New Zealand: Foreign Investment Critical to Growth

Matthew Klein Student ID #1835648 Econ 4331W 5/6/08

Abstract:

There has been much discussion in New Zealand regarding the domestic savings rate. Policy makers believe that higher domestic savings will lead to an increase in investment. Growth theory shows us that an increase in investment will, temporarily, lead to higher growth and higher investment will lead to higher per capita output. Despite a lagging and declining savings rate over the past 30 years, New Zealand, a small open economy, has managed to grow quite steadily. In an open economy, investment comprises of domestic savings and foreign savings. I intend to show that the access to foreign capital in New Zealand, as a result of economic policy reforms in the 1980s, has overcome a lagging domestic savings rate and allowed the country to maintain an investment rate comparable to the other OECD countries. The goal of this paper is to investigate the link between savings, investment and growth and show that policy reforms in New Zealand designed to increase domestic savings are not justified by growth theory alone.

Contents 1 2 3 4 5 6 7 Introduction..4 Introduction to Economic Growth Theory...5 New Zealand Results...7 Access to Foreign Capital..................................................................................13 Conclusion.....15 References..17 Appendix18

Introduction:

There has been a great deal of discussion regarding the low domestic savings rate of New Zealand. The question that has been raised is whether New Zealand would improve its growth rate by fostering policies to increase domestic savings. From 1975 to today, domestic saving has decreased and yet New Zealand has managed to maintain a healthy growth rate. It is my contention that the ready access to foreign capital flowing into New Zealand in both foreign investment and diversified portfolios as a result of the policy changes in the 1980s has overcome the lack of domestic savings and allowed the country to maintain a steady positive growth rate. It is the authors contention that policies that do promote an increase in national saving would benefit the country a great deal in the long run in reducing the countrys vulnerability to economic shocks and strengthening the growing financial market, but the results of the last three decades are significant evidence that growth theory alone does not provide significant justification for the changes. The balance of this paper will be broken down into four sections. First, Ill discuss the theory behind the relationship between savings and growth both in an abstract Solow Model, which deals with a closed economy, and as it pertains to an open economy. Second, Ill show the results of New Zealand over the past thirty years and discuss the changes made in the economic policy that opened up New Zealands highly regulated economy to foreign capital. Next, Ill address the availability of foreign capital in an isolated open economy and explain how foreign capital affects the New Zealand situation

by discussing the value of foreign saving compared to national saving. Finally, Ill draw conclusions based on the evidence explained in the previous three sections.

I. Introduction to Economic Growth Theory

Neo-classical theory shows a positive and robust correlation between domestic savings rates and the investment share as a percentage of GDP. In theory, investment is equal to savings and growth theory suggests that higher investment will lead to higher growth output. In practice, Estimates for the post-OPEC period 1974-79 imply that each extra dollar of domestic saving increases domestic investment by approximately 85 cents in a sample of 17 OECD countries (Feldstein, 1983:121). It is important to note that if capital is allocated appropriately, the result can be sustained economic growth. The Ministry of Economic Development in New Zealand notes, Investment in new capital increases the amount and quality of machinery, equipment and infrastructure available for workers to use in the production process, thus raising the capital-labor ratio and increasing labor productivity (Underlying Determinants, 2007). While it is unclear whether growth causes savings, savings causes growth or outside factors aid in the relationship; it is accepted that countries that save more and allocate their investment into technology and human capital tend to grow faster. Higher saving leads to further output growth which leads to additional saving lending to capital deepening. This phenomenon can be seen in the graph below with a distinct positive correlation between the investment share and the GDP per capita. In a closed economy, savings is equal to investment and is comprised of household, government, and business investment.

Investment Share vs. GDP per Capita OECD Countries (1995)

$35,000.00
Luxemburg

$30,000.00
United States Sw itzerland Norw ay Denmark Austria Germany Australia Belgium Canada Sw edenNetherlands France Iceland Italy United Kingdom Finland New Zealand Ireland Spain Portugal Czech Republic Japan

$25,000.00 GDP per Capita

$20,000.00

$15,000.00

$10,000.00
Mexico

Greece Hungary Slovak Republic Poland

$5,000.00

Turkey

$0.00 5% 10% 15% 20% Investment Share 25% 30% 35%

(1.1)

