A Closer Look at the Balance of Payments

Econote (New Zealand)
A Closer Look at the Balance of Payments

Summary Among industrial countries, only Portugal can claim a poorer external deficit than New Zealand. The deterioration in New Zealand's current account balance is often cited as one of the key factors underpinning the continued underperformance of the NZD. Our analysis suggests that New Zealand's external deficit has peaked as a % of GDP. However, any improvement is likely to be very gradual, suggesting that large deficits are likely to remain a feature of New Zealand's economic landscape for the foreseeable future.

Introduction Over the past year, the NZD has depreciated by nearly 15% against the USD and 18% against the JPY. Despite performing somewhat better than that against the AUD, GBP and EUR, on a trade-weighted basis the NZD has lost just over 10% of its value over this period. One of the many explanations cited for the NZD's poor performance is New Zealand's burgeoning current account deficit - now one of the largest in the developed world (see DBW of 7 July). In this article we take a closer look at the factors driving the various components of the external deficit and discuss the likely evolution of the deficit over the next three years.

New Zealand's external deficit is one of the largest in the developed world New Zealand's current account deficit has deteriorated sharply over the 1990s. At 8.2% of GDP in the year to March 2000, amongst developed countries New Zealand's deficit is exceeded only by that of Portugal (although international comparisons are complicated somewhat as, unlike New Zealand, some countries do not record retained earnings as an outflow).

The extent of the deterioration is overstated to a degree by a number of one off and exceptional factors. For example, the import of a naval frigate added $631m to imports in December 1999 (0.6% of GDP). A programme of fleet replacement has also seen a large number of aircraft imported over the past year, boosting total imports of transport equipment by around $500m (0.5% of GDP) (offset to some extent by re-exports of aircraft). This activity is unlikely to be repeated over the coming year or two. Adjusting the deficit to abstract from these influences suggests that the underlying current account deficit may be closer to 7 - 7.5% - lower than the headline deficit but still very high by international standards. Higher oil prices have also been a key factor underpinning growth in imports, perhaps adding another 0.5% of GDP to the current account deficit over the past year, though whether or not this increase proves to be temporary remains to be seen.

A reduced trade balance has fuelled the deterioration As the chart below shows, the increase in the current account deficit over the past year or so has stemmed largely from a deterioration in the trade balance. Indeed, since late last year, the annual trade balance (defined on a balance of payments basis) has moved into negative territory for the first time since 1986. The deficit on the investment income balance has also widened, though this has been offset to some extent by an improvement in the balance on services.

As the table below illustrates, the sharpness of the deterioration in the trade balance and investment income balance was unexpected. The worse than expected trade balance was largely due to stronger than expected import volumes, reflecting both stronger than expected economic growth, the one-off factors discussed above and a higher than forecast import penetration rate. The terms of trade were also less favourable than expected. The worse than expected investment income balance reflected greater than expected earnings on foreigners New Zealand asset holdings - a component of the current account balance that is very difficult to forecast accurately.

The deterioration in the external deficit has been a factor undermining the NZD We believe that New Zealand's large current account deficit has been one of the factors undermining the NZD (see DBW of 7 July). This reflects the net currency flows that lie behind the deficit and, more importantly, the impact on investors' perception of the currency adjustment needed to bring about an eventual improvement in the deficit.

The trend deterioration in New Zealand's external balance was of little concern to investors during the mid 1990s. The economy remained strong and short-term interest rates were very high as the RBNZ battled to prevent domestic demand pressures in the housing market from spilling over into generalised inflation. The fact that New Zealand's deficit stemmed from private dissaving - Government savings broadly met its investment needs - also helped to mitigate investor concern.

However, with the domestic economy weakening, largely reflecting a cyclical downturn in the housing market, higher petrol prices, and a slump in consumer and business confidence (the latter largely due to concerns about aspects of Government policy), New Zealand's poor currency fundamentals have come into sharper focus. The NZD hit a new all-time low of USD 0.4235 on 24 August after a disappointing export outcome saw a poorer than expected merchandise trade balance reported for July (superceded subsequently by a new low of USD 0.4208 on 1 September).

In our view, to the extent that domestic factors are contributing to recent movements in the NZD - as opposed to developments in the USD - evidence of a sustainable improvement in the external deficit is likely to be important if NZD sentiment is to improve. The remainder of this article surveys the outlook for the various components that make up the current account balance.

Rising import penetration ratio appears largely invariant to the exchange rate As the chart below shows, rising import penetration has been a feature of the New Zealand economy for at least the past 15 years (as it has in many other countries). The trend likely reflects a number of factors, including the removal of tariff and other barriers, changing tastes, and greater awareness of cheaper imported goods (and greater competitive need to access these markets). Swings in the real exchange rate appear to have only a moderate impact on the penetration rate, which can best be described as having evolved around a linear trend.

Although some of the structural factors underpinning the rise in import penetration are likely to be less important in future, our forecast implies a further rise in penetration over the period ahead. In line with past relationships, we have assumed that the magnitude of the rise will be moderated slightly relative to trend given the stimulatory level of the exchange rate.

Export volumes should benefit from favourable environment The primary sector has been through a difficult two years, with drought conditions and both the Asian and Russian financial crises having a negative impact on the industry. The past year, however, has seen a spectacular recovery in this sector, with overall conditions said by some in the industry to be the best experienced in 20 years. Looking forward, the future continues to look bright. Good weather, strong world growth prospects, rising world prices, and a low TWI are combining to produce a promising outlook.

