New Zealand: Staff Report for the 2000 Article IV Consultation

The resilience displayed by the New Zealand economy throughout the turbulence is a clear testimony of the benefits of the economic reforms. Executive Directors appreciated these developments, and cautioned against reforms that could reduce labor and product market flexibility, and suggested that the authorities should be flexible and pragmatic in their implementation. They commended the authorities for the high quality of economic and financial statistics, and agreed that the country is well placed to absorb shocks without undue economic or financial distress.

Abstract

The resilience displayed by the New Zealand economy throughout the turbulence is a clear testimony of the benefits of the economic reforms. Executive Directors appreciated these developments, and cautioned against reforms that could reduce labor and product market flexibility, and suggested that the authorities should be flexible and pragmatic in their implementation. They commended the authorities for the high quality of economic and financial statistics, and agreed that the country is well placed to absorb shocks without undue economic or financial distress.

I. Executive Summary

1. The New Zealand economy came through the adverse shocks of the past 2–3 years smoothly, but is facing greater uncertainty in the period ahead. Real GDP expanded by 3½ percent in 1999; and inflation remained low in 1999 and thus far in 2000, despite a tightening in input markets and a sharp depreciation of the currency. The current account deficit widened to 7 percent of GDP for the year through the first quarter of 2000; since then, however, export growth has been strong, largely reflecting the boost to competitiveness from the fall in the exchange rate and the improvement in farm output.

2. Focusing on the fact that the payoff to the reforms of the past 15 years in terms of per capita growth has been disappointing, the left centrist government that took office late last year has signaled a shift in direction in several aspects of structural policies. Broadly speaking, the shift is in the direction of tighter regulation of labor and product markets, a larger role for the government in industrial policies and increased emphasis on “closing the gaps” between the different segments of the population. The recent sharp weakening in business and consumer confidence, and the steep fall in the New Zealand dollar—attributed to the large external imbalances, relatively weak growth prospects as well as the direction of some of the policy changes being implemented in New Zealand—have clouded the economic outlook.

3. The mission supported the authorities’ management of macroeconomic policies to date. Looking ahead, in light of the mixed picture for the outlook in different sectors of the economy, further tightening of monetary policy should be gradual and continually reassessed. The projected fiscal stance in 2000/01 and in the medium term is broadly appropriate, but the risks are predominantly on the downside, because of the potential for expenditure overruns and lower–than–forecast revenues.

4. On growth, saving, and investment, the discussions focused on areas where additional actions are necessary to boost saving and competitiveness, and areas where there is a risk of weakening the gains from earlier reforms. Specifically, the mission recommended more rapid deregulation of agricultural producer boards, and more emphasis on workforce training and R&D spending. The mission also suggested caution in the implementation of recent changes to the labor legislation which are intended to give greater power to the unions, and those under consideration to tighten regulations in certain sectors as these could undermine labor and product market flexibility.

5. The evidence on external vulnerability indicators and the experience of adjustment to shocks over the recent past supports the staff’s earlier assessment that New Zealand is well placed to absorb shocks without undue economic and financial distress. However, New Zealand remains vulnerable to sharp adverse shifts in market sentiment.

II. Introduction

6. The wide–ranging macroeconomic and structural reforms undertaken over the past 15 years have led to a marked improvement in economic management and in a number of aspects of economic performance—fiscal consolidation and a sharp reduction in public debt, low and stable inflation, and an increase in output and employment growth. Two themes underlying the entire set of reforms—which began in the mid–1980s and continued through the mid–1990s—were the establishment of a legislative and institutional framework to improve public sector management, and a decisive move away from the pervasive controls and interventions that had characterized virtually all aspects of the economy. The key pillars were reforms of the monetary and fiscal policy frameworks through the Reserve Bank Act (1989), the Public Finance Act (1989), and the Fiscal Responsibility Act (1994), and the reform of labor markets through the Employment Contracts Act (1991).

7. Notwithstanding these improvements, a central question in recent years is why the reforms have not succeeded in generating growth rates sufficient to close more rapidly the gap with other advanced economies (Box 1). Closely related is the issue of the vulnerabilities associated with the sustained large external imbalances generated by the sizable current account deficit which has averaged over 5 percent of GDP since the mid–1970s. Key underlying structural weaknesses are the relatively inefficient investment of the past—which has resulted in relatively slow progress in the diversification of production and exports—and the low savings rate, in part, this reflects the fact that progress in deregulating the agricultural sector and reforming the social transfer system—superannuation, unemployment and other welfare benefits—has been relatively slow, leaving distortions to incentives to work, save, and invest.