Source: Penn World Tables

The relationship between investment and growth can most easily be shown in the Solow Growth Model. While this models use is simplified to work in a closed economy, it is a valuable tool to examine the basics of this issue. The Solow model consists of a Cobb-Douglass production function with constant returns to scale where output (Y) is equal to the sum of its inputs, capital(K) and labor(L), multiplied by a technology factor(See Appendix). This production function is then paired with a capital accumulation equation that shows the growth of the capital stock where the change in the capital stock (Kt+1 Kt) over time is the result of the rate of saving(s) as a percentage of output(Y) minus the depreciation (d) of the capital stock. Deriving this equation to put it in per capita terms leaves us with the equation 1.4 (Appendix), where (n) represents the population growth rate. Graphing the relationship between savings and depreciation shows that an increase in saving(s) will push the steady state of the economy to a higher

output level. This is the root of our theory that an increase in domestic saving will increase the capital stock and increase the per capita output of the economy.
An Increase in the Investment Rate
1.2

0.8

y 0.6

0.4

0.2

0 1

(1.5)

(Jones, 30)

It should be noted that an increase in investment only increases the GDP growth rate in the short term. The economy will see a long term level effect in increased aggregate GDP. In order to maintain long term growth, the country will need to allocate its investment efficiently in technology and human capital. All of our discussion up until this point has pertained to a closed economy where national investment is equal to domestic savings. In an open economy, investment isnt constrained by domestic saving because the economy has access to foreign saving. As our financial markets become more integrated and capital can flow across borders more easily, we have to ask if domestic saving is critical to growth.

II.

New Zealand Results

What has been particularly interesting about New Zealands case is that the country has remained competitive despite a very lagging domestic savings rate. This is very contrary to what theory suggests and it is important to analyze the past to understand its sustainability going forward. According to OECD data, over the last 30 years New Zealand has had a downward trend in national saving as a percentage of GDP as seen in figure (2.1). What is especially concerning is that in recent years national saving has plummeted near negative territory leaving zero domestic capital to use for investment to sustain growth.

Net National Savings Rate

12% 10% 8% % of GDP 6% 4% 2% 0% -2% -4%
19 87 19 89 19 91 19 93 19 95 19 97 19 99 20 01 20 03 20 05

New Zealand

OECD Median

(2.1)

Source: OECD Factbook, 2007

The above chart reflects a broad scope of the national saving, but further analysis will show that this is widespread. Figure (2.2) shows how government, business, and household savings have contributed to this effect. Since 1995, New Zealand has seen an increase in both business and government saving, however a further deepening in the household deficit has kept the overall national savings near 4%.

(2.2)
Source: NZ Department of Treasury

Part of the reason for the falling savings rate in the household sector are the economic reforms implemented in the mid 1980s. During the 1970s and early 1980s New Zealand was heavily impacted by the 1973 energy crisis. Throughout the 1970s, New Zealand struggled with rising oil costs and a continuing worsening or the terms of trade leaving the country with deeper and deeper deficits. The growth rate, which for years was very competitive with other OECD countries, began to lag and the country started to see a rising unemployment rate and stagflation. Meanwhile, New Zealanders continued to spend and the government consistently ran budget deficits. It was under this environment that New Zealand sought to reform their economic system. Under Prime Minister Robert Muldoon (1975-1984), many changes were implemented in an effort to make the economy more liberalized. From 1976-1981, control on interest rates were relaxed. Some deregulation was implemented in transport and meat processing and New Zealand started to move towards privatization in these industries. Despite these moves to promote a more liberalized economy, policy makers implemented a wages and price freeze in 1982. To combat the economys reliance on imports, especially oil, the government made several large investments in energy and

capital intensive industry. Coined Think Big projects, Muldoon borrowed large sums of money from overseas and invested them into major industrial projects. It is debated whether the Think Big projects were ultimately successful as the projects did significantly raise the countrys debt levels from 4.6 % in 1982 to 6.5% in 1984(Goldfinch, 79). The economy did reap benefits during the construction and the projects did have a positive impact on the balance of payments. Most importantly, the projects did open up the highly regulated New Zealand economy to foreigners which was an important step en route to liberalization. Many of the projects today are quite profitable, however many of these are now owned by foreign investors. With new government leadership in 1984, New Zealand continued its reform. Over the next 10 years reforms were made in nearly all aspects of the economic system. Among these reforms were: Deregulation of interest rates Adoption of a free floating currency Opening the banking sector to foreign competition Adoption of a market-based system of monetary policy Privatization of several major industries including banking Removal of regulatory constraints on borrowing and lending Reduce constraints to trade Massive cuts made to the welfare system

