The Road Ahead
Reserve Bank governor Don Brash explains why he is optimistic about the future of the New Zealand economy, despite the international uncertainties.
Sunday, December 6th 1998, 12:00AM
The international economic environment is more uncertain, and more downright unnerving, than for a very long time.
In the middle of last year, Thailand was forced to abandon its previously-pegged exchange rate and devalue its currency. By the end of last year, the currency crisis which had begun in Thailand had spread to Indonesia and South Korea, with large-scale capital flight, heavy loss of foreign exchange reserves, sharp falls in exchange rates, and drastic falls in share prices. Those countries have seen a huge increase in bankruptcies and extreme poverty, and have been grappling with banking crises which make the problems which we faced in the late 1980s look totally trivial by comparison. Indonesia has seen a fall in total output reminiscent of the falls experienced by developed countries in the thirties, and Korea is not far behind.
Japan has seen nearly a decade of extremely sluggish growth, and is today enduring a prolonged recession. The Japanese Government has recently passed legislation to assist in the re-capitalisation of the country’s banking system, and voted the equivalent of NZ$1 trillion for that purpose. Nobody knows whether that enormous sum will be sufficient to restore the Japanese banking system to health.
The Russian government recently defaulted on its debt, and threw not only the banking system of that country into further confusion but created unprecedented turbulence in international financial markets. The exchange rates of other emerging markets were put under great strain; one of the largest US hedge funds came to the brink of collapse (after losing virtually all of its US$4 billion in equity); the US dollar fell against the Japanese yen by more in two days than in any other two-day period since floating currencies began in 1973; and large numbers of companies in the US found themselves quite unable to borrow in the capital market.
Business confidence in the United Kingdom has recently fallen to its lowest level since 1980, while one of the largest banks in the United States estimates that that country will be in recession next year.
And looming over all is the possibility of a large ‘correction’ in US, and therefore in global, share prices. At mid-November levels, the S & P 500 index of US share prices valued the shares in that index at over 100 percent of US GDP, compared with a comparable figure of 81 percent at the market peak in 1929. At the same time, the dividend yield on the shares in the
S & P 500 index was, at 1.4 percent, slightly under half that at the market peak in 1929. Many observers regard the US share market as considerably over-valued at prevent levels.
Addressing the National Association for Business Economics in early October, Alan Greenspan, the chairman of the US Federal Reserve Board, said that at no time since he first became a professional economist as a young man in 1948 had he seen a situation quite like it.
In recent weeks, the position in financial markets appears to have stabilised somewhat, and many people, Greenspan included, are feeling rather more relaxed about the outlook. Most observers still see positive growth in the United States, Europe and Australia next year. In several of the crisis countries of Asia there have been impressive steps taken to restore economic health. But the risks in the international economic environment clearly continue to be substantial.
Implications for New Zealand
Plenty of people have become very worried about the outlook for the New Zealand economy, and I am often asked why there seems to be ‘no plan’ to deal with the situation. In a fundamental sense, successive New Zealand Governments began preparing for this situation nearly 15 years ago with policies to systematically improve the resilience and flexibility of the economy.
In recent years there has been a systematic attempt made to reduce the extent to which government over-spends its tax revenue, in other words to reduce the fiscal deficit, and in this way to reduce the size of the government debt relative to the size of the economy.
(New Zealand's) debt level which is very much lower than that in most other countries, and it puts the country in a good position to handle any adverse events which hit us from overseas.
Secondly, we have a banking system which is intensely competitive, and as sound as at any time in my memory. Of course, having a sound banking system does not make us unique, but it does make us distinct from almost all of the countries which are now experiencing severe economic difficulties.
Thirdly, in March 1985 the New Zealand dollar was floated and the Reserve Bank has not intervened in the foreign exchange market since that time. Not everybody sees that as an unmixed blessing, but in my view the policy has had two very important benefits.
First, it has meant that, as views about the risks of holding New Zealand dollar assets change, the value of the currency changes, without any political or bureaucratic intervention, indeed without any need for political or bureaucratic decision.
Second, the fact that everybody has known that the exchange rate was floating has strongly discouraged banks and other companies from borrowing money overseas without taking appropriate forward exchange cover. Sadly, it seems that in virtually all countries which have had pegged exchange rates, banks and companies have borrowed overseas in foreign currencies without hedging the exchange rate risk, and have as a result suffered huge losses when (and I say ‘when’ rather than ‘if’ since I know of almost no pegged exchange rates which have lasted much more than a decade) those pegged exchange rates came ‘unpegged’. Yes, there were companies which suffered losses with the depreciation of the New Zealand dollar over the last 18 months, but, although I am sure those losses were painful, in very few cases have they proved fatal. Indeed, a great many companies have welcomed the lower exchange rate. The situation in Thailand, Indonesia, and Korea has been very different.
