Public Information Notice No. 04/50

Public Information Notice: IMF Concludes 2004 Article IV Consultation with New Zealand

May 5, 2004

On April 30, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with New Zealand.¹

Background

The New Zealand economy has performed strongly in recent years. Despite the global slowdown and periods of drought at home, real GDP growth averaged about 3¾ percent during 1999-2003. The strong economic performance reflects the ongoing benefits from the extensive structural reforms that have been implemented since the early 1980s and the continued confidence in the macroeconomic environment fostered by transparent monetary and fiscal policy frameworks.

Growth slowed in early 2003 but rebounded in the latter part of the year. Real GDP growth declined from 4¼ percent in 2002 to a seasonally adjusted annualized rate of 2¾ percent in the first half of 2003, amid heightened international geopolitical tensions, concerns about SARS, and declines in farm output and hydroelectric generation related to a drought. However, with an improved international environment and better weather conditions, output growth rebounded to over 4 percent seasonally adjusted annualized rate in the second half of the year. Residential investment and household spending have been robust, reflecting strong income growth, real income gains from the New Zealand dollar's appreciation, the strength in net immigration, solid employment growth, wealth effects from rising house prices, lower interest rates, and financial innovation. Business investment growth has also strengthened, in response to emerging capacity constraints, lower interest rates, and declining prices (in New Zealand dollars) for capital goods imports. However, net exports deteriorated reflecting the relative cyclical position and the continued appreciation of the New Zealand dollar.

Although the external current account deficit has widened, external liabilities have declined as a share of GDP. The current account deficit widened from about 2½ percent of GDP in 2001 to 4½ percent of GDP in 2003. Net external liabilities declined from their peak of 87 percent of GDP at end-1998 to 76 percent of GDP at end-2003, reflecting both the strong GDP growth over this period and valuation gains from the recent appreciation of the New Zealand dollar.

Inflation has remained within the official 1-3 percent target range, despite increasing resource constraints. CPI inflation declined to 1½ percent in each of the four quarters through March 2004 from 2¾ percent in 2002. There were, however, sharply divergent trends in the major components of the CPI. In particular, tradables inflation is now negative owing to the impact of the sizable currency appreciation, while nontradables inflation has increased sharply, led by a jump in housing-related costs, most notably for the purchase and construction of new dwellings. Even excluding the housing component, however, nontradables price inflation is running at over 3 percent. Employment growth averaged over 2½ percent during 2002 and 2003, and the unemployment rate declined to a 16-year low of 4.4 percent in September before rising slightly to 4.6 percent in December. Although businesses are reporting increased labor shortages, particularly of higher-skilled workers, measures of private sector wage growth have so far picked up only moderately. At the same time, the capacity utilization rate is at a relatively high level.

The New Zealand dollar appreciated substantially during 2002 and 2003, but has depreciated somewhat since reaching a seven-year high in mid-February 2004. Overall, since end-2001, the New Zealand dollar has risen by nearly 50 percent vis-à-vis the U.S. dollar through end-April 2004, by 7 percent relative to the Australian dollar, and by 27 percent on a trade-weighted (TWI) basis. The TWI is now 8 percent above its ten-year average. The medium-term appreciation reflects a combination of comparatively high interest rates in New Zealand, the country's strong recent growth performance relative to most other developed countries, and strengthening commodity prices in U.S. dollar terms, along with weakness in the U.S. dollar.

Monetary policy has successfully kept inflation in the target range. Between April and July 2003, the Reserve Bank of New Zealand cut the official cash rate (OCR) by a total of 75 basis points in three moves—bringing the rate to 5 percent—based on its assessment that economic activity was likely to cool in response to weak external conditions, an appreciating currency, and slowing net immigration. However, the RBNZ increased the OCR by 25 basis points each in January and April 2004, when indicators of economic activity suggested that domestic demand going forward could be more robust than expected. The RBNZ also noted in April that it would continue to watch economic indicators closely to determine if further rate increases would be required later in 2004.

The fiscal position has continued to strengthen during the past year. The operating surplus nearly doubled to 4¼ percent of GDP in 2002/03 (fiscal year starting July 1), and the overall cash surplus widened to almost 2 percent of GDP. Factors contributing to the improvement include significantly better-than-expected tax revenues, lower spending, and higher Crown entity surpluses. Gross government debt declined to 28 percent of GDP, with net debt (excluding the assets of the New Zealand Superannuation Fund) falling to 13½ percent.

Real GDP growth is projected to ease to 3 percent in 2004 and 2½ percent in 2005. However, the outlook is subject to considerable uncertainty with the economy operating at a high level of resource utilization, slowing net immigration, continued strength in domestic demand, an improving world economy, and the specter of further currency appreciation. Medium-term prospects remain favorable. Beyond 2006, real GDP growth is projected to increase to an average of around 3¼ percent, owing mainly to a gradual improvement in net exports. The external current account deficit is forecast to remain broadly unchanged, with improvements on the goods and services account offset by a widening investment income deficit. The inflation rate is expected to be around 2 percent over the medium term.

Executive Board Assessment

Executive Directors welcomed the strong performance of New Zealand's economy in recent years, which reflects the authorities' continued skillful management of macroeconomic policies and the ongoing benefits from the extensive structural reforms that have been implemented since the 1980s.

Directors considered that the foundations for sustained economic growth remain firmly in place. Nevertheless, with the economy operating at a high level of resource utilization, continued strength in domestic demand, volatility in the exchange rate, and slowing net immigration, they urged the authorities to be ready to adapt policies as needed to ensure that the economy remains on a sound growth path.

