New Zealand and international financial markets: have we lost control of our own destiny?
Over the last 20 years, the world has become ever more closely integrated. While it is estimated that world GDP has increased by `only' 85 percent over that period, the movement of international travellers has increased nearly threefold, and world trade has increased by sixfold. Increasingly large numbers of people all over the globe read newspapers published simultaneously in several locations to cater for a world market, and watch television news programmes also designed to cater for a world market.
But nowhere is the integration of the world economy more evident than in the explosive growth of world financial markets. It is estimated that in 1973, the daily turnover in world currency markets was less than US$20 billion. Even in 1983, the daily turnover was estimated to have been only US$60 billion. By 1995, according to the Bank for International Settlements, the daily turnover in world currency markets had reached the astonishing figure of US$1.2 trillion. This daily figure is equivalent to approximately 25 percent of the value of all world trade in 1995. In New Zealand's case, daily turnover in the foreign exchange market is estimated to have been on average the equivalent of some NZ$12 billion in April 1995, roughly half of that involving the New Zealand dollar. Put another way, turnover involving the New Zealand dollar in one week exceeded the value of our total exports last year. In the course of a month, turnover was substantially greater than our entire annual GDP.
Even in the New Zealand market for government bonds, daily turnover is currently averaging about NZ$750 million, so that in only 27 trading days the turnover is equivalent to the total New Zealand dollar government bonds held by the market.
Surely figures like this confirm our worst fears, that financial markets are totally beyond the power of the nation state to control or even influence - especially if the nation state is a relatively small country like New Zealand, where our total foreign exchange reserves, at about NZ$4 billion, are less than a single day's turnover in the New Zealand foreign exchange market? At very least, isn't our exchange rate totally driven by these vast flows of money, to the detriment of the real economy where exporters, importers, and ordinary New Zealanders work and try to earn a living? Haven't we become the plaything of international speculators whose only interest is making a fortune at our expense?
These concerns are by no means confined to New Zealand. The French Government was convinced, in 1993, that international speculators were trying to derail the country's economic policies by betting that the franc would have to be withdrawn from the European Exchange Rate System. James Carville, who directed Mr Clinton's presidential election campaign in 1992, expressed the same sense of frustration at the international financial market when he said: `I used to think that, if there was reincarnation, I wanted to come back as the president, or the pope. But now I want to be the bond market: you can intimidate everybody.'1
The influence of international financial markets in perspective
Are these fears valid, and if so, what can a small nation state like New Zealand do to protect some vestige of independence? Before looking at New Zealand's own situation, it is, I think, worth making four general points about the relationship between the international financial markets and the scope which nation states have to pursue their own economic policies.
First, while the power and size of financial markets are indeed substantial, that power is hugely exaggerated by quoting the gross turnover figures in currency and bond markets. Financial markets typically buy and sell financial instruments in large volumes to make absolutely minuscule margins. The same instrument can change hands several times during the course of a month, or even an hour. If I were to hand over a Treasury bill with a face value of NZ$10 million to a person sitting in the front row of this audience, and they were to pass it around the whole room before handing it back to me, the total `turnover' would be in excess of NZ$1 billion, but, assuming I did get it back, the net movement of cash would have been exactly nil. Obviously, people do not pass financial instruments around simply with the intention of returning them within an hour to their original owner, but there are plenty of transactions in the financial market which are not very different in character. The `turnover' may be large, but the actual impact on anything is pretty trivial.
Another way of looking at this is to look at the size of New Zealand's current account balance of payments deficit, currently around NZ$4 billion per year. This means that, exactly offsetting the fact that we are spending NZ$4 billion more on importing goods and services than we are earning through the export of goods and services, there is a capital inflow of the same size - perhaps in the form of New Zealanders borrowing this amount from overseas suppliers or banks, perhaps in the form of overseas institutions buying New Zealand government securities, perhaps in the form of a foreign company investing in plant and machinery in New Zealand, perhaps in the form of New Zealand companies liquidating some earlier offshore investment. But the net flow of capital over the year is an inflow of NZ$4 billion, and it can not be either more or less, no matter what the daily turnover in the currency market, or the bond market, or the money market. If the gross inflow is more than NZ$4 billion, the excess will be reflected in a gross capital outflow so that the net inflow remains just NZ$4 billion. And this net inflow, spread over the whole year, is only about 15 percent of the annual value of exports of goods and services.
