The Rankin File: #12

Including Derek Sicklen's reply, and Keith's rejoinder.

New Zealand has had a deficit on the balance of payments current account since 1974. 1973 was the last year in which export and foreign investment earnings exceeded import and foreign investment payments. Yesterday, a record deficit of $NZ 6 billion was announced.

The balance of payments, defined strictly, is always zero. Everything that New Zealanders buy from non­New Zealanders is paid for in some way, whether from current earnings (ie exports), from asset sales, or from other forms of foreign investment.

The important feature of the balance of payments is its two sub­components: the current account and its flipside, the capital account. The current account balance, through the laws of arithmetic, is always the opposite of the capital account balance. The former (current account) is the balance on earnings. The latter (capital account) is the balance on foreign investment.

Since 1974 the current account balance has always been less than zero (ie negative, in deficit). Therefore the capital account balance has always been greater than zero (ie positive, in surplus). A surplus on capital account is generally considered to be bad news; it represents an increase in a nation's liabilities to foreign interests. The exception - when it is not bad news - is when foreign investments generate domestic incomes in excess of the costs of servicing the investments.

Orthodox economic theory suggests that a capital account surplus is the result of the current account deficit, and not the converse. Under such a scenario, the current account deficit has some cause, such as excessive domestic demand, a lack of domestic savings, or an overvalued exchange rate. In the days of fixed exchange rates, the problem would often arise from the exchange rate being fixed too high by the government of the day. New Zealanders might buy imports even though some New Zealand workers were unemployed, because imports were artificially cheap.

Under a system of floating exchange rates, it is not so simple. The problem lies in the reason why the exchange rate is too high. The Government does not set the exchange rate. Typically the exchange rate is too high because of a capital account surplus. Rather than the capital account surplus being the result of the current account deficit, the current account deficit becomes the result of the capital account surplus.

The Economics 101 theory of international economics claims that it is impossible for a nation with a floating currency to have a balance of payments deficit on current account. The market always sets the price of the currency. This was the theory used to justify New Zealand's shift to float the dollar.

On closer examination, the reason for the lack of a deficit (or a surplus) is that the floating currency model assumes that there is no capital account. If there is no capital account then the current account balance must always be zero; if there is no capital account then the current account of the balance of payments is the balance of payments, which cannot be anything other than zero.

In the era of high oil prices, from 1974 to 1985, it was sound policy for New Zealand to run a current account deficit. The alternative would have been a massive devaluation of the New Zealand dollar. In those days, it was appropriate for oil­poor countries to borrow from oil­rich countries, at least until the international economy settled at a new equilibrium, which it did in the late 1980s.

After 1985, however, international conditions were ideal for New Zealand to have its current account in balance if not in surplus. What happened instead was that the capital account went into a massive surplus after the exchange rate was floated, thereby causing a new growth in the current account deficit. This case did not conform with undergraduate teaching. From 1985, big capital account surpluses have caused equally big current account deficits.

Why has New Zealand had a capital account surplus since 1985? Not because of an overheated domestic economy; nor because of an inability of New Zealanders to save. Rather, it is because a central feature of public policy in New Zealand has been to generate a net inflow of foreign capital. This policy was pursued despite the fact that the rationale for floating the exchange rate depends crucially on there being no net inflow of foreign capital.

New Zealand governments have conducted this policy in two ways. First, they have used high interest rates as a tool ostensibly to reduce inflation. This monetarist "one tool fixes all" approach is simply incompatible with any commitment to balancing the current account. The anti­inflation policy works only to the extent that a net inflow of foreign capital causes the exchange rate to be overvalued. And an overvalued exchange rate is always known to cause a current account deficit. This policy is now entrenched as the 1989 Reserve Bank Act.

From mid-1994 to early 1997, the Reserve Bank has quite explicitly pursued a high interest rate policy, with the full intention of a capital account surplus pushing up the exchange rate and thereby reducing import prices. Not surprisingly, the current account deficit has steadily increased; a faithful mirror image of the policy­driven capital account surplus.