Directors noted that in the current environment, with resource pressures still tight and an uncertain path for the exchange rate, determining the appropriate monetary policy setting is particularly challenging. In this context, they considered that the Reserve Bank of New Zealand's (RBNZ) recent decision to raise the official cash rate was prudent and consistent with the monetary policy framework.

Directors emphasized that the floating exchange rate regime has served New Zealand well. Reflecting New Zealand's strong relative cyclical performance and strengthening commodity prices, they noted that the real effective exchange rate had appreciated significantly from its cyclical trough in late 2000 to its peak in February 2004, when it was well above its 10-year average. They concurred with the authorities' decision to increase the level of international reserves given the changes that have taken place in the international economy since the mid 1980s when the RBNZ last significantly raised these reserves. In connection with the indication that the RBNZ would contemplate exchange market intervention if the exchange rate were viewed as being "exceptionally and unjustifiably" high or low, Directors were generally of the view that this policy was consistent with the inflation targeting framework and would be in line with that used in many other developed countries provided, as the central bank has emphasized, it would not defend a particular exchange rate level. Some Directors, however, noted that the efficacy of such intervention to moderate exchange rate cycles is unproven.

Directors continued to support the sound medium-term orientation of fiscal policy. In this connection, they endorsed the government's objective of achieving budgetary operating surpluses over the economic cycle sufficient to meet contributions to the New Zealand Superannuation Fund (NZSF), while keeping gross debt trending down over the longer term and meeting capital spending requirements. Directors agreed that the improvement in fiscal prospects relative to the 2003 budget provides the authorities with an opportunity to introduce a limited number of new fiscal initiatives, including the Future Directions package, beginning in the 2004 budget. However, to support monetary policy in the near term, they stressed that the authorities should hold the line on spending to what was proposed in the December Economic and Fiscal Update, maintain prudence and discipline in making expenditure decisions, and save any further unanticipated gains in revenue.

Over the longer term, New Zealand will face significant spending pressures owing to population aging and rising healthcare costs. Directors considered that the establishment of a partial pre-funding of future pension liabilities through the NZSF was an important step to address some of these pressures. Nonetheless, they suggested that other measures are likely to be needed to contend fully with the long-term fiscal challenges, including further changes in the structural parameters of the pension and healthcare systems. They emphasized that such measures should be adopted sufficiently early to help smooth fiscal costs over time and allow individuals to adapt their savings behavior.

Directors emphasized the importance of the government's efforts to raise the labor force participation rate and build an even more skilled workforce, including by providing the right incentives to move people from welfare to work; improving education, training, and access to childcare; and maintaining labor market flexibility. In this context, they noted that the Future Directions package could play a significant role by providing in-work benefits that lower the high effective marginal tax rates currently faced by welfare recipients when they take up employment. They also supported enhancing labor force participation by tightening up and strictly enforcing eligibility requirements for receiving benefits. In addition, Directors stressed that recent and proposed changes in labor legislation should be implemented in ways that do not impair the flexibility of New Zealand's labor market. To reduce infrastructural bottlenecks, they advocated further investments in the electricity and transport sectors.

Directors strongly backed New Zealand's ongoing commitment to the multilateral trading system, and its active participation in the Doha Round. They noted that the tariffs imposed by New Zealand on most imports are low or zero, and that tariffs in the few remaining heavily-protected sectors are slated for further reduction starting in 2006. Directors observed that New Zealand continues to face substantial trade barriers in key areas, including agricultural products, and many Directors urged industrial countries to reduce these barriers.

Directors agreed that New Zealand remains generally well placed to absorb adverse shocks without undue economic distress. They concurred that the recent substantial widening of the external current account deficit mainly reflected the sharp appreciation of the New Zealand dollar and the relatively strong cyclical position of the economy. Directors believed that the low and declining level of public debt, the relatively stable source of external financing, the general soundness of corporate and banking sector balance sheets, and the strong risk management culture in New Zealand's financial institutions should limit New Zealand's vulnerability significantly. Nevertheless, they cautioned that the size of the external debt position could leave New Zealand potentially vulnerable to sharp shifts in market sentiment and recommended strengthening national savings. Also, while debt servicing remains manageable, they observed that households could be subject to somewhat more stress than in the past in the event of a substantial increase in interest rates. Directors, therefore, endorsed continued close monitoring of sectoral balance sheets.

In this context, Directors welcomed New Zealand's participation in the Financial Sector Assessment Program. They concurred with the general finding of the Financial System Stability Assessment (FSSA) that New Zealand's financial sector has a high degree of short-term stability and an overall sound outlook. They noted that the discipline of New Zealand's market-based disclosure regime is supplemented by home country supervision of the major foreign banks and supported by a well-functioning market environment and sound economic policies. They observed that the banking system is well capitalized, highly profitable, and employs sophisticated risk management systems. They also noted that the banking system is highly resilient to shocks from large exchange rate swings, house price declines, and negative supply shocks. Nevertheless, Directors recommended continued vigilance in regard to potential shocks and the need to ensure prudent lending practices in the housing market.

Directors endorsed the FSSA's main recommendations, which aim at preserving stability in the medium and longer term. These recommendations included strengthening the RBNZ's ability to undertake timely, focused monitoring of bank risks; further developing its ability to manage a situation in which the solvency of a systemically important bank comes into question and to handle associated stresses on the financial system; and, given the unique role of Australian-owned banks in New Zealand, enhancing cooperation and coordination between supervisors in the two countries.

Directors welcomed New Zealand's invitation to the Financial Action Taskforce to send a team to examine Anti-Money Laundering and Countering the Financing of Terrorism issues.