TREASURY WORKING PAPER 01/32

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1 TREASURY WORKING PAPER 01/32 Saving and growh in an open economy Iris Claus, David Haugh, Gran Scobie and Jonas Törnquis Absrac Concern has been raised by an apparen lack of saving in New Zealand. I is ofen argued ha policies which foser savings are imporan, as higher savings will conribue o higher economic growh. This paper invesigaes he link beween saving, invesmen and growh. In paricular, i focuses on issues poenially imporan in an open economy such as New Zealand. Theory predics ha increased oal saving will lead o higher invesmen and oupu. In an open economy, oal saving comprises saving by domesic agens (governmen, firms and households) plus foreign saving. Diversified porfolios, large inflows of foreign invesmen ino New Zealand and invesmen raes comparable o hose in oher OECD counries sugges ha New Zealand, so far, has been able o access foreign saving o mee invesmen demands. Domesic saving does no appear o have consrained invesmen and hence growh. JEL classificaion: E21, E22, O16 Keywords: Economic growh, saving, capial flows Corresponding auhor: Iris Claus, The Treasury, P.O. Box 3724, Wellingon, New Zealand, Iris.Claus@reasury.gov.nz, elephone: David Haugh, The Treasury, P.O. Box 3724, Wellingon, New Zealand, David.Haugh@reasury.gov.nz, elephone: Gran Scobie, The Treasury, P.O. Box 3724, Wellingon, New Zealand, Gran.Scobie@reasury.gov.nz, elephone: Jonas Törnquis, The Treasury, P.O. Box 3724, Wellingon, New Zealand, Jonas.Tornquis@reasury.gov.nz, elephone: Disclaimer: The views expressed in his Working Paper are hose of he auhor(s) and do no necessarily reflec he views of he Treasury. The paper is presened no as policy, bu wih a view o inform and simulae wider debae.

2 CONTENTS 1 Inroducion The link beween saving, invesmen and growh Access o foreign capial How does New Zealand compare o oher OECD counries? The New Zealand experience Concluding remarks...31 References...32 Appendix: Definiion of raings...35 Lis of figures Figure 1: The Solow-Swan model...5 Figure 2: Growh rae of income per efficiency worker...5 Figure 3: Supply and demand of loanable funds...13 Figure 4: Ne naional saving, invesmen and he curren accoun (all as a percenage of GDP) and real GDP growh...17 Figure 5: Saving, invesmen and real GDP growh in New Zealand...18 Figure 6: Impulse responses (in percen)...22 Figure 7: Proporion of New Zealand governmen bonds held for non-residens...23 Figure 8: New Zealand household holdings of domesic and foreign equiy...24 Figure 9: New Zealand s curren accoun and Sandard and Poor s Raings Group foreign currency credi raing...26 Figure 10: New Zealand s curren accoun and Moody s Invesors Service foreign currency credi raing...26 Figure 11 : Toal foreign invesmen (as a percenage of GDP, hree-year moving average)...28 Figure 12: Equiy liabiliies versus borrowing...30 Figure 13: General governmen versus corporae borrowing (dollar millions)...30 Lis of ables Table 1: Share of foreign equiies in oal equiy porfolios (end of 1996)...11 Table 2: Feldsein-Horioka equaion for New Zealand...19 Table 3: Granger causaliy ess...20 Table 4: Cross correlaions

3 SAVING AND GROWTH IN AN OPEN ECONOMY * 1 INTRODUCTION I is ofen argued ha policies which foser saving are imporan as higher saving will conribue o higher economic growh. The purpose of his paper is o invesigae he link beween saving, invesmen and growh, wih paricular focus on issues poenially imporan in a small open economy such as New Zealand. The main conclusion of he paper is ha domesic saving does no appear o have consrained invesmen and hence growh in New Zealand. The corollary is ha i is unlikely ha higher levels of domesic saving would lead o higher invesmen and improved growh. Promoing growh would no alone provide jusificaion for inervenions o raise domesic saving. The remainder of he paper is organised as follows. Par 2 esablishes he heoreical link beween saving, invesmen and growh. Par 3 discusses issues poenially relevan in open economies: access o world financial markes, he home bias in equiy holdings (or, more generally, in overall asse posiions), he saving-invesmen puzzle of Feldsein and Horioka (1980) and he susainabiliy of curren accoun deficis. Par 4 compares saving and invesmen raes, he curren accoun and real oupu growh across seleced OECD counries and Par 5 considers he New Zealand experience in more deail, wih paricular focus on he poins discussed in Par 3. Concluding remarks are conained in Par 6. 2 THE LINK BETWEEN SAVING, INVESTMENT AND GROWTH Some accouning ideniies 1 In a closed economy, ex pos, he value of a counry s gross domesic produc equals gross naional expendiure, i.e. all goods and services are absorbed domesically. Toal absorpion consiss of governmen consumpion (G), household consumpion (C), and firms invesmen (I). In an open economy, oal spending by residens comprises he absorpion of domesically produced goods and services and goods and services produced abroad. The difference beween residens spending on domesically produced goods and services and oal absorpion is impors (M). Expors (X) are foreign spending on domesically produced goods and services. If he rade balance is in defici, i.e. impors exceed expors, absorpion (A) exceeds oupu (Y), i.e. Y A = X M (2.1) where A = G + C + I. The curren accoun balance (CAB) is defined as he sum of he rade balance (X M), ne income paid abroad (y a ) and ne ransfers paid abroad () * The auhors would like o hank Maryanne Aynsley, Bob Buckle, David Gal, Lesley Haines, Viv Hall, Gary Hawke, Leslie Hull, Geoff Lewis, Sruan Lile, Nahan McLellan, Dorian Owen and Les Oxley for valuable commens. The paper has also benefied of commens from paricipans a he Vicoria Universiy of Wellingon symposium Susainable and excessive curren accoun deficis (November 2001). Special hanks are due o Claire Gardiner and Graham Howard for heir assisance in obaining daa. 1 For more deails see Makin (2000). 2

