The contribution of foreign borrowing to the New Zealand economy

New Zealand's persistent current account deficits and high external debt level remain central to ongoing economic policy debate. However, what is often overlooked is the potentially positive macroeconomic contribution made by foreign finance. This paper suggests that foreign capital inflows, the counterpart of current account deficits, have in fact made a significant contribution to New Zealand national income from a growth accounting perspective. A stylised national balance sheet that includes New Zealand's assets and foreign liabilities also places the stock of foreign debt in proper context and reveals that national wealth gains have been significant as well.


Introduction
The size and persistence of New Zealand's current account deficit (CAD) and associated foreign debt remain at the centre of ongoing economic debates about the economy's international economic performance. Much of the commentary views the foreign inflows as a cause for concern. The external deficit has averaged over 4.8% of gross domestic product (GDP), since the float of the exchange rate in 1985. Relative to GDP, the associated foreign borrowing and net stock of foreign liabilities reached over 90% by the end of 2006, making New Zealand, like Australia, one of the largest international borrowers for its size within the OECD group of economies.
The CAD rose from 2.8% of GDP in 2001 to 9.7% in 2006. Media commentary routinely assesses CAD outcomes as 'improving' if imbalances narrow and 'worsening' if they widen. More serious assessments of the economy's external position portray the CADs and associated foreign debt as a source of macroeconomic risk and cause for policy concern. See, for instance, Cline (2007), Edwards (2007) and Skilling (2005). Bollard (2005) argues that 'currently standing at 8 per cent of GDP, New Zealand's current account deficit is at levels that cannot be sustained indefinitely' and 'that the eventual adjustment of the high current account deficit could make the job of maintaining price stability more difficult'. Edwards (2007) estimates that the increase in the current account deficit has raised the probability of an adjustment of 3% of GDP to 20%, although for a 5% adjustment in GDP the probability was only 5%. However, he concluded that 'the current external imbalances should not be a cause for great concern'. If foreign investors judge that current account deficits are unsustainable, it is to be expected that such deficits would tend to self-correct as the exchange rate depreciates. This has been the experience of Australia in the early 1980s, East Asian countries in the late 1990s and the USA at present.
Current account deficits are also often perceived as a problem of trade competitiveness, which unfortunately can trigger direct policy 'solutions' that are inevitably distorting, such as export subsidies or higher tariffs on imports. However, what these trade-oriented perspectives generally ignore is that deficits on the current account side of the balance of payments are directly related to domestic saving and investment flows and matched by surpluses on the financial and capital account side.
These financial account surpluses reflect the growth of international capital mobility, which has expanded substantially since the worldwide liberalisation of financial markets in the early 1980s. Accordingly, domestic saving and investment rates for individual economies have become more independent, or less correlated, so that capital mobility in the Feldstein-Horioka (1980) sense has increased.
Contrary to popular perception, several theoretical approaches that focus on financial and capital flows rather than trade transactions yield the result that international borrowing confers net macroeconomic welfare gains. For instance, neoclassical foreign investment theory (Grubel, 1987, MacDougall, 1960 proposes that both creditor and debtor nations reap income gains from international trade in real capital, whenever the marginal product of capital differs across national borders. Viewed in this light, external imbalances reflect differences in investment opportunities rather than necessarily, poor trade competitiveness.
Alternatively, the inter-temporal approach to the external accounts (Frenkel & Razin, 1996;Makin, 2003Makin, , 2004Obstfeld & Rogoff, 1996;Sachs 1981Sachs , 1982, based on saving-investment behaviour and well-founded expectations about future returns on capital, concludes that capital inflow in the form of borrowing unambiguously raises consumption possibilities and national income if that borrowing facilitates additional domestic capital accumulation. As in the neoclassical foreign investment approach, this macroeconomic welfare improvement results from the tendency of expected rates of return on capital to equalize across borders. The inter-temporal approach has been applied to New Zealand by Kim et al. (2001Kim et al. ( , 2006. Using data from 1982 to 1999, their 2006 paper concluded that there was no evidence that the conditions for solvency had been violated and large deficits were not a cause for concern. Rather, these deficits were the result of optimal decisions by economic actors. The study by Kim et al. (2006) did not cover the period since 2000 when the deficits have grown appreciably. Munro and Sethi (2006) revisit this question using an extended data set, and their results concur with Kim et al. (2006). However they note that worsening of the trade account may threaten long-term solvency.
In subsequent work (Munro & Sethi, 2007), they develop a richer model of the current account and find again that the movements in the current account can be explained by the response of economic agents making optimal decisions given the costs of borrowing and the expected returns to investment. Mercereau and Miniane (2004) demonstrate that the results of present values models should be treated with caution as the estimates can be subject to errors when applied to small samples.
