The Treasury today released a research paper which outlines an analytical framework to answer the question as to why inflation-adjusted interest rates have on average been higher in New Zealand than in most Organisation for Economic Cooperation and Development (OECD) countries over the past couple of decades.
The working paper, entitled Why are real interest rates in New Zealand so high? Evidence and drivers, concludes that New Zealand’s relatively high real interest rates over most of the past two decades have been primarily driven by saving and investment imbalances within the local economy, rather than by an exogenously imposed country risk premia.
Key conclusions of the paper are that:
- New Zealand real interest rates have on average declined over the past two decades. This is consistent with the downward trend in real interest rates in most OECD countries. However, the premium on New Zealand real interest rates relative to most other OECD countries has remained high. Low rates of national saving relative to investment (domestic imbalances) have maintained the wedge between New Zealand and international real interest rates over most of the past two decades because domestic imbalances make higher real interest rates necessary to maintain inflation within the official target range over the medium term.
- Country risk premia, (in particular, default risk premia) could also potentially drive a wedge between New Zealand actual interest rates and the “world” rate. However, the evidence for New Zealand suggests that this has not been a material driver of the interest rate premium over the past two decades.
- The overvalued New Zealand dollar is consistent with foreign inflows seeking out a higher yield currency (carry trade), rather than foreign investors reluctantly lending to a risky debtor.
- Seeking out the higher yield, foreign capital flows into New Zealand which puts upward pressure on the exchange rate. It is this relationship between the real exchange rate, exchange rate expectations and the real interest rate that has helped maintain the premium on New Zealand’s real interest rates relative to that in other OECD economies.
- A permanent increase in national saving, all else equal, would reduce domestic imbalances and take pressure off domestic resources, which would permit the inflation target to be achieved with lower average domestic interest rates. As the premium on New Zealand interest rates relative to interest rates elsewhere would be smaller, it would be expected that the exchange rate would be lower on average too – at least for a few years.