4 CAB = X M + ya + (2.2) where ne income paid abroad (y a ) plus consumpion of fixed capial (or depreciaion) is he difference beween he gross domesic produc (Y) and naional income (Y n ). The link o saving and invesmen is as follows. Gross saving (S) is he difference beween GDP and consumpion by households and he governmen (C + G). Gross domesic invesmen is he difference beween oal absorpion and consumpion, i.e. ( Y C G) (A C G) = S I = X M (2.3) Equaion (2.3) hence implies ha when he rade balance is in defici, impors exceed expors and gross domesic invesmen exceeds gross saving. Moreover, i can be shown ha he difference beween domesic saving (S d ) and ne domesic invesmen (I ne ) is equal o he curren accoun balance S d ne I = CAB (2.4) where domesic saving (S d ) is he difference beween naional disposable income (Y d ) and governmen and household consumpion, and ne invesmen (I ne ) is gross domesic invesmen ne of depreciaion. Disposable income (Y d ) is he difference beween naional income (Y n ) less ne ransfers paid abroad (). 2 In a closed economy, domesic saving mus equal invesmen ex pos. In an open economy, he difference beween domesic saving and ne domesic invesmen is he curren accoun balance. When he curren accoun balance is in defici, he excess of ne domesic invesmen over saving is financed by foreign funds or ne capial inflows as measured by ne foreign invesmen or he capial accoun surplus. In oher words, an economy wih access o foreign capial can augmen is capial sock hrough foreign invesmen. An increase in he sock of capial, in urn, will increase oupu as discussed in he nex secion. The heoreical link The (closed-economy) neoclassical growh model of Solow (1956) and Swan (1956) is a useful saring poin for esablishing he heoreical link beween saving, invesmen and growh. Despie is rudimenary demand srucure and neglec of inernaional borrowing and lending, i yields useful insighs ino he effecs of saving, echnological advance and populaion growh. In paricular, he Solow-Swan model shows ha an increase in he sock of capial leads o a higher level of oupu and faser growh a leas in he shor o medium erm. Once he new level of oupu is reached, growh reurns o is iniial level. This resul carries over o more complicaed models. The Solow-Swan model of long-run economic growh consiss of a producion funcion, which relaes he inpus in he economy o he oupus produced, and a capial accumulaion equaion, which describes how capial accumulaes in he economy. The producion funcion is assumed Cobb-Douglas wih consan reurns o scale in capial 2 This follows from S I y a = Y C G y a I = Y n + y a + d C G y a I = Y d + + d C G I = (Y d C G) (I d) = X M y a = CAB for CAB < 0, where d denoes consumpion of fixed capial. 3

5 K ) and labour ( L ); ha is doubling he inpus, ( Y, i.e. K and L, leads o double he oupu, α 1 α L Y = A K (2.5) where A is an exogenous produciviy parameer and 0 < α < 1 is he income share of capial. Noe ha he producion funcion has diminishing reurns in capial (labour); ha is doubling capial (or labour) alone increases oupu by less han double. Because domesic saving mus equal domesic invesmen in a closed economy, capial accumulaion is given by K + K = sy dk (2.6) 1 where sy denoes privae saving (i.e. saving is a fixed fracion s of curren income Y ) and d is he rae of depreciaion. The wo key engines of growh in his model are exogenous echnological change and labour force expansion. Produciviy is assumed o grow a a consan rae g A = (1 g) A (2.7) and he labour force, which equals populaion, grows a rae n L + = (1 + n) L (2.8) 1 Because produciviy and he labour force are growing, he seady saes will no be saionary and oupu, for example, will grow. To express he sysem in erms of saionary seady saes, he capial accumulaion equaion (2.6) is normalised by dividing by A L, he wo exogenous variables in he sysem ha are rending K + 1 A L K A L = sy A L dk A L (2.9) or 1 k + 1 k = (sy ((1 + n)(1 + g) + d)k ) (2.10) 1+ (1 + n)(1 + g) where k and y are capial and oupu per efficiency worker ( A ).3 The link beween saving, capial and oupu can be illusraed wih he Solow diagram. Figure 1 plos he producion funcion, y, he saving funcion, sy, and savings needed o mainain any given level of capial, (( 1+ n)(1 + g) + d) k, all as a funcion of capial per L 3 K + 1 K + 1 A + 1L + 1 This follows from = = k + 1(1 + g)(1 + n). A L A L A L

6 efficiency worker, k. Time subscrips are dropped as he diagram describes he long run. The savings funcion and savings needed o mainain a given level of capial inersec a he long-run equilibrium, seady sae, where capial accumulaion is zero, poin (k*, y*). Figure 1: The Solow-Swan model y y** y* y ((1+g)(1+n)+d)k s'y sy k* k** k The Solow diagram can be used o invesigae how changing he saving rae affecs he economy. For example, consider he effec of an increase in he saving rae from s o s '. The seady sae capial per efficiency worker increases from k* o k** and income per efficiency labour rises from y* o y**. However, once he economy adjuss o is new level of capial, i resumes is former growh rae. This can be seen in Figure 2, which plos income per efficiency worker over ime. Figure 2: Growh rae of income per efficiency worker y y** y* * ** ime 5

