Bernard Hickey: Five ways to control the NZ$ and capital flows

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The version of the free market we had wasn't really free or perfect. All it delivered was instability and debt.

Here's what I mean.

New Zealand's per-capita GDP is still at 2004 levels despite the addition of NZ$97.5 billion in extra foreign debt since then. We actually shed jobs in exporting over the last decade.

Our current (lack of) rules on capital flows, foreign debt and investment policies created a situation where we sent a cumulative NZ$96.3 billion out of New Zealand over the last 5 years in the form of interest payments on foreign debt and dividend payments to foreign investors.

We were essentially borrowing money and selling assets to pay the interest on the money we already owed. This is not sustainable without some major changes to the way we run our economy, our banking system, our currency system and our tax system.

New Zealanders and our policymakers believed that if we opened our borders for goods, services and capital then we would be better off in the long run. But all this freedom did was let our base instincts to consume now and pay later run free.

It also let some very bright investment bankers design fancy derivatives that delivered them huge short term bonuses in exchange for long term risks that have been transferred to the taxpayer in many countries. It is only through luck and some rich Australian taxpayers that we haven't had to do the same here.

We weren't the only ones who believed in free, unfettered movements of capital and it all seemed like a good idea at the time. Who doesn't love freedom?

But the efficient market hypothesis has been proved wrong. We can't trust our companies, our banks and, ultimately, ourselves anymore.

We now face international currency wars, mass money printing and the eventual restructuring of the global currency landscape, possibly with a changing of the reserve currency guard from the US dollar to something else.

The Institute of International Finance, which represents 420 financial institutions in 70 countries this week called for a new 'Plaza Accord' or Bretton Woods Agreement to restructure the global currency system.

It's clear something failed and something will change in global currency system, whether we like it or ignore it or not.

So what might the future look like and what should we do in the meantime?

Here's 5 ideas for ways to change the way we preserve, create and transfer capital and our currency.

1. Intervene in currency markets to push the New Zealand dollar down

There is a significant risk that as central banks in the Northern Hemisphere crank up into a series of competitive devaluations that the New Zealand dollar is pushed up vs the US dollar, the euro and the Japanese yen, but not versus the Australian dollar.

With interest rates at or near zero per cent in America and Japan investors are looking for somewhere safe with a positive return and where there appears little danger of money printing.

The Bank of Japan cut its official rate to 0 per cent on Tuesday. America is gearing up for a second round of money printing. This is forcing many others to try to stop the capital flows this is unleashing from swamping their currencies. Brazil is doubling its tax on foreign buying of Brazilian bonds. South Korea is about to impose new controls. Taiwan intervened to keep its dollar down on Tuesday.

Luckily for New Zealand exporters to Australia, the one currency more in demand than our own is the Australian dollar.

But in the end that won't save us. Our trade with China, now our second largest trading partner, is in US dollars and the Chinese are reluctant to let their currency appreciate vs the US dollar.

This is the tension at the heart of the global trade and currency systems. It is being expressed in all sorts of ways, including laws being passed in Congress giving President Barack Obama the right to impose tariffs on most Chinese imports.

If the New Zealand dollar surges under the weight of capital inflows from carry-trading, yield-hunting investors and those hunting for safety away from the money printing, then the Reserve Bank needs to be ready to sell New Zealand dollars. It worked before in 2007 and made the taxpayer a tidy profit. It can work again.

2. Increase the Core Funding Ratio to 90 per cent from 75 per cent

One of the mechanisms by which New Zealanders increased their foreign borrowing in the last 5 years was through the banking system.

Our big four Australian owned banks ventured into the international wholesale money or Commercial Paper (CP) markets to borrow cheaply for short terms. They then shovelled it on to New Zealand home buyers in the form of relatively low fixed rate mortgages, which in turn flowed through into the housing market and the consumer spending that sluiced off that.

This encouraged New Zealanders to borrow and pushed up the exchange rate.

At one point in late 2007 more than half of New Zealand bank funding was from these short term 'hot' money markets.

Not uncoincidentally, at the same time the New Zealand dollar went over 80 US cents and the Reserve Bank of New Zealand intervened to push it lower.