8. Questioning the effectiveness of the reforms in light of this disappointing growth performance, the Labor-Alliance coalition government that took office in November 1999 has signaled a shift in some policies and has launched reviews of others. Broadly speaking, the shift is in the direction of tightening regulation of labor and product markets, and increasing the government’s role in economic, social and industrial policies, in part, to “close the gaps” between various segments of the population (Box 2).

III. Recent Economic and Policy Developments and Short–Term Outlook

9. Economic activity recovered strongly in late 1999 and remained healthy through the first quarter of 2000. The sharp acceleration in growth in the second half of 1999—at an annualized rate of 9 percent—resulted in an expansion in real GDP in 1999 of 3½ percent. A rebound in the agricultural sector following two successive droughts, and robust performance in sectors benefiting from strong external demand aided the recovery. The recovery was supported by accommodative macroeconomic policies and the depreciated exchange rate. The momentum of growth slowed to a more sustainable pace in the first quarter of 2000, while the composition shifted toward net exports, as domestic demand, which had led the recovery, slowed sharply (Figure 1).

uA01fig01

Contribution of Demand Components of Growth

(In percent)

Citation: IMF Staff Country Reports 2000, 138; 10.5089/9781451830163.002.A001

1/ Quarterly 12 month percent change.
FIGURE 1
FIGURE 1

NEW ZEALAND: SELECTED REAL ECONOMIC INDICATORS, 1995–2000

Citation: IMF Staff Country Reports 2000, 138; 10.5089/9781451830163.002.A001

Sources: Statistics New Zealand; and staff estimates.1/1999 q4 excludes the purchase of a navy frigate equivalent to 0.6 percent of GDP.

New Zealand’s Growth in Comparative Perspective1/

New Zealand’s macroeconomic, structural and institutional reforms since the mid–1980s were wide-ranging and, in many ways, are considered internationally unique. They opened the economy up to competitive pressure and market forces both domestically and internationally, and substantially improved the credibility of economic management. In recent years, an issue that has preoccupied policy makers and observers alike is why New Zealand’s growth rate, albeit increasing in recent years, has remained consistently below the OECD average since the reforms began.

What are the facts about New Zealand’s growth performance over time and across a small group of comparator countries? The table below starts in 1973, when the New Zealand economy experienced a sharp structural break at the time the U.K. joined the European Community. This event resulted in the loss of preferential access by New Zealand to its major export market Also shown is the OECD average growth performance and that of a group of economies that are either structurally similar or that have performed very strongly in recent years. The year 1985 is treated as the first year of the reform period.

Annual Average Growth in Real GDP

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Source: WEO database

In light of the variability of New Zealand’s growth rates, period averages tend to be a better representation of underlying trends in the economy. Several facts are noteworthy in the table above.

1. There is little difference in New Zealand’s average annual growth rate between 1973–84 (“pre-reform”) and 1985–99 (“post-reform”).

2. A finer division of the “reform” period into five-year subperiods reveals that, after a period of low growth in the late 1980s, real GDP growth has been increasing. This is consistent with the findings of studies of the pattern of growth following structural adjustment, namely that there could be an initial period of adjustment costs during which output growth could slow.

3. A comparison with OECD averages during the 1973–84 and 1985–99 periods suggests that the gap with the OECD average growth rate has not changed in the two subperiods.

4. However, the comparative experience in the “post” reform period is more complex—New Zealand lost considerable ground vis-à-vis the OECD in the late 1980s immediately after the reforms were launched, but in the 1990s, the difference in growth rates has narrowed markedly.

Recent evidence on TFP growth in New Zealand suggests that there has been a pick-up in productivity growth since the early 1990s.2/ Conway and Hunt (1998) use data through 1996 to show that the growth rate of trend TFP does exhibit an upward shift from end–1991. Likewise, Diewert and Lawrence (1999) find that trend TFP growth was about zero during 1984–93, but picked up to 1.5 percent during 1993–58. During the more cyclically-balanced period of the 1990s as a whole, TFP growth averaged 1.1 percent—about the median for industrial countries. However, Diewert and Lawrence are unable to find conclusive evidence to permit disentangling cyclical from structural reasons for the upward shift in TFP growth.

Regardless of how the stylized facts are interpreted, the reasons for the disappointing growth payoff to the reforms remain a live question. Examining cross-country differences in structural aspects of the economy reveals that the widest gaps are in the development of human resources in New Zealand, broadly defined to include technical and management skills.