Numerous studies have examined the links between international capital flows, investment and economic growth. Yet this body of work focuses mainly on emerging economies and yields mixed results. While numerous studies (Bailliu, 2000;Chandra, 2005;Haveman et al. 2001;Klein & Olivei, 1999) find that capital inflow does positively influence national income, especially through the foreign direct investment channel, others (Carkovic & Levine, 2005;Edison et al., 2002;Rodrik, 1998) find either a minimal or nil effect. This remains an empirical puzzle in light of the strong case for increased international trade in saving on theoretical grounds.
When foreigners finance expansion of New Zealand's capital stock, the rise in external liabilities is also matched by an increase in the nation's real assets. In short, foreign investment supplements domestic saving, allowing the economy to accumulate real capital quicker than it would have done otherwise. Without that capital inflow over past decades, the combined saving of the private and public sectors would have implied less investment and hence lower real output growth. In the absence of access to world capital markets, domestic interest rates in New Zealand would rise. This would tend to encourage some additional saving but the rate of capital formation would be unambiguously lower. For an analysis of the relation between saving and the current account deficit in New Zealand see Wilkinson and Le (2008).
The economic policy significance of CADs, which necessarily match net capital inflow, critically depends on whether the extra real output made possible by foreign funds exceeds the real servicing cost on that source of finance. As the Reserve Bank notes: New Zealand's level of foreign debt has developed an increasing trend, repeatedly recording new highs and becoming a greater source of risk. Increased foreign debt puts pressure on New Zealand to grow fast enough to meet increased debt servicing obligations -otherwise the debt will not be sustainable. (Reserve Bank of New Zealand, 2007, p. 10) Generating additional income sufficient to meet the debt servicing costs on foreign liabilities is crucial; but it is a necessary, not sufficient, condition to ensure long run sustainability. Since economic theory suggests that net gains from capital inflow should unambiguously be positive, the central question is: to what extent has New Zealand actually benefited, in terms of income and wealth, as a result of capital inflows that have enabled the NZ capital stock to grow faster than otherwise? Makin (2006) proposes an extended growth accounting method for estimating the contribution of foreign borrowing to the Australian economy. In this paper we apply the same approach to gauge the contribution of foreign capital to New Zealand's income growth by deriving rates of return on foreign funded capital and their implications for national income for the period 1988 to 2006. Using national balance sheet analysis it also evaluates New Zealand's foreign debt with reference to counterpart national assets.
The paper provides evidence that, in fact, the necessary condition for the longrun sustainability of the current account does appear to have been met; that is, the use of foreign savings has augmented the capital stock and generated additional income more than sufficient to meet the obligations on the foreign liabilities. This conclusion is consistent with the intertemporal approach in which current account imbalances and national income are determined simultaneously and which shows how the large current account deficits experienced over recent decades by Australia, the United States and New Zealand can coincide with periods of strong economic growth and low saving in those economies.
The remainder of this paper is structured as follows. Section 2 briefly analyses trends in domestic saving and investment and their implication for the external account. Section 3 examines links between saving, investment, capital inflow and national income before applying a growth accounting approach to data from New Zealand's national and external accounts to estimate the contribution of foreign capital to New Zealand's national income. Section 4 then shifts attention to macroeconomic stock values by presenting a prototypical national balance sheet that offsets New Zealand's foreign liabilities against its national assets to derive a national wealth series. Section 5 concludes the paper by summarising the main findings and highlighting their implications for economic policy. The data used in this paper are drawn from the official statistics system maintained by Statistics New Zealand, known as Infoshare. Free web-based access can be obtained via: http:// www.stats.govt.nz/infoshare/.

Saving, investment and the external imbalance
The floating of the New Zealand dollar in the late 1980s and subsequent liberalisation of capital controls significantly enhanced the economy's integration with international capital markets. At the same time, New Zealand has had a relatively low saving rate as a proportion of GDP compared with average saving rates for the OECD group as a whole ( Figure 1). Despite this, New Zealand has more often than not invested more as a share of GDP than the advanced economy average, particularly since the turn of this century ( Figure 2).
A CAD signifies the extra domestic investment that capital inflow finances over and above that domestic investment (expenditure on fixed assets including machinery and equipment, dwellings, non-dwellings, road works and livestock), which is funded by domestic saving. This is shown in Figure 3.