7 Prior o he increase in he saving rae, he raio of income o efficiency labour (y*) is consan ( y* = 0); ha is income grows a he same rae as efficiency labour. The increase in he saving rae leads o an increase in he efficiency labour capial sock from k* o k** and income from y* o y** (Figure 1). To move o he higher equilibrium sock of capial k**, capial mus grow faser for some ime han efficiency labour, i.e. he raio of capial o efficiency labour is increasing. Because of faser capial sock accumulaion, income will also emporarily grow faser han efficiency labour. However, once he new seady sae (k**, y**) is reached, capial and income will grow again a he same rae as efficiency labour, i.e. y** is consan. This implies ha a counry willing o inves more of is oupu (and consume less) can enjoy a emporary growh spur; however, increased savings will no raise growh indefiniely. One unrealisic simplificaion in he Solow-Swan model is ha he saving rae is deermined exogenously. Saving decisions are deermined by agens rae of ime preference and reflec ineremporal rade-offs. Alhough higher savings lead o higher per capia income and a higher growh rae in he shor and medium erm, welfare is no necessarily enhanced. This is because he gain occurs a he expense of curren consumpion. In he Ramsey model as consruced by Ramsey (1928), Cass (1965) and Koopmans (1965), he pah of consumpion and hence he saving rae are deermined endogenously, by opimising households and firms who inerac on compeiive markes subjec o ineremporal budge consrains. In he Ramsey and oher opimising models, here is also a posiive link beween saving and oupu, i.e. increased savings lead o increased oupu hrough capial accumulaion. However in hese models, he saving rae, in general, is no consan like in he neoclassical Solow-Swan growh model, bu is insead a funcion of he per efficiency labour capial sock. These opimising models (boh represenaive agen and overlapping generaions models) are hus consisen wih he empirical evidence ha suggess ha saving raes ypically rise wih per capia income (discussed furher in Par 4) and are probably a more accurae descripion of he real world. 4 The models discussed so far generally ake echnological change as exogenous and simply assume echnological progress grows along a consan pah. In conras, endogenous growh models focus on undersanding he economic forces underlying echnological progress. Leading his research was P. Romer (see Romer 1986 and 1990). The 1986 Romer model endogenises echnological progress by allowing for exernaliies (or posiive spillover effecs), while he 1990 model explicily akes ino accoun research and developmen. The resul ha changes in he invesmen rae (or saving rae) have no long-run effec on economic growh also holds for he Romer model. Changes in he rae of saving or invesmen affec he growh rae along a ransiion pah o he new seady sae alering he level of income. Bu again, once ha level is reached, he growh rae resumes is iniial rae. In conras o he neoclassical and Romer models, where increased saving does no have a long-run impac on economic growh, he AK model predics ha here will be a 4 For more deails on he Ramsey and oher opimising agens models see Barro and Sala-i- Marin (1995). 6

8 permanen change hrough capial deepening (see Jones 1998). 5 The reason he AK model has his characerisic is because he producion funcion has consan reurns o scale in capial. The producion funcion in he AK model ses α in equaion (2.5) equal o 1 and is given by Y = AK (2.11) where he level of echnology, A, is assumed o be some posiive consan (raher han ime dependen). In he AK model, an increase in he saving rae will have a permanen effec on he rae of growh of he economy. Higher saving increases capial and a larger capial sock leads o higher growh. This is because he marginal rae of reurn o capial is posiive even as he capial sock grows infiniely large 6 Y lim = A > 0 K K (2.12) However, he empirical evidence does no suppor he AK model and i is unlikely ha a counry can susain indefinie growh in per capia income hrough capial deepening. Consan reurns o scale would imply ha he exponen on capial was 1. Convenional esimaes of he capial share using growh accouning sugges ha he capial share is abou 1/3. If one broadens he concep of capial o include human capial and exernaliies like learning by doing or oher posiive exernaliies due o he presence of ideas and echnology, he exponen becomes 2/3 or maybe 4/5, bu here is lile evidence o sugges ha he coefficien is 1. Foreign saving 7 In a small open economy, where capial is mobile, invesmen is no consrained by domesic saving as firms have access o foreign saving. Wih an infiniely elasic supply of foreign funds does i maer for growh wheher capial is accumulaed from domesic or foreign saving? In an open economy, he producion funcion is given by Y = f(a,k d,,k f,,l ) (2.13) where, as before, A is a produciviy parameer. Two sources of capial are disinguished: K d, denoes domesically sourced capial and K f, is foreign sourced capial. L denoes labour. The sources of oupu or gross domesic produc growh can be idenified by he oal differenial of equaion (2.13), i.e. 5 The AK model akes is name afer is producion funcion, see equaion (2.11). 6 Y Y In he case of he Cobb-Douglas producion funcion, lim lim = 0 K K = K α K. 7 This secion follows Makin (2000). 7

9 dy = f + f K f A (A,K (A,K,K,L)dA + f d,k d f f,l)dk f + f L Kd (A,K (A,K d,k d f,k f,l)dl,l)dk d (2.14) where f A (.) da, fk d (.) dk d, fk f (.) dk f and f L (.) dl denoe he parial derivaives wih respec o A, K d, K f and L respecively. Time subscrips are dropped for simpliciy. However, because some of he oupu mus be paid o foreigners for he use of heir capial, naional income (Y n ) is less han oupu (Y) by he ineres cos paid for he use of foreign capial. Naional income is hus given by Y n = Y r K (2.15) w f Equaion (2.15) assumes ha he economy is small and faces an infiniely elasic supply of capial on he inernaional marke a he world ineres rae ( r w ). For simpliciy, we also absrac from a counry risk premium. Growh of naional income (afer allowing for paymens o foreigners) can be wrien as dy n = dy r dk (2.16) w f or dy n = fa (.)da + fk (.)dk d + fl (.)dl + (fk (.) rw ) dk f (2.17) d f domesic sources foreign sources Equaion (2.17) shows ha an increase in foreign invesmen will enhance naional income if he erm ( fk (.) rw ) dk f f is posiive. In oher words, provided he reurn on foreign capial (adjused for depreciaion) exceeds he rae of ineres paid on foreign borrowing, foreign invesmen will raise he level of he domesic counry s naional income. Boh naional income and oupu growh in he borrowing counry will be higher han i would have been in he absence of he foreign capial flow. 8 Does an inflow of foreign capial decrease domesic saving? In he absence of open capial markes, he domesic ineres rae will exceed he world rae. Thus, opening he economy o inernaional capial movemens will resul in a lower rae of ineres domesically. The domesic ineres rae will be equal o he world rae plus an adjusmen for a counry risk premium. The effec of access o foreign capial and lower domesic ineres raes on saving is heoreically ambiguous. This is because lower ineres raes make curren consumpion less expensive in relaion o fuure consumpion, and hence consumpion would be expeced o rise and domesic saving o fall (he subsiuion effec). However, a he same ime, lower ineres raes reduce household income from ineres 8 Naional income and oupu growh in he lending counry will also be higher. 8

