since 1989 (when the public data start). New Zealand hasn’t been the worst of these countries, but the record is pretty underwhelming. And Greece, Spain and Portugal each look a bit worse than they deserve because there is so much excess capacity in those economies right now.
My other chart this morning is about the slope of the interest rate yield curve. Very broadly speaking, yield curves are generally upward sloping. That is, short-term interest rates tend to average a bit lower than long-term interest rates. But New Zealand has been different.
As I showed the other day, long-term interest rates in New Zealand have been higher than those in other advanced countries. But short-term interest rates have been even higher. That is what this chart captures. It uses OECD interest rate data, The data aren’t ideal: the long-term interest rates are government bond rates, and the short-term rates are those on private sector securities. But as that is so for each of the countries it shouldn’t materially complicate cross-country comparisons.
I’ve deliberately only drawn the chart to the end of 2008. Since the near-zero lower bound on short-term nominal interest rates became an issue for an increasing range of countries, looking at the slope of the yield curve has not had the same meaning (since short-term rates can’t be cut as low as they otherwise would).
Over that 17 year period – in which each country had several interest rate cycles – New Zealand stood out. If foreign investor concerns were at the heart of why interest rates were so high, long-term rates would be high relative to short-term rates (relative to what is seen in other countries). That is the situation in Greece now. But as the chart illustrates, in New Zealand it the other way round. Our short-term interest rates averaged much higher relative to long-term interest rates than was the case in the other countries shown. It suggests that we should be looking for things that drive short-term rates for our explanation as to why New Zealand interest rates have been persistently so high (again, relative to other countries’ rates). It also nicely illustrates my observation the other day that New Zealand interest rates have long been regarded as unsustainably high, and not just by government officials and other pointy-headed analysts. The slope of the yield curve is set in the market. Private investors have expected our short-term interest rates to fall relative to long-term interest rates (whereas in these other countries there was no such expectation). But those expectations have been wrong. Persistent surprises in how long our interest rates have stayed up relative to those abroad can help explain why the exchange rate has been so persistently strong. My former colleague, Anella Munro, covered some of this ground, in rather more technical terms, here.
And finally, some brief answers to a commenter’s question. On Friday a commenter asked:
Michael, your analysis seems to make sense – that it’s more pressure on resources than risk premium that explains persistently high NZD interest rates
But it also raises, for me, some further questions.
My understanding is that when the NZ Government used to borrow in USD, back in the 1970s and 1980s,(when NZ was probably a worse credit risk than it is today), it did so at a rate only a small margin above the rate at which the US government borrowed. And I imagine that, today, NZ banks borrow USD at much the same rate as that at which US banks borrow. So if the only difference is in the currency of denomination (ie, the counterparties and the countries are the same) doesn’t that suggest that the explanation for the persistently high NZ interest rate has to have something to do with the currency?
Second, if there has been persistent pressure on resources, why would that not have been been closed by net imports?
Grateful for any responses you may be able to offer.
On the first question, yes New Zealand credits borrow internationally in USD at much the same interest rates as similarly-rated borrowers from other countries do. A AA-rated New Zealand bank is likely to pay much the same US interest rate on a bond issue as, say, a AA-rated Swedish bank might. That certainly helps make the point that, whatever, is accounting for the differences between, say, New Zealand dollar and Swedish krone interest rates it is not the credit quality of the borrowers. The credit ratings of our banks are as good as those anywhere.
But does that mean that it is all to do with the exchange rate? Well, yes and no. I would argue that it is the ability of the exchange rate to move that makes the material cross-country differences in interest rates possible[1]. Since expected risk-adjusted returns should be roughly equal across advanced countries, interest rates on New Zealand dollar assets can only be higher than those on assets denominated in another currency (for similar quality borrowes) for any length of time, if the New Zealand dollar is expected to depreciate against that currency over time. When the interest rate gap opens up, the New Zealand dollar tends to rise until it reaches a level that is not regarded as sustainable. At that point, the expected future deprecation more or less offsets the yield advantages. There is an alternative story, in which the NZD is such a volatile currency that we have to pay premium interest rates to attract the foreign capital we need. But again, if such premia exist, and are material, they should result in a surprisingly weak exchange rate. That hasn’t been the New Zealand story – indeed, the only sustained period of weakness in the New Zealand exchange rate was around the turn of the century when our policy rate was quite low relative to those abroad (our OCR briefly matched the Fed funds target rate in 2000). Such premia – whether to do with the NIIP or a volatile exchange rate – should tend to encourage resource-switching towards the tradables sector, in a (self-stabilising) manner that reduces future perceived vulnerability and any risk premia. I scarcely need to point out that we’ve seen nothing of that sort over 25 years.
And just briefly, the second question was whether, if there has been persistent pressure on resources, why that would not have been closed by (net) imports. The simple answer to that is because the economy can be thought of as made up of tradable bits and non-tradable bits. If everything in the economy were fully tradable, then any excess demand in New Zealand could be expected to be fully met through imports. Since tradables prices are set largely in world markets, there would be no sustained domestic pressures on the inflation rate (and no real need for a domestic monetary policy, or our own currency). Most of the interesting stuff arises from the fact that much of the economy is not freely tradable across borders, and tradables and non-tradables aren’t fully substitutable (I need a haircut, my mother needs rest-home care, and so on). So when we see persistent incipient excess demand pressures, some of the pressure shows up in the current account, and some in interest rates. As a result, despite a pretty strong government balance sheet, New Zealanders’ have run large current account deficits over the last 25 years, and we have had high interest rates relative to those in other advanced countries. Excess demand pressures, arising domestically, largely explain both phenomena.
[1] As I illustrated in one of my very early posts, back in the 1890s, when the New Zealand government was very heavily indebted, but the exchange rate was fixed, the gaps between New Zealand and UK government bond yields were much smaller than those in recent decades.
croaking cassandra 