'Politics and NZ's risk premium' - Deutsche Bank
Data Flash (New Zealand) - Strategy
'Politics and NZ's risk premium'
It has been suggested that the policies of the new Government have increased the risk premium on NZ assets.
However, it is difficult to find evidence of this. For instance, the differential between NZ and US interest rates (both real and nominal) has not increased since the election.
Even when other factors are considered it is difficult to find any evidence that the political risk premium on NZ assets has increased.
This is not to say that government policy changes have not been negative for growth. It could be that a higher risk premium has been offset by the negative impact from these changes on NZ's growth prospects.
A number of commentators have suggested that the policies of the Labour/Alliance Government have reduced the attractiveness of NZ as a destination for investment. Or, to put it another way, that the risk premium on NZ assets has increased.
This note attempts to measure whether there has in fact been an increase in the risk premium on NZ interest rates. The method by which this is attempted is by modelling the spread between NZ and US bond yields, with the "unexplained residual" capturing the "political" risk premium (among other things). The note also looks at the performance of the NZD.
Relative movements in NZ interest rates
Note: Real yields are defined as 10Y Government bond yields deflated by the CPI (core CPI in the US and CPIX in NZ).
The natural place to begin a study of the NZ risk premium is to look at what has happened to NZ interest rates on a relative basis. The usual "risk-free" proxy for interest rates is the US Treasury bond yield. The chart above shows how the differential between real and nominal NZ and US 10Y yields has evolved over the past decade. The chart shows there has been a trend decline in the real differential since mid-1991, the point at which NZ inflation moved into the RBNZ's target band. Interestingly, there has been no trend shift in the gap between NZ and US nominal interest rates.
From this chart it is hard to conclude there has been any increase in the risk premium on NZ interest rates since the 1999 election. Indeed, the real bond differential is currently at its lowest level in the past 10 years.
Note: Australian real rates are defined as the 10Y bond yield less the Treasury's measure of core inflation
Of course, a major theme in bond markets in recent years has been convergence. Given this, it is interesting to see how NZ has fared relative to the market it is most often compared to - Australia. The chart above shows a clear break in the relationship between NZ and Australian interest rates in the mid-1990s. Again, however, there is no evidence of a change in the relationship since the Labour/Alliance Government came into power.
Of course, this does not "prove" that politics is not having an impact. There may be other "factors" at work that are offsetting an increase in the political risk premium. This issue is looked at in detail in the technical annex. The conclusion, however, seems to be unchanged. Namely, when taking into account other factors it is difficult to conclude that politics is having an impact on NZ interest rates.
Does the performance of the NZD point to concerns over government policy?
Rather than showing up in interest rates, perhaps concerns over the direction of government policy are being reflected in the performance of the currency (though if it is this begs the question of why aren't investors seeking higher interest rates as an offset). Certainly, given the movement in commodity prices the NZD looks significantly undervalued.
However, this is not unique to NZ. Both the AUD and CAD look undervalued when compared to commodity prices. More to the point for the purposes of this study, the NZD/AUD cross is only marginally lower than the level prevailing prior to the election.
Having said this, the NZ TWI is presently 12% below its average level for the past 10 years. In comparison, the Australian TWI is around 5% below its 10 year average. Given the divergence in the external positions, with the NZ current account deficit now much larger than Australia's when over the past decade the deficits as a % of GDP have been similar, this is perhaps not surprising. Again, it is difficult to pin the performance of the NZD on the new Government.
While we believe that some of the Government's policies will be negative for NZ's economic prospects, it is difficult to find evidence that NZ currently has to pay a premium as a result. The present gap between NZ interest rates and those elsewhere can be explained by the usual suspects and without the need to point to an increase in the political risk premium.
Similarly, the performance of the NZD is not all that different from the performance of the AUD - especially when the relative deterioration in NZ's external position is taken into account.