10 paymens and will encourage greaer saving (he income effec). 9 Which of hese wo effecs dominaes can only be deermined empirically. Much of he evidence is uncerain. Generally, he ineres rae sensiiviy of domesic saving is found o be small. This suggess ha domesic saving may be lile affeced by he presence of foreign saving. Access o foreign capial makes he borrowing counry unambiguously beer off. Savings decisions are deermined by agens rae of ime preference and ineremporal rade-offs. Inernaional capial movemens allow a counry o consume more in fuure while mainaining curren consumpion. Increasing domesic saving would lower ineres paid o foreigners for he use of heir capial, bu no necessarily increase welfare. This is because higher savings imply lower consumpion. However, i is clear ha he reduced ineres paymens o foreigners would increase naional income in fuure. Theoreical models of growh predic ha higher saving and invesmen will resul in a higher level of per capia income and emporarily faser growh. Bu once he new level of income is reached, he growh rae will resume is iniial rae. There is lile empirical evidence for models ha predic ha increased saving has a long-run effec on economic growh. In a closed economy, invesmen is consrained by domesic saving. In an open economy, where capial is mobile, domesic saving and invesmen can diverge wihou necessarily impeding growh. When a counry s rade balance is in defici, impors exceed expors and gross domesic invesmen exceeds gross domesic saving. The quesion hen becomes Is capial sufficienly mobile?. 3 ACCESS TO FOREIGN CAPITAL A necessary condiion for access o foreign capial is he exisence of inegraed financial markes. Subsanial heoreical and empirical work has invesigaed he role of financial markes in economic growh and developmen. 10 Using differen measures of financial deph indicaors covering he banking secor, and he sock and bond markes, various empirical sudies have found a significan relaionship beween financial developmen and growh across counries. Tha is, more developed counries have more developed financial markes. 11 Feldsein and Horioka (1980) In a well-known paper, Feldsein and Horioka (1980) claim ha even among indusrial counries, capial mobiliy is sufficienly limied so ha invesmen raes ulimaely depend on domesic saving raes. As evidence, hey repor cross-secion regressions of average gross domesic invesmen raes on gross naional saving raes for a sample of 16 OECD counries over he period The resuls show a slope coefficien of close o 1 (0.887). Feldsein and Horioka argue ha a coefficien of close 9 For borrowers, lower ineres raes ha reduce ineres paymens encourage greaer curren consumpion and less saving, i.e. he income and subsiuion effec operae in he same direcion. 10 For a recen review of he lieraure see Khan and Senhadji (2000). 11 See, for example, King and Levine (1993) and Khan and Senhadji (2000). 9

11 o 1 indicaes ha mos of he incremenal saving in each counry has remained here. If capial markes were indeed highly mobile, he slope coefficien would be much smaller han 1, as a counry s saving would end o seek ou he mos producive invesmen opporuniies worldwide. As a consequence, risk adjused ineres raes would end o equalise. The empirical resuls produced by Feldsein and Horioka are in conras o oher evidence ha capial is quie mobile and he similar raes of ineres on comparable asses ha are observed across a range of indusrial counries. This cass doub on he robusness of hese resuls. Over he period , capial was no as mobile inernaionally as oday, and Obsfeld and Rogoff (1996) show ha he Feldsein- Horioka resuls are much weaker (0.62) for a sample of 22 OECD counries over he period Taylor (1994) finds ha he Feldsein-Horioka resuls migh be he resul of omied variable bias. Conrolling for (i) relaive price effecs, (ii) he age srucure of populaion, and (iii) he ineracion of he age srucure wih he growh rae of domesic oupu, he cross-secional saving-invesmen relaionship disappears. 12 Anoher inerpreaion of he Feldsein-Horioka resuls is ha he high coefficien on saving is due o specific individual counry effecs raher han low mobiliy. Using hree differen panel daa esimaion procedures and daa for a group of en OECD counries for he period , Corbin (2001) provides evidence of his hypohesis. Home bias in equiy porfolios While he Feldsein-Horioka claim ha domesic invesmen is ulimaely deermined by domesic saving is probably an over-simplificaion, home bias in equiy porfolios does sugges ha here may be some barriers o capial mobiliy. Research on inernaional porfolio choice consisenly predics ha invesors should pu much more of heir wealh ino foreign asses han hey acually do; i.e. invesors appear o engage in a sub-opimal degree of inernaional diversificaion (see Glassman and Riddick 2001). This home bias in invesors equiy porfolios occurs despie rapid growh of inernaional capial and equiies markes and may be evidence ha capial, a leas in he form of equiy, is no very mobile inernaionally. 13 When French and Poerba (1991) firs repored on he home bias porfolio puzzle, hey found ha a he end of he 1980s, Americans held abou 94 percen of heir equiy wealh in he U.S. sock marke. The proporion of domesic equiy in Japanese and Briish invesors porfolios was abou 98 and 82 percen respecively. The home equiy bias may be somewha less imporan for some smaller counries and has shown some endency o decline over ime (Tesar and Werner 1998). By he end of 1996, abou 10 percen of U.S. equiy wealh was invesed abroad, while he proporion of foreign equiy in Japan and he Unied Kingdom rose o 5.3 and 22.5 percen (Table 1). The share of foreign equiy in Canada and Germany was abou 11.2 and 18.2 percen respecively. 12 Feldsein and Horioka (1980) used saving and invesmen as shares of oupu a domesic prices. This ignores ha i is changes in relaive prices ha affec decisions abou real quaniies of consumpion and invesmen. 13 The home bias in bonds appears o be smaller. 10