Of course, I do not want to pretend that having a floating exchange rate can protect New Zealand from adverse events abroad. Those shocks still hurt. But the floating exchange rate spreads the burden of adjusting to those shocks around the economy. It also enables us to choose both our own inflation rate and our own monetary policy.
Those who ask why nobody is coming up with a plan to protect New Zealand from the Asian crisis are asking the wrong question. New Zealand already has a plan. It was set in the mid-1980s, when we as a nation set about reforming our economy to be more flexible, more open, and more adaptable. In effect we decided that rapidly adapting to international shocks was better than trying to pretend we could resist or avoid them. That was the judgement we made, remembering that throughout most of our history vulnerability to changing terms of trade has been the dominant story of the New Zealand economy. The evidence so far is that that judgement was right.
The role of the Reserve Bank
The bank, and the framework within which we are required to operate by law, make an important contribution to New Zealand’s ability to weather adverse events, including the present international storm.
But first, a couple of disclaimers. The first is an acknowledgement that monetary policy has only a relatively small effect on the economy’s long-term potential growth rate. To be sure, by keeping inflation low monetary policy can minimise the costs, distortions and resource misallocation which often accompany high inflation. I believe that it is reasonable to claim that, at the margin, this reduction in costs and improvement in resource allocation assists the economy to grow at a faster rate than would otherwise be the case. Over long periods of time, this small improvement in the economy’s potential growth rate is undoubtedly worth having. But the main things determining our potential growth are things like how good our education system is, how well we invest our savings, how government policies affect incentives to acquire skills, how efficiently the public sector uses resources, how good our managers are, how fast the labour force grows, and a great many other factors. Monetary policy helps, but can not single-handedly convert a slow-growth economy to a fast-growth economy.
The second point to acknowledge is that, no matter how good the Reserve Bank is at forecasting the economy, neither we nor any other central bank can eliminate the business cycle. The time delays between monetary policy action and the impact of that action on the real economy are too long, and too uncertain, to make any pretence that we can achieve such an ambitious objective. There will continue to be periods of above-trend growth, and there will continue to be periods of below-trend growth, and occasionally of recession.
Since the mid-1980s the Government has instructed the Reserve Bank to use monetary policy to achieve one goal only, namely stable prices. We do that because it is now the almost unanimous view of economists and economic policy-makers here and abroad that, in the long-term, the best and only thing which monetary policy can do to assist economic growth and employment is to keep inflation very low.
Inflation targeting is as appropriate for times when inflationary pressures are weak as it is when inflationary pressures are strong.
If New Zealand were hit with further bad economic news from overseas, no amount of good monetary policy could prevent that being painful to many people and businesses. But monetary policy targeted at keeping inflation both above 0 and below 3 percent would materially assist us in dealing with the pain.
The New Zealand economy, as it is structured now, bends in the wind rather than breaking. As the Asian crisis and the drought have hit, so the exchange rate and interest rates have fallen to help the economy get back into growth. This has occurred without drama, panic or any kind of speculative or national crisis. The markets and the Reserve Bank have not ended up in a tug of war, and in that sense the system has worked well.
The outlook for the economy
The key conclusion of our (November monetary policy) statement was that, with the New Zealand economy weaker than we had expected earlier in the year, there is a level of excess capacity in the economy which provides scope for considerable economic growth without threatening an increase in inflation. The weak global economy supports the view that an imminent increase in inflationary pressures from that source is unlikely.
Given this outlook, we indicated that we saw a continuation of relatively easy monetary conditions for the next year or so as being appropriate to keeping the inflation rate within the target.
If we are right in our projections we believe that in the second half of this year the economy has been growing slowly. Next year, we see growth of around 3 percent, and the following year growth should be around 4 percent.
Unfortunately, and notwithstanding the reduction in unemployment for the September quarter, we still see some further increase in unemployment over the next year, before unemployment again starts to decline.
I can’t tell you precisely what interest rates will do, or precisely what the exchange rate will do. At this stage, we believe that overall monetary conditions will be able to remain relatively easy, relatively stimulatory, for the foreseeable future, without threatening an increase in inflation.
But whether this relatively easy set of monetary conditions consists of a lower exchange rate and somewhat higher interest rates, or alternatively a higher exchange rate and somewhat lower interest rates, depends entirely on how savers both here and abroad perceive the risks and returns of investing in New Zealand dollar assets as compared to the risks and returns of investing in foreign assets.
We in the Reserve Bank are pledged to do whatever is necessary to keep inflation below 3 percent and above zero. In the long-term, building a reputation for keeping inflation low is the only way in which we can contribute to interest rates staying at an appropriate level. It is also the best contribution which we can make to the success of your business, and the ongoing prosperity of all New Zealanders.
Don Brash is the governor the Reserve Bank of New Zealand. This article is extracts from his "The Road Ahead" speech which is being made to small and medium-sized businesses throughout New Zealand.
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