In general these reforms have done what they were sought to do, but some of these have led to a further decrease in savings by promoting consumption. Reforms in the financial sector made credit more available to households through more lenient terms and

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increased competition in banking has made access to mortgage financing more affordable. Increasing competition in the banking sector has only made credit cheaper and, in so doing, has promoted borrowing. A reduction on the constraints to trade made more import goods available to the consumer at a cheaper price. These policies have all done a good job of attracting foreign capital, but have done little to encourage the country to save on its own. Despite the lag in savings, New Zealand has remained competitive in investment (Figure 2.3). Since investment spurs economic growth directly as opposed to saving which is believed to promote growth indirectly, the country has also managed a healthy growth rate over this time (Figure 2.4). As long as New Zealand is meeting its investment requirements, there is reason to believe that it will continue to grow at a healthy rate.
Investment Share, OECD Countries (1995)
35%

30%

25%

20%

15%

10%

5%

0%
x ic Me Italy te s Sta ited Un n ed e Sw e ce Gre nd Ir ela ey Turk d lan m Ic e gdo Kin ited lic Un pub Re va k Slo ry nga Hu d lan Po o Fin in Spa iu m Belg nce Fra al tug li c Por pu b Re e ch Cz a rk nm De ds rl an the Ne d lan w Ne an Jap nd r la itze Sw y rw a No tr ia Aus rg bou em Lux any rm Ge li a s tr a Au a nad Ca nd ala Ze

(2.3)

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New Zealand GDP per capita Growth 3 Yr Moving Average, (1970-2000) 12% 10% Growth Rate 8% 6% 4% 2% 0% 1973 1979 1994 2000 1970 1976 1982 1985 1988 1991 1997 GDP per capita Growth

(2.4)

How has New Zealand maintained an investment share of 22% of GDP over the past 25 years with a net national savings rate at around 6% in 1975 and falling to under 2% in recent years? The answer lies in the policy reforms that began to introduce more foreign capital into the New Zealand market. While many of the policy reforms that were implemented had a side effect of curbing domestic saving, the liberalization of the economy took major strides in introducing foreign capital into the economy. Before the Think Big projects of the early 1980s, New Zealand was one of the most regulated OECD countries. New Zealand moved from being what the Economist claimed was one of the more hidebound economies outside the former Communist bloc, to amongst the most liberal in the OECD. From having some of the highest tariffs in the world in 1970, New Zealand has now amongst the lowest levels of trade protection, particularly for agricultural products (Goldfinch, 75). An example of the results of reforms on the foreign trade market can be seen in the below table which shows that New Zealand has few barriers to entry and is among the most attractive countries in the world for new business.

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Ease of Doing Business # of Procedures to Entry 2 6 5 9 12 9 19 Minimum Cost to Capital Incorporate* Requirement* 0.2 1.1 0.5 10.3 153.1 15.1 360.8 0 0 0 0 155 23.4 619.1

Country New Zealand Singapore United States Chile Haiti Laos Chad

Rank 1 2 3 25 134 147 152

Days to Incorporate 12 6 5 27 203 198 75

Table 1: *Figures represent percent of annual GDP per capita income (World Bank)

III.

Access to Foreign Capital

Over the last 30 years, New Zealand has seen an increasing reliance on foreign capital to maintain its high investment rate as discussed in the previous section. The technological age has allowed for an increasingly integrated world financial market with free flowing information and instantaneous transfer of currency across the world. While there has been a decrease in household saving, those that are saving are increasingly investing overseas. Over the past 20 years, New Zealand has seen an increase in household foreign equity holdings from 10% in 1986 to nearly 50% today. What this means is that households are diversifying their savings with foreign equity. This evidence suggests that despite the isolation from other major foreign markets that the barriers to investment in New Zealand are increasingly relaxing. The result of these relaxed regulations can be seen decisively in figure 3.1. Since 1990, New Zealand has consistently spent nearly all of its disposable income in exchange for overseas borrowing. In 2006, borrowing increased to nearly 10% of GDP.

