For thirty years New Zealand has run a current account deficit, averaging around 5% of GDP. To cover this cash outflow, New Zealanders have sold assets to, or borrowed from, foreigners. As a result New Zealand’s net foreign liabilities are around 75% of GDP, a very high ratio by international standards.
Despite recent years having enjoyed higher prices for our exports and recession depressing imports, the current account deficit has remained around 5%, and the only relief from further deterioration in our foreign indebtedness has been the one-off Christchurch reinsurance accruals totalling over 10% of GDP.
There are two problems with high net foreign liabilities. The first is you can hit a tipping point, where foreigners willingness to lend collapses and an Iceland/Greece scenario results.
The second, and more insidious, is that the on-going return paid to overseas owners of our net foreign liabilities diminishes the proportion of our GDP that accrues to New Zealanders.. Around 6% of our annual GDP is for the benefit of foreigners. The earnings of our four Australian owned Banks are more than New Zealanders’ share of the earnings of all NZX listed New Zealand headquartered stocks.
The failure to grow exports and sustain import substitution is also directly a major reason why growth in New Zealand’s GDP has been disappointing, and why employment growth has been in low paid jobs with contraction in middle income employment in sectors such as manufacturing.
If New Zealand is to do better in coming decades in growing per capita incomes, particularly for low and middle deciles, New Zealand must make its over-riding economic objective substantive growth of its foreign exchange earning or saving sectors.
This starts with explicit, forceful and unambiguous statement by successive governments that this is New Zealand’s over-riding economic objective, and that all macro and micro economic policy will be subservient to it.
The importance of this is that for three decades potential participants in earning or saving foreign exchange have believed government’s attitude was the opposite. That the government either didn’t care how they fared or believed the infallible hand of markets would achieve equilibrium. Thirty years have shown the naivety of the latter view. Since investment decisions are forward looking, is it any surprise that faced with a likely unfavourable future environment to which policy makers would be indifferent, that there has been under-investment?
Assuming there is acceptance of this over-riding objective, what then might be some logical changes in macro and micro economic policy?
The TINA’s of this world, wedded to the laissez-faire Washington Accord economics that has caused this global economic crisis and should now be totally discredited, immediately say well of course you want to intervene in the foreign exchange market. This is a classic straw man tactic. Ironically, it is those of this economic faith who are most reliant on the exchange rate being at the right level, since they rely almost solely on market prices to achieve outcomes. Exporters and import substitutors understand economics is more complex and multi-faceted and that addressing the exchange rate is but one component, though an important one, of a comprehensive and consistent approach on many fronts to achieving the objective.
However, addressing the exchange rate question, it is first important to recognise that past and present exchange rates will have been a key determinant of profitability and cash flow generation, and hence the ability and willingness of current participants to invest. But also, further investment in fixed assets, innovation, staff etc will depend upon participants’ projections of future exchange rates. The failure of government to care about the exchange rate inevitably leads to pessimistic projections and hence under-investment.
Thus, the government must demonstrate that it has the willingness and capability to address an undesirably high exchange rate. And contrary to the straw man implication there are options that should be developed, ranked and prepared for activation.
For example, to address the carry trade interest rate differential cause of an over-valued dollar there are ways to drive a wedge between the interest rate overseas capital receives and the interest rate domestic borrowers pay. The latter is what monetary policy has manipulated to contain inflation within the one and three percent band. The former is what drives global capital flows and from time to time is the most dominant determinant of the exchange rate.
Two ways you can create this wedge are a levy on all domestic borrowing and non-resident withholding taxes on interest and dividend payments.
Both of these have been suggested, but with regrettably little debate reflecting both entrenched economic beliefs and risk aversion to any innovation. A common failing in this is to see all the possible loop-holes and unintended consequences in any innovation, while ignoring that the status quo is full of both and has patently delivered and sustained a structurally unbalanced economy. We know people evade paying income tax. That doesn’t stop us having income tax. Similarly, no doubt some would try to avoid a levy. But some simple rules, such as no tax deductibility of interest paid nor enforcement of a security unless you can demonstrate the levy has been paid, and the fact that easily audited Banks are so dominant in domestic lending are likely to make avoidance a minor issue.
Another argument against driving a wedge between the interest rate capital receives and the cost to borrowers is that this will reduce the return to domestic savers. And it is correct, that a comprehensive approach to addressing the country’s structural imbalance requires a rise in domestic savings both to replace foreign liabilities and to fund increased investment in the internationally tradeable sectors. However, obvious and consistent actions can be taken to address this concern.