The second way in which New Zealand has conducted the policy of having a net inflow of foreign investment is through the process of sending Finance Ministers overseas, not to beg for export access to Europe as they once did, but to sell New Zealand as an attractive destination for foreign investment, as a destination not lacking in public and private assets for sale.

Why does the government deliberately choose to have a surplus on the capital account of the balance of payments? That amounts to a deliberate policy for New Zealanders (or at least some New Zealanders) to consume at a level that cannot be sustained by New Zealand's earnings.

I cannot know for sure why any government would choose such a self­contradictory policy, but I suspect that it may be because the whole reform process was only ever intended to benefit one section of the New Zealand population. That section today is able to live a lifestyle of conspicuous consumption; a lifestyle for a few being funded by cumulative increases in New Zealand's foreign liabilities. Each year, more New Zealand workers are having to work less for themselves and their families, and more for their creditors; for New Zealand's creditors.

Reply to The Balance of Payments Deficit, by Derek Sicklen from Sydney, 9/10/97.

1. Capital v. current account. I'm a little sceptical about a priori causality running between the current and capital accounts. By definition they must be equal (excluding items such as unrequited transfers). Using the same logic the CAD must equal the deficit of domestic saving versus domestic investment but there is, in my view, absolutely no causal relationship between these two at the level of the national accounts. Thus, just as I have a problem with the notion that the CAD 'causes' a capital account surplus, so I have difficulty with the reverse. If 2+4=6, what does this tell us about causation? Does the left hand side 'cause' the right hand side? If I change the 2 to something else I have no idea how the other numbers will simultaneously change, except that whatever happens the remaining expression will be an identity. An identity is an identity is an identity - there is and can be no causation running between the two sides purely because of the identity. Any causation needs to be explained in greater detail and particularity.

2. The exchange rate is 'too high'. What does this mean? If it means that the exchange rate is such that it doesn't bring about current account balance (or trade balance) then this is a circular argument - i.e. you can't argue that the exchange rate is overvalued and therefore causes a trade deficit if the definition of an overvalued exchange rate is its failure to balance imports and exports. Personally, and even allowing for things such as PPP, I think there is no meaning in the notion of an 'overvalued' or 'undervalued' exchange rate, especially in a floating currency regime. An increase or decrease in the exchange rate may induce trade or other flows but this does not imply over/undervaluation. In Australia's case, for example, the exchange rate follows commodity prices, but not the commodity prices representative of Australia's export mix. This is a conundrum but nonetheless casts doubt on almost all known theories of exchange rate determination including interest rate differentials.

3. Appropriateness of CAD in 1970s. Why was it appropriate for NZ to run a CAD in the 1970s rather than have a substantial currency depreciation? It could be argued that a much lower exchange rate may have stimulated more exports and import substitution which could have helped avert some of the economic malaise that struck NZ after, say, 1984. I'm not that familiar with the NZ data, but the logic of this argument would need to be rebutted.

4. My own thoughts regarding the link between current and capital accounts are that there are separate factors driving each, and their equality is a creature of the national accounting identities. Thus, for Australia, I see the following as principal causes of the growth of the CAD over recent decades:

• Import penetration caused by very sharp reductions in import protection. This has also weakened Australia's ability to compete with imports in the future and thus is self-expanding. Of the last post-1991 CAD blowout in Australia, some 75 per cent was due to the trade deficit, and this was due to a high manufactures deficit combined with a drought which affected agriculture.
• Decisions in the 1970s by some major TNCs to stop exporting from Australia, especially in some key manufactures such as autos. The reasons for these decisions are unclear, but may include reactions to the Whitlam Labor government's policies, including large, unilateral and unpredicted tariff cuts which hurt auto and other manufacturers badly.
• Increased interest payments on foreign debt due to overly tight monetary policy (aimed, as you say with respect to NZ, at fighting inflation) combined with a deregulated banking sector chasing fee and transaction-based income from foreign capital raisings - i.e. both supply and demand side factors increased foreign debt. The growth of global funds management has exacerbated this by facilitating the transfer of existing local debt to offshore fund managers.
• Increased dividend repatriations as a result of greater foreign ownership of domestic companies following reductions in foreign investment restrictions.