12 Table 1: Share of foreign equiies in oal equiy porfolios (end of 1996) Canada 11.2 Japan 5.3 Germany 18.2 Unied Kingdom 22.5 Unied Saes 10.0 Source: Rowland and Tesar (2000) The reasons for home bias in equiy porfolios are no well undersood. Trading coss are unlikely o be he reason as he urnover rae on non-residen holdings of equiy appears o be greaer han he urnover rae for residen owners (see Tesar and Werner 1995). Oher poenial explanaions range from informaion asymmeries, differenial ax reamen of domesic and foreign equiies and he significan share of nonradeables in mos counries oupu. 14 The nonradeables explanaion is as follows. Suppose people can rade shares of fuure naional oupus. They can also rade claims on oher counries oupu of nonradeables. Bu because nonradeables canno cross naional borders, a foreign owner of such a claim mus be paid in radeables. The opimal share of a counry s nonraded goods indusries held domesically depends on he uiliy funcion. If, as is commonly assumed, he uiliy funcion is addiively separable in he consumpion of radeable and nonradeable goods, hen, in equilibrium, all claims o a counry s nonraded oupu will be held domesically. 15 In oher words, once people have fully diversified heir porfolios of claims o radeables, hey canno gain furher by diversifying heir holdings of nonradeables (Obsfeld and Rogoff 2000). This implies ha if, say, 50 percen of oal oupu consiss of radeables, hen abou half of invesors porfolios should be held abroad. 16 Susainabiliy of he curren accoun The discussion in Par 2 showed ha he difference beween domesic saving (S d ) and ne domesic invesmen (I ne ) is equal o he curren accoun balance. Those counries who are ne savers will lend o hose who are ne borrowers. This ineremporal borrowing and lending achieves faser accumulaion of invesmen and a more efficien allocaion of global capial. Boh lending and borrowing counries sand o gain from hese capial flows and he associaed foreign invesmen. The availabiliy of foreign funds depends, in par, on he susainabiliy of he curren accoun. Susainabiliy of he curren accoun, in urn, depends on he abiliy o generae sufficien rade surpluses in fuure o repay exising deb and he willingness of foreign invesors o coninue lending (Milesi-Ferrei and Razin 1996). 14 Informaional asymmeries and he lemons problem are discussed furher below. 15 An addiively, separable uiliy funcion implies ha he marginal uiliy of consumpion of he radeable good does no depend on consumpion decisions abou he nonradeable good and vice versa. 16 Deermining he opimal share of nonraded goods indusries held domesically becomes more complicaed for he case of non-separable preferences (see, for example, Baxer, Jermann and King 1998). 11

13 ! Ineremporal solvency A counry is solven if he presen discouned value of is fuure rade surpluses equals is curren accoun indebedness or ne exernal deb. A counry s curren accoun defici is susainable if he solvency condiion holds (assuming everyhing else consan). In oher words, susainabiliy implies ha he exernal deb does no increase wihou limis. In he presence of economic growh, persisen curren accoun deficis can be consisen wih solvency, provided ha fuure rade surpluses are sufficienly large. This resul is derived as follows. As noed in Par 2, he curren accoun balance (CAB) is he sum of he rade balance (X M), ne income paid abroad (y a ) and ne ransfers paid abroad (). For simpliciy, we assume ha ne ransfers paid abroad equal zero. Alernaively, he curren accoun balance can be wrien in erms of socks, as he change in ne foreign asses (NFA) NFA NFA = X M + y a = X M rnfa (3.1) where r denoes he rae of ineres paid on foreign deb (assumed consan over ime); and hence rnfa equals ne income paid abroad. Equaion (3.1) can be wrien as 17 s 1 ( 1+ r)nfa = s= 1+ r ( X s Ms ) (3.2) I saes ha he presen value of an economy s ne resource ransfer o foreigners, i.e. fuure rade balances (X M), mus be equal o he value of he economy s iniial deb o foreigners. Thus, a counry s ineremporal budge consrain holds if, and only if, he counry pays off any iniial foreign deb hrough sufficienly large fuure surpluses in is balance of rade. However, i can be shown ha an economy wih growing oupu can have persisen curren accoun deficis ha are susainable. A counry s curren accoun will be susainable in he long run if he foreign deb o oupu raio is consan. Suppose ha long-run, seady sae oupu ( Y ) grows a rae g, i.e. s Y + s+ 1 = (1 g) Ys (3.3) If he counry s curren accoun is susainable, i.e. he deb o oupu raio is sable, hen exernal deb will also grow a g NFA + s+ 1 = (1 g) NFA s (3.4) 17 This follows from NFA = (1 + r)( (X M ) + NFA +1) = (1 + r)(x M ) + (1 + r)(1 + r)( (X +1 s s s. s= 1+ r M +1) + NFA +2 ) = ( X M ) 12

14 This implies ha for a curren accoun defici o be an equilibrium, he counry only needs o pay he difference beween he ineres rae and is growh rae 18 ( Xs Ms ) (r g)nfa = Y Y s s s (3.5)! Willingness of foreign invesors o lend The availabiliy of foreign funds is also deermined by he willingness of inernaional invesors o lend o a ne debor counry. One imporan facor deermining a counry s supply of exernal finance is he (mean) rae of reurn on domesic asses, which is likely o be influenced by he expeced growh performance of he borrowing counry. The supply of foreign funds, in urn, deermines he cos of foreign borrowing o he domesic counry. In a small open economy he supply of foreign funds is infiniely elasic and he cos of borrowing is deermined by he world ineres rae (plus some counry risk premium). Figure 3 plos he supply and demand of loanable funds as a funcion of he ineres rae in a small open economy. For simpliciy, we assume ha he counry risk premium is zero. Figure 3: Supply and demand of loanable funds r S A' B' rw O A B D k kf The demand curve for capial is downward sloping and given by D. The domesic supply curve of loanable funds is deermined by domesic saving and given by S. The world ineres rae is denoed by r w and, because he risk premium is assumed o be zero, deermines he cos of borrowing of firms. A rae r w, domesic lenders will supply OA of capial and foreign lenders will provide AB. Domesic firms cos of borrowing will increase or decrease wih changes in he world ineres rae or changes in he counry s risk premium. If he world ineres rae rises because of a decline in world saving and/or he counry s credi (or exchange rae) risk 18 This follows from NFA s 1 NFA s = g NFA s = (X s Ms ) + r NFA s +. 13