1 Further details can be found in the forthcoming Selected Issues paper.2 Conway, Paul and Ben Hunt, “Productivity Growth in New Zealand: Economic Reform and the Convergence Hypothesis,” Reserve Bank of New Zealand Working Paper 98/2, June 1998, and Diewert, Erwin and Denis Lawrence “Measuring New Zealand’s Productivity,” New Zealand Treasury Working Paper 99/5, March 1999.

New Zealand—Fiscal and Structural Initiatives Taken by the New Government

The following fiscal and structural policy changes have either been implemented or proposed by the Labour-Alliance government that came into power in November 1999.

Fiscal Policy

  • Income tax cuts announced by the previous Government (increases in income thresholds) were cancelled, and the top marginal income tax rate was increased from 33 percent to 39 percent for incomes over $NZ 60,000 effective April 1, 2000.

  • The fringe benefit tax was raised from 49 percent to 64 percent.

  • The excise tax on tobacco was increased with effect from May 10, 2000.

  • The revenues from the changes in tax policy will be used to fund various spending initiatives, including an increase in Superannuation payments (to ensure a minimum 65 percent pension benefit rate), and an increase in the income threshold to qualify for interest-free student loans.

  • The Government will use a part of projected structural surpluses to partially pre-fund future superannuation costs.

Structural Policy

  • In August 2000, a new Employment Relations Act (ERA) was passed to replace the Employment Contracts Act (ECA) of 1991. The ERA seeks to rebalance employee and employer power in industrial relations by strengthening the role of labor unions. The draft Bill met with considerable opposition from the business community and was revised in some areas, but the basic thrust remained intact when it was passed. The law will be effective from October 2000.

  • In March 2000, the adult minimum wage was raised from $NZ 7/hour to $NZ 7.55/hour. At the same time, the age threshold for eligibility for the adult minimum wage was lowered from 20 to 18. The government is currently considering raising the ratio of minimum wages that would apply to 16–17 year old youth from the current level of 60 percent of the adult minimum wage to somewhere between 60 percent and 100 percent; and to introduce a minimum wage for those on training contracts at a rate between 60 and 100 percent of the adult minimum wage.

  • In April 2000, provisions for a competitive workplace accident insurance market, which had been introduced only in mid–1999, were reversed and the state-run company (ACC) was reinstated as the monopoly provider of such insurance.

  • In April 2000, the Government cancelled the July 2000 tariff reductions planned by the previous government and announced that unilateral tariff reductions would be frozen until at least July 2005. The 1998 Tariff (Zero Duty) Amendment Act, which included the abolition of all tariffs by 2006—four years earlier than scheduled by the APEC Borgor Declaration of 1994—was abolished. Previously agreed tariff reductions in the context of bilateral or multilateral agreements will go ahead.

  • In April 2000, the Commerce Act, which regulates the process of competition in New Zealand, was amended to: redefine the threshold for a ruling of anticompetitive behavior from the current “dominant position” criterion to a “having high market power” criterion; redefine commensurately the threshold for mergers and acquisitions; and strengthen the deterrents to anti-competitive behavior.

  • The government has initiated reviews of the regulatory regimes for the telecommunications and electricity sectors to ensure that they are compatible with greater competition. Draft recommendations from both reviews are currently under consideration. In the telecommunications sector, the recommendations include the establishment of an industry-specific regulatory body with fairly wide-ranging powers.

  • The government has announced a new, more activist industrial policy through the establishment of a new Crown entity—Industry New Zealand—which will target regional development, small and mediumsized enterprises, and provide assistance to exporters through export guarantees and credit financing.

10. However, there are signs that the momentum of growth weakened sharply in the second and third quarters of 2000. Since April 2000, there has been a sharp fall in business and consumer confidence. Some observers attribute the fall in confidence to uncertainty about the direction of policies and the feeling that the economic environment is likely to become less business friendly, and others point to the increases in interest rates since November last year. The weakening of confidence has thus far been reflected in a fall in profit expectations, investment intentions and labor force participation rates. There are also indications of a softening in activity such as declining building consents, continued weak credit growth, and a moderation in retail sales, GST receipts, and capacity utilization rates.

uA01fig02

New Zealand: Business and Consumer Confidence

Citation: IMF Staff Country Reports 2000, 138; 10.5089/9781451830163.002.A001

Source: National Bank of New Zealand, Business Outlook and Westpac Trust1/ Percentage expecting improvement in general business conditions minus percentage expecting deterioration.

