New Zealand - 2010 Article IV Consultation Preliminary Concluding Statement of the IMF Mission
March 31, 2010
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.
1. New Zealand has been able to ride out the global financial crisis better than many other advanced countries. This was because of demand from fast-growing Asian markets and the robust Australian economy, a flexible exchange rate, and the absence of a banking crisis. In addition, a significant fiscal and monetary policy stimulus cushioned the blow from the global crisis. Nevertheless, the crisis highlighted long-standing vulnerabilities due to sizable household and external debt.
2. In the near-term, a gradual economic recovery is expected to continue. Accommodative fiscal and monetary policies are supporting domestic demand and real GDP is projected to expand by about 3 percent in 2010 and 2011. The unemployment rate is projected to lag the recovery and peak at 7½ percent in 2010. Over the medium term, growth is projected to fall back to our estimate of potential of about 21/3 percent. Nonetheless, the prospects of rebalancing toward the tradables sector have worsened with the recent strengthening of the New Zealand dollar, and we project the current account to widen over the medium term.
Risks to the outlook
3. On the external front, the main downside risks are that the global recovery stalls and Chinese demand drops sharply, with negative spillovers for commodity prices. In addition, , risk premiums could rise for countries with high external debt, such as New Zealand, which could raise the cost of capital, constrain growth, and worsen the current account deficit. An increase in global risk appetite is also possible, which may lead to a further appreciation of the exchange rate, making it difficult to rebalance growth toward the tradables sector. An upside risk is that a sharper-than-expected global recovery could raise export income.
4. On the domestic front, a stronger-than-expected recovery may force an earlier tightening in monetary policy, putting upward pressure on the exchange rate. However, faster-than-expected deleveraging by households and businesses may slow the recovery.
5. The strong fiscal position prior to the crisis allowed sizable fiscal easing that helped cushion the impact of the crisis. However, the medium-term fiscal outlook has worsened because income tax cuts and many of the spending initiatives were permanent and revenue projections have been revised down. As a result, cash budget deficits of about 3–6 percent of GDP are projected over the next 4–5 years.
6. The mission supports the fiscal stimulus through June 2010 and welcomes the government’s longer-term net debt target of 20 percent of GDP. Net core Crown debt is expected to rise from 5 percent of GDP to a peak of 30 percent of GDP by 2016, a smaller increase than in most advanced countries. Thereafter, net core Crown debt is projected to fall below 20 percent of GDP by 2024. We welcome steps taken to contain expenditure growth.
7. Nevertheless, we advise further spending restraint to return to surpluses earlier than planned. Faster consolidation over the next 3–4 years would take pressure off monetary policy and the exchange rate, thereby helping rebalance the economy toward the tradables sector and contain the current account deficit. The mission recommends returning the budget to surplus by 2014, unless the downside risks to growth materialize. This would achieve the 20 percent of GDP net debt target at an earlier date. The following considerations support faster consolidation:
• Upfront adjustment would create fiscal space as insurance against future shocks that may arise in coming years. A key lesson from the global financial crises is the desirability of fiscal space to run larger deficits when needed without raising market concerns about fiscal sustainability.
• Although public debt is projected to remain low by advanced country standards, New Zealand’s large gross external debt (over 130 percent of GDP) calls for greater prudence on the fiscal side. If global interest rates rise because of large sovereign and bank borrowing in advanced countries, low public debt would help contain the rise in New Zealand’s cost of capital.
• Our analysis shows that faster fiscal consolidation would lead to a depreciation of the exchange rate, a smaller sovereign risk premium, and a lower current account deficit.
• While the probability is extremely low, the government may need to take on more external debt should the banks once again have difficulty raising funds in global markets. This limits the extent to which public debt can be increased without hurting investor confidence.
• Finally, reaching a lower level of debt earlier than planned would put the budget in a stronger position to deal the fiscal costs of ageing.
8. Concrete measures to reduce spending should be introduced to return the budget to surplus earlier. Expenditure is projected to remain high at 34 percent of GDP by 2015 compared with 31 percent of GDP in 2008, mainly because of higher social spending. There is scope to better target transfers to households and improve the efficiency of public service provision and capital spending. The mission recommends adopting a commitment to save any positive revenue surprises and to consider the introduction of spending caps.
9. Tax reforms could help raise potential growth. Shifting the tax burden from income to consumption–as suggested by the Tax Working Group–would raise incentives to work and invest, thereby increasing growth over the medium term and improving competitiveness. Reducing tax incentives to invest in rental properties may help improve the allocation of capital. Our analysis suggests that a 1 percent of GDP shift of capital and labor income taxes to GST would likely raise the level of real GDP by almost 1 percent after 5-6 years.
10. To address longer-term pressures on the budget, early steps should be taken to contain the projected growth in health care and pension costs. Measures could include improving the efficiency of health care spending and linking the pension eligibility age to life expectancy.
11. The mission supports the current accommodative monetary policy stance and the RBNZ’s intention to gradually return to neutral rates once the recovery is well established. Over the next few years, inflation is likely to stay within the RBNZ’s 1–3 percent target albeit toward the upper end of that range. We estimate that the output gap will not close before 2013. Inflation is being limited by a tightening in monetary conditions over the past year with the appreciation of the currency, higher medium-term interest rates, and an increase in funding costs of banks, as they compete for retail deposits.