15 increases, he cos of borrowing increases. Conversely, he cos of borrowing will fall if he size of he world porfolio increases or he counry s risk premium declines. 19 Wih no disorions, markes will always clear. However, in a world wih imperfec informaion, lenders may no always be willing o lend. Capial markes may no always clear and credi raioning can occur. Credi raioning means ha some borrowing counries may no be able o borrow even if hey offered o pay a premium above world raes (see Sigliz and Weiss 1981). Inernaional invesors may be unwilling o lend a higher ineres raes because higher ineres raes increase he average riskiness of invesmen projecs. Higher ineres raes increase he probabiliy of making a bad loan. This is because hose, who are willing o pay high ineres raes, may, on average, be worse risks. They are willing o borrow a high ineres raes because hey perceive heir probabiliy of repaying he loan o be low. 20 A decline in he supply of foreign capial and increase in he cos of borrowing is unlikely o be fully offse by higher domesic saving. To offse a shorfall in foreign saving he domesic supply of loanable funds curve would need o shif downward. This would only occur if domesic savers were prepared o supply he same amoun of saving a a lower rae of ineres, a he same ime when he world ineres had risen. This seems improbable, and hence i is unlikely ha domesic saving will increase enough o make up for he decline in foreign saving. If domesic saving does no increase, hen domesic invesmen and oupu will fall following a decline in he supply of foreign capial. Foreign deb versus foreign equiy There are wo broad caegories of foreign invesmen: deb and equiy. The corporae finance lieraure on he opimal capial srucure of firms provides a useful saring poin for discussion. Under he assumpion ha (i) financial markes are complee and (ii) informaion and ransacion coss are non-exisen, he Modigliani and Miller (1958) heorem saes ha he mix of deb and equiy used o finance firms expendiures is irrelevan o he choice of invesmen projec. In oher words, wheher a firm finances is invesmens wih deb or equiy does no affec he expeced profiabiliy of an invesmen projec he same invesmen decisions would be made, irrespecive of he mix of deb and equiy finance. However, informaion and ransacions coss do exis because of an informaion asymmery beween borrowers and lenders. Borrowers generally know more abou heir invesmen projecs han lenders. The mos famous illusraion of he problems caused by asymmeric informaion is Akerlof s (1970) lemons problem. Equiy will be under-priced since invesors will be suspicious of he fundamenals of any firm ha is willing o sell an equiy share. Because of he lemons problem, a good firm would prefer o issue deb raher han equiy. Thus, firms wih he highes credi raing will 19 Figure 3 also shows how he opening of capial marke increases he supply of funds available o domesic firms and hence oupu. The auarky sock of capial is deermined where he demand and domesic supply curves inersec. Access o world capial markes lowers he cos of borrowing and increases firms capial sock. 20 Higher ineres raes may also induce firms o underake projecs wih lower probabiliies of success bu higher payoffs when successful. Increasing he rae of ineres increases he relaive araciveness of riskier projecs, for which he reurn o he lender may be lower. 14

16 issue bonds firs and hen equiy if exernal finance is required. 21 Some firms wih a high credi raing will also choose o issue equiy o avoid unnecessary bankrupcy in a world of uncerainy where firms are subjec o unforeseen shocks. The informaion asymmery is likely o be augmened in he presence of open capial markes because of addiional informaional asymmeries beween foreign and domesic invesors. One way o reduce or overcome he informaional asymmeries beween foreign invesors and domesic firms is foreign direc invesmen (FDI). This is because purchasing a conrolling ineres in a firm allows he foreign invesor o gain full insigh ino he firm s business. One would hus expec FDI o dominae oher forms of global finance in counries where informaion asymmeries beween foreign and domesic invesors are paricularly imporan. Because of he lemons premium, raising capial hrough equiy financing or foreign direc invesmen is more cosly han issuing bonds. However, as noed before here may be oher moivaions for equiy financing. For example, equiy allows for greaer risk sharing. In he case of foreign direc invesmen foreign invesors will bear par of he counry s risk in he even of a negaive shock. Foreign direc invesmen may also improve producive efficiencies by allowing counries o beer exploi secoral comparaive advanages (Hull and Tesar 2000b). In addiion, i can involve echnological spillover or ransfer of echnology and enrepreneurial skills. Bosworh and Collins (1999) examine 58 developing counries from and find ha one dollar of foreign direc invesmen is associaed wih an addiional 50 cens of domesic invesmen. 4 HOW DOES NEW ZEALAND COMPARE TO OTHER OECD COUNTRIES? The remainder of he paper considers he empirical link beween saving, invesmen and growh in New Zealand. We sar by briefly comparing he New Zealand experience o ha in oher seleced OECD counries. Figure 4 plos ne naional saving, oal gross fixed capial formaion (invesmen), he curren accoun, all as a percenage of GDP, and real GDP growh for 12 seleced OECD counries: Ausralia, Canada, Finland, Germany, Ireland, Japan, Korea, New Zealand, Norway, Sweden, he Unied Kingdom and he Unied Saes. The series were obained from he OECD naional accouns daabase, excep for New Zealand. Daa for New Zealand were consruced from Saisics New Zealand official daa. 22 Daa are ploed from 1972 o If firms can also borrow from banks, hey will prefer issuing deb o equiy o borrowing from banks. This is because bank borrowing incurs inermediaion coss (see Hull and Tesar 2000a). 22 SNA93 daa for New Zealand are only available from 1987 onwards. Prior o 1987 daa were consruced by splicing on he growh raes of he SNA68 series o he levels of he SNA93 series, apar for real GDP. The GDP measure prior o 1987 is a calibraed chain daa series. Quarerly SNA93 chain-linked daa were regressed on he fixed weigh SNA68 daa for he period for which boh were available (June 1987 o June 2000). Parameer esimaes from his regression were hen used o derive an esimae of he chain series from he fixed series for he period from Sepember 1977 o March 1987 for which he fixed series bu no he chain series is available. 15

