The Hindu Business Line : Is `carry trade' impacting New Zealand economy?

Since 1990, New Zealand had been running a current account deficit at a very reasonable level (2.5-5 per cent). But in recent times (this November, in particular) the country's current account deficit has become the largest in the industrialised world (9.8 per cent). Yet, the New Zealand dollar is on a high vis-à-vis the US dollar.

Theoretically, it is difficult to find an explanation for such an expensive New Zealand dollar in this context, and the traditional explanations include the high export price and relative depreciation of the US dollar against leading currencies. But the Finance Minister of New Zealand, Mr Michael Cullen, thinks otherwise. He feels that hedge funds are the main culprits.

He may be close to truth. To blame could be the popular `carry-trade' used especially by the hedge funds. This is a mechanism by which borrowings are made in low-interest currencies to invest in high-yielding assets. Thus, it is possible to borrow yen from Japan and the US because of the low interest expectations (for example, 0.25 per cent in Japan),and fuel demand for assets in another country, such as New Zealand.

High-yielding bonds

Historically, New Zealand has depended on its dollar-denominated bonds to finance its external deficit. This means these short-term bonds are lucrative for opportunistic investors. For example, Japanese retail investors have a healthy appetite for the high-yielding Kiwi-denominated bonds.

After all, a return of 7.25 per cent per annum in an appreciating currency is hardly to be ignored. Indeed, this interest rate is one of the highest in the developed world. Another rise in interest rate is expected, in order to make New Zealand's financial assets more attractive to international investors.

According to some quarters, carry-trade is considered a vehicle for lower volatility. The Bank of Japan estimates that there are about ¥15,000 billion (US$128 billion) outstanding in carry-trade activities worldwide. Imagine the damage this may cause to both destination and origin countries if financial institutions are caught by the turning tide.

Experts may cite the example of the US whose consistent twin deficits — budget and current account deficits — are a serious problem now due to its failure to do anything to curb household and government borrowing or to boost savings.

There are also alternative explanations for this. The developed economies are considered the only destinations for the developing economies with current account surplus. Most people and countries see the US as the destination for investment because of its economic size, strong financial sector, competitive economy, transparency and good governance.

Though hungry for capital, developing economies have failed to create the right environment to attract investments. This requires a genuine effort on the part of policy-makers and specific policy interventions. Efforts are especially needed to make the rural sector attractive, as otherwise the urban-centric growth model is difficult to sustain in the long run because of many macroeconomic imbalances. Sometimes, even the bureaucrats are confused with poverty-reduction/ alleviation strategies.

Driven by Real-estate

But the above explanations may not hold true in the case of New Zealand. The economy is now real-estate driven Home prices appear overvalued in many developed economies such as New Zealand. According to an estimate, the ratio of average house prices to rents or incomes is about 40 per cent above its long-term average in both New Zealand and Australia. What are the possible explanations?

The deficits are met by short-term borrowing, such as carry-trade. That is partly explained by the low inflation rate. But if the market starts to wobble, investors may look for alternatives.

New Zealand would then have to brace for what could be a housing price bubble, with all the attendant risks related to inflation, currency and the government's solvency. If this happens, the "good days" may be over for New Zealand.

(The authors are Professors at the International Management Institute, New Delhi.)

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