Public Information Notice No. 13/51

Public Information Notice: IMF Executive Board Concludes 2013 Article IV Consultation with New Zealand

May 14, 2013

On May 13, 2013, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with New Zealand.¹

Background

Growth appears to have strengthened in the last months of 2012 and is estimated at 2½ percent for the year, as subdued household consumption and business investment and budget deficit reduction have been offset by strong agriculture production and continued expansion in the construction sector. Earthquake-related reconstruction is gathering pace.

Inflation remains subdued, with the exchange rate dampening tradable price inflation. Wage pressures are contained and by a range of measures the labor market remains soft. However, pressures have emerged in the housing market, notably in Auckland where supply bottlenecks persist and in Christchurch where construction cost inflation has accelerated.

The Reserve Bank of New Zealand (RBNZ) has kept the policy rate at 2½ percent for two years given uncertainty over the global outlook, soft domestic demand, benign inflationary expectations, and the strong New Zealand dollar. Favorable offshore borrowing conditions have reduced banks’ funding costs and contributed to a further lowering of lending rates. Net government debt grew from 5½ percent of GDP in 2008 to 20 percent in 2011, as a consequence of the policy response to the global financial crisis and the two earthquakes. The government has since established a medium term deficit reduction plan that aims to reduce the structural budget deficit by about 6 percent of GDP over four years, mainly through spending restraint.

The current account deficit in 2012 widened somewhat to 5 percent of GDP, reflecting some terms of trade losses, although it is well below the 8 percent level in 2005-08. Net external liabilities remain high at 72 percent of GDP at end-2012.

The banking sector remains sound. Asset quality remains good, the ratio of nonperforming loans to total assets is low and continues to decline from its peak, and return-on-assets is in line with the pre-crisis average. Capital adequacy has improved and is well above the Basel III capital requirements which the RBNZ began to put in place in January. Banks have shifted toward more stable funding sources facilitated by a combination of strong deposit growth and slower credit growth. Reliance on offshore wholesale funding has been reduced and is of longer maturity, and deposits now meet around half of banks’ funding requirements. Banks’ balance sheets are fully hedged against exchange rate risk.

The growth forecast for this year, currently at 2¼ percent, is subject to uncertainty. An increase in construction activity is offset by headwinds from budget deficit reduction, the strong dollar, and the recent severe drought. Over the medium term, output growth should peak at 2¾-3 percent as reconstruction spending increases further before converging to a trend rate of about 2½ percent. Underlying inflation is expected to increase but remain modest. Rising house prices, which are already elevated by standard metrics, are a growing concern, as they could lead to an increase in debt-financed household spending which would put pressure on aggregated demand, and increase the risk of an abrupt price correction. Other threats include the financial and economic fallout from an intensification of European sovereign debt problems and a slowdown in China, Australia, and other parts of Asia.

Executive Board Assessment

Executive Directors commended the authorities’ strong track record of prudent macroeconomic management in the wake of the global economic downturn and devastating earthquakes. While a recovery is underway, growth this year is likely to remain modest, with an increase in construction activity offset by headwinds from budget deficit reduction, the strong dollar, and the recent severe drought. Risks arise from persistent low national savings and large external liabilities, and from high and rising house prices. Directors welcomed the authorities’ continued efforts to reduce these vulnerabilities.

Directors agreed that the current accommodative monetary policy stance is appropriate, although a tightening may be warranted if house-price and credit expansion begin to fuel inflationary pressures. They were reassured that the reserve bank’s credibility and the effective monetary transmission mechanism would allow a smooth response to changing circumstances. A few Directors pointed out that higher interest rates could lead to further exchange rate appreciation.

Directors welcomed the medium-term consolidation plan and its focus on expenditure restraint. The planned pace of deficit reduction strikes the right balance between sustaining aggregate demand and limiting public debt growth. It withdraws fiscal stimulus at the right time by making room for increases in reconstruction spending. It also reduces pressure on monetary policy, creates fiscal space, and could help to raise national savings. Directors considered that the relatively modest public debt provides some scope to delay the planned deficit reduction in the event of a sharp deterioration in the economic outlook.

Directors noted that New Zealand’s large net liabilities reflect historically low household savings rates and a structural savings-investment imbalance. They agreed that the causes of low household savings will need to be addressed to reduce pressure on the exchange rate and limit current account deficits. In this context, Directors welcomed the shift in the composition of taxation from income to consumption taxes and looked forward to follow-up on the conclusions of the Savings Working Group. Directors further observed that other factors contributing to the overvalued exchange rate include a continuing gap between domestic and foreign interest rates and increased portfolio flows.

Directors agreed that banks remain sound, with recent stress tests showing that the major banks could withstand a variety of sizeable shocks. They observed, however, that banks remain exposed to highly leveraged borrowers and to rollover risks associated with large short-term offshore funding needs. Directors welcomed the reserve bank’s consideration of using macroprudential tools in a judicious way to limit risks in the housing market, as a complement to macroeconomic and microprudential measures.