Secondly, while we often think of these `speculators' as foreign, and I suppose George Soros, the American funds manager, is seen as typical, the reality is that when nation states are forced to capitulate to the pressure of financial markets it is often locals who exert at least the initial pressure. It is now widely recognised, for example, that it was Mexicans and not foreigners who triggered the severe foreign exchange crisis which hit Mexico at the end of 1994, no doubt because it was locals who most quickly saw the untenable position which Mexican Government policy had created. Although I can not prove it, I strongly suspect that it was New Zealand companies and individuals who triggered the foreign exchange crisis of July 1984 in this country; again, it was the locals who could recognise that the policies being followed by the Government were inconsistent with holding the exchange rate at its then value.
Thirdly, it is of course untrue to suggest that the constraints represented by the international financial market are in some sense new. Throughout the nineteenth century, when most countries were on the Gold Standard, running a current account deficit caused a loss of gold reserves, a consequential contraction of the liquidity of the local banking system, and a sharp contraction in economic activity. In this century too, the `external constraint' has been an almost constant focus of attention, in New Zealand as in many other countries. The unchanging reality is that, if a country is a net borrower, it potentially yields some influence to its creditors, and the more substantial its borrowing needs the more influence is ceded. In that respect, countries are not very different from people.
Fourthly, given the allegedly large influence of the international financial markets it is surprising how different economic policies are in different countries. Thus for example, there are, even among OECD countries, countries which are running public sector deficits of 10 percent of GDP and New Zealand which is running a surplus; countries whose net public sector debt is in excess of 100 percent of GDP and others where the ratio is less than 30 percent; countries where the government spends more than 60 percent of GDP and others where government spends little more than 30 percent; countries with inflation running at more than 10 percent annually and others where inflation is less than 2 percent; countries where unemployment is above 20 percent of the work-force and others where it is less than 6 percent; countries whose exchange rate is pegged to another currency and others where the exchange rate is freely floating. It would therefore be untrue to suggest that the international financial market had somehow forced a common set of economic policies on the world.
Foreign direct investment and sovereignty
This afternoon, I do not propose to say very much about the influence of foreign direct investment - in other words, about the influence of foreign equity investment where the foreign investor achieves a significant element of ownership and control in its New Zealand investment. I am assuming that the next speaker will address that subject and in any case I have dealt with the case for and against foreign direct investment in another context. But since I do not at this stage know what the next speaker will say on the matter, and the matter touches on my own subject, let me briefly record my own view that foreign direct investment does not in any way reduce New Zealand's own freedom of policy choice or sovereignty.
To be sure, New Zealand is now a country where a significant number of our largest companies and institutions are owned and controlled overseas. The banking sector now has only one New Zealand-controlled bank in it, and that a very small one. Most of the major insurance companies are owned and controlled overseas. There is no New Zealand-owned company in the motor vehicle assembly industry. There are few New Zealand-controlled companies in the oil industry (and none in the petrol distribution industry). There is very substantial foreign investment in the hotel industry, in the telecommunications industry, in the forestry industry, and in many other industries.
Does this mean that we have, as a result, `lost our sovereignty'? Not at all. Every company, whether locally-controlled or foreign-controlled, operates in New Zealand to make a profit for its shareholders, not out of any sense of altruism. In making that profit, they are bound to obey New Zealand laws, bound to pay New Zealand tariffs on imports, bound to pay staff the going wage rate, bound to pay New Zealand taxes, bound to obtain consents under the Resource Management Act. In other words, they are subject to New Zealand control. To be sure, before a foreign company makes an investment in New Zealand, New Zealand has no power to compel that company to invest here, any more than the government can compel a New Zealand company to make an investment which does not seem warranted. After the investment has been made, a foreign owner is as much at the mercy of the New Zealand authorities as the owner of a New Zealand company, which is why stable and predictable policies are so important if New Zealand does want to attract such investment.