11. After a short–lived strengthening in early 1999, the real effective exchange rate has weakened considerably since early 2000 and is now at an all–time low. After depreciating by 18½ percent in real effective terms between mid–1997 and end–1998, the $NZ appreciated by some 7 percent through April 1999. Since then, however, the dollar has weakened steadily to a historical low at present, and recently, at a somewhat faster pace than the Australian dollar. The weakness of the dollar has been attributed to the large current account deficits, a reduction in the demand for $NZ denominated assets with the narrowing of interest rate differentials, a weakening of investor sentiment as a result of the direction of some of the new government’s policies,1 and the perception that New Zealand is relatively less well positioned to benefit from the productivity gains that have come to be associated with “new economy.”2

uA01fig03
Source: Bloomberg, Reserve Bank of New Zealand WEB, WEFA.

12. Inflation remained low during 1999 and thus far in 2000 despite a tightening in the labor market and in capacity utilization rates, but there are signs of pressures in the pipeline. Through the first quarter of 2000, employment grew strongly—full time employment rose 3⅓ percent (y/y) in the first quarter of 2000—and the unemployment rate declined rapidly from a peak of 7¾ percent at end 1998 to 6⅓ percent at present—the lowest level since 1996 (Figure 2 and Table 1). Capacity utilization rates rose sharply and the output gap is estimated to have been eliminated by early 2000 (Figure 1). Wage growth has nevertheless been moderate and the target measure for inflation remained between 1 and 1¼ percent (y/y) during most of 1999, before moving to 1.8 percent in March 2000 and further to 2 percent in June. Much of the increase in the second quarter reflected higher fuel prices and tobacco and alcohol excises, suggesting that underlying inflation remains subdued. However, forward looking indicators such as inflation expectations, producer prices, and pricing intentions suggest upstream pressure on the CPI from sharply higher oil prices and a broadening of the pass–through of the exchange rate depreciation.

FIGURE 2
FIGURE 2

NEW ZEALAND: LABOR MARKET AND INFLATION INDICATORS, 1995-2000

Citation: IMF Staff Country Reports 2000, 138; 10.5089/9781451830163.002.A001

Source: Statistics New Zealand; and staff estimates.
Table 1.

New Zealand: Selected Economic and Financial Indicators, 1996-2001

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Sources: Data provided by the New Zealand authorities; and Fund staff estimates and projections.

Estimate of national saving equals investment plus current account balance excluding migrants’ transfers.

Fiscal year ending June 30.

Equals revenue less expenditure plus net surplus attributable to state-owned and Crown entities.

Staff estimates; equals operating balance net of cyclical effects, revaluations and changes in accounting rules.

August 2000.

October 6, 2000.

Data for end-March of each year.

Data based on International Investment Position statistics.

Residual maturity of less than one year; data based on Total Overseas Debt statistics.

July 2000.

Trade-weighted index (June 1979 = 100).

IMF Information Notice System index (1990 = 100).

13. The current account deficit widened to near 6¾ percent of GDP in 1999 from about 4¼ percent in 1998 but is likely to narrow in 2000. The widening deficit was mainly due to a worsening of the trade balance. This resulted from rapid import growth in 1999, coupled with subdued export growth as the agricultural sector recovered from the droughts. Since early 2000, however, export growth has been strong—at 20 percent (y/y) in value terms in the three months through July 2000, largely reflecting the boost to competitiveness from the fall in the real effective exchange rate this year and the improvement in agricultural output. The deficit on the income account increased to around 6 percent of GDP, which, in turn, reflects New Zealand’s high external indebtedness—net foreign liabilities stand at around 100 percent of GDP (Figure 3 and Table 2).

uA01fig04

Current Account Balance

(In percent of GDP) 1/

Citation: IMF Staff Country Reports 2000, 138; 10.5089/9781451830163.002.A001

1/ Quarterly balance as in percent of quarterly GDP.2/ For 1997 q4 very does to zero.
FIGURE 2
FIGURE 2

NEW ZEALAND: BALANCE OF PAYMENTS AN D EXTERNAL INDICATORS, 1995-2000

Citation: IMF Staff Country Reports 2000, 138; 10.5089/9781451830163.002.A001

Sources: Statistics New Zealand; IMF, World Economic Outlook; and staff estimates.1/ Expenditure based2/ Exported-weighted average based on data for partner countries that account for at least 95 percent of trade of New Zealand
Table 2.