First, is to move New Zealand’s taxation regime away from favouring foreign savings over domestic savings. This policy has done much damage to New Zealand’s head-quartered corporate sector. New Zealand cash flows have been of more value to foreign owners than New Zealand tax residents. Little wonder that whenever a New Zealand corporate falters it is bought by a foreigner. And this has been reinforced by low thin capitalisation rates and a blind and naïve attitude to overseas investment approvals. Whereas the United States political system frustrated Chinese acquisition of the American oil and gas company Unicol and the Australian government rejected Shell’s acquisition of Woodside, New Zealand allowed Shell and Apache to buy Fletcher Challenge Energy, the dominant New Zealand oil and gas company generating over $300 million of cash annually, and then Shell ceased new exploration in this country. There is clear support for a home bias in corporates’ capital expenditure. A comprehensive programme focused on the over-riding objective would integrate the development and promotion of domestic champions in key foreign exchange generation areas. Overseas investment approval processes should recognise this. Justice Miller’s recent High Court decision requiring a foreign purchaser to add something more than a domestic owner is a step in the right direction in this regard.
But returning to savings and taxation. Accompanying a levy on all domestic borrowings, which could be expected to raise at least two billion dollars per annum of new taxation, might be taxation changes supporting domestic savings, such as exempting from New Zealand resident income tax (and symmetrically removing tax deductibility for) the inflation component (maybe set at a fixed rate such as the middle of the Reserve Bank band) of all interest payments. This could be accompanied by doing the opposite on remittances of interest and dividends to foreign capital – abolishing the approved issuer exemption (2% tax rate) and imposing non-resident withholding taxes to the maximum permissible under taxation treaties up to the New Zealand corporate tax rate.
This note is not actually saying whether or not any of these are the right actions to be taken. Rather it is attempting to say that there are a host of initiatives that could be taken to make investing in foreign exchange generating activities more attractive. It is not good enough to put up one straw man, intervening in the foreign exchange market, to shut down debate and continue with a discredited laissez-faire approach.
But a comprehensive and consistent programme would, as has been stated earlier, be much wider than exchange rate focused. It would include both actions that apply to all participants and actions specific to individual sectors and even individual players. Again the bogie against picking winners should be seen for the naïve argument it is. We may be relatively pure in this regard in comparison with everyone else (regrettably), but we are not pure. Farmers exemption from income tax on the inflation component of their livestock, cash flow taxation for forestry, rebates and grants for the film industry, special taxation rules for petroleum exploration are examples of where special treatment for specific sectors has occurred under successive governments in recognition that without it New Zealand based participants would be even more out of the game, and even less investment would have occurred. And even the purist needs to acknowledge that many forms of taxation are not only a non-market intervention but also bear no relationship to external costs or benefits and hence there is no way of knowing whether variations for particular sectors advance or hinder economic efficiency. The theory of second best acknowledges that if any assumption underlying an economic theory is wrong, all bets are off. It is patently clear that the theories of perfect competition and international comparative advantage are riddled with critical assumptions that are false. Slavish adherence to them has no intellectual underpinning.
A comprehensive, consistent and co-ordinated programme to boost foreign exchange creation would take both generic actions (such as on savings ad taxation) as well as sector specific actions. And most of all it would be a programme that is taken to the public as a matter of national primacy and urgency, and that gains the public’s support for decisive action. We need to grow foreign exchange generation and domestic savings by an incremental five percent of GDP, that is $10 billion per annum. Identify the initiatives that will do this, assign responsibility for each one and get immediate action.
For example, on the generic level, address risks to Government savings, most obviously by incremental lifting of the starting age of national superannuation, ceasing interest free student loans and making Kiwisaver compulsory without any taxation subsidies.
But even more important than lifting public and private savings is growing investment in and output from the foreign exchange generating sectors. Without this, lifting savings will just increase unemployment; as we are seeing in Spain and Greece with their fiscal consolidation.
So, turning to increasing investment in foreign exchange generation sectors, take water storage schemes.. 95% of the rainfall that falls on New Zealand goes out to sea, yet we have polluted streams, rivers and aquifers and have land that with irrigation could deliver much higher foreign exchange earnings. But we go round and round in circles about how we might store floodwater and use it to both enhance the environment and increase rural revenues, and nothing happens.
Or aquaculture. With the fifth largest marine zone, why are we not the World’s leader in research into how to maximise revenues from a cubic metre of water in an environmentally beneficial way? Why do we sit on the sidelines while there is a moratorium on new licences and then overly complex legislation that results in a lost decade?
Why is our competitive advantage in a Professor Porter cluster in the breeding and racing of thoroughbred horses in a downwards spiral, while across the Tasman it goes from strength to strength?
Why does it take years to get international scale convention centres, any new mines, or petroleum exploration?
And then we wonder why the income gap with Australia keeps widening and per capita incomes, particularly for lower deciles, are static.
The status quo is not good enough. Acknowledge the primacy of growing foreign exchange generation and domestic savings, identify the initiatives needed and take action.
- Hugh Fletcher is a former member of the NZ Reserve Bank board.