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National Savings and Overseas Borrowing 1990-2005

10,000 5,000 0 Millions $ -5,000 -10,000 -15,000 -20,000
19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05

0.0% -2.0% -4.0% National Savings -6.0% -8.0% -10.0% -12.0% Net Overseas Borrowing Net Percentage of GDP

(3.1)

It would seem as if a reliance on foreign capital would only stand to benefit the country as it allows New Zealanders to consume and satisfy utility today instead of tomorrow. The investment share of GDP has been, on average, around 22% which places it near the middle of other OECD countries with Japan and Korea near 30% and the U.S. and U.K under 19% (Figure 2.3). If investment is a direct factor to growth, than it would appear that domestic savings has not been critical to New Zealands success. While all evidence suggests that New Zealands growth has not been hindered by the falling savings rate, it is worth noting that there are drawbacks to using foreign capital. Conventional neo-classical theory suggests that foreign savings is a perfect substitute for domestic savings. However, the assumptions that make this possible, such as frictionless markets and rational behavior are unlikely to hold even as the world financial markets become more sophisticated. The New Zealand Treasury finds that, There is now considerable evidence suggesting that foreign and domestic saving are not perfect substitutes and that geography (particularly distance) and the size of the economy are important determinants of international financial flows(NZ Treasury, Low Domestic Savings/Reliance on Foreign Savings). Barriers relating to cross-border investment can include language, institutional and regulatory differences, high costs of

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acquiring information about small markets and behavioral considerations such as home bias. Home bias is a phenomenon that is not totally understood or quantified, but represents a greater likelihood of an investor to invest in their own country. All of these factors work against New Zealand, which is a small market that is isolated from the other major financial markets. Furthermore, a large reliance on foreign capital puts strain on the economy and can be seen risky to foreign investors. The larger the deficit is to GDP, the higher the cost to borrow due to a high risk premium. This can, ultimately, create barriers in funding new investments and, in general, threatens the stability of the economy.

IV.

Conclusion

The question of whether fostering polices to bolster the savings rate would benefit New Zealand is far more complicated than can be seen with a basic Solow model. Weve addressed that foreign capital is not a perfect substitute for domestic capital because of the countrys isolation from major financial markets and its higher risk premium. While the world financial markets continue to become more integrated, such a reliance on foreign saving is dangerous in the long term. A culture is being created through habit and if the evidence weve seen over the past 30 years turns out to be cyclical, New Zealand could face significant trouble maintaining growth if foreign capital dries up. Policies that maintain a balance between national and foreign investment will make New Zealand more risk adverse and protect the economy from an economic downturn. Such policies would also trickle down all the way to household saving where households would benefit

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by being more resilient during economic shocks such as unemployment or a fall in asset values, like were seeing in the housing market in the U.S. In addition, households would benefit from being better prepared for their retirement years. There are clearly numerous benefits to maintaining a higher national savings rate; the empirical evidence does not suggest that higher growth is one of these benefits. While it is universally agreed that higher investment leads to faster growth, there is also evidence that suggests that foreign capital is, while not perfect, an adequate, substitute. From 1975 to 1995, evidence has shown that the national savings rate has fallen and the national investment rate has remained competitive with other OECD countries. Foreign capital has made this possible and it is possible that this will remain the case for years to come. Based on this evidence, there appears to be no direct relationship linking domestic savings to growth in New Zealand and promoting an increase in national savings does not appear to lead to an increase in the per capita growth rate.

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Works Cited:
Claus, Iris and David Haugh, Grant Scobie, and Jonas Trnquist (2001) Savings and Growth in an Open Economy. New Zealand Treasury Working Paper 01/32. De Long, J. Bradford and Lawrence H. Summers. Equipment Investment and Economic Growth 1990 Feldstein, M. and C. Horioka (1980). .Domestic saving and international capital flows.. The Economic Journal 90: 314-328. Feldstein, Martin. "Domestic Saving and International Capital Movements in the Long Run and the Short Run." European Economic Review, Vol. 21, (1983), pp. 129-151. Goldfinch, Shaun. Economic Reform in New Zealand: Radical Liberalisation in a Small Economy The Otemon Journal of Australian Studies, Vol. 30, (2004), pp. 75-98 Infometrics Ltd (2000). .New Zealands Venture Capital Market.. New Zealand Treasury Working Paper 00/19. Jones, Charles I. Introduction to Economic Growth. New York: W.W. Norton & Company, Inc. 2002 Scobie, Grant and Iris Claus, Saving in New Zealand: Measurement and Trends, Treasury Working Paper 02/02

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Appendix Figure 1.2: Figure 1.3: Figure 1.4: Y = AKL1- Kt+1 Kt = sY dKt k = sy (d + n)k

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