May 29, 2008

The Consequences Of Not Heeding Calls For Fiscal Restraint

Brian Fallow reminds us today of the consequences of a rating downgrade - much higher interest rates. He quotes the warning from S&P just after the Budget

"It is critical for New Zealand to maintain fiscal restraint given the uncertain global financial conditions and the imbalances in its own economy. The large current account deficit leaves New Zealand vulnerable to foreign investors losing confidence in its ability to meet its obligations and this could lead to a sharp reversal in capital flows."

Fallow's review of IMF advice is also a bit worrying -

The IMF has studied 109 episodes of strong capital inflows (its tactful term for current account blowouts) among developed countries and what happened when the inflows slowed.
The implications are sobering.
New Zealand's latest episode was unusually large and long-lasting. Deficits of 8 per cent of GDP are 3 to 4 percentage points larger than the norm for this country.
In other countries a correction of that size has meant GDP growth 2 percentage points weaker over the following two years, and domestic demand 4 percentage points weaker.
In short the IMF seems to be warning us to expect two years' worth of what we are going through now - treading water, and frigid water at that. If the adjustment is smooth.
In the context of global financial market turmoil and heightened levels of risk aversion, it might not be.
"Future disruptions could take the form of a global credit squeeze, as seen recently, or could be a more specific loss of investor confidence in New Zealand," it said.
But the IMF goes on to assure us that "a complete loss of access to foreign funding, however, is unlikely given the good credit rating of New Zealand banks".
That credit rating is backed by New Zealand's strong fiscal position, sound monetary policy framework, and flexible exchange rate and labour market, it says.

The Hive is firmly of the view that lower interest rates in the short term are essential if we are to avoid even more serious economic problems. Lower interest rates should mean a lower exchange rate. As Fallow notes, this means higher prices for imported products such as fuel, but the upside is where we want to be, an export led recovery. Lower interest rates are not going to happen anytime soon if Government (or the opposition) spend too much, or release too much through too generous a tax cut. If National is to trump the Government's tax cut, it is going to have to make commensurate savings. If they don't or if the Government goes crazy on expenditure pledges pre-election, we will have a serious problem, the consequences of which we don't want to contemplate. In this context Fallow's piece today is both well timed and should be essential reading for all parties.