International financial markets and restraints on policy
What of other forms of international capital? Do we risk losing control of our own destiny, or at least losing power to make our own policy, by opening the economy to other forms of international capital? Allowing foreign individuals and institutions to buy non-controlling interests in companies listed on the stock exchange, or to buy government New Zealand dollar bonds or Treasury bills, or to deposit in New Zealand banks does not provide any access to technical know-how, market knowledge, or entrepreneurial initiative (in the way that foreign direct investment typically does), but it clearly provides resources to enable New Zealand to finance a higher level of investment activity than we are willing to finance from our savings.
This is not to deny that we might be wise to improve our own level of national savings. Indeed, I would be delighted to see New Zealanders improve their savings performance, and an improved savings performance would be a necessary counterpart to any reduction in foreign investment in New Zealand.
But whatever our level of savings, the willingness of foreigners to invest in our shares, bonds, bills, and bank deposits provides additional resources which can, in principle, make it possible for us to increase our level of investment. That is surely desirable. It is worth noting that the investment by foreign institutions in New Zealand dollar government securities as at the end of May alone amounted to in excess of NZ$14 billion, slightly more than half of the total of such securities held by the market. There can be little doubt that, without that investment, interest rates in New Zealand would be very substantially higher than they now are.
Moreover, such investment clearly does not `threaten our sovereignty' by controlling anything: we are discussing the purchase of non-controlling shares, and fixed interest instruments.
But what about the freedom that these foreign investors have to take their money and go? Undoubtedly, the fact that foreign investors could decide to sell their shares or government securities, or to withdraw their deposits from New Zealand banks, does act as a constraint on policy. As I have just mentioned, a decision by foreign investors to `take their money and go' would almost certainly result in an immediate and substantial increase in interest rates in New Zealand (to say nothing of the sharp fall in the sharemarket), even without allowing for the impact of any desire on the part of New Zealand investors to withdraw also.
So doesn't the risk of this happening involve a serious loss of national sovereignty? As I have indicated, the desire to avoid this happening certainly does constrain policy. But I would argue that the constraint is an entirely healthy one. The only reason why large numbers of foreign investors might want to leave New Zealand in a hurry would be fear - almost certainly fear of having a substantial part of their investment stolen by inflation and its consequences. So to keep the confidence of overseas investors, New Zealand governments have to follow policies designed to keep inflation well under control. And since keeping inflation well under control is now recognised as the best contribution monetary policy can make to the successful functioning of the economy - the best contribution monetary policy can make to economic growth, employment, and export competitiveness - and indeed the best contribution monetary policy can make to a fair society - this constraint on policy is not only not detrimental to the interests of New Zealanders but is in fact beneficial. In other words, the fact that foreign investors can always choose to depart serves as a very important bulwark against the possibility that some future government might decide to again allow inflation to get out of control, to the detriment of all New Zealanders.
The freedom that New Zealand investors also enjoy to invest abroad rather than in New Zealand acts as an identical bulwark against poor policy decisions.
Note that financial markets do not constrain the Government's ability to spend more on early childhood education, or on hip replacement operations, or on any number of other objectives. They do not constrain the Government's ability to adjust the rates of income tax. But as agents for savers, here and abroad, they do constrain the Government's ability to debase the currency and that is surely a constraint which New Zealanders should welcome.
Although neither the Reserve Bank of New Zealand Act nor the Fiscal Responsibility Act were enacted with foreign investors primarily in mind, both pieces of legislation are hugely important in maintaining the confidence of overseas investors in New Zealand. Neither piece of legislation denies the right of government to operate policy as the government thinks in the best interests of New Zealanders. But both Acts oblige the government to tell the public - including savers both here and abroad - of their future intentions, to be `transparent' in the Wellington jargon. That has to be desirable in any free and democratic society.