Thus, although I do see a causal relationship between the CAD and capital inflow, it is not one derived from the arithmetic of the accounting identities. Nor is it based on capital inflow (or policy) resulting in an overvalued exchange rate. Indeed, the Australian exchange rate fell (in line with commodity prices) quite sharply in the early-mid 1980s, suggesting that exchange rate factors were unlikely to have encouraged either excessive importation or excessive capital inflow. Further, other non-capital account factors are involved.

As is my understanding of different economies' growth performances, so too I have the view that there are different roots to the CAD paths displayed by each country. The fact that each country with a CAD has a surplus on capital account does not, to me at least, provide the reasons for the CAD.

Rejoinder to Derek Sicklen

I agree that there is no systemic causal relationship, at the level of the national accounts, between the current account and the capital account. There must be a causal relationship either way, however, if policy or some other exogenous factor forces either the current account balance or the capital account balance to diverge from zero. The balance not directly affected by the exogenous factor must adjust.

If 2+4=6 and you change the 2, then either of or both of the 4 or the 6 must change. But if you change the 6, then the left side of the identity must change. My point has always been that government or central bank policy has been, for most of the time since 1985, to run a net current account deficit in order to ensure that the exchange rate is higher than it would otherwise have been, and not simply to attract foreign capital.

My definition of a policy-driven "overvalued exchange rate" is simply an exchange rate set higher than would have been set by the market in the absence of the policy. My argument is simply a matter of comparative statics; contrasting two situations where one exogenous variable (in this case policy) takes effect.

Taking both the whole context of the international economy as it was in the late 1970s and the nationalist view that borrowing may make adjustment less disruptive, I believe that New Zealand policymakers in the late 1970s did the right thing. They borrowed and devalued the currency, with the devaluation being less than it would have been had the currency been floated and unsupported. Furthermore borrowing, if done wisely (as some of it was), has the potential to boost fixed capital investment in new industries, reflecting changes in a nation's comparative advantage.

It is not clear to what extent the Government saw the problems of the late 1970s as cyclical or structural. A huge devaluation would have led to massive and painful restructuring. If the problem was cyclical - as indeed it proved to be given the realignment of oil prices in the mid­1980s - then the devaluation would have given disastrously incorrect price signals. As it was, the devaluations were enough to generate a large increase in manufactured exports. The New Zealand economy proved to be among the three best performers (ie in terms of GDP growth and growth in shares of international trade) during the world recession of the early 1980s.

We cannot say that the current account and the capital account are determined by entirely independent causes. There must be some equilibrating force leading to balance where the factors driving the two sides of the identity would otherwise lead to a contradictory outcome.

My view of protection is that it does act as an alternative to a devaluation. Thus a general import tariff is not unlike a tax on foreign exchange. In New Zealand in the early 1980s, the maintenance of import tariffs and the expansion of export subsidies certainly enabled the exchange rate to be higher that it would otherwise have been. Roger Douglas argued before 1984 that it would be better to simultaneously devalue, remove export subsidies, and get started on reducing all forms of import protection. Hence the speculative run on the New Zealand dollar during the 1984 election campaign. With Roger Douglas expected to become Minister of Finance, the direction of any movement in the currency became a one­way bet. Many people took that bet, and, in the end, profited handsomely by so doing.

I agree that there are many factors determining current payment flows and capital inflows and outflows, and that each country is different with respect to these factors. Nevertheless, I conclude that the effective implementation of a policy to drive the exchange rate up must lead to a higher current account deficit. In the case of New Zealand after 1985, a capital account surplus was the means by which the exchange rate was forced up.

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