Mission Concluding Statement 

New Zealand: IMF Staff Concluding Statement of the 2017 Article IV Mission

March 6, 2017

New Zealand is enjoying a strong expansion driven by record high net migration, strong construction activity, and accommodative monetary policy. Policy challenges lie in managing the pressures of strong growth on infrastructure and on housing, particularly in Auckland. Easing housing supply constraints will be important to safeguard the long-term attractiveness of New Zealand for skilled labor and business. The review under the Financial Sector Assessment Program (FSAP) concluded that the financial sector appears to be sound and that its resilience could be further enhanced by expanding the macroprudential toolkit to be ready to manage remaining risks from high household debt if needed; increasing capital buffer requirements to reflect concentration in the financial sector; and strengthening financial sector oversight and crisis resolution regimes.

Context

1. New Zealand has enjoyed a solid economic expansion in recent years. Construction has been an important driver, with above average residential investment ratios, accommodative monetary policy has supported demand more broadly, and the economy has absorbed and benefited from increasingly stronger net migration. House prices have increased rapidly, while household debt (as a percent of income) is high and rising. Despite the deployment of macroprudential measures, related macro-financial vulnerabilities have been a concern. Inflation has mostly been below the Reserve Bank of New Zealand’s (RBNZ) 1-3 percent target range, partly reflecting the weak global economy, and the New Zealand dollar has stayed relatively strong. The terms of trade have remained above average, although dairy price declines in 2014-15 led to losses and some financial distress in the sector.

2. The economy has picked up further momentum. Real GDP growth accelerated to about 4½ percent through 2016, with broad-based strength in demand and employment, rather than weakening as expected earlier. The unexpected strength reflected in part more persistent increases in net migration and stronger consumption, and as a result, the economy is now operating broadly at capacity. Headline inflation returned back into the target range in 2016Q4, reflecting the rebound in oil prices and a recovery in non-tradables inflation. Housing markets have remained buoyant, although house price growth in Auckland has slowed.

Outlook and Risks

3. The baseline outlook is favorable. Economic growth is projected to remain strong and above trend into 2018, with subsequent moderation toward trend growth of around 2¾ percent. Near-term strength is underpinned by investment, including residential and infrastructure investment, the production impact of the recent recovery in dairy prices, and with further, albeit moderating, net migration adding to demand. Inflation is projected to rise gradually toward the 2 percent mid-point of the RBNZ target range.

4. Household debt vulnerabilities are expected to stabilize in the medium term but will remain high. Tighter macroprudential policies, higher interest rates, moderating net migration, and easing housing supply constraints should result in lower house price increases. As credit growth slows, in turn, household debt will stabilize relative to income at high levels in international comparison, and banks’ international net wholesale funding needs will moderate, containing related vulnerabilities.

5. Risks to the near-term growth outlook have become more balanced. There are upside risks from both stronger net migration and terms of trade. With stronger activity and incomes, house price increases would likely speed up. On the downside, tighter external financial conditions and macroprudential constraints could slow credit, investment, and growth.

6. Rising household debt remains a risk to financial stability. It would amplify a high-impact downside shock—which would likely be external— through household deleveraging and a housing correction. While the FSAP found banks to be generally resilient, there would be feedback effects to the financial sector and, possibly, bank balance sheet stress in a drawn-out downturn, including through the impact on other borrowers as aggregate demand falls. In addition, if dairy prices decline under such a downside shock, the sector could experience financial stress.

Policies

7. Economic policies should focus on managing risks and opportunities from strong economic and population growth. Macroeconomic policy settings are broadly appropriate. Containing household balance sheet vulnerabilities will be critical for financial sector stability while underlying demand-supply imbalances in the housing market are being addressed. Providing infrastructure and the services needed to promote human and knowledge-based capital will be essential for maintaining growth opportunities.

Macroeconomic management

8. Current monetary policy settings appropriately address low inflation. Inflation is expected to return gradually to the mid-point of the target range. Risks to inflation are broadly balanced. But downside risks still are a bigger concern after a long period of inflation below target, strong labor force growth, and the fact that some of the recent uptick in inflation was temporary because of higher oil prices. If there was an unexpected upshift in the inflation path, including, for example, because of stronger domestic or global growth, domestic financial conditions would tighten in response, thereby reducing further upside risks to actual inflation.