17 ! Saving Figure 4 shows ha saving raes have varied subsanially across OECD counries. Saving has been lowes in Finland, wih an average rae of 1 percen of GDP, while Korea and Japan experienced he highes average raes, a around 21 and 18 percen respecively. Saving has also been relaively high in Norway, a around 12 percen of GDP. In he res of he counries, saving raes have averaged beween around 4 percen (New Zealand) and 9 percen (Germany). Moreover, ne naional saving was lower over he 1990s compared o he 1970s and 1980s in Ausralia, Canada, Germany and New Zealand.! Invesmen While New Zealand s measured saving rae is lower han in oher OECD counries, his does no appear o have affeced invesmen. In fac, New Zealand s average invesmen rae a around 22 percen ranks in he middle of OECD raes, which range from around 30 percen (Korea and Japan) o slighly less han 19 percen for he Unied Kingdom and he Unied Saes. Norway s average invesmen rae is also high, wih abou 26 percen. Overall, invesmen raes have been fairly sable in Ausralia, Canada, Germany, Japan, New Zealand, he Unied Kingdom and he Unied Saes. In conras, in Finland and Sweden, hey appear o have dropped o a lower level in Moreover, invesmen has been quie volaile in Ireland, Korea and Norway, seadily declining in Norway and rending upward in Korea. In Ireland, he invesmen rae fell over much of he 1980s, bu rose over he 1990s.! Curren accoun Alhough Korea has had high (and rising) invesmen raes, domesic saving has been sufficien o mee srong invesmen demand. As a resul, is curren accoun as a percenage of GDP, on average, has been zero. The curren accoun also has flucuaed around zero in Germany, Finland and Sweden. In Finland and Sweden, he curren accoun was in defici unil 1993; however, since hen, curren accoun surpluses have offse previous deficis. The relaively small curren accoun defici in Finland prior o 1993 and balanced curren accoun over he period as a whole is somewha surprising, given Finland s high raes of invesmen and low saving raes. The curren accoun in Ausralia, Canada, Ireland, New Zealand, he Unied Kingdom and he Unied Saes has been in defici. Ireland s curren accoun reached a rough a 13 percen of GDP in 1981; however, since 1987 i has shown a small surplus. In Ausralia, Canada and New Zealand, he curren accoun has been in defici, associaed wih relaively low raes of ne naional saving. In he Unied Kingdom and he Unied Saes, boh invesmen and saving raes have been low. Japan and Norway, on average, have had curren accoun surpluses. High raes of invesmen have been more han offse by high raes of ne naional saving. 16

18 Figure 4: Ne naional saving, invesmen and he curren accoun (all as a percenage of GDP) and real GDP growh Ausralia Canada Finland Germany Ireland Japan Korea New Zealand Norway Sweden Unied Kingdom Unied Saes Curren accoun as a percen of GDP Invesmen as a percen of GDP Ne naional saving as a percen of GDP Real GDP growh Source: OECD, Saisics New Zealand and The Treasury. 17

19 ! Real GDP growh Average real GDP growh has varied across counries beween percen (Canada, Germany, Japan, Sweden, New Zealand and he Unied Kingdom) and around 7 percen (Korea). A 5.4 percen, average real oupu growh also has been high in Ireland. In Ausralia, Finland, Norway and he Unied Saes real oupu growh has flucuaed around 3 percen. These numbers and Figure 4 show ha here is no obvious empirical link beween domesic saving, invesmen, he curren accoun and real oupu growh. For example, Japan has experienced high raes of saving and invesmen (and a curren accoun surplus), bu is real oupu growh raes have been relaively low. Korea has also had high saving and invesmen raes, bu is real oupu growh raes have been high (and he curren accoun balanced). In conras, Finland s saving rae has been very low, bu is average growh rae comparable o hose in oher OECD counries. 5 THE NEW ZEALAND EXPERIENCE The Feldsein and Horioka claim To examine he empirical link beween domesic saving, invesmen and real oupu growh in more deail for New Zealand, we firs esimae he Feldsein-Horioka equaion, discussed in Par 3. Daa used in he esimaion are he same as in Par 4 excep for invesmen. Invesmen is gross fixed capial formaion in plan machinery and equipmen plus residenial and non-residenial building. The measure of invesmen excludes oher consrucion, ranspor equipmen, inangible fixed asses and land improvemens. This is because he null hypohesis of a uni roo in he raio of oal gross fixed capial formaion o (nominal) GDP could no be rejeced a convenional levels of significance. The raio of saving o oupu and real GDP growh are saionary a convenional levels of significance. Figure 5 plos he daa. The esimaion period is 1980 o Regressing he raio of invesmen o oupu agains a consan and he raio of saving o oupu using ordinary leas squares (OLS) produces a slope coefficien on he saving rae of However, he equaion is mis-specified. The Durbin and Wason (1951) saisic, which ess for firs-order serial correlaion in he residuals, rejecs he null hypohesis of no posiive auocorrelaion. Figure 5: Saving, invesmen and real GDP growh in New Zealand Raio of saving o oupu Raio of invesmen o oupu Real oupu growh Source: Saisics New Zealand and The Treasury. 18