Depreciation of capital, also known as capital consumption, accounts for a major share of gross domestic saving in New Zealand, in common with other advanced economies that characteristically have large, ageing capital stocks ( Figure 4). As a result, net saving has been relatively low, averaging only 2.4% of GDP over the period.
Capital inflow therefore normally funds extra net capital accumulation of the same value as the external imbalance. In other words, foreigners finance that much more domestic investment in New Zealand than reliance on domestic saving alone would permit through intermediated loans to resident firms, equity participation and purchases of real assets from residents. When foreign investors directly purchase real domestic assets such as property, the proceeds of the sale of domestic assets also supplement the pool of funds available for domestic investment.

Foreign capital and national income
Consistent with the intertemporal approach to the open economy, which abstracts from trade flows and exchange rates, external imbalances and international borrowing are primarily related to domestic saving and investment behaviour. Under autarky conditions, total investment spending must be funded from domestic saving, the residual between domestic output and consumption. In contrast, with perfect capital mobility, a small economy's domestic borrowing requirement over and above available domestic saving can be satisfied by foreign lenders (investors) lending at the exogenous real world interest rate. Domestic investment therefore exceeds domestic saving to the extent of foreign borrowing. If the real-world interest rate is lower than the real interest rate would be under capital autarky conditions, then for given domestic  (1) Gross saving is calculated as S ¼ I -CAD.
(2) Net national saving is calculated as Net ¼ Gross -depreciation. saving, investment when international borrowing is permitted should be higher than under autarky. In this way foreign borrowing raises national income because the extra units of foreign financed capital, times their marginal product, add to GDP.
However, foreign borrowing must be serviced, leaving a net national income gain equivalent to the difference between the additional output and income paid abroad to foreign investors. In short, international capital mobility enables lower domestic interest rates and higher national income, provided the productivity of the extra foreign-financed capital exceeds its cost.
If foreign lenders perceive high foreign debt as a sign of heightened country risk and diminished creditworthiness, they may demand an interest premium to compensate. The more averse foreign investors are to rising foreign debt, the higher the risk premium and, at some point, foreigners could conceivably judge the level of lending risk prohibitive. For estimates of the risk premium in New Zealand, see Hawkesby et al. (2000).
Foreign-debt-related risk therefore causes macroeconomic welfare losses since potential national income gains from foreign borrowing are not realised, although foreign borrowing still confers a net welfare gain provided the equilibrium interest rate allowing for risk is less than the autarky rate would be. Although interest risk premia limit potential growth, it also follows that the higher the risk premium, the slower foreign debt accumulates, suggesting that rising risk premia act to stabilise foreign debt levels.
The main qualification to the argument about the benefits of allowing unrestricted flows of funds across borders is that reversals of capital inflows make economies vulnerable to crises. Capital flight in response to new information about exchange rate risk, default risk or deteriorating fiscal and monetary policy settings can impose substantial short-term economic, social and political costs on borrower economies.
These costs are transmitted in the first instance through higher domestic interest rates and lost output, as well as through large exchange rate depreciations and the associated higher inflation. While we recognise that these are legitimate concerns, a major purpose of this paper is to estimate the real income gains from foreign capital flows; we therefore abstract from the broader issues of risk management.
To identify the contributions made by specific factors to economic growth, standard growth accounting suggests it is necessary to focus on key factor inputs. Conventionally, the capital stock, the domestic labour force, and total factor productivity, have been identified as the key sources of economic growth. In open economies however, there is a difference between domestic investment that is funded out of the pool of domestic saving, and domestic investment financed by foreign borrowing.
We now use a growth accounting approach to estimate national income gains for New Zealand attributable to foreign borrowing. To do this, we essentially follow the same derivation expounded in Makin (2006) as previously applied to Australia's foreign borrowing experience. International macroeconomic accounting dictates that an economy's current account deficit, or its use of foreign saving, S f through net capital inflow or foreign investment, equals its domestic investment, I, and domestic saving, S h , gap (S f ¼ I-S h ). Hence, increases in the domestic real capital stock, k, are partly financed by domestic saving, and partly by foreign borrowing Accordingly, we can specify a macroeconomic production function as where g is multifactor productivity, k h is that part of the total domestic capital stock that has been financed by domestic saving, k f is that part of the total domestic capital stock has been foreign-financed, and ' is hours worked by the domestic labour force. The sources of increased GDP in the short run are revealed by total differentiation of the macroeconomic production function in equation (1).
