Public Information Notice No. 07/51

Public Information Notice: IMF Executive Board Concludes 2007 Article IV Consultation with New Zealand

May 7, 2007

On April 27, 2007, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with New Zealand.¹

Background

The economic downturn that commenced in 2005 has proved to be short-lived. In early 2006, the economy appeared to be cooling quickly, with quarterly growth dropping to zero and confidence and demand indicators deteriorating. Some needed rebalancing of the economy took place. Once growth began to falter in late 2005, expectations for monetary easing were brought forward, and, in conjunction with signs that the global carry trade might unwind, the exchange rate fell by 15 percent in the first half of 2006. By the second half of 2006, the trade balance was showing some improvement, as a result of slower domestic demand, and a recovery in exports, albeit aided by a run-down of inventories.

Over the last few months, the cycle has turned again. A range of indicators in late 2006 and early 2007 suggest that domestic demand has regained momentum. These include a resurgent housing market and improved business and consumer confidence. House sales rebounded during 2006, in part due to higher net immigration, while competition between banks and ready access to external funds served to dampen the rise in mortgage interest rates. While headline CPI inflation fell to 2¾ percent by end-2006, aided by lower oil prices, resources remain stretched and nontradables inflation has declined only gradually. With resource pressures continuing, inflation is likely to pick up again once one-off effects recede. The current account deficit remains uncomfortably large, at 9 percent of GDP at end-2006.

Given the worsening medium-term prospects for inflation, the RBNZ adopted a progressively stronger tightening bias, and raised the OCR in March and April 2007. Driven by strong tax revenues, the central government's operating surplus before revaluations and accounting changes (OBERAC) reached 5 percent of GDP in 2005/06 (fiscal year ending in June), and the government recorded a positive net financial asset position for the first time. The operating surplus is projected to decline to 3¾ percent of GDP in 2006/07, as the budget becomes stimulatory owing to pre-announced spending initiatives.

GDP growth is projected to rise to about 2½ percent in 2007, from 1½ percent in 2006, but to remain below potential until 2009. The primary driver is higher private consumption growth, with household incomes benefiting from the tight labor market and increased income support from government. Exports are expected to grow only modestly given the high exchange rate although increases in commodity prices are providing some offset. A period of growth below the economy's potential will gradually help alleviate the resource pressures that have accumulated in recent years, putting downward pressure on inflation and aiding the narrowing of the current account.

Executive Board Assessment

Executive Directors commended the New Zealand authorities on their continued implementation of sound macroeconomic policies anchored in a well-established framework in the face of a challenging environment. While economic growth has recently picked up, activity in the tradable sectors has remained flat and the housing market has yet to cool. There has been little easing of resource pressures, household debt ratios have further increased, and the current account deficit has remained unusually large with capital inflows keeping the exchange rate at a high level. Directors noted that many of these pressures reflect the exposure of the New Zealand economy to global and regional developments, and they called for continued vigilance to possible shocks. Some Directors suggested that these issues also be examined in a more integrated way, in the context of regional and global surveillance.

Directors considered the recent increases in the Official Cash Rate (OCR) to be appropriate in light of still-stretched resource utilization. They noted that while lower oil prices have temporarily lowered headline inflation, the resurgence in domestic demand has raised inflation prospects over the medium-term horizon. Directors broadly welcomed the readiness of the authorities to implement monetary tightening even though they recognized the risks of higher short-term capital flows.

Directors generally regarded the continuing flexibility of the exchange rate as a valuable shock absorber for the economy. Nonetheless, the exchange rate is well above its long-run average and is not supportive of an unwinding of the sustained, large current account deficit. Directors recognized that a correction might be delayed by continuing capital inflows, but also pointed to the risk of a sharper depreciation in case of a global event such as a sudden unwinding of the carry trade. In this context, they emphasized the robust health of the banks and the corporate sector as factors that would help limit the depth and duration of a subsequent slowdown.

Directors welcomed New Zealand's strong fiscal position and commended the authorities' continued adherence to a stable and transparent medium-term fiscal framework. They endorsed the authorities' goal that fiscal policy should avoid complicating the task of monetary policy, but questioned whether the current stimulatory fiscal stance would effectively help achieve this goal. Directors recognized that the stimulus mainly reflects pre-announced spending decisions and that the medium-term fiscal framework limits the ability to adjust fiscal policy in the short run. Nonetheless, they recommended that the automatic stabilizers continue to be allowed to work, and that fiscal stimulus be contained as much as possible in the period ahead. In particular, Directors advised shifting to the extent possible the mix of fiscal measures planned for 2007/08 toward greater tax reductions and smaller expenditure increases so as to moderate any expansionary effect. Several Directors also suggested exploring the scope for increasing the flexibility of the fiscal framework. Many Directors cautioned that tax credits for activities such as R&D would represent a step away from the current orderly tax arrangements, and could create distortions.

Directors observed that in light of the challenging macroeconomic policy environment, supplementary stabilization measures to limit buoyancy in the housing market deserve consideration. Directors broadly supported the view that limiting the ability to deduct losses on housing-related investments from other income, combined with more active enforcement of current tax laws, might help to discourage property speculation. Also, there might be merit in tightening prudential regulations. This could involve the application of varying risk weights on mortgages according to the loan-to-value (LTV) ratio and the presence of mortgage insurance, and raising banks' awareness of the risks associated with "low-doc" and high LTV mortgages. Overall, Directors nevertheless shared the authorities' view that these measures would not be a panacea given their likely limited impact, and that the OCR should remain the primary instrument of monetary policy.

Directors emphasized that early and sustained efforts would be essential to successfully manage the significant long-term fiscal issues facing New Zealand. They welcomed the release of the first report on the long-term fiscal position, which has raised awareness of the challenges ahead. Going forward, Directors stressed that improving productivity in the health care system is likely to be particularly important, as well as a review of pension arrangements. Directors welcomed the authorities' emphasis on increasing domestic savings, including through the introduction of the KiwiSaver scheme, and encouraged a broad review of the taxation of savings vehicles.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities. The staff report (use the free Adobe Acrobat Reader to view this pdf file) for the 2007 Article IV Consultation with New Zealand is also available.