New Zealand -- 2009 Article IV Consultation, Preliminary Concluding Statement of the IMF Mission
March 23, 2009
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
March 23, 2009
Macroeconomic outlook and risks
1. After several years of strong growth, the New Zealand economy entered into recession in early 2008, dragged down initially by the end of the housing boom and a drought, and later by the global downturn. New Zealand is in a better position than most advanced countries to face the global storm, given its sound macroeconomic policies, including a flexible exchange rate, low level of public debt, flexible labor markets, and healthy banking sector.
2. The near-term outlook is weak. The global economy is undergoing its deepest recession since World War II, with real GDP projected to fall by 3½ percent in the advanced countries in 2009. While the depreciation of the NZ dollar cushions the blow from lower external demand, households are constrained by high debt levels, falling house and equity prices, and uncertain employment prospects. Business investment is also held back by a fall in confidence, weaker profitability, and to some extent tighter credit conditions. Staff expects the New Zealand economy to contract by about 2 percent in 2009, with a gradual recovery over the medium term. Downside risks in the outlook are high and linked to the unprecedented uncertainties surrounding the depth and duration of the global recession.
3. A key vulnerability for New Zealand is the high level of short-term external debt, mostly owed by banks. So far, good credit ratings and the depreciation of the exchange rate have allowed banks to refinance their external debt. Moreover, neither banks nor most borrowers have material exchange rate risk associated with their debt. However, a low probability but high impact event would be a loss of investor confidence in banks or the sovereign. This could lead to a further increase in the cost and/or reduced availability of external funding, which would require a more painful economic adjustment.
4. The fiscal position remained strong in 2007–08, with a surplus of 3 percent of GDP and positive net financial assets. Personal income tax cuts (staggered over three years) and increased expenditure introduced last year will provide a significant fiscal stimulus and help cushion the impact of the global downturn on New Zealand. However, the recent deterioration in the economic outlook, combined with the policy measures taken last year, have resulted in a sharp worsening in the fiscal projections over the medium term. On current policies, staff projects a deficit of 1½ percent of GDP in 2008–09 and about 6 percent of GDP by 2012-13, with gross public debt getting close to 50 percent of GDP by 2013. Such an increase in public debt would be larger than expected for the Euro area, but in line with forecasts for Japan, the U.K. and the U.S.
5. The staff shares the authorities’ concerns about the expected deterioration of the fiscal position. New Zealand’s high external debt constrains fiscal policy’s room for maneuver, given the risk of undermining investor confidence. In light of these concerns, there is very limited scope for additional fiscal stimulus beyond the sizable stimulus already in the pipeline.
6. Preserving investor confidence will require a credible strategy to reduce the deficit over the medium term. The mission is encouraged by Minister English’s statement that the increase in public debt projected in the Budget Policy Statement is outside of the range considered prudent, and that the government will not allow it to eventuate. Staff advises that concrete measures be laid out in the May 2009 budget to stabilize gross public debt in the medium term and bring it back to around the current level in the longer term.
7. The bulk of the measures to be taken for medium-term fiscal consolidation should aim to have an impact in 2010-11 and beyond, when growth is projected to recover. While the focus of this consolidation should be on the expenditure side given the increase in spending in recent years, the size of the required adjustment is large, and revenue measures will likely be needed to close the gap. Options for expenditure reduction include cutting low priority programs—preferably those with the least impact on demand in the near term—and improving ‘value for money’ in public sector services. Options for increasing revenue over the medium term should aim at minimizing the impact on long-term growth.
8. Given the downside risks to the economic outlook, medium-term projections should be based on conservative revenue assumptions. The mission encourages the authorities to prepare contingency plans in case the economic and fiscal outlook deteriorates further. In that event, the authorities should allow the automatic stabilizers to operate, but put in place offsetting measures that would reduce the deficit in the medium term.
9. Over the long term, key budgetary risks are the growing healthcare costs and public pension outlays. These risks should be addressed before the demographic pressures intensify, by reforming health care and the public pension schemes.