Certainly, the rewards of that transparency, and the confidence it has engendered, have been substantial. In the mid-eighties, the New Zealand government was having to pay 18 or 19 percent to borrow 10 year money in New Zealand dollars, because nobody trusted the currency to maintain its value. This was some 10 percentage points more expensive than the U.S. government was having to pay to borrow 10 year money in U.S. dollars. By early 1994, we were borrowing 10 year money in New Zealand dollars at less than 6 percent, and for a time we could borrow more cheaply in New Zealand dollars than the U.S. government could borrow in U.S. dollars. This reflected our vastly improved inflation performance, the confidence created by the transparency of the Reserve Bank Act, and the determined efforts of Government to reduce the public sector debt. For most of the last five years, New Zealand has been able to borrow long-term money in its own currency at rates appreciably lower than the Australian government has been able to borrow in Australian dollars, and somewhat lower than the United Kingdom government has been able to borrow in sterling.
More recently, the situation has deteriorated somewhat. Of course, the absolute cost of borrowing 10 year money has climbed, a reflection of interest rates increasing throughout the world. More telling is the fact that our margins against the United States and Australia have deteriorated quite sharply. Whereas for most of the last two years, New Zealand has had to pay only 1 to 1.5 percent more for 10 year money than the U.S. government, today the margin of cost above the U.S. is nearer 2.0 percent. Whereas for much of the last five years, New Zealand has been able to borrow 10 year money at a margin of 1 to 2 percent below the cost faced by the Australian government, today that margin has virtually disappeared.
The risk perceived by investors in New Zealand dollar instruments has clearly risen. There are no doubt various reasons for that. One of them is a recognition that New Zealand's balance of payments situation is rather worse than seemed likely six months or so ago. Another is almost certainly some concern about the implications of the new electoral system, and the uncertainty caused by that system about the political shape of the next Government.
That we have to pay a relatively higher interest rate now than used to be the case some months ago, and would have to pay a much higher rate still if the prospect of higher inflation were threatened by any significant change in the current monetary policy framework, is really just a local illustration of a more general phenomenon. A recent OECD study shows clearly that countries with big budget deficits, big current account deficits, and a history of high inflation `now pay a penalty in the form of higher real interest rates'.2 We do not, of course, currently have a big budget deficit (though big budget deficits are not very far in our past); but we do have a reasonably significant and growing current account deficit, and we had, through the seventies and eighties, one of the worst inflation records in the OECD.
As Goh Chok Tong, Singapore's Prime Minister, said at a dinner to mark the 25th anniversary of the establishment of the Monetary Authority of Singapore last month, quoting Alan Blinder, until recently deputy chairman of the Federal Reserve Board, financial markets have the sensitivity of a gazelle, the speed of a cheetah, and the memory of an elephant. In other words, financial markets are acutely sensitive to risk, flee in the twinkling of an eye at any perceived sign of danger, and take a long time to forget the source of danger. Perhaps that is not so surprising: a person who touches a very hot element, moves her hand very quickly and normally does not touch the element again before receiving some reliable confirmation that the element has cooled. The Reserve Bank Act does not guarantee that the element will stay cool, but it does guarantee that, if it is going to get hot, everybody knows about it in advance. In other words, the Reserve Bank Act does not prevent the government from choosing to override the price stability objective chosen for monetary policy by Parliament, but it does require any government choosing some other objective to tell everybody that that is what their new instruction to the central bank is. That way, people can remove their hands from the element before it gets hot. As already mentioned, the existence of the Act in its present form has without question been a significant factor in reducing interest rates in New Zealand beyond what would have seemed likely given our relatively recent history of high inflation.
International financial markets and the New Zealand exchange rate
In the last part of my speech, I want to address three questions. First, isn't it true that international financial markets, through their vast resources, can push exchange rates around at whim? This is certainly a widespread perception, influenced in part by the view that trading volumes in foreign exchange markets vastly exceed the value of exports and imports, as already noted. Yes, international financial markets do have huge resources available to them, and yes, they do affect the value of the New Zealand exchange rate, but it is very easy indeed to exaggerate that influence.
The exchange rate at any point of time is determined by the overall desire of both New Zealanders and foreigners to hold New Zealand dollars. This is affected by what we are earning from exports and what we are spending on imports. It is affected by interest rates in New Zealand in comparison to interest rates overseas. But it is also heavily influenced by confidence, and perceptions of risk.