20 Correcing for firs order serially correlaed errors using he ieraed Cochrane-Orcu mehod (see Hamilon 1994), he Durbin-Wason es can no longer rejec he null hypohesis of no auocorrelaion (posiive or negaive). The resuls from he adjused Feldsein-Horioka equaion are repored in Table 2. The slope coefficien of he saving rae in he modified equaion is 0.548, significanly less han 1. However, he Engle (1982) es for firs order auoregressive condiional heeroscedasiciy and he Breusch and Pagan (1979) es for condiional heeroscedasiciy canno rejec he null hypohesis of heeroscedasiciy in he errors In he presence of heeroscedasiciy, he OLS esimaes are sill unbiased and consisen, bu no efficien. Heeroscedasiciy implies ha he sandard errors for he slope coefficiens are likely o be oo small (and hose of he consan oo large). 25 The R-squared saisic indicaes he proporion of variabiliy in invesmen explained by he consan and domesic saving. According o his saisic, he consan and domesic saving explain abou 72 percen of he variaion in invesmen. Table 2: Feldsein-Horioka equaion for New Zealand Variable Coefficien Sandard error T-saisic P-value Consan Saving R-squared (cenered) Adjused R-squared Durbin-Wason Granger causaliy Regression analysis considers he dependence of one variable on oher variables, bu i does no necessarily imply causaion. To answer he quesion wheher saving causes oupu growh or oupu growh causes saving, we use he definiion of causaliy proposed by Granger (1969). A ime series { y } is said o Granger cause anoher ime series { z } if z can be prediced beer by using pas values of y han by using pas z only. To es wheher or no saving Granger causes oupu growh, for example, we esimae he following equaion via OLS, assuming a paricular auogressive lag lengh p, GDP = c + α GDP + α GDP α GDP + β S β S + µ (4.1) p p 1 1 p p and perform an F-es of he null hypohesis of no Granger causaliy, i.e. 23 Resuls are no repored, bu available upon reques. 24 In general, residual heeroscedasiciy can ake wo forms: (i) he residuals are some funcion of he variables used in he regression; (ii) he variance is no consan over ime. 25 The null hypohesis ha he slope coefficien is no significanly differen from 1 would no be rejeced a he 10 percen level if he sandard error was greaer han

21 H : β = β =... = β 0 (4.2) p = The es is valid asympoically. An alernaive approach, suggesed by Geweke, Meese and Den (1983) is o regress curren oupu growh on pas oupu growh and pas, presen and fuure saving raes. Empirical ess for Granger causaliy can be sensiive o he choice of lag lengh and he Granger and Geweke-Meese-Den ess are performed for differen lags. The Granger es is performed for lags 1 o 4. The Geweke-Meese-Den es is performed for wo differen ses of lags: (i) including he dependen variable wih wo lags and he curren independen variable, wih wo lags and one lead, and (ii) he dependen variable wih four lags and he curren independen variable, wih four lags and wo leads. Table 3 repors he resuls. Table 3: Invesmen does no Granger cause saving Saving does no Granger cause invesmen Saving does no Granger cause oupu growh Oupu growh does no Granger Granger causaliy ess Granger Geweke-Meese- Den 1 lag 2 lags 3 lags 4 lags (i) (ii) (0.785) (0.162) (0.201) (0.386) (0.763) (0.123) (0.037) (0.445) (0.507) (0.224) (0.036) (0.340) (0.409) (0.033) (0.184) (0.414) (0.085) (0.183) (0.549) (0.335) (0.214) (0.714) (0.665) (0.037) cause saving Noe: Bold figures indicae ha he null hypohesis of no Granger causaliy is rejeced a convenional level of significance. P-values are provided in parenheses. Table 3 shows ha he direcion of causaion beween saving and invesmen and saving and growh is ambiguous. The Granger es provides evidence ha saving Granger causes invesmen and oupu growh. In conras, he Geweke-Meese-Den finds evidence of Granger causaliy from invesmen and oupu growh o saving. Cross correlaions beween saving and invesmen and oupu growh, repored in Table 4, also show ha here is no clear link beween he variables. 26 For example, he correlaion beween saving and pas oupu growh is posiive. This implies ha higher oupu growh is followed by increased saving in fuure. However, he correlaion beween saving and fuure oupu growh is negaive. This may be inerpreed as households increasing heir consumpion (and hence lowering savings) in anicipaion of higher oupu growh in fuure. 26 The cross correlaion funcion of x and y is calculaed using he following formula: ρ x,y (x x)(y k y) ( k) =. 2 2 (x x) (y y) 20

22 Table 4: Cross correlaions Saving () Invesmen (-4) Invesmen (-3) Invesmen (-2) Invesmen (-1) Invesmen () Invesmen (+1) Invesmen (+2) Invesmen (+3) Invesmen (+4) Oupu growh (-4) Oupu growh (-3) Oupu growh (-2) Oupu growh (-1) Oupu growh () Oupu growh (+1) Oupu growh (+2) Oupu growh (+3) Oupu growh (+4) A hree-variable VAR To examine he dynamic iner-relaionship beween domesic saving, invesmen and real oupu growh, i.e. how does saving respond o an unforeseen increase in oupu growh, for example, we esimae a hree-variable vecor auoregression (VAR) model. A VAR is a sysem of equaions, where each variable depends on is pas realisaions as well as he pas realisaions of all oher variables in he sysem. Impulse responses of he VAR can hen be used o examine he response of he variables in he sysem o paricular shocks. The vecor represenaion of he VAR is given by x = c + ϕ(l) + ε (4.3) x 1 where x denoes he vecor of variables in he model, i.e. saving, invesmen and real oupu growh, c is a vecor of consans, ϕ (L) is a ph degree marix polynomial, and ε is a vecor of error erms. To obain he impulse responses, which race ou he response of he variables in he sysem o specific shocks, idenifying resricions need o be imposed. We impose he resricion ha saving is exogenous and ha real oupu growh is a funcion of pas saving and invesmen raes The resricion implies a Choleski decomposiion wih he following ordering: saving, invesmen, real oupu growh. For a non-echnical inroducion o VARs see Buckle, Choy, Claus, Haugh and Szeo (2001). 28 Likelihood raio ess a he 5 percen level chose a lag lengh of 2 o eliminae serial correlaion from he residuals. 21