However, when Lehman Brothers and AIG collapsed in September 2008 these 'hot' markets froze, giving the banks and the Reserve Bank an almighty fright.

The Reserve Bank then decided to set the banks a target for how much of their funding should come from long term and stable sources, rather than the shorter term and unstable 'hot' CP markets.

This target is the Core Funding Ratio, which says banks must have 75 per cent of their funding from longer term bond and local term deposit markets by midway through 2012. The interim limit at the moment is 65 per cent See more details here.

This has forced the banks to reduce their reliance on 'hot' money and hunt harder for funding from local term deposits, pushing these rates up sharply relative to the Official Cash Rate.

This simultaneously has encouraged more local savings and less foreign borrowing. It essentially forces New Zealanders to save locally to repay foreign debt through the banking system.

So what's wrong with lifting the Core Funding Ratio to 90 per cent or even higher? It would make our system safer and make our economy less vulnerable to another freeze on international capital markets.

3. Restrict foreign investment in large New Zealand assets

The government has already broached this subject by having a review into foreign purchases of farmland. The result was a fudge where the government gave ministers the power to reject such acquisitions, but did not change the Overseas Investment laws.

But why limit it to farmland?

Right now nations with large capital surpluses and those looking to diversify out of US dollars are looking for hard, food-producing and commodity-producing assets in stable, easy countries such as New Zealand and Australia.

The Australians have repeatedly blocked foreign attempts to buy strategically large chunks of gas and iron ore. We should do the same, if only to prevent the influx of foreign capital looking to exit the devaluing currencies from boosting our currency and destroying our export sector.

We should have a proper debate about it. This week Harvard University's pension fund bought the largest dairy farm in central Otago with nary a squeak of debate, unlike the case of the possible sale of Crafar Farms to the Chinese. Let's do this properly.

4. Restrict investment overseas by New Zealand investment funds, particularly those with some government control or mandate

One of the problems both old and young New Zealand businesses face is a lack of local capital to fund either growth overseas or ownership succession at home.

All too often the easy option has been to sell out to a foreign company. In many cases this has either led to a steady drain of profits and dividends offshore or the loss of technology and expertise.

One solution is to require New Zealand fund managers, particularly those receiving a government subsidy of sorts through Kiwisaver or controlled by the government in the form of the NZ Super Fund, to invest a certain portion of their funds here.

The NZ Super Fund is already making great strides to lift its proportion of New Zealand investments from its current 20 per cent to the 40 per cent recently mandated by the Finance Minister Bill English.

What's wrong with making it more than 60 per cent? Do we really believe all the modern portfolio theories about global capital markets and investment returns over the long run? I've certainly lost the faith and would much rather the money was invested here than in some US dollar denominated asset that's about to be devalued sharply.

KiwiSaver funds should also be subject to a government mandate to invest locally. Just over 40 per cent of the NZ$5.5 billion invested in KiwiSaver has been invested overseas.

It should also be closer to 60 per cent. It may not be easy or cheap for fund managers to find investments here. But that's what they're being paid for isn't it? The real danger with KiwiSaver is we force more savings to fix a local capital shortage and the majority is simply shipped offshore because it seems easier and cheaper to do it.

If there is ever going to be a move to compulsion then there has to be a quid pro quo for that effective public subsidy to the funds management industry: keep it local.

5. Encourage investment in high wage exporting businesses rather than low wage consumption businesses

If New Zealand is going to be able to afford to support an ageing population and keep its higher skilled youth paying taxes in this country then we need plenty of interesting and highly paid jobs.

The NZ Institute's excellent 'A Goal is not a strategy' report highlights how New Zealand needs to prioritise development of high skilled, high value export sectors such as Information, Communications, Technology and Niche Manufacturing rather than low skilled and low value jobs in local services, commodity exports and low value tourism.

We need more software engineers and less night porters.

So what might that mean? It should mean increasing taxes on low value investing in property, encouraging investment in higher value businesses and celebrating the success of entrepreneurs and businesses such as Rod Drury's Xero that aim for international success with high wage local jobs.

I'd suggest for a start a land tax and a capital gains tax to discourage highly geared investments in land and buildings. I'd suggest rules on bank capital that encourage lending to businesses with intellectual capital, rather than just land and buildings.

INTEREST.CO.NZ