Public Information Notice No. 00/91

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

October 27, 2000

On October 13, 2000, the Executive Board concluded the 2000 Article IV consultation with New Zealand.¹

Background

Following the strong recovery in late 1999, growth in economic activity slowed markedly in the first half of 2000. A rebound in the agricultural sector following two successive droughts and strong domestic demand caused a sharp acceleration in growth in the second half of 1999, and resulted in an expansion in real GDP of 3½ percent for the year as a whole. Since the beginning of 2000, the composition of growth has shifted sharply toward net exports, and away from domestic demand. The recent decline in domestic business and consumer confidence and the fall in the $NZ to historical lows — attributed to large current account deficits, the perception that New Zealand is in a relatively weak position to benefit from the productivity gains of the “new” economy, as well as to some recent changes to government policies — has reinforced this shift. Forward indicators confirm that the strength of activity is likely to be different across sectors. Declining building consents, continued weak credit growth, and a moderation in retail sales and capacity utilization rates all point to slow domestic demand, but business confidence surveys indicate optimism about the outlook in externally oriented sectors.

Inflation remained low during 1999 and early 2000, despite the fall in the exchange rate and the tightening in input markets, as competitive pressures in both manufacturing and retail sectors have limited the pass through of higher costs onto final consumer prices, but there are now signs of pipeline price pressures. Through the first quarter of 2000, the unemployment rate declined rapidly to the lowest level since 1996, and capacity utilization rates rose sharply. The target measure for inflation, however, remained between 1 and 1¼ percent during most of 1999, before moving slightly above the mid-point of the band (0-3 percent) in March 2000 and to 2 percent in the June quarter (mainly because of one off-factors, such as higher fuel prices and tobacco and alcohol excises).

The current account deficit widened to 7 percent of GDP in the year to Q2, 2000 but is likely to narrow considerably in 2000. The widening deficit reflected rapid import growth in 1999 as well as the deficit on the income account — in turn, reflecting New Zealand’s high external indebtedness (net foreign liabilities are around 100 percent of GDP). After subdued agricultural export growth in 1999, export growth has been strong since early 2000, largely because of the boost to competitiveness from the fall in the real effective exchange rate this year and the recovery in farm output from the effects of the drought.

With the unexpectedly sharp recovery in output since mid-1999 and the resultant narrowing of the output gap, the RBNZ launched a monetary policy tightening cycle in November 1999, raising the Official Cash Rate five times (from 4½ percent to 6½ percent) through May 2000. However, citing the uncertain outlook for the period ahead, the RBNZ left the OCR unchanged at its August review.

The 2000/01 budget targets an operating surplus of 0.9 percent of GDP — consistent with a broadly unchanged fiscal policy stance — and increasing structural surpluses in the medium term. On the expenditure side, the budget places additional emphasis on social spending and industrial policy, while revenue growth is expected to exceed GDP growth owing to the tax increases implemented earlier in 2000. The government has reiterated its pre-budget commitment to adhere to a cap for new spending initiatives of $NZ 5.9 billion over the next three fiscal years. However, some two-thirds of that amount has already been committed, leaving a very tight constraint on spending for the rest of the term. Over the medium-term, operating surpluses are projected to rise steadily to 2½ percent of GDP in 2003/04, with a similar increase in the structural balance, and net debt is to fall to 16½ percent of GDP.

The new government has launched a number of initiatives to review and revise some aspects of structural policies. Key amongst these include a change in the industrial relations framework through the replacement of the Employment Contracts Act (ECA) with the new Employment Relations Act (ERA) strengthening the role of labor unions; the removal of the provisions for a competitive insurance market for workplace accidents introduced only in 1999 and the reinstatement of the state-run ACC as the monopoly provider; a review of competition policy; the freezing of previously planned unilateral tariff reductions; a review of monetary policy operations; and the proposed introduction of partial prefunding of public pension costs to smooth the transition associated with demographic changes.

As for the near- and medium-term outlook, the staff’s projections are for output growth of about 3¾ percent in calendar year 2000 and to 2½-3 percent over the medium term. There are, however, considerable downside risks to these growth projections. The strong trading partner outlook and the large real effective depreciation of the exchange rate are expected to continue to provide a boost to exports, while the higher interest rates and falling confidence are expected to act as a dampener of domestic demand. These trends are projected to result in a narrowing of the current account deficit to about 6 percent of GDP in 2000, before tapering off gradually to around 4 percent by 2005. With little prospect of a strengthening of the $NZ in the near future and the long period of tightening margins, the pass-through to inflation of higher import prices should broaden, making it very likely that inflation will breach the upper band of the target range by the end of 2000. For the year as a whole, CPI inflation is forecast to be around 2½ percent in 2000 and 2001, and slightly above the mid-point of the target range over the medium term.

