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Global macro & geopolitics from a small economy perspective

NZ capital markets: The next generation of action

David Skilling
The New Zealand Herald, 8 May 2014

Over the past 15 years substantial positive change has occurred in New Zealand’s capital markets. Notable changes include the establishment of the New Zealand Superannuation Fund, the introduction of KiwiSaver, and the various tax reforms to encourage personal savings. There is now much greater recognition of the centrality of New Zealand’s capital markets to New Zealand’s economic performance. And at an individual level, these policy changes are leading to the development of different attitudes towards saving and investing.

There is much to celebrate. And it is an illustration of the difference that sustained attention to the state of the New Zealand financial sector can make. This is reassuring, because ongoing sustained attention is now required to push forward the next generation of action with respect to capital markets. This next generation of action is needed to address a series of risks and challenges, as well as to capture emerging economic opportunities.

First, the challenges. Despite the improvements over the past decade, substantial risks and financial exposures remain. New Zealand’s current account deficit remains high at around 3.5% of GDP (while most other small advanced economies run surpluses) and our high level of external liabilities is an outlier. New Zealand’s capital markets remain small relative to other small advanced economies (with a market capitalisation of 47% of GDP, relative to 150% in Singapore, 71% in Denmark, and 64% in Finland). And New Zealand’s household debt levels remain at worrying levels. Concerns about bubbles are overblown, but these outcomes do combine to generate substantial exposures for a small, open economy like New Zealand.

In this context, we should take seriously the risks associated with the global financial system. The search for yield in a very low interest rate environment over the past several years has distorted a range of asset prices around the world (equities, bonds, property prices, among others). The IMF’s recent Financial Stability Report lists a wide range of risks associated with the ongoing process of transition to more normal conditions: for example, the cross-border spill-overs from the ending of QE, dealing with increased leverage in many emerging markets (including China), and the increased potential for risks to radiate across the international system.

The potential for global financial turbulence is a significant exposure for New Zealand given the lower resilience associated with small economies, together with the scale of New Zealand’s external liability position. Indeed, the recent IMF report on New Zealand’s financial stability noted the risks to New Zealand in this regard. For the moment, New Zealand’s healthy fiscal position and strong growth prospects reduce these risks, but history shows that investor sentiment on small countries can change quickly.

To build resilience against these risks, New Zealand’s ongoing focus on fiscal discipline and reducing public debt over time is vital. Without New Zealand’s fiscal discipline, it is unlikely that we would be in the good shape we are (it is instructive that small countries tend to be fiscally conservatives, and have emphasised fiscal consolidation over the past several years). And policy efforts to encourage household savings should be continued.

Second, action is also required to position New Zealand to capture emerging opportunities. New Zealand firms have real economic strengths in sectors including agriculture, tourism and the weightless economy. These firms require capital in order to expand at scale, and to take advantage of the substantial market opportunities in Asia and elsewhere. Without access to risk capital, New Zealand firms will lose these opportunities to competitors. And to the extent that it is New Zealand capital that can be deployed against these opportunities, New Zealand will capture a larger share of the value.

Further progress is required in improving the scale and functioning of New Zealand’s capital markets. For every high profile success story like Xero, there are also stories of New Zealand companies that find it difficult to scale up from a New Zealand base with New Zealand capital. And as New Zealand’s population and economy grows, additional capital will be required to enable New Zealand to invest in the infrastructure needed to support this growth.

These are of course long-standing issues. But there is a need now to move from problem diagnosis to meaningful action. Actions that should be on the agenda to ensure that capital is able to be deployed to productive ends include: ongoing efforts to boost government and personal savings; more active government balance sheet management, including thinking about how the balance sheets of government-owned financial institutions could best be used; more aggressive efforts to attract FDI into New Zealand to strengthen the productive base of the economy; providing vehicles that give New Zealand investors a better ability to deploy capital in productive sectors from agriculture to venture capital; and progressing a capital gains tax on property investment.

New Zealand is in an economic sweet spot at the moment. One important driver of this is the state of the international environment, such as strong demand from China and positive foreign investor sentiment. But over the next decade New Zealand will be moving into a more complex and challenging international environment, for which we need to prepare ourselves. Further strengthening our capital markets and national saving performance is vital to building economic resilience and sustaining our economic performance. We should fix the roof while the sun is shining. It is not a time for complacency.