Economics: Borrowing bloats exchange rate

The Government made no secret it was borrowing more than it needed in the year to 30 June 2011. Early in May, Prime Minister John Key told Parliament the Government’s bond programme for the year had recently been extended to $20 billion. This was more than required for the year, but the Debt Management Office was front-loading some borrowing to take advantage of favourable market conditions.
This meant new debt had averaged $380 million week, an “absolutely unaffordable” increase, Key said. This inevitably invited follow-up Opposition questions about whether the Government could afford to spend $44 million week on tax cuts for the wealthiest 10 percent of our country, and so on – but that’s another issue. The focus here is on borrowing and its consequences.
On 7 June, when questioned about the Government’s borrowing requirements, Finance Minister Bill English elaborated: the Debt Management Office had borrowed about $5 billion more than was strictly necessary in 2010/11 to take advantage of beneficial market conditions. Over the next 12 months, as consequence, it would borrow about $5 billion less because it already has the money in the bank. Given the state of world financial markets, he regarded this – in hindsight – as “a very smart move”.
English then was asked who was running the economy: Mr Key, who had said the extra borrowing would have no impact on the exchange rate, or his Finance Minister, who said it would, thereby providing further reason for reducing debt?
That’s not exactly what English had said. He had told news media the Government borrowed the money at lower interest rates, but he conceded that borrowing extra money might have helped push up the value of the dollar. Once the Government started to borrow less from July, the pressure on the dollar should be eased.
Labour’s finance spokesman David Cunliffe exploited the disparate remarks from the Government’s leader and deputy to say they were “at odds over whether borrowing $380 million week instead of $300 million is affecting the exchange rate”. And so: “Who should Kiwis believe?” He saw the good sense in borrowing at favourable market rates, “but when the Leader and Deputy Leader have clearly not bothered to talk to each other about the potential impact, then we should be worried about the Government’s lack of direction…”
There’s no evidence the two did not talk to each other. But let’s hope they have proper grasp of the exchange rate effects of their borrowing. If they need refresher course, they might consult Listener column by economist Brian Easton some two years ago. It explained the well-established economic proposition that capital inflows (which include borrowing) lift the exchange rate at the expense of the economy’s ability to earn and conserve foreign exchange by production and sales.
That’s what had happened to the New Zealand economy since 2002, when we embarked on great splurge of foreign borrowing, Easton contended. “Not surprisingly, the tradeable sector stagnated while the internal sector expanded rapidly, its expenditure fuelled by the borrowing.”
Offshore borrowing was not necessarily bad. “If” the funds were invested in strengthening the tradeable sector, foreign-exchange-earning production was enhanced, so when the borrowing splurge was over, the strengthened industry could take over again (as well as service and pay off debt). It’s an important “if”.
Easton concluded it was absurd to expect the Reserve Bank to hold down the New Zealand dollar while we continue to borrow heavily offshore. Some short-term measures could influence the exchange rate, but in the medium term the Reserve Bank could not keep the dollar low when we are over-borrowing.
Whether we are still over-borrowing is open to argument. But Treasury forecasts show the current account balance deteriorating from 0.5 percent of GDP surplus (2010/11) to seven percent deficit in 2014/15 while our overseas net debt worsens from -78.6 percent of GDP to -85.3 percent. M

Bob Edlin is leading economic commentator and NZ Management’s regular economics columnist.

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