In many respects, confidence is a much more important influence on the exchange rate than small movements in relative interest rates. Thus, for example, through most of 1993, interest rates in New Zealand fell, both in absolute terms and relative to interest rates in major overseas capital markets, yet the exchange rate appreciated through most of the year. Confidence in the gradually improving fiscal position, and in the likelihood that the Reserve Bank Act would prove an enduring feature of the landscape, was undoubtedly an important factor in that outcome. On the other hand, despite quite a sharp rise in domestic interest rates over the last three months, the exchange rate has barely changed from its level three months ago. That in turn speaks of increasing nervousness on the part of investors. (And it is the confidence, or lack of it, of all investors, whether local or foreign, which is crucial, not simply the confidence of offshore funds managers.)
Incidentally, despite the small size of New Zealand's foreign exchange reserves in relation to the resources at the disposal of large overseas institutions, the volatility of the New Zealand exchange rate in recent years has actually been fairly low in comparison to the volatility experienced by several of the currencies of much larger countries, such as Australia, Japan, and Germany - quite the reverse of what might be expected by those focused only on the small size of the New Zealand economy in relation to the `vast size' of the international financial market. In my own view this is the result of two factors.
First, it is a direct result of the monetary policy predictability created by the Reserve Bank Act: because financial markets understand that the Bank is committed to delivering stable prices and that in a small economy the exchange rate has a fairly direct effect on prices, there is an understanding that the Bank will adjust monetary policy to prevent any rapid movement in the exchange rate, either up or down, threatening to jeopardise the price stability objective. As a direct result, volatility in the exchange rate is reduced.
Secondly, in my judgement the fact that the Bank is committed not to intervene in the foreign exchange market unless it is absolutely necessary to counter `disorderly market conditions', has a demanding view of what constitutes `disorderly market conditions', and has not in fact intervened in foreign exchange markets directly since the New Zealand dollar floated in March 1985, that fact has reduced the attractiveness of the New Zealand foreign exchange market to those who would engage in aggressive speculation on our exchange rate. Those who play for big stakes in international currency markets tend to look for situations where they have substantial potential gains with limited downside risks. Ideally, they are looking for a situation where a central bank is trying to hold a currency's value against a widespread perception that the currency is over-valued. The ideal situation is that of the New Zealand dollar in July 1984, or sterling in September 1992: the speculator may win handsomely at the expense of the taxpayers in the target country, and stands to lose almost nothing if the central bank succeeds, against all the odds, in holding the value of the currency. If a big speculator, domestic or foreign, wants to take a big gamble on the future value of the New Zealand dollar today, he has to hope that some other big speculator will, in due course, be willing to buy him out of his position. The Reserve Bank will not do so. That has tended to make the New Zealand foreign exchange market a relatively unattractive `playground' to the big speculative players.
International financial markets and the volatility of capital flows
But what about the volatility of capital inflow? Doesn't this cause all sorts of potential difficulties for domestic policy? The short answer is `yes', and a great deal of time is being spent internationally debating how to handle this problem. Some countries are worried that strong capital inflow expands the liquidity of the local banking sector and leads to strong inflationary pressures, and this is true if the country receiving the capital inflow is committed to trying to hold its exchange rate stable (in other words, where the central bank is buying the foreign exchange arising from the capital inflow by creating additional local currency). Others worry that strong capital inflow tends to push up the exchange rate, to the detriment of local export competitiveness, and this is true if the central bank of the country receiving the capital inflow is not buying the foreign exchange arising from the inflow.
The reality is that capital inflow by its nature permits a country to spend more than it is earning, or invest more than it is saving - in other words to run a current account deficit. The current account deficit is `created' in part by the increase in the inflation-adjusted, or real, exchange rate which is the direct result of the capital inflow. Either the nominal exchange rate remains stable but the real exchange rate appreciates because of higher domestic inflation, or the nominal exchange rate rises with domestic inflation remaining low - but either way, the real exchange rate rises somewhat in response to capital inflow. In New Zealand, we have chosen to allow the nominal exchange rate to appreciate somewhat in response to capital inflow while keeping inflation low, in recognition of the important benefits of general price stability.