9. The strong fiscal position provides room to accommodate the needs from strong population growth. Compared to the previous budget, the updated baseline expenditure path already incorporates higher infrastructure spending and new growth-friendly measures, as discussed below. This is expected to result in a positive fiscal impulse in the current fiscal year. With the economy approaching full capacity, this impulse is helpful. Current budget plans appropriately imply a counter-cyclical fiscal stance going forward. Stronger-than-expected revenue for cyclical reasons should be used to reduce public debt.

Strengthening macro-financial resilience

10. While prospectively stabilizing at a high level in the medium term, housing-related macro-financial vulnerabilities are expected to increase in the near term. A root cause of these vulnerabilities is a demand-supply imbalance in the housing market, especially in Auckland, which has resulted in a house price boom and overvaluation, and high levels of household debt. The authorities have taken steps to enable more housing supply (see paragraph 14). Even with these measures (which could be broadened), the resolution of demand-supply imbalances will take time, and vulnerabilities should be contained with macroprudential policies in the meantime.

11. The RBNZ’s macroprudential toolkit needs broadening. Exposure limits to high loan-to-value ratios (LVRs) have reduced the potential losses on bank balance sheets if a household defaults. But they do not protect banks against an increase in the number of households defaulting, the probability of which has increased with the rising debt-to-income (DTI) ratios on new loans. To strengthen household balance sheet resilience and reduce the probability of household defaults under downside shocks, the macroprudential toolkit should be extended to include a DTI or (stressed) DSTI instrument, in line with recommendations by the FSAP. These directly target the most acute household vulnerability. Other macroprudential instruments available to the RBNZ are approaching their practical limit (LVRs) or address the problem indirectly, with limited effectiveness and higher risks of unintended consequences. The new instrument should be activated in the event that effects of the most recent macroprudential package on credit growth prove to be temporary.

12. Bank balance sheet resilience should be strengthened further through increases in bank capital requirements under the ongoing RBNZ capital review. The large banks feature a strong similarity in business models with a high risk concentration in mortgage lending and the dairy sector and significant reliance on foreign funding, which adds a systemic risk dimension. Hence, aiming for capital adequacy ratios for New Zealand’s large banks that are somewhat higher than the Australian Prudential Regulation Authority’s (APRA’s) “unquestionably strong” capital targets for the large Australian banks could be a reasonable benchmark.

13. Upgrades to oversight and crisis resolution regimes would add to financial system resilience. The FSAP has identified several areas in which the authorities are encouraged to undertake structural upgrades, including : (i) to increase the weight of regulatory discipline in order to reinforce self and market discipline in New Zealand’s three-pillar approach to bank regulation; (ii) to foster even stronger home-host supervisory cooperation with APRA; (iii) to adopt current reform plans to align the regulatory and supervisory framework for financial market infrastructure with international standards; (iv) to broaden the regulatory perimeter for the asset management industry; and (v) to clarify the operation of the Open Bank Resolution framework and strengthen the financial safety net.

Supporting growth opportunities

14. Measures to lift potential growth should focus on leveraging the benefits from high net migration, innovation, and interconnectedness. These benefits could help compensate for New Zealand’s remoteness and small market size. The following policies would seem most promising in this respect:

• Targeting housing supply bottlenecks more broadly would safeguard the attractiveness for high-skilled immigration and business. Measures, such as the Auckland Unitary Plan and the Housing Infrastructure Fund, should be complemented by a comprehensive reform of urban planning legislation and measures to support local infrastructure financing. The latter could include some central government funding (given wider agglomeration benefits), more efficient property taxation, and user charges.
• Redirecting saving incentives from housing to other investments. A broader capital gains tax on real estate would lower the incentives for investment in housing. Limiting negative gearing for rental properties would work in a similar direction.
• Providing support for innovation. These efforts could go beyond the current budget announcement of the “Innovative New Zealand” program, which increased financing for science and some R&D grants, and subsidies for tertiary education by 0.1 percent of total annual spending. If the pilot is successful, spending should be ramped up.
• Continuing efforts toward further trade liberalization, in regional and multilateral fora, as intended. Expanding access to service export markets would also strengthen domestic services sector productivity. Even broader market access for agricultural products would also help, including by raising incentives for diversification and innovation in the sector.

The IMF mission would like to thank the authorities and counterparts in the private sector and other organizations for engaging discussions.