Executive Board Assessment

Executive Directors considered the resilience displayed by the New Zealand economy through the turbulence of the past 2-3 years as being clear testimony of the benefits of the economic reforms of the past 15 years. Following a short-lived recession in 1998, growth recovered strongly in the second half of 1999, owing to appropriate macroeconomic management, favorable weather conditions, and the recovery in the region; inflation remains under control; the current account deficit-albeit still high-now looks set to narrow markedly; and the financial and corporate sectors have fully absorbed the impact of the adverse shocks of the past 2-3 years without distress.

Directors endorsed the recent conduct of monetary policy and noted that the key challenge for the period ahead is to steer the economy pragmatically to support growth while avoiding a buildup of inflationary pressures. Although slowing activity suggests that the balance of risks may have shifted away from a sustained increase in inflationary pressures, Directors considered that, if a further tightening of monetary policy over the coming year became necessary, such tightening should be gradual and continuously reassessed in light of the uncertainty surrounding the strength of economic activity.

Directors regarded the targeted near- and medium-term fiscal operating surpluses as being appropriate from a demand management point of view and from the point of view of contributing to reducing external imbalances. However, they saw mainly downside risks to the achievement of these objectives, both because of weaker revenues resulting from lower growth, as well as the tight constraint on discretionary spending for the rest of this government’s term. Because a key driver of sentiment is the market’s perception of the government’s ability to control public finances, Directors urged the authorities to keep a close watch on expenditures and to formulate well-specified contingency plans to offset possible slippages in achieving the targeted surpluses.

Directors noted that the large external imbalances and the fact that growth in New Zealand has not been sufficient to close more rapidly the gap with other advanced economies remain key policy concerns. In this context, they took the view that the reexamination of elements of the reform process may be appropriate. However, in light of New Zealand’s vulnerability to external investor sentiment, it is especially important that the economic rationale for policy changes be well understood lest they be seen by markets as a step backwards, with attendant negative effects on investor confidence. At the same time, Directors sympathized with the authorities’ view that trade restrictions in partner countries are hampering growth.

Directors took the view that, to increase the growth dividend, additional actions are necessary in some areas, while in others there is a need to avoid the risk of weakening the gains that have already been achieved. They noted that the authorities’ focus on human capital development is appropriate, but pointed out that the increase in tax rates on high-income earners could exacerbate the country’s “brain drain.” Directors welcomed the ongoing reforms to deregulate parts of the agricultural sector, and recommended more rapid progress in deregulating the dairy sector. It was noted, however, that limits to expansion of this sector arise from partner country protection.

Directors cautioned against undertaking reforms that could reduce labor and product market flexibility, and suggested that the authorities be flexible and pragmatic in implementing such measures. Chief among these are the Employment Relations Act and the restoration of the ACC as the monopoly provider of workplace accident insurance. In this regard, it was noted that the review of the telecommunications sector was intended to enhance competition. Directors noted that efforts to coordinate and integrate ongoing economic and industry development programs are useful, but suggested that the role of Industry New Zealand be tightly specified from the start so as to prevent a drift into activist industrial and regional development policies.

Directors commended the authorities for their proposals to address the longer-term pressures on public pension expenditure. They expressed broad support for the authorities’ plans to pre-fund a part of future pension liabilities by building up a separate trust fund, and sought early progress in defining institutional arrangements and the investment strategy to safeguard the fund’s assets. Directors also suggested that consideration be given to parametric reforms to lower future pension costs and encourage private saving.

As for private saving, Directors considered that the recent increases in top income tax rates and in the pension benefit rate could lower private saving, and suggested that the forthcoming comprehensive review of the tax and transfer regimes focus on clearly identifying and removing disincentives to private saving and to productive investment.

Directors welcomed the fact that the primacy of the price stability objective and the autonomy of the Reserve Bank of New Zealand are not subject to review in the upcoming monetary policy review. They observed, however, that the inclusion of additional clauses in the contract that governs the conduct of monetary policy could reduce the clarity of the framework and, over time, could complicate monetary policy formulation. Directors also cautioned against actions that could be perceived as weakening instrument independence of the Reserve Bank.

As for New Zealand’s external vulnerability, Directors noted that the country continues to be well placed to absorb shocks without undue economic or financial distress, as evidenced by the experience of adjustment to shocks over the past few years. In particular, the high degree of hedging tends to mitigate the external vulnerability of New Zealand’s economy. However, the large external imbalances imply that New Zealand remains vulnerable to sharp changes in investor sentiment. Thus, policymakers have to be especially mindful of the effects of their actions on confidence and focus on policies that are clearly aimed at reducing disincentives to saving, and improving the economy’s competitiveness and medium-term growth prospects.

Directors commended the authorities for the high quality of economic and financial statistics and welcomed the efforts to improve the frequency, timeliness, and coverage of these statistics.