But what if the capital inflow suddenly stops, or worse goes into reverse? Then the real exchange rate has to adjust downward. If that happens gradually, there is no problem, but if it happens abruptly, the disruption can be considerable - industries competing on international markets, or competing against imports on the domestic market, are suddenly very much better off (though may be unable to increase production quickly in response to the more attractive environment), but the rest of the community experiences a sudden loss of real income. These sudden changes are, at the very least, unhelpful.
To avoid the costs of this kind of volatility, it is important that the overall policy environment be as stable and predictable as possible. This has certainly been the case in New Zealand over recent years and we have benefited greatly from that. It meant that we received absolutely no negative fall-out, and possibly some positive fall-out, in reaction to the world-wide `flight to quality' following the Mexican crisis of late 1994. The new electoral system has reduced the predictability of policy somewhat in recent months, and we are paying a price for that currently. It will obviously be important to restore policy predictability as soon as possible.
Could exchange market volatility be reduced by a tax on foreign exchange transactions
But my final point relates to the possibility that, despite having an eminently stable policy regime which does not in any way threaten to expropriate the savings of investors, we may still encounter shifts in international market sentiment which could be very damaging to our interests. Could we reduce our vulnerability in some way, perhaps by `throwing sand in the wheels' of the international market, or, expressed more formally, by seeking to directly reduce the volume of foreign exchange market transactions relating to New Zealand?
The most famous proposal along these lines was one put forward in 1978 by James Tobin, an American economist awarded the Nobel prize in economics in 1981. He suggested applying a small tax, perhaps 0.5 percent, on the value of all foreign exchange transactions. This would, he believed, have negligible impact on foreign exchange transactions relating to payment for exports or imports, or to long-term investment decisions, but would effectively prohibit all of the transactions relating to very short-term `speculative' transactions. Thus, for example, a 0.5 percent tax on an overnight `round trip' transaction would be equivalent to a tax of 365 percent at an annual rate, and the overnight transaction would not occur. (Note that Tobin did not see this tax as an effective way of raising much revenue, because he recognised that the vast majority of foreign exchange transactions, by value, would cease to occur if the tax were introduced. Indeed, that would be its purpose.)
But most observers believe that the Tobin tax would not have the desired effect for two quite different reasons. First, the tax would almost certainly fail to make a significant impact on the volume of financial transactions in, say, the New Zealand dollar unless the tax were to be applied by all countries where trading in New Zealand dollars could take place. There would be little point in applying the tax in New Zealand if trading in New Zealand dollars could simply continue in Sydney, Singapore, Hong Kong, Tokyo, London or New York. Trading in New Zealand dollars already occurs in all of those centres and more, and would no doubt accelerate considerably if New Zealand were to introduce a tax of that type.
Secondly, most observers now doubt the premise on which Tobin based his proposal, that reducing turnover in the foreign exchange market would have the effect of reducing volatility in the exchange market. Even in the unlikely event that all actual and potential centres of foreign exchange trading would agree to introduce a tax on foreign exchange transactions, and the volume of transactions shrank dramatically as a consequence, it is not at all clear that this would have the effect of reducing exchange rate volatility. On the contrary, it seems very likely that, with much less liquidity in the market, individual transactions relating to `real business opportunities' (large export transactions, large import purchases, large investments, and so on) would have a much larger effect on the exchange rate than is now the case. Far from reducing exchange rate volatility, a tax on foreign exchange transactions would very likely increase it.
At the end of the day, New Zealand is a part of the world economy and gains enormous benefits from that fact. Being part of the world economy involves some risk. Having a sound framework within which monetary and fiscal policy can deliver a stable environment for the benefit of all helps to minimise that risk, and helps us to deal with the occasional shocks which the world economy sends our way. Switzerland is subject to the same risks and the same shocks: I doubt if many Swiss ever seriously contemplate opting out.
1 The Economist, 7 October 1995, page 15
2 The Determinants of Real Long-Term Interest Rates, by Adrian Orr, Malcolm Edey and Michael Kennedy, OECD, 1995.