where f i denotes the derivative of GDP for i ¼ g, k h , k f , '. Gross domestic product differs from national disposable income for economies that are foreign borrowers by the amount of net income paid abroad. Therefore, where Y is national disposable income and r f is the effective interest rate on foreign borrowing, inclusive of dividends. So, The main sources of variation in the effective foreign interest rate are world interest rate movements and a time varying interest risk premium. Using the above equations, the sources of national income growth are revealed as Domestic sources of growth are grouped within the first set of brackets, whereas the second set groups foreign sources. Hence, national income gains can be attributed to a combination of domestic and foreign factors. To estimate the contribution of foreign borrowing to national income, it is necessary to derive values for the second bracketed term of equation (5). We assume the productivity of capital in use domestically is invariant to the source of its funding since foreign borrowing is largely intermediated through commercial banks. The production function is assumed to be Cobb-Douglas in form as the division of national income between capital and labour has been relatively stable for New Zealand over the past decade. The marginal product of capital can therefore simply be estimated using national accounts data as The net marginal product is then simply the difference between the marginal product of capital and the estimated rate of capital stock depreciation, as shown in Table 1. (1) Productive capital stock data in 1995-96 prices from nvpcs series INFOS SNCA.S5RK95ZZ.
The difference between the marginal product of capital and the estimated depreciation rate.
Next, using balance of payments flow and stock data it is possible to estimate the real effective cost of foreign capital and the annual national income gain attributable to the capital inflow, as shown in Table 2. While it would be of interest to analyse the sectoral distribution of foreign investment, currently available data do not allow this. In the case of Australia, much of the capital inflow is directed to the banking and financial sectors, where it ultimately is invested but not recorded.
The fact that the marginal cost of capital is below the estimated marginal product may at first blush be taken as an indication of under investment. However it is more correctly seen as a reflection of a disequilibrium state. It is this disequilibrium that is the driving force behind foreign capital inflow. When the equilibrium point was reached, at which marginal costs and benefits were equated, capital inflows would cease. Here we are concerned with measuring the transitional net income gains as the economy gropes toward (but never reaches) an equilibrium state.
It is now possible to estimate the variation in real national income due to fluctuations in world interest rates that raise or lower the servicing cost of external liabilities as implied in the last term of equation (1). This is shown in Table 3, which combines these data with Table 2 results to yield the real cumulative national income gains that have resulted from past capital inflow.
Hence, New Zealand's cumulative national income gain from net foreign capital inflow over the period was around $5.9 billion. Since the New Zealand workforce on a 'full time equivalent' basis was 1.9 million in 2005-2006, the extra accumulated income attributable to the use of foreign capital was around $2600 per worker, or $3300 when converted to prices. From 1995-1996-2006  (1) Measure of net foreign liability based on data in current price from series (INFOS IIPA.S5AAB).
(3) Ex post real cost of foreign capital is the ratio of net income payments to net foreign liabilities less annual inflation rate which is derived from series INFOS CPIQ.SE9A. (4) The difference between the net marginal product of capital from Table 1  income per worker rose by $17,680 in 1995-1996 prices. This implies that the additional income per worker from foreign investment amounted to some 15% of the total income gain over the decade. However, the annual income gains estimated on this basis most likely understate the total contribution of foreign capital and should be considered minimum values. This is because part of capital inflow is direct foreign investment, which entails the transfer of technology, work practices and management techniques that boost multifactor productivity. Hence, part of the multifactor productivity improvement over this time would be attributable to foreign capital rather than exclusively to domestic sources as assumed in the estimation method employed.

Foreign debt, national assets and national wealth
To this point, we have examined the contribution of foreign capital to the New Zealand economy strictly in flow terms. While inflows of foreign saving obviously add (1) Owing to the lack of data for net foreign debt and net income payments on foreign debt data before 2000, the proxy for implicit foreign interest rate is derived by equally weighted 10 year government bond rates from Australia, the USA and the UK. This is justified on the grounds that foreign investments in NZ from these countries account for over 50% of total foreign investments since 1995 and the amount from each is approximately the same.   (2) Other construction (3) Transport equipment (4) Plant machinery and equipment (5) NZ investment abroad (7) National assets (8) 1996 to external indebtness, the additional domestic investment that foreign saving funds also contributes to growth of the economy's capital stock, with implications for national wealth. Hence, we now shift our attention from assessing the impact of foreign capital inflows on national income, to examining the significance of the stock of foreign debt. We do this by constructing a stylised national balance sheet that includes aggregate measures of national assets, external liabilities and national net worth (or national wealth). National assets are comprised of the capital stocks of the private and public sectors (including dwellings and consumer durables) as well as New Zealand investment abroad. On the other hand, national liabilities include total foreign investment in New Zealand in the form of equity and debt holdings of foreigners.