New Zealand: Balance of Payments and External Debt, 1995-2000

(In percent of GDP)

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Sources: Data provided by the New Zealand authorities; and Fund staff estimates and projections.

Based on IFS data; The figure for 1999 represents first quarter at annual rate.

Calculated as a residual.

Based on IFS data.

Data based on Total Overseas Debt statistics.

Residual maturity of less than one year.

Data for end-March of each year, based on the international Investment Position statistics.

14. Despite an increase in interest rates since November 1999, monetary conditions remain relatively easy due to the fall in the exchange rate. The sharp fall in the trade–weighted exchange rate in 1997–98 and the decline in interest rates (90–day rates fell from 9 percent to 4½percent during 1998) at the onset of the recession in early 1998 resulted in a substantial easing of monetary conditions—the monetary conditions index (MCI) fell from a level of 1000 in early 1997 to about–450 at end–1998.3 In response to the unexpectedly rapid growth in the second half of 1999 and the resultant narrowing of the output gap, the RBNZ raised the OCR five times from 4½ percent to 6½ percent between November 1999 and May 2000. Nevertheless, monetary conditions remain relatively easy in view of the weakening exchange rate.

uA01fig05

Monetary Conditions Index

(Dec qtr 1996=1000)

Citation: IMF Staff Country Reports 2000, 138; 10.5089/9781451830163.002.A001

15. The fiscal stance in 1999/2000 (July–June) was broadly unchanged from that of the previous year. The operating surplus in 1999/2000 was 1.4 percent of GDP (compared with the budget target of a zero balance, and an estimate of 0.4 percent of GDP at mid–year). While this represents a decline of about ½ percent of GDP relative to the outturn in 1998/99, adjusted for valuation changes, the fiscal stance was broadly unchanged (Table 3).4 Apart from favorable valuation changes, the larger–than–budgeted surplus in 1999/2000 is a result of: higher revenues (reflecting the more rapid economic recovery and the part-year effect of the increase in income and excise taxes), which were not fully offset by increases in expenditure (arising from the part–year effect of the increase in the superannuation benefit rate from 60 percent to 65 percent of the average wage).

uA01fig06

Fiscal Balances

(In percent of GDP)

Citation: IMF Staff Country Reports 2000, 138; 10.5089/9781451830163.002.A001

Table 3.

New Zealand: Central Government Budget, 1994/95-2000/01 1/

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Sources: New Zealand Treasury, Budget Economic and Fiscal Update; financial statements of the Government of New Zealand for the year ended 30 June 2000; and staff estimates and projections.

Fiscal year ending June 30.

Equals revenue less expenditure plus net surplus attributable to state-owned and Crown entities.

Staff estimates; equals operating balance net of cyclical effects, revaluations and changes in accounting rules.

Includes SNZ519 million corresponding to movements in ACC valuations.

16. 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. Overall, both revenue and expenditure are projected to remain virtually unchanged in terms of GDP from last year in line with this government’s longer term fiscal objectives. Revenue growth is expected to result mainly from the full–year effects of the tax increases implemented earlier in 2000. On the expenditure side, there is additional emphasis on social spending, particularly for education, health, welfare and industrial development policies. The government has reiterated its pre–budget commitment to adhere to a cap of $NZ 5.9 billion (equivalent on average to 1.7 percent of GDP per year) of new spending over the next three fiscal years, of which some two–thirds has already been committed. Net Crown debt is slated to fall marginally just above 20 percent of GDP in 2000/01. Over the medium term, operating surpluses are projected to rise steadily to 2½ percent of GDP by 2003/04, with a similar increase in the structural balance, and net debt is to fall to 16½ percent of GDP.

17. The authorities have initiated plans to partially address the longer–term pressures on the budget arising from an aging population, expected to begin around 2010 and to plateau in 2040. An important initiative is the proposal to partially prefund future pension liabilities—currently equal to about 4 percent of GDP and expected to rise to 9 percent by the second half of the century—by building a separate Superannuation Trust Fund (Box 3) with capital contributions of ½ percent of GDP in 2001/02, 1 percent of GDP in 2002/03, and 1½ percent of GDP in 2003/04. The plan would involve a move from the current system of funding pension costs from general revenues to one in which the government would pay in advance a part of the future costs, rather than relying solely on a PAYG system. The prefunding scheme is intended to smooth the transitional costs associated with the change in demographic structure, while preserving both the universal publicly funded pension and the link between pensions and the average wage. However, the authorities have not announced any details of how the fund will operate, except that the fund will be “ringfenced” from any other use and that it will be managed on a prudent commercial basis independently of the government, most likely in a Crown entity.

