Public Information Notice No. 03/57

Public Information Notice: IMF Concludes 2003 Article IV Consultation with New Zealand

May 2, 2003

On April 30, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with New Zealand.¹

Background

Despite significant slowdowns in activity in some major overseas markets, New Zealand has maintained a strong pace of economic growth over the past three years. The economy's performance reflected its enhanced flexibility, stemming from the structural reforms of the 1980s and 1990s, and the prudence of macroeconomic policies. Favorable commodity price developments and a competitive exchange rate provided a strong stimulus to exports, raising growth sharply initially during this period. Subsequently, the impact of the increase in exports on incomes in the farm sector filtered through the rest of the economy, and domestic demand surged, led by private consumption and housing investment. Unusually strong net immigration inflows also provided a stimulus to demand. The annual average real GDP growth was 4.4 percent in 2002. Strong demand conditions contributed to pushing capacity utilization rates to high levels and reducing unemployment to 4.9 percent in the December 2002 quarter. Pressures on resources kept inflation towards the top end of the official 1-3 percent target range in 2002, but the rate declined to 2½ percent in the March 2003 quarter.

After falling sharply in 1999 and 2000, the value of the New Zealand dollar stabilized during 2001, before appreciating substantially in 2002 and into early 2003. Since end-2001, the New Zealand dollar has risen by 34 percent vis-à-vis the U.S. dollar and 21 percent on a trade-weighted basis. The earlier depreciation, in combination with favorable commodity prices, led to strong export growth which helped to narrow the external current account deficit from 6¼ percent of GDP in 1999 to around 3 percent in 2002. Rising imports of consumer goods (on the back of the pick-up in domestic demand) and weaker export prices in 2002 eroded some of the improvement in the trade balance over the course of the year, but rising service receipts and falling factor income outlays have provided some offset. With the relatively strong current account position, net capital inflows have eased during the past two years which has helped to reduce New Zealand's net external liabilities from 89 percent of GDP at end-March 1998 to 82 percent at end-March 2002.

Better-than-expected economic activity prompted the Reserve Bank of New Zealand (RBNZ) to tighten monetary policy in the first half of 2002. In March to June, the RBNZ raised the overnight cash rate (OCR) by a total of 100 basis points to 5.75 percent in four steps. At subsequent reviews in 2002, the RBNZ left rates unchanged, reflecting concerns about a deteriorating external environment and its implications for New Zealand. At the January and March 2003 OCR reviews, the OCR also was left unchanged, but the RBNZ suggested that the sharp appreciation of the currency may have shifted the balance of risks around the future path of interest rates. However, the RBNZ cautioned that any cut in the interest rates would be conditional on the emergence of clear signs of reduced resource pressures and medium-term inflation. At its scheduled review on April 23, the RBNZ cut the OCR by 25 basis points noting that these conditions had been met. Available data suggested that growth in the New Zealand economy was slowing as the RBNZ had expected, and the Bank was more confident that inflationary pressures would ease.

The fiscal surplus rose in 2001/02 and is expected to strengthen further over the medium term. In 2001/02, reflecting stronger tax revenues, the operating surplus (OBERAC) rose by nearly ½ percentage point to 2¼ percent of GDP. Medium-term projections in the December Economic and Fiscal Update 2002 suggest that the OBERAC could rise to 2¾ percent of GDP in 2002/03 and to nearly 4 percent by 2006/07. Projected operating surpluses are more than sufficient to meet the required contributions to the New Zealand Superannuation Fund, as well as additional capital expenditures and other planned government investments. Accordingly, gross debt is expected to decline to around 23½ percent of GDP, and net debt would fall to around 11 percent by 2006/07.

The pace of economic growth is expected to ease in 2003 to around 2¾ percent, given the weak external environment, the fall in commodity prices, and the sizeable currency appreciation. Private consumption would account for most of the slowdown in growth, reflecting weaker disposable income growth and slower population growth. Although uncertainties associated with military conflict in Iraq have diminished, uncertainty about the strength of external demand remains a major downside risk to the outlook. Some additional downside risks have emerged, including the impact on trade and tourism of the outbreak in Asia of Severe Acute Respiratory Syndrome and recent dry weather conditions in some parts of the country, which could have adverse implications for agricultural and hydroelectric power production. On the upside, there is a risk that with consumer confidence remaining high, near-term domestic demand growth could prove stronger than expected. New Zealand's medium-term economic prospects are favorable, with growth expected to rise to a rate in line with estimates of the economy's potential of around 3 percent over the medium term. Inflation is expected to return to around the middle of the official target range in 2003 and remain there. The current account deficit is projected to return to its average level of the 1990s of around 4 to 4½ percent of GDP.

Executive Board Assessment

Executive Directors commended the New Zealand authorities for the performance of the economy. Directors attributed this success to the authorities' continued skillful management of macroeconomic policies and to the wide-ranging structural reforms undertaken since the mid-1980s, which have contributed to New Zealand's robust economic growth, made the economy more flexible, and increased its resilience to external shocks. Although growth prospects are expected to moderate over 2003, the strong institutional and macroeconomic frameworks should continue to serve the country well.

