New Zealand 2011 Article IV Consultation--Preliminary Concluding Statement
March 21, 2011
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.
Macroeconomic Outlook and Risks
1. New Zealand’s recovery has stalled since mid-2010. Domestic demand has remained soft, as cautious households and businesses look to strengthen their balance sheets by slowing debt accumulation amid a weak housing market and an uncertain outlook. Moreover, two earthquakes have caused substantial damage and disruption to activity in the Canterbury region, which accounts for about 15 percent of the national economy.
2. Large uncertainty surrounds the economic outlook, particularly related to the size and timing of reconstruction from the Canterbury earthquakes. We assume that the total damage from the earthquakes amounts to NZ$15 billion (about 7½ percent of 2011 GDP), of which residential buildings account for NZ$9 billion. In the near term, the earthquakes will slow activity, with growth projected at 1 percent in 2011, supported by elevated terms of trade and the Rugby World Cup later in the year. Assuming that the bulk of reconstruction takes place during 2012-16, we project growth to rise to 4 percent in 2012 and converge to the estimated potential rate of 2⅓ percent in outer years.
3. Risks are tilted to the downside.
• On the external front, a faltering of emerging Asia’s rapidly growing demand for commodities could adversely affect exports and income, directly through lower commodity prices and indirectly through negative spillovers from Australia. Moreover, New Zealand’s large net foreign liabilities expose it to a possible rise in long-run real interest rates as a result of high funding requirements of banks and sovereigns in advanced economies. The Japan earthquake, unrest in the Middle East and North Africa, and volatile oil prices add uncertainty to the global outlook.
• Domestically, the recent earthquakes may have a greater-than-expected negative impact on confidence and growth. In addition, a sharp fall in house prices, which appear overvalued, would hit household balance sheets, likely depressing domestic demand and encouraging further deleveraging. Similar falls in Australian house prices, which also appear overvalued, could spill over to New Zealand, given the strong links in the business cycle.
• Upside risks stem from a faster-than-expected recovery in major advanced economies pushing up commodity prices or stronger spillovers from Australia. Faster-than-expected reconstruction in Canterbury could create bottlenecks and push up inflation.
4. The recent reduction in the Official Cash Rate (OCR) was appropriate given that the economic outlook has weakened. Lowering the OCR reduces the risk that the earthquakes lead to a severe downturn. The output gap remains sizeable (about -3 percent for early 2011) but we project it to close around 2013/14 as reconstruction proceeds. At present, inflation expectations for two years ahead are below 3 percent, the upper end of the Reserve Bank of New Zealand’s (RBNZ) target band despite a series of shocks to headline inflation from the increase in the goods and services tax (GST), the expansion of the Emissions Trading Scheme, and higher global oil and food prices.
5. To contain inflationary pressures, monetary policy will need to be tightened when it becomes clear that the recovery is under way. A shift toward floating rate mortgages in recent years and high household debt mean that consumer demand is more sensitive to interest rate hikes. Therefore, the effect of monetary stimulus could be removed relatively quickly. Higher marginal bank funding costs relative to the policy rate imply a lower neutral policy rate (around 4½ percent) than in the past. Moreover, with inflation projected to be in the upper range of the target band for several years, the RBNZ needs to guard against medium-term inflation expectations becoming anchored at too high a level.
6. If growth falters or global financial markets are disrupted again, the RBNZ has scope to cut the policy rate and provide liquidity support for banks if necessary. This proved effective in the recent crisis. The flexible exchange rate also provides an important buffer.
7. Reflecting the impact of the earthquakes and slower-than-expected economic recovery, we project the 2010/11 fiscal deficit to reach 9 percent of GDP, much larger than budgeted. We assume that the earthquakes increase public expenditure in the current fiscal year by NZ$6.5 billion (on an accrual basis), including expenditure of NZ$3 billion funded by the Earthquake Commission. The sharper-than-expected increase in the fiscal deficit is an unavoidable consequence of the earthquakes and raises net core Crown debt (excluding assets of the Superannuation Fund and advances) to 22½ percent of GDP by June 2011.