18. The new government has launched a number of initiatives to review and change certain aspects of structural policies. Key amongst these include modifications to the industrial relations framework aimed at strengthening the position of labor unions (Box 4); the removal of the provisions for a competitive insurance market for workplace accidents that had been introduced only in 1999; an amendment of the Commerce Act to redefine the threshold for a ruling of anti–competitive behavior; freezing unilateral tariff reductions planned by the previous government, until at least mid–2005; the launching of a review of the monetary policy framework (Box 5); and the establishment of a new entity—Industry New Zealand—charged with the implementation of industrial policies focused on regional development.

New Zealand—A Recent Chronology of Key Public Pension Policy Developments

New Zealand Superannuation (NZS) is a universal, pay-as-you-go public pension system funded from general tax revenuesthere is no payroll tax. All pensioners receive the same pension depending on their marital status, and the pension is based on the level of nationwide average wages.

  • In 1977, the Government established New Zealand’s first “pure” universal public pension. Benefits began at age 60, and were set at 80 percent of the average wage for couples (48 percent for singles). Qualifications were liberal: only 10 years of residence were required, and there were no income or asset tests. Government pension costs quickly doubled to 7 percent of GDP.

  • To rein in costs, various Governments in the 1980s reduced the generosity of the system. In 1985, a surcharge was placed on other retirement income (effectively introducing means testing). In 1989, the 80 percent “replacement ratio” was suspended.

  • Further reforms followed in the early 1990s: it was agreed to raise the retirement age to 61 immediately, and to 65 by 2001; pensions were indexed to prices alone; and the surcharge was increased and its base broadened. Pension expenditure fell to 5 percent of GDP by mid-decade.

  • In 1993, an Accord on Retirement Income Policies was reached, which included: a transitional benefit to partially offset the effects of the increase in the retirement age; bounding a couple’s combined pension in a band of 65–72½ percent of average wages; and commissioning of a six-yearly Periodic Group Report (from 1997) to look broadly at the effects of demographic changes on pension spending. Also, the Office of the Retirement Commission was established to publicize the need to increase private retirement savings, and the public pension system was renamed NZS.

  • The National-New Zealand First coalition government posed a national referendum on superannuation in September 1997. A fully-funded, privately managed, defined contribution scheme with a government “top-up” was rejected by 92 percent of voters. Also, in April 1998, the surcharge on other retirement income was eliminated, returning New Zealand to a pure universal pension scheme.

  • In December 1998, the minority National Government set up a Superannuation 2000 Task Force, charged with developing a pension policy consistent with long-term fiscal sustainability (and to report its findings in 2000). The floor on the pension benefit rate was reduced to 60 percent.

  • In November 1999, a Labour-Alliance coalition government came into power and disbanded the Superannuation 2000 Task Force. In March 2000, the government announced the immediate restoration of the floor of the pension benefit rate to 65 percent, as well its plans to “pre-fund” future superannuation payments out of projected operating surpluses beginning in 2001/02. Cumulative contributions would be about 3 percent of GDP over the first three years.

  • The 2000 Budget spelled out further details of the pre-funding scheme. Annual contributions would be determined using a rolling, 40-year tax smoothing model, which implies the existence of an investment fund into the 22nd century. Also, the fund would be run on a commercial basis through a Crown entity, and be subject to income taxes. The precise investment objectives and instruments (and the extent to which assets could be invested abroad) have yet to be finalized.

New Zealand—Labor Market Arrangements

Background

New Zealand has a long history of strong central controls on the labor market and industrial relations dating from the late 19th century. For most of the 20th century, the labor market was characterized by the registration (and special legal status) of unions and the settlement of enforced agreements (awards) through mandatory, state-provided arbitration. The post-war labor market exhibited wage rigidities owing to compulsory union membership, “blanket” coverage for wage claims, government arbitration and, in the 1970s, generalized wage adjustments, all buttressed by external tariff barriers and a lack of domestic competition. While some attempts at reform took place in the 1980s (e.g., aimed at reducing state involvement in labor market outcomes), the labor market was largely excluded from the first wave of reforms.

Employment Contracts Act (ECA), 1991

  • The ECA was a fundamental break with past labor market arrangements as it gave primacy to agreements between freely contracting individuals (“freedom of association