If government policies are indeed negative for NZ's growth prospects it may seem somewhat strange that there is little evidence of a higher risk premium. This could reflect the implications for short-term interest rates flowing from the "hit" that business confidence has taken as a result of some of the Government's policy initiatives. Namely, if the future track for short-term interest rates is lower as a result of the fall in business confidence then this provides a significant offset to a higher risk premium. However, as outlined in the annex, if anything NZ bond yields are lower than might be expected even when the level of short-term interest rates is taken into account.
Perhaps the explanation is that relative to the things that bond investors are most concerned about, namely inflation and the stability of the currency, the policy changes seem relative minor. The RBNZ's sole objective remains price stability and the Government continues to run a fiscal surplus. Should these "fundamentals" be threatened then the risk premium on NZ assets could rise sharply. Thankfully, changing these is not on the Government's agenda.
Modeling the risk premium on NZ interest rates
While a simple examination of interest rate differentials (both real and nominal) suggests no increase in the risk premium on NZ interest rates, this does not mean that politics is not having a negative impact. It could be the case that other factors have offset the negative impact of government policy.
In a world of free capital flows, real interest rates in NZ should be equal to the risk free rate of interest plus a country specific risk premium. Changes in the country specific risk premium will be a function of many factors, such as the current account, the fiscal position and such like.
Unfortunately, defining real interest rates is problematic. The simple trick of deflating nominal interest rates by the CPI has little theoretical justification. After all, for a 10Y bond it is inflation over the next 10 years that is relevant in determining real returns not historical inflation. However, coming up with a reasonable measure of long term inflation expectations is difficult to say the least.
In the relatively low and stable inflation environment of the 1990s, movements in nominal yields are likely to have had a much greater impact on movements in real interest rates than shifts in inflation expectations. Hence, in the rest of the analysis the focus is on explaining relative shifts in nominal yields (as measured by the 10Y NZGB/UST spread) rather than real interest rates.
The next issue is determining the range of factors that might explain movements in the NZ/US bond differential, since the unexplained differential is going to be at least partially attributable to "political" factors. Obviously there is a wide range of potential candidates. To reduce the number, those factors that are related to monetary policy such as relative shifts in the output gap, growth and inflation differentials and such like have been collapsed into the central bank policy tool - namely, short term interest rates.
Previous research has shown the current account deficit to be an important determinant of interest rate differentials, perhaps related to potential concerns over the exchange rate. It could be argued that NZ's relative current account position is the relevant variable. However past research has shown that the gap between the NZ and US current account deficits has less explanatory power than NZ's current account deficit on its own.
US swap spreads have also been used as an explanatory variable. Other things equal, a shift in US swap spreads will have an impact on the attractiveness of investing in NZ bonds.
Using these factors, the following equation has been estimated:
10Y spread = -0.4 + 0.3(ss) - 0.98(H) - 0.1(CA) + 1.1(swap) (t stat) (6.8) (- 1.9) (-1.7) (3.1)
where: ss = 3M interest rate differential between NZ and US
H = % of NZ bonds held by non-residents
CA = NZ current account deficit as % of GDP
Swap = US 10Y swap spread R2 = 0.66
The equation was estimated using quarterly data from June 1991.
Given the present set of exogenous variables, the equation predicts a 10Y bond spread of 140 bp. This is twice the present 10Y NZGB/UST spread of 70 bp.
The fact the actual bond spread is well below the predicted spread suggests there has not been an increase in the political risk premium on NZ interest rates.
One problem could be that the relationship between the dependent and explanatory variables has changed. In previous research we have shown that the widening in US swap spreads over the past 12 months has not been associated with a widening in peripheral $-bloc spreads as might have been the case in the past. If swap spreads are dropped from the regression equation then the gap between the actual and predicted spread narrows substantially. In fact, it falls to less than the standard error on the regression equation. Even after doing this, however, the actual spread is less than the predicted and thus still suggests there has been no increase in the political risk premium on NZ assets.
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