Lessons from capital inflows
Posted September 25, 2008on:
Capital inflows are the reverse side of the current account deficits that we like to discuss on this blog (most recently here). For some reason a capital account surplus is often seen as a good thing by journalists while a current account deficit is seen as a bad thing (ht Bluematter). This does not make sense to us as economists, as we know they are the same thing.
However, I suspect the difference in attitude stems from some dose of reality – fundamentally there are good and bad elements in a current account deficit/capital account surplus, and when the two attitudes shown by journalists are put together we get a fairly good breakdown of what is really going on 🙂
They find that capital inflow bonanzas have become more frequent as restrictions on international capital flows have been removed, that these episodes can last for quite some time (lulling policy makers into thinking that they are permanent), that they end with an abrupt reversal “more often than not,” that they are are associated with greater incidence of banking, currency, and inflation crises (except for in the high income countries), and that economic growth tends to be higher in the run-up to a bonanza and then systematically lower
Now New Zealand is a country that has had some capital inflows – so lets discuss what this view of capital inflows means for us:
Capital inflows stemming from lower world interest rates
Fundamentally, the type of inflow Dr Rodrik mentions, and the type of inflow that New Zealand has experienced stems from the fact that the rest of the world seemed has been willing to loan us credit cheaply in recent years.
Now there is nothing wrong with being offered a loan at a lower interest rate – as long as when you take the loan you have reasonable knowledge surrounding the risk and returns associated with the activity you are borrowing for.
We have used this capital to fund a whole bunch of capital and buy houses, and have seen our savings rate excl housing fall.
If people have purchased housing in the hope of capital gains over the last two years – then they are likely to be disappointed with their use of credit. Although that is disappointing for these people that have borrowed it is not really a national problem.
But growth is faster during the inflow, and slows once the inflow is at an end
Really, I don’t see how this is a very exciting result. Economic growth is faster when the cost of credit is lower and slows once the cost of credit rises – this result is simply common sense. When we have to slow our rate of borrowing to the rest of the world (which we will have to, as our current account deficit as a proportion of GDP exceeds GDP growth) interest rates will rise and GDP growth will fall. That is just how it is.
This does not imply that the experience of lower interest rates for a little while is painful – fundamentally there is a period of time when people were willing to loan to us cheaply, and we used that time to invest and get ourselves to a better economic situation. As a result, the capital inflow was beneficial – but surely we can’t expect it to increase GROWTH forever!
But a sharp reversal – that doesn’t sound pretty
No it doesn’t, and no it is not pretty. A sudden turn around in investor appetite would see domestic interest rates climb markedly.
As long as households and businesses have an idea of the risks surrounding the interest rate on debt they are borrowing this isn’t something we have to worry about – as they will take this into consideration when making their choices. In this case, borrowing activity would have already taken these risks into account.
The main fear we have is that households and firms may not realise the risks associated with the credit environment – implying that they may have borrowed to heavily on the basis of expectations of low interest rates out into the future. It is this situation that can cause especially costly readjustments.
So where are we
Even though consumption has reversed and incomes have held up strong investment activity and rising imported goods prices have seen the current account position worsen in June. However, it is inconceivable that the current account deficit will remain at this level for much longer.
Tighter world credit conditions, rising interest rates in NZ, and a sharp pullback in imports are all factors that are likely to occur very soon. Overall the sharp rise in our terms of trade (to its highest level since June 1974) may save the day in NZ – giving us an income boost just in time to allow us to repay debt.
In this situation, a sharp decline in our terms of trade would be the main factor to fear – hopefully we are not in for a repeat of the events of 1974!