With regard to macroeconomic policies, Directors noted that New Zealand's inflation targeting framework has provided a sound and credible basis for formulating monetary policy. Modifications to the framework under the new Policy Targets Agreement (PTA) have been useful, as they provide some additional flexibility in conducting monetary policy. Directors were not convinced that, at some point in the future, it would be useful to modify the PTA to define the policy objective as seeking inflation outcomes over the medium term around the midpoint of the target range in order to further ground inflationary expectations, as the staff had suggested. Directors observed that the floating exchange rate regime is an integral part of the inflation targeting framework. It has served New Zealand well by allowing the country to conduct independent monetary policy and by providing flexibility in adjusting to structural reforms and economic shocks.

Directors generally supported the current monetary policy stance. Although a few Directors would have looked for further evidence of moderating inflation, most Directors welcomed the recent rate cut, in view of the anticipated slowdown in growth and expected easing in price pressures. Directors agreed with the Reserve Bank of New Zealand's view that, while the recent currency appreciation may have shifted the balance of risks, any further easing in monetary policy should be conditional on clear signs that resource pressures are easing and price inflation is set to remain comfortably within the target range over the medium term.

Directors viewed the Government's fiscal management approach as providing a solid medium-term anchor for fiscal policy. The objectives of running an operating surplus sufficient to meet the requirements for contributions to the New Zealand Superannuation Fund and keeping gross debt below 30 percent of GDP on average over the economic cycle provide adequate flexibility for fiscal policy to respond to cyclical pressures and should be easily understood and monitored by the public. Directors noted that over the longer term, the fiscal position faces substantial costs associated with the aging of the population. While acknowledging the significant uncertainties surrounding these projected costs, they suggested that measures to deal with these costs should be adopted sufficiently early to allow smoothing of the fiscal burden over time and to enable households to adapt their savings behavior appropriately.

Directors welcomed the favorable budgetary position projected for the next five years, but they noted the significant uncertainties regarding the size of prospective fiscal surpluses. They supported the authorities' cautious approach of postponing any new policy initiatives to the 2004 budget, by which time the strength of the underlying fiscal position may be clearer.

Directors agreed with the authorities' focus on promoting economic growth, and pointed to the labor market as a key area where policy changes can raise potential growth. They suggested that reducing disincentives for moving from welfare to work should help to further raise the labor force participation rate-already one of the highest among OECD countries. In particular, Directors saw merit in simplifying the income support system and making accompanying changes in the incentives provided through the income tax system. A few Directors also suggested that measures to tighten benefit requirements might be useful in encouraging labor force participation. Additionally, Directors noted that labor market flexibility has served the country well, and advised caution with respect to the introduction of measures to set wage levels or of new regulations that might impair it.

Directors noted that private and personal saving levels in New Zealand are low relative to the averages for OECD countries. They agreed, however, that there appear to be no major impediments or distortions adversely affecting savings behavior, with one possible exception-namely, the general expectation that the government will meet its future pension and health care obligations without significant changes in benefits or in the future tax burden. This possibility reinforces the need for the government to suitably address longer-term fiscal pressures in a timely manner. Directors advised against using the tax system for broad-based savings promotion purposes, although they acknowledged that some tightly focused measures may be useful.

Directors supported the basic objectives of the Government's Growth and Innovation Framework as a way of expanding New Zealand's links with the global economy and contributing to higher growth over time. Directors underlined the importance of economic diversification and urged the authorities to continue on the path of market-based reforms to accelerate growth. They advised caution on a more general interventionist role for the government in the economy, for example through significant direct assistance targeted at individual firms or specific sectors.

Directors noted that owing to New Zealand's economic structure and small size, trade policies in other countries impose significant costs on New Zealand and adversely affect its growth performance. They considered that progress in multilateral trade negotiations, especially in agricultural products, will be crucial for providing an important stimulus to growth. Bilateral trade agreements aimed at improving New Zealand's access to foreign markets should be comprehensive and designed to operate in a nondiscriminatory manner to minimize distortionary effects.

On external vulnerability, Directors agreed that New Zealand continues to be well placed to manage adverse economic shocks. Although the growth of foreign currency-denominated external debt and the shortening of its maturity in recent years might suggest some cause for concern, Directors felt that several important factors mitigate the foreign exposure risk to the financial system, including the credibility and soundness of economic policies, the robustness of the banking sector and its integration into global capital markets, and the high degree of hedging. Against this background, Directors looked forward to New Zealand's participation in the Financial Sector Assessment Program (FSAP) during 2003, which should improve understanding of potential vulnerabilities in the financial system as well as of New Zealand's distinctive approach to banking supervision, which emphasizes market-based supervision. In this regard, they welcomed the authorities' work in preparing for the FSAP review, including stress testing of the banking system based on risk factors specific to New Zealand.

Directors welcomed the significant progress made in dealing with anti-money laundering and combating the financing of terrorism issues, and looked forward to a full assessment during the FSAP review.

Directors encouraged the authorities to continue their efforts to improve the frequency, timeliness, and coverage of economic and financial statistics.