Following a period of decline, a moderate recovery in sheep and beef numbers is anticipated while dairy numbers are expected to continue to rise. Consequently a further substantial increase in agricultural production appears likely, with average returns also likely to rise on the back of firmer world prices and the weak NZD. Forestry export volumes are also expected to increase dramatically over the period as an increasing proportion of forest reaches harvest maturity.

Strong world growth and the low value of the exchange rate should also assist manufacturers to expand export sales. Nominal exports of so-called elaborately transformed manufactured goods to the US rose 46% in the year to June, reflecting the strong US economy and the weak NZD. Nonetheless, overall growth in manufactured exports has perhaps been a little weaker than historical relationships may have suggested. In part, this may reflect greater caution by exporters in the face of expectations that the weakness in the NZD was unlikely to last (many exporters no doubt recalling the run up in the NZD during the mid 1990s). If so, the lags between the fall in the exchange rate and an expansion of exports may simply have lengthened, in which case export growth may strengthen further over the coming year. On the other hand, anecdotal evidence suggests that New Zealand exporters have faced strong `third country' competition in overseas markets, especially from Asian countries left with spare capacity following the Asian crisis.

We expect the volume of total manufactured exports to rise by around 8% on average over the next three years (compared with an average growth rate of 9% over the past decade), with the balance of risks pointing to an even better result.

New Zealand's terms of trade have declined during the 1990s The deterioration in the merchandise trade balance over the past decade has been exacerbated by a trend decline in the terms of trade. Despite rising prices for New Zealand's export commodities over the past year, an even sharper rise in import prices has seen the terms of trade plummet, largely reflecting rising oil prices (the latter accounting for over $680m of the deterioration in the trade balance over the past 12 months). Had the terms of trade over the past year been at the levels recorded in 1990 - some 8% higher than current levels - a trade surplus of just over 1% of GDP would have been recorded, rather than a deficit of 0.8% of GDP.

The trend decline in the terms of trade implies that export volume growth must exceed that of imports in order for the trade balance to stabilise. However, over the ten years to March 2000, the volume of goods imported increased by 92%, whereas the volume of goods exported increased by just 65%. By way of comparison, Australia increased its exports and imports of goods by 105% and 104% respectively.

Looking forward, our forecast assumes that a gradual decline in oil prices together with continued robust growth in New Zealand's export commodity prices will lead to a recovery in the terms of trade. On the basis of this assumption, the annual trade balance is forecast to improve from a deficit of 0.8 of GDP in March 2000 to a surplus of 2.2% of GDP in March 2003. To the extent that this view proves too optimistic, the outlook for the merchandise trade balance would be less positive than our forecasts portray.

Strong growth in the tourism sector should underpin an improving services balance One particularly bright spot in the balance of payments picture is the balance on services. Short-term visitor arrivals in July were 17% higher than a year earlier, driven by strong world growth and New Zealand's increasing price competitiveness as a tourist destination. Arrivals from the US increased by nearly 40% over the same period. The falling NZD means that the average amount spent per tourist has also increased. Based on continued, though less rapid, growth in tourism earnings over the period ahead, our forecasts suggest that the balance on services could move into surplus for the first time since at least 1966.

A deterioration in the investment income balance will cap the overall improvement As a result of successive years of large current account deficits, the stock of net external liabilities has risen sharply. In 1990, net external liabilities amounted to around 65% of GDP. We estimate that the stock has risen to over 90% of GDP in 2000. The return that foreigners earn on their net assets is reflected in the deficit on the investment income balance.

The investment income balance has deteriorated from less than 5% of GDP in the early 1990s to 7.5% of GDP in the year to March 2000. Given our forecast of a continuation of significant current account deficits over the near-term, at best, the deficit on the investment income balance seems likely to stabilise at around 7.8% of GDP over the next three years.

The balance on transfers has changed little Net transfers have been relatively constant over the last decade as a proportion of GDP, subtracting around 0.4% of GDP from the current account deficit in the early 1990s and 0.5% of GDP in the year to March 2000. We see little reason to expect a significant change in the transfers balance over the period ahead.

Current account deficit has probably peaked but decline is likely to be gradual Given the analysis above, we conclude that New Zealand's external deficit has peaked. However, any improvement is likely to be very gradual. From a deficit of 8.2% of GDP in the year to March 2000, the deficit is expected to decline to around 6.9% of GDP in March 2001 and 4.9% of GDP in March 2003. The latter level corresponds to the average deficit recorded since 1982 and is broadly sufficient to stabilise net external liabilities as a proportion of GDP. This suggests that large deficits are likely to remain a feature of New Zealand's economic landscape for the foreseeable future.

Conclusion New Zealand's poor external deficit has been one of the factors weighing heavily on the NZD over the past 12 months or more. Our analysis suggests that the current account deficit has peaked, but that any improvement is likely to be gradual.

It is worth noting that our forecast assumes a appreciation of the NZD from current levels - the TWI is assumed to reach 54.2 by March 2003 (from 48.0 presently). To the extent that the NZD underperforms this assumption, a more substantial improvement in the current account balance is possible.

Darren Gibbs Senior Economist (64) 9 351 1376

Revised historical balance of payments data is due for release on 18 September. Data for Q2 2000 will be released on 22 September.

This, along with an extensive range of other publications, is available on our web site http://research.gm.db.com

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