Mission Concluding Statement 

April 2, 2012

Overview. The authorities’ current macroeconomic policy stance is appropriate. With output below potential and expected inflation within the target range, monetary policy should remain accommodative for now, and should act as the first line of defense against near-term adverse shocks. The authorities’ planned deficit reduction path strikes a balance between the need to limit both public and external debt increases while containing any adverse impact on economic growth during the recovery. The financial sector is currently sound, and the authorities should ensure that banks’ liquidity and capital buffers are adequate given banks’ dependence on offshore wholesale funding and their exposure to highly leveraged households and farmers.

Supporting Near-Term Recovery

Output and inflation. The pace of New Zealand’s economic recovery is likely to remain modest. Output growth should pick up somewhat in 2012 as earthquake reconstruction spending is expected to gain pace, although the size and timing of this spending is still uncertain. Other sources of demand will remain soft, however, as global growth prospects have worsened and households are still highly leveraged and will need to save to strengthen their balance sheets. The spare capacity and elevated unemployment will contain wage and inflation pressures in the near term.

Monetary policy stance. Under these conditions, the current accommodative monetary policy stance is appropriate. The Reserve Bank of New Zealand (RBNZ) lowered the policy rate in March 2011 to cushion the impact of the February earthquake, and has since kept the rate on hold given a stronger exchange rate, soft domestic demand, and benign inflationary expectations. With the shift toward floating rate mortgages in recent years, household consumption should be more sensitive to interest rate changes, allowing the RBNZ to remove the monetary stimulus fairly quickly when required.

Managing near-term risks

External risks. Emerging weaknesses in the global economy and a possible upheaval in the global financial system pose risks. The main channels are:

• Lower export demand. Australia and China are the top two destinations for New Zealand exports, leaving growth prospects vulnerable to their economic outlook.
• Worsened terms of trade. Prices for New Zealand’s commodity exports are largely underpinned by demand from global markets. Falling demand could significantly weaken the terms of trade from recent historically high levels. However, declines in commodity prices in the past have been offset to some extent by a weakening of the exchange rate, helping to buffer the impact on the domestic economy.
• Increased cost of external funding. While New Zealand banks have little direct asset exposure to European borrowers, they do rely heavily on offshore wholesale funding. A worsening of global financial conditions could raise the cost of this funding, putting upward pressure on interest rates for domestic firms and households.
• Rollover risks. Banks’ persistent reliance on offshore wholesale funding leaves them vulnerable to the tail risk of a temporary shutdown of global funding markets. While the probability of this event is difficult to determine, it has fallen since late 2011. In addition, banks are less vulnerable than during the market disruption in late 2008, as the share of retail deposits and the average maturity of bank liabilities have been steadily increasing over the last three years and the source of funding is diversified across different regions and products.

Housing sector risks. Although affordability ratios and debt servicing ratios have recently improved, house prices still remain elevated. A sudden price correction, possibly triggered by higher borrowing costs or a shock to household incomes, could reduce consumer confidence, worsen banks’ balance sheets, and impair the economic recovery. The likelihood of this risk materializing in the near term, however, is low.

Tail risks and downside scenarios. Many of the above risks are highly linked—for example, a hard landing in China, which would negatively affect Australia, would consequently reduce demand for New Zealand exports, worsen terms of trade, and could trigger a sudden decline in house prices. This could in turn weaken consumer demand and growth, and negatively affect banks’ balance sheets. The downside macroeconomic impact of such a scenario could be substantial.

Managing risks. The authorities have policy space to respond to near-term shocks, with monetary policy serving as the first line of defense. The RBNZ has the scope to lower interest rates and loosen monetary conditions to help buffer against a downside scenario. As evident during the crisis, the free-floating New Zealand dollar provides an additional cushion against external shocks, including disruptions to offshore funding and a negative terms of trade shock. The authorities would also be able to provide emergency liquidity support to banks, a measure which proved effective when wholesale markets shut down in the wake of the 2008 crisis. Moreover, New Zealand’s relatively modest public debt gives the authorities some scope to delay their planned deficit reduction path in the event of a sharp deterioration in the economic outlook.

Reducing External Vulnerability

Current account. Reflecting low national saving relative to investment, New Zealand has run persistent current account deficits resulting in large net external liabilities. Deficits are expected to widen this year as terms of trade decline and earthquake reconstruction activity gathers pace. Increasing national saving would be an important part of reducing net external liabilities, and much will depend on whether the recent increase in the household savings rate represents a structural break from the past. Fiscal deficit reduction (discussed below) would also contribute to raising national savings and reducing future current account deficits.

