Public Information Notice No. 08/56

Public Information Notice: IMF Executive Board Concludes 2008 Article IV Consultation with New Zealand

May 19, 2008

On May 9, 2008, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with New Zealand.¹

Background

New Zealand has experienced a decade-long economic expansion, but resource constraints have emerged in recent years with rising capacity utilization and unemployment falling to historical lows. This combined with rapidly appreciating house and share prices resulted in demand pressures increasing nontradables inflation. Domestic demand became increasingly satisfied with imports, widening the current account deficit to more than 8 percent of GDP. The large current account deficits increased net foreign liabilities to almost 90 percent of GDP, accumulating primarily as debt on banks' balance sheets.

In response to rising inflation, the Reserve Bank of New Zealand (RBNZ) raised the official cash rate from 5.0 percent in 2003 to its current level of 8.25 percent. However, competition in the mortgage market, in part reflecting banks' access to abundant international liquidity, slowed the transmission into mortgage rates. Searching for yield, international investors responded to the wide interest rate differential, and inflows of foreign capital appreciated the exchange rate.

The fiscal position has strengthened over the past several years. Large surpluses emerged as revenue outcomes consistently surprised on the upside, moving the public sector into a positive net financial asset position. However, the strong performance has increased pressures to bring the fiscal position more in line with the medium-term targets by cutting taxes and increasing spending.

The banking sector is sound, with stable profits, high capitalization, and few nonperforming loans, but vulnerabilities exist. On the liabilities side, the global financial market turmoil has increased funding costs and highlighted the rollover risk associated with banks' short-term debt. On the asset side, the large mortgage book leaves banks exposed to heavily indebted households.

Executive Board Assessment

Executive Directors commended the New Zealand authorities for their continued implementation of sound macroeconomic policies and structural reforms that have resulted in ten years of robust economic expansion. More recently, however, inflation has increased, the current account deficit has grown, and capacity constraints have emerged, presenting the authorities with challenges in the period ahead. Directors were confident that the authorities' current policy settings, supported by the anticipated evolution of external and global developments, will help to address these challenges.

Directors welcomed the focus of New Zealand's fiscal policy on sound medium-term objectives, which has delivered a low level of public debt and a positive net financial asset position. They agreed that, with surpluses in excess of the level required by the medium-term fiscal framework, the authorities' strategy of reducing the surplus gradually, if economic conditions permit, is appropriate. However, flexibility and caution will be needed with respect to the magnitude and timing of any easing, so that it occurs only after inflation pressures have abated and it is clear that the fiscal resources exist to reduce taxes or increase spending. Several Directors encouraged the authorities to save any revenue overperformance in 2008/09 (July-June), as they had in previous years.

Directors considered that the current tightened stance of monetary policy is appropriate. During 2007, retail mortgage rates became more responsive to increases in the official cash rate, moderating house price inflation and slowing overall activity. More recently, tightening international credit conditions have contributed to further mortgage rate increases, reducing credit demand. Directors concurred that monetary policy should remain on hold pending clearer indications of the risks and the future path of the economy.

Directors observed that inflows of foreign capital, attracted by wide interest rate differentials, and strong commodity prices—particularly for New Zealand's dairy products—have contributed to an appreciation of the currency. Directors noted that as inflation pressures moderate and the policy interest rate normalizes, capital inflows should ease and the exchange rate depreciate. However, the equilibrium level of the real effective exchange rate is likely to remain above its historical average, because a portion of the rise in commodity prices will likely be permanent.

Directors noted that the financial sector remains sound. Banks are profitable, well capitalized, and the quality of their assets appears to be high. Banking sector vulnerabilities present some policy challenges, however. Banks' assets are concentrated in residential mortgages, and banks have significant exposure to the short-term international wholesale funding markets. The current tightening in international capital markets is putting upward pressure on bank funding costs and highlighting rollover risks. Directors acknowledged that disruption to foreign capital inflows that raises demand for domestic liquidity would need to be accommodated by the RBNZ. They agreed with the measures to improve access to liquidity from the RBNZ. They also welcomed the steps taken by the RBNZ to review its liquidity policy for banks to encourage the diversification of funding sources and the lengthening of maturities.

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.