10. Falling oil prices and the downturn in activity, as well as tight monetary policy earlier on in the cycle, have helped ease inflationary pressures and reduce inflation expectations. Staff projects headline inflation to fall to less than 1 percent in December 2009 (year-on-year), and to return gradually to the middle of the 1-3 percent range by 2012-13.
11. The substantial easing of monetary policy since mid-2008 has been appropriate. The sizable reduction in the official cash rate over the last few months has largely, though not fully, been passed through to rates for new borrowing, particularly for residential mortgages. The monetary stimulus already in train should help support demand.
12. The Reserve Bank should continue to reduce the official cash rate. The outlook for growth and inflation is weak, credit growth is slowing, and credit standards have been tightened. Also, increased spreads on bank borrowing and lower inflation expectations have offset some of the impact on real lending rates. Finally, households with fixed rate mortgages will benefit from lower interest rates only with a lag.
13. The mission agrees with the authorities that further easing of monetary policy should proceed in smaller steps, and that rates should be set so that New Zealand remains competitive in international capital markets. By contrast with many advanced countries, monetary policy remains effective in New Zealand. However, the staff encourages the authorities to consider alternative instruments, including quantitative easing, and their potential efficacy in the unlikely event that such measures are needed.
14. The banking sector has weathered well the global crisis so far: it remains profitable, with low levels of nonperforming loans. The introduction in late 2008 of retail and wholesale funding guarantees for banks, and the extension of the Reserve Bank’s liquidity facilities, have supported confidence in the financial system. Banks’ offshore funding needs have been eased by the depreciation of the exchange rate, as foreign currency borrowing now provides more NZ dollars than a year ago. Moreover, new funding arrangements with parent banks have helped fill the gap left by the limited access to medium-term funding. Nevertheless, banks’ exposure to short-term external debt remains high.
15. Banks are also vulnerable to an increase in loan defaults. A sharp rise in unemployment could seriously affect the quality of mortgage books, while farmers are highly indebted and exposed to a fall in commodity prices. The mission welcomes the Reserve Bank’s current review of capital adequacy associated with agricultural lending. For other business loans and mortgages, banks should be required to conduct extreme stress tests to assess their vulnerability to a sharp jump in unemployment, a large drop in house prices, and a significant increase in funding costs. Banks’ capital is well above the regulatory minimum. However, if extreme stress tests were to point to the need for some banks to increase provisioning and raise capital, this should be done early, as it would be more difficult to raise capital from shareholders if banks come under stress. The key objective is to sustain banks’ strong balance sheets, which is crucial for maintaining access to offshore funding.
16. The mission encourages the authorities to push ahead with the implementation of prudential liquidity rules. It welcomes the decision to make the Reserve Bank the regulator of non-bank financial institutions, and the regulator and supervisor of the insurance sector. The mission also welcomes the ongoing collaboration with the Australian authorities on banking supervision, regulation, and crisis preparedness.
17. The sharp fall of the exchange rate since mid-2008 was driven by the narrowing of interest rate differentials and the fall in commodity prices. According to staff estimates, the depreciation brought the currency broadly in line with fundamentals and, combined with the domestic recession, should lead to a narrowing of the current account deficit over time.
18. Continued disruptions in global markets might hamper access to balance-of-payments financing. In this context, the government’s wholesale funding guarantee and increased term funding from Australian parents have provided important cushions. If in the event of a large shock these prove insufficient, official foreign exchange reserves, the government’s offshore borrowing capacity, and some use of the swap facility with the U.S. Federal Reserve should limit the extent of a disruptive economic adjustment. This underlines the need to maintain fiscal sustainability and strong sovereign ratings. The mission encourages the authorities to facilitate the expansion of term funding from Australian parent banks to their New Zealand subsidiaries.
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The IMF team has enjoyed the candid and interesting discussions, and much appreciates the authorities’ hospitality and thorough preparations for the mission.