12. The rising wedge between the policy rate and bank funding costs suggests that the neutral policy rate is likely to be lower than in the past. Moreover, when the RBNZ begins to tighten, the transmission of the policy rate to mortgage rates should be relatively fast, as many households have refinanced mortgages at variable rates. In a downside scenario, monetary policy still has room to be loosened.
13. The inflation targeting framework served New Zealand well during the global financial crisis. The official cash rate (OCR) was high before the crisis, at 8¼ percent, because of monetary tightening in response to inflationary pressures in 2007/08. The framework was flexible enough to allow a substantial cut in the OCR to 2½ percent by early 2009. The cuts were largely, though not fully, passed through to rates for new borrowing, unlike in some advanced countries. Importantly, the inflation target effectively anchored medium-term inflation expectations and was helpful in reducing the likelihood of deflation in the midst of the recession.
14. The present inflation target of “1–3 percent on average over the medium term” is appropriate and consistent with international best practice. Increasing the inflation target would provide no clear benefits in the New Zealand context, and may entail a number of costs, including greater inflation uncertainty and reduced credibility of the authorities’ commitment to price stability. In turn, this could lead to a higher cost of capital and lower potential growth given New Zealand’s reliance on international capital markets to fund current account deficits and rollover sizable external debt.
15. Banks remain sound but faced some funding difficulties during the global crisis. Nonperforming loans have increased to about 1½ percent of total loans, but banks raised capital and provisioning. The wholesale funding guarantee helped them obtain term funding until they were able to access the market directly late last year. Banks have increased liquid assets and lengthened the maturity of their wholesale funding.
16. A key domestic vulnerability is banks’ exposure to household debt of over 150 percent of disposable income. However, this exposure proved to be relatively low risk in the recent recession. Factors mitigating the mortgage risks include the fall in mortgage rates, the absence of a sharp rise in unemployment, and only a small fall in house prices. Nonetheless, risks remain. House prices are high relative to historical price-to-income ratios and debt-service burdens will rise with a return to neutral policy interest rates. Other vulnerabilities include banks’ significant exposure to dairy farming, where global prices have been volatile, and to commercial property and small and medium-sized enterprises.
17. A conservative approach to bank regulation and supervision helped banks weather the crisis. As a result, banks had relatively low leverage and high capital adequacy with Tier I ratios of 7-8 percent in 2007. In implementing the Basle II framework, the authorities required the banks to hold higher capital buffers than in other countries. For example, a 20 percent loss given default floor was adopted for residential mortgages, which is higher than the Basel II 10 percent floor. We welcome the Reserve Bank’s current review of capital adequacy associated with agricultural loans.
18. The mission supports closer collaboration with Australian authorities on regular stress tests and crisis management. The tests use more extreme scenarios than in past exercises, reflecting the international experience with the financial crisis. Capital and provisioning should be strengthened if these tests suggest the need. We welcome the crisis management toolkit, developed with the Australian authorities, and the intention to undertake a Trans-Tasman crisis management exercise in 2011.
19. In response to the crisis, discussions are ongoing in international fora to improve regulation and supervision of the financial sector. We support the Reserve Bank’s intention to investigate the costs and benefits of potential macro-prudential policy tools, particularly some of the proposals coming out of the Basel Committee on Banking Supervision. Some of these macro-prudential measures may be useful to manage risks arising from excessive bank credit growth during upswings. However, it is important to keep the lending channel to the private sector open, and balance the benefits of these measures against the risk of encouraging intermediation outside regulated institutions.
Exchange rate and external vulnerability
20. The free floating exchange rate regime remains appropriate, as it enables an independent monetary policy and provides a useful buffer against shocks. Prior to the crisis the RBNZ was able to increase the policy rate to contain inflationary pressures fuelled by the housing boom. Moreover, the flexible exchange rate has moved broadly in line with world commodity prices and thereby reduced the volatility of New Zealand farm incomes.
21. While there is uncertainty, our estimates suggest the currency is presently overvalued by 10-25 percent. Part of the overvaluation may be temporary and the exchange rate may depreciate as the interest rate differential narrows with eventual tightening by the U.S. Federal Reserve. Assuming the exchange rate remains at present levels, we project the current account deficit to widen to over 8 percent of GDP by 2015.
22. Low household saving is a fundamental factor behind large current account deficits and rising external debt in recent years. Our analysis suggests that a shift of the tax burden from income to consumption would raise household savings. In addition, higher government savings would contribute to higher national savings.
23. High external debt remains a key vulnerability, especially short-term debt. While short-term external debt has fallen and market conditions have improved in the past year, rollover risks remain as short-term external debt is high by advanced country standards.
24. The mission welcomes the introduction by the RBNZ of a prudential liquidity policy, including a core funding ratio, which should reduce banks’ reliance on short-term external funding. Banks are already substantially lengthening their debt and planned increases in the core funding ratio over the next two years will further reduce their vulnerability to short-term external debt. However, if needed the core funding ratio could be increased more than currently planned.
25. Vulnerabilities related to external debt would be reduced by structural reforms to raise productivity and labor force participation, thereby lifting potential growth and export capacity. The government is considering a number of reforms with this aim, including tax and benefit reform, streamlining regulation, and establishing a Productivity Commission.
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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.