Exchange rate assessment. New Zealand’s free floating exchange rate regime is expected to play a role in reducing external vulnerabilities. Our analysis suggests that the New Zealand dollar is currently stronger than would be needed to bring the current account deficit to a level that is sustainable over the longer term. However, part of the current strength of the New Zealand dollar reflects the positive interest rate differentials with major currencies which may dissipate with eventual tightening by the central banks.

Increasing Public Savings

The government’s deficit reduction plan. Reflecting the recession, past revenue and spending decisions, and the impact of earthquake-related spending, the fiscal deficit (on an accrual basis) reached a record high of 9¼ percent of GDP in 2010/11, raising net government debt to 20 percent of GDP by mid-2011 from a low of 5½ percent in 2008. The government’s medium-term deficit reduction plan is aimed at limiting the increase in public debt to preserve the fiscal space to guard against future economic risks and at contributing to lowering external debt. To this end, the 2011/12 budget plans to reduce the fiscal deficit to about 6 percent of GDP, and return to budget surplus by 2014/15, mainly through spending control. According to this plan, net government debt would peak at about 30 percent of GDP in 2015, and decline to 20 percent of GDP by 2021. We support the government’s ongoing efforts to keep the deficit reduction path on track.

Benefits of this plan. The pace of deficit reduction entails an improvement of about 5 percent of GDP in the structural balance over the next five years. In our view, this strikes the right balance between the need to limit public debt increases while containing any adverse impact on economic growth during the recovery. Specifically:

• It contains the aggregate demand impact by withdrawing fiscal stimulus in line with expected increases in private sector and earthquake-related reconstruction spending.
• It creates fiscal space to help the country cope with a possible sharp reduction in domestic economic activity or potential liabilities associated with future adverse shocks. Over the longer term, it will create space to deal with aging and rising health care costs.
• It will limit pressure on monetary policy and therefore the exchange rate, helping reduce the current account deficit.
• It could contribute to containing the increase in New Zealand’s large net foreign liabilities.

Maintaining Financial Stability

The banking sector is dominated by four large subsidiaries of Australian banks that have proved resilient to the recent turbulence in the global financial markets. Since then bank profits have increased and nonperforming loans have fallen to less than 2 percent of total loans. Banks’ balance sheets remain fully hedged against exchange rate risks. Capital adequacy has improved since 2007, and all banks are well positioned to meet the Basel III capital requirements. In fact, the RBNZ currently requires that capital ratios be determined using more conservative risk weights and loss-given-default standards than in many other countries. The RBNZ has continued to strengthen regulation and supervision of nonbanks.

Balance sheet risks. On the asset side, banks’ large exposure to highly indebted households and to the agriculture sector is a key vulnerability. Household debt remains high at about 150 percent of disposable income, and a rise in mortgage rates together with an increase in unemployment could lead to an increase in nonperforming loans. A large fall in dairy and meat prices would reduce the quality of agricultural loans but the capital requirements for these loans have been strengthened since mid-2011. On the liability side, banks have made steady progress in lengthening the maturity profile of their wholesale funding since 2008 and increasing the share of retail deposits, but the total stock of banks’ gross external liabilities remains above 70 percent of GDP and loan-to-deposit ratios remain high.

Prudential measures. We support the authorities’ intention to implement key features of Basel III in early 2013. At the same time, we encourage the authorities to assess on an ongoing basis the balance between banking sector soundness and efficiency to ensure that the systemically important banks’ large wholesale funding needs and their exposure to highly leveraged households and farmers do not pose a sizable potential fiscal liability. The proposed Open Bank Resolution framework could help ensure business continuity and limit the fiscal costs of bank failure. Other options to strengthen prudential norms could include setting banks’ capital requirements above the Basel III minimum or raising the core funding ratio more than the planned 75 percent. The IMF’s upcoming review of the Australian financial sector (FSAP), which will also cover New Zealand banking subsidiaries, should be useful for New Zealand in assessing appropriate prudential norms.

Stress tests. Stress tests of banks in 2009-10 (conducted together with the Australian authorities) show resilience to higher unemployment and a sharp fall in property prices, but did not include funding shocks. Future stress tests could be more stringent and include a disruption to bank funding and a large increase in longer-term interest rates.