Estimates of national assets are constructed by including residential buildings, non-residential buildings, other constructions, transport equipment, plant machinery and equipment, consumer durables and New Zealand investment abroad.
Statistics New Zealand provides data in real terms (in 1995-1996 constant prices) except for investment abroad data. This series is deflated by a private consumption deflator as, conceptually, wealth embodies present and future consumption possibilities available to domestic residents. Table 4 shows the composition of national assets. Overall, these increased by 46% over the past ten years.
The total external liabilities include total foreign investment in New Zealand in the form of equity and debt holdings of foreigners. Table 5 shows each component of external liability. Foreign portfolio investment in New Zealand is the fastest growing component among others. It has increased 146% from $28 billion in 1996 to $69 billion in 2006. In the last column of Table 5 we show the estimate of national wealth (assets minus external liabilities).  National wealth grew at an average annual rate of 2.7% or a total of 30% during the 10 years to 2006. While total liabilities grew from $104 billion to $195 billion, an annual growth rate of 6.7%, the accumulation in national assets exceeded that of external liabilities in absolute terms, resulting in the increase in national wealth ( Figure 5). The vertical distance between the total national assets and national wealth corresponds to external liabilities (the dotted area). The area below (with vertical shading) represents the gain in national wealth.
National wealth per worker and per head has increased from $168,000 and $70,000 to $180,000 and $81,000 respectively. This implies that, on average, every New Zealander was $11, 000 'wealthier' in 2006 than in 1996 (or $14,000 in 2007 prices). In summary, despite the increase in external liabilities that has followed from New Zealand's use of foreign capital, net wealth has risen over the last decade both in aggregate and per capita.

Concluding remarks
Periodically, concern is expressed about New Zealand's external account imbalance. However, what is sometimes neglected in this debate is the positive role that foreign capital inflows make to New Zealand's economic development. When foreign funds finance expansion of the domestic capital stock, the rise in external liabilities is matched by an increase in the level of plant, equipment, buildings and dwellings. In turn, this allows for greater production of output, economy-wide. Extra real capital therefore leads to higher national output per worker and a rise in real incomes.
In this paper we have estimated these national income gains using a growth accounting approach. This yielded average income gains of $2600 per worker arising on a cumulative basis from capital inflow over the period 1996-2006. At a minimum, these represent some 15% of the total increase in national income per worker over that period.
Similarly, from a stock perspective, as long as foreign capital inflow contributes to an enlarged domestic capital stock, the increase in external liabilities is matched by higher fixed assets in the national balance sheet. By constructing a prototypical national balance sheet, we estimate that growth in the value of New Zealand's assets has greatly exceeded the rise in external liabilities to the extent that national wealth per head has risen by $14,000 in 2007 prices between 1996 and 2006.
The inference that the rise in external liabilities constitutes a macroeconomic problem implies that resident enterprises that have borrowed offshore to finance the acquisition of real assets have been acting imprudently, and have consequently put the economy at risk. Yet, in the case of foreign borrowing, borrowers, lenders and the institutions channelling the funds should normally be expected to assess whether the income stream generated through the use of foreign capital would be sufficient to meet future repayments.
The evidence presented in this paper is that the contribution of foreign capital has indeed been more than sufficient to meet the cost of borrowing. The contribution of this analysis is to dispel any fears that foreign capital may not have made a positive contribution to real national income. Any intervention that might limit the inflow, other things equal, would result in New Zealand foregoing the real income gain that accompanies the use of foreign capital.
Unfortunately there are no available data to indicate the destination of foreign investment; this would add a richness to the analysis in future research. Likewise, the currency denomination and maturity structure of foreign borrowing would be a valid area for further work, but lay outside the scope of this paper. In addition, our results are 'partial' in the sense they do not develop a full counter-factual position in the absence of foreign capital flows. This would be a much larger undertaking requiring a more general equilibrium model for simulation. We have also abstracted from the explicit identification of the contribution of human capital to economic growth in order to focus on the contribution of foreign and domestic capital. The impact of investment in human capital would be incorporated in the contribution of productivity growth.
The evidence we present meets the necessary condition for long run sustainability, i.e. that the additional income generated is more than sufficient to meet the higher debt servicing obligations incurred by the use of foreign savings. However, this does not necessarily constitute sufficient grounds to take a benign position with respect to the level of the foreign debt. Whether the stock of accumulated debt represents a potential problem for the stable evolution of the economy is a different question. Furthermore, these results carry no inference about whether the national savings rate is optimal or not. While recognising the real concerns that might arise from holding an 'excessive' level of foreign debt, this paper has focused on the contribution of borrowing. Here the evidence is encouraging.