IMF Executive Board Concludes 2014 Article IV Consultation with New ZealandPress Release No. 14/271
June 9, 2014
On June 5, 2014, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation1 with New Zealand and considered, and endorsed, the staff appraisal without a meeting on.2
The economic expansion is becoming increasingly embedded and broad-based, with growth exceeding 3 percent in the second half of 2013. The drivers include supportive financial conditions, record high export commodity prices, resurgent construction activity related to the Canterbury post-earthquake rebuild and general housing shortages, and a substantial increase in net immigration. Business and consumer confidence indicators have risen to the highest levels since the global financial crisis. The labor market continues to strengthen with the unemployment rate falling to 6 percent despite increasing labor force participation.
With the high exchange rate damping tradable price inflation, headline inflation has remained below the mid-point of the target band but underlying pressures may be building. Nominal wage inflation has so far remained subdued. Nevertheless, house prices appear elevated by historical and international comparisons and most measures of affordability.
Strong terms of trade have narrowed the 2013 current account deficit to 3¼ percent of GDP. Net foreign liabilities remain high at 67 percent of GDP ay end-2013. The current account deficits are projected to widen in the medium term, partly related to the post-earthquake reconstruction investment.
After keeping the policy rate at 2½ percent for almost three years, the Reserve Bank of New Zealand (RBNZ) began tightening monetary policy in March 2014 and has raised the policy rate to 3 percent. The RBNZ also indicates that it expects to increase the policy rate steadily over the next two years.
In response to house price inflation and to boost financial sector resilience the RBNZ last year took a number of prudential measures including requirements for banks to hold higher levels of capital against their high loan-to-value (LVR) housing exposure and tight limits on lending above 80 percent LVR threshold. The result has been a sharp reduction in high LVR lending.
Supported by healthy output growth, the government’s aim of reducing the budget deficit is going according to plan. The deficit is currently projected to decline almost ½ percent of GDP to less than ½ percent of GDP this year due to restraint in expenditure growth. The plan would reduce public debt from its peak of 26 percent of GDP in 2013 to about 20 percent by 2018. The government just concluded selling stakes in state-owned enterprises, which generated proceeds of about 2 percent of GDP.
Financial system remains sound. The banks are well capitalized—all comfortably meet the new Basel III minimum capital requirement—and liquidity buffers are solid. Non-performing loan ratios are low and declining. Banks continue to shift toward more stable funding sources, and use of offshore borrowing has been reduced and is of longer maturity.
Growth is forecast to increase to about 3½ percent this year and moderate to a trend rate of 2½ percent over the medium term. Strong construction activity is expected to remain an important driver for near-term growth. The terms of trade are projected to ease somewhat due to an assumed moderation in global dairy prices, but remain high relative to historical levels and continue to boost growth in national income. With the economy set to grow above trend in the near-term, pressure on core inflation should follow, particularly from the construction sector.
Executive Board Assessment
In concluding the 2014 Article IV consultation with New Zealand, Executive Directors endorsed the staff’s appraisal as follows:
The economic expansion is becoming increasingly embedded and broad-based. Headline inflation has remained subdued, but with the economy set to continue to grow above trend in the near term, pressures on core inflation should follow. The key external risk to the outlook remains a sharp slowdown in growth in China, which would affect New Zealand directly through the terms of trade and indirectly through its impact on Australia, a key trading partner. Bouts of financial market volatility could also lead to widespread contagion and raise the cost of New Zealand banks’ offshore borrowing. Domestically, house price inflation remains high and there remains a risk of house price overshooting and accompanying vulnerabilities.
Staff welcomes the Reserve Bank’s shift toward a policy of withdrawing monetary stimulus, with the clear signal that rates would be increased further over the next two years. In addition to the longer-term benefits, deficit reduction will play an important role in supporting monetary policy through the current cycle, allowing for lower interest rates than would otherwise be the case and reducing pressure on the exchange rate.
New Zealand’s large net external liabilities, although relatively stable, are a longstanding source of risk and reflect several decades of low household savings rates. Given a structural savings-investment imbalance, reducing pressure on the exchange rate and limiting current account deficits in a lasting way will require addressing the reasons for low savings, rather than being the task of short-term macroeconomic management. Aside from these structural factors, there are a number of short-term factors contributing to the currently overvalued exchange rate, including historically high terms of trade and an appetite for relatively safe New Zealand assets. If global monetary conditions were to become less stimulatory, the exchange rate would likely depreciate over time, reducing the current account deficit over the medium term.
With public debt relatively low and interest rates above the zero bound, the authorities have monetary and fiscal policy space to respond to shocks, and the free-floating New Zealand dollar provides an additional cushion against terms of trade and other external shocks. Restrictions on riskier mortgage lending introduced in October should help reduce the likelihood of an unsustainable acceleration in house price inflation, although it is still too early to assess their full impact. Over the longer term, policies to address housing supply constrains will continue to play an important role in containing price pressures and increasing affordability.
Banks remain sound, and recent stress tests show that the major banks would be able to withstand a sizeable shock to output, terms of trade, rising unemployment, and a fall in property prices. Nevertheless the banks face longstanding structural issues that will remain sources of risk over the medium term, including reliance on offshore borrowing. The recently introduced macro-prudential policy measures provide additional tools to safeguard financial sector resilience. These tools should be viewed as a complement to macroeconomic and micro-prudential measures. They should be used infrequently, with caution, and with the primary objective of limiting the buildup of system-wide risk.