Mission Concluding Statement 

New Zealand - 2014 Article IV Consultation - Concluding Statement

March 31, 2014

Overview. Growth prospects have improved for the near term. Business and consumer confidence is strong and commodity prices for key exports remain high. With excess capacity largely exhausted the Reserve Bank (RBNZ) has begun tightening monetary policy. The government’s plan to return the budget to surplus is on track. The main external threat to the outlook continues to be a sharp slowdown in China. Domestically, rapid house price inflation remains a concern, and the RBNZ’s prudential measures to slow high loan-to-value mortgage lending are welcome. The authorities’ macroeconomic framework remains sound and provides policy space to respond to adverse shocks. The flexible exchange rate continues to serve as an important buffer.

Developments and outlook. The economic expansion is becoming increasingly embedded and broad-based, and growth is forecast to increase to about 3½ percent this year. The drivers include supportive financial conditions, historically high commodity prices, resurgent construction activity related to the Canterbury post-earthquake rebuild and general housing shortages, and a substantial increase in net immigration. Headline inflation has remained subdued, with the strong exchange rate dampening tradable price inflation and offsetting growth in non-tradable inflation. With the economy set to continue to grow above trend in the near-term, pressures on core inflation should follow, particularly from the construction sector.

Risks to the Outlook

External risks. New Zealand’s growth prospects remain exposed to external developments, and in particular a sharp slowdown in growth in China. About two thirds of New Zealand’s exports of goods go to China, Australia, and other parts of Asia. As such, any adverse development in the region would have a substantial impact on New Zealand’s terms of trade. Although an orderly exit by other advanced economies from unconventional monetary policy could have the welcome effect of weakening the exchange rate, a bumpy exit and repeated episodes of financial market volatility could lead to widespread contagion and raise the cost of New Zealand banks’ offshore borrowing.

Domestic risks. The speed of the Canterbury post-earthquake rebuild and its interaction with the wider economy are uncertain. But more pressing are risks related to the housing sector. By historical and international comparisons and most measures of affordability, New Zealand’s house prices appear elevated. With house price inflation running high, there remains the risk that expectations-driven, self-reinforcing demand dynamics and price overshooting could take hold. The government’s steps to help alleviate supply bottlenecks, measures to tighten standards for mortgage lending, and an increase in mortgage rates should help ease price pressures. But a sudden price correction—possibly triggered by a shock to household incomes or borrowing costs—could reduce consumer confidence, impact overall economic activity, and hurt banks’ balance sheets.

Tail risks and downside scenarios. Many of the above risks are closely linked—for example a sharp slowdown in China could weaken growth prospects in Australia, triggering a broad-based fall in demand for New Zealand’s exports, and lead to a sudden decline in house, farm and commercial real estate prices. This in turn could weaken consumer demand and negatively affect banks’ balance sheets and their willingness to lend. The downside macroeconomic impact in a scenario where shocks compound each other could be large.

Managing risks. The authorities have monetary and fiscal policy space to respond to shocks. The RBNZ has scope to adapt monetary conditions to help buffer against a downside scenario, and the free-floating New Zealand dollar provides an additional cushion against terms of trade and other external shocks. New Zealand’s modest public debt gives the authorities scope to delay their planned deficit reduction path in the event of a sharp deterioration in the economic outlook. The new macro-prudential policy framework improves the RBNZ’s ability to safeguard financial stability, allowing it to take additional measures if needed to guard against the risks that would arise from an unsustainable acceleration in house price inflation. As a longer term measure, policies to address housing supply constraints will continue to play an important role in containing price pressures and increasing affordability.

Macroeconomic Management

Monetary policy stance. The integrity and credibility of the RBNZ’s monetary policy framework and the free floating exchange rate have played a key role in delivering macroeconomic stability and enhancing the resilience of the New Zealand economy. With growth set to exceed trend and inflationary pressures starting to emerge, we welcome the RBNZ’s shift toward a policy of withdrawing monetary stimulus, with the clear signal that it expects to increase rates steadily over the next two years. This could also help to cool house price inflation. Going forward effective monetary policy transmission should allow for a nimble policy response should growth circumstances change.

Fiscal policy. The government’s priority to return to budget surplus will help preserve its favorable standing with external creditors against the background of relatively high net foreign liabilities, and create fiscal space to cope with future economic shocks and deal with aging and health care costs that are expected to increase over the long term. Deficit reduction also has an important role to play in supporting monetary policy through the current cycle by making room for increases in private sector and earthquake-related reconstruction spending, and thereby allowing for lower interest rates than would otherwise be the case and reducing pressure on the exchange rate. To this end, any revenue over-performance while demand pressure remains strong should be used to pay down government debt rather than being used for higher spending.

External Stability

Current account. New Zealand’s persistent current account deficits and relatively high net external liabilities reflect structural saving-investment imbalances. The deficit narrowed last year as a result of the strong terms of trade, but is expected to widen as growth in private consumption and investment remains strong. Investment related to ongoing earthquake reconstruction will also continue to add to the deficit through the forecast horizon. Reducing pressure on the exchange rate and limiting the current account deficit in a lasting way will require structural measures to address the savings-investment gap, rather than being the task of short-term macroeconomic management.

Exchange rate assessment. Our estimates suggest that even with the strong terms of trade, the New Zealand dollar is currently stronger than would be consistent with stabilizing net foreign liabilities over the long run, and on this basis appears to be overvalued. There are other factors contributing to the current level of the exchange rate, including the gap between domestic and foreign interest rates, New Zealand’s favorable growth outlook, and an appetite for relatively safe New Zealand assets. If any of these factors were to ease, the exchange rate would likely depreciate. The government’s ongoing deficit reduction plan should also ease pressure on the exchange rate by boosting national saving. However, global liquidity could remain ample for some time, and New Zealand’s non-agricultural tradable sector will need to continue to adapt by further increasing efficiency to remain competitive.

Safeguarding Financial Sector Stability

Overview. New Zealand’s financial system remains sound. The banks are well capitalized—all comfortably meet the new Basel III minimum capital requirement—and liquidity buffers are solid. Non-performing loan ratios are low and declining. Banks continue to shift toward more stable funding sources, and use of offshore borrowing has been reduced and is of longer maturity. Stress tests show that the major banks would be able to withstand a series of sizeable shocks. Nevertheless the banks face longstanding structural issues that will remain sources of financial sector risk over the medium term. The four largest banks are systemically important with broadly similar business models, and their reliance on offshore funding, while declining, is still high by international standards and represents a risk. Residential mortgages and agricultural lending account for most of banks’ assets, sectors vulnerable to price fluctuations and where leverage is still high. Although as subsidiaries the major banks are not dependent on borrowing from their Australian parents, they are still vulnerable should a parent get into trouble which could affect their access to offshore borrowing.

Prudential policies. We support the RBNZ’s recent introduction of a number of measures in response to house price inflation and to boost financial sector resilience, including tight limits on high loan-to-value ratio lending. Some recent data suggest that the measures have had an impact, cooling mortgage lending. More generally, the available tools under the new macro-prudential policy framework should be viewed as a complement to macroeconomic and micro-prudential tools, used sparingly and with caution, and primarily with the objective of limiting the buildup of system-wide financial risk.