8. We advise returning to fiscal surpluses by 2014/15, if the economic recovery proceeds as expected. Prior to the February earthquake, the Prime Minister announced the intention to return to a small surplus by 2014/15, one year ahead of the government’s earlier plan. The earthquakes have worsened the deficit in the near term, but in our view it is both feasible and desirable to stick to the medium term target for the following reasons:
• Fiscal consolidation would create a buffer against future shocks. It would also relieve pressure on monetary policy and thereby the exchange rate, helping rebalance the economy and contain the current account deficit.
• Although public debt is projected to remain low by advanced country standards, New Zealand’s large net foreign liabilities (about 85 percent of GDP) calls for fiscal prudence. If global interest rates rise, low public debt would help contain the rise in New Zealand’s cost of capital.
• In a tail risk scenario where banks’ asset quality deteriorates sharply, they present a contingent fiscal liability that limits the extent to which public debt can be raised without hurting investor confidence.
• Reducing net public debt to below 20 percent of GDP over the next ten years would put the budget in a stronger position to deal with the fiscal costs of aging.
9. We encourage the government to take concrete measures to control spending and thereby strengthen the credibility of budget plans. Even excluding earthquake-related expenses, government expenditure has risen significantly in recent years (up by 6 percent of GDP over the 6 years to 2010/11). Over the same period, the structural balance deteriorated from a surplus of 3 percent of GDP to a deficit of 5 percent of GDP in 2010/11. Reducing expenditure relative to GDP would be needed to return to structural surpluses. To this end, there is considerable scope to trim transfers to middle-income households, rationalize capital spending (which is high by advanced country standards), and improve the efficiency of public service provision.
10. We also welcome the government’s plan to better manage its balance sheet, including its intention to consider selling a stake in state-owned enterprises. The government could also consider selling other assets, which would help reduce gross public debt and may limit the increase in New Zealand’s borrowing costs.
11. We support the government’s intention to save excess revenue. Higher-than-expected growth, possibly arising from higher commodity prices, could boost tax revenue. In a downside scenario of lower growth, there is some limited space to delay the exit from budget deficits, while taking credible measures to return to structural surpluses over the medium term.
12. We welcome the tax reform announced in the 2010/11 budget, including by increasing the GST rate from 12½ to 15 percent, cutting personal income tax rates, and reducing tax incentives to invest in properties.
13. In the long term, the budget faces considerable pressure from aging and rising health care costs. To contain the public share of costs in these areas, policy action will be needed. Health care spending growth could be reduced by improving the efficiency of delivery and the public pension cost increases could be contained by raising the retirement age and moving away from full indexation of benefits to wage increases.
Financial sector stability
14. The soundness of the banking sector was crucial to the resilience of the economy during the global financial crisis. The banking sector remains profitable and tier one capital adequacy has improved to about 10 percent. Nonperforming loans have increased to 2 percent of total loans, still low by advanced country standards, and sound regulation and supervision helped maintain stability.
15. Banks’ exposure to highly indebted households and farmers and sizeable short-term offshore borrowing remain key vulnerabilities. House prices appear overvalued and a sharp decline would create strains. While banks’ exposure to high risk mortgages is low and household net wealth (mainly housing) exceeds 500 percent of disposable income, household debt exceeds 150 percent of disposable income. A large fall in commodity prices would impair the quality of agricultural loans.
16. The potential risks are mitigated by the RBNZ’s conservative prudential supervision. In implementing the Basel II framework, the RBNZ required banks to assume higher rates of loss-given-default than in many other countries. We welcome the RBNZ’s current review of capital adequacy associated with agricultural loans. For household and corporate lending, we would encourage the RBNZ to review assumptions regarding probability-of-default and loss-given-default in light of recent experience in countries where banks incurred large losses.
17. We support continued cooperation with the Australian authorities to conduct stress testing. Last year’s joint stress test results suggest banks’ resilience to sizeable but plausible shocks. The test results for New Zealand banks as a whole could be published. However, a more severe downside scenario of a sharp fall in commodity and house prices and a jump in global longer-term interest rates could hurt growth and raise unemployment for a substantially longer period than in the recent stress tests. We recommend explicitly including funding risk in future scenarios, encompassing a disruption to bank funding and a large increase in longer-term real interest rates. The latter could come from a rise in global rates and an increase in New Zealand banks’ risk premium.
18. We encourage the authorities to consider the merits of raising bank capital gradually to levels significantly above the Basel III requirements for New Zealand banks as a buffer against negative shocks. The four large banks alone comprise about 80 percent of the banking system and their assets amount to almost 160 percent of GDP. Given their size, they are perceived as too big to fail and pose a sizeable contingent fiscal liability. While the proposed “open bank resolution” could help limit the fiscal costs of a bank failure, higher capital requirements could reduce the fiscal risk further. In addition, higher capital buffers would limit the risk that a deterioration in bank asset quality could raise their cost of capital and create offshore funding difficulties.
19. We welcome the RBNZ’s continued work on the costs and benefits of potential macroprudential measures. A large number of macroprudential tools are being discussed internationally. The introduction of a core funding ratio for banks in April 2010 may help constrain excessive credit growth during upswings. Some other measures such as countercyclical capital requirements and loan-to-value ratios could be introduced, depending on the specific conditions faced.
20. Initiatives to improve crises management are welcome. The planned Trans-Tasman crisis management exercise with Australia later this year is an important step to identify possible challenges in a banking crisis.
External vulnerability and saving
21. Reflecting low national saving, New Zealand has run current account deficits for three and a half decades. The result is high net foreign liabilities of about 85 percent of GDP (mostly debt). In 2011, we expect the current account to be close to balance due to continuing weak domestic demand, terms of trade gains, low world interest rates, and re-insurance inflows related to the earthquakes. However, as the recovery gathers pace and world interest rates rise, we project the current account to deteriorate to a deficit of about 7 percent of GDP in 2016, which would raise net foreign liabilities above 90 percent of GDP.
22. Our analysis suggests, subject to large uncertainties, that the New Zealand dollar is overvalued by 5 to 20 percent from a medium term perspective. Part of the overvaluation reflects the positive interest rate differential, which may dissipate with eventual tightening by major central banks.
23. The core funding ratio has contributed to a substantial decline in banks’ reliance on short-term offshore funding. However, short-term external debt remains high at 50 percent of GDP, exposing the economy to funding risks. Therefore, we advise that the core funding ratio be increased more than planned over time to reduce short-term external debt further.
24. As evident during the crisis, the flexible exchange rate provides an important buffer against shocks, including possible disruptions to offshore funding. A large depreciation of the New Zealand dollar would reduce the U.S. dollar funding needed to meet banks’ desired domestic funding.
25. Raising national saving is key to containing the projected increase of the current account deficit. In our view, fiscal consolidation is the surest way to raise national saving. Our analysis for New Zealand suggests that a 1 percent of GDP increase in public saving would raise national saving by about ⅓-½ percent of GDP. Population aging over coming years in New Zealand will likely put downward pressure on the private saving ratio, as a growing share of the population begins to drawdown their savings to fund retirement. This implies that a sizeable increase in public saving may be needed to raise national saving.
26. We support the recommendations of the Savings Working Group on tax reform. They include indexation of interest income and expenses for inflation and further shifts from income to consumption taxation over the medium term, while maintaining the broad base for the GST. We would also advise continuing efforts to broaden the tax base, including looking at capital gains tax settings and introducing a land tax, in order to fund growth enhancing tax rate reductions.
27. 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. We welcome efforts to streamline regulation and improve government service provision. In addition, the recent report of the Welfare Working Group has identified major deficiencies in New Zealand’s welfare system that need to be addressed. We support the working group’s recommendation to reduce long-term benefit dependency by encouraging beneficiaries to seek employment.
28. We welcome the recent publication by Statistics New Zealand of institutional accounts that improved household and corporate saving data. We also encourage the authorities to subscribe to the IMF’s Special Data Dissemination Standard and present fiscal data in line with the IMF’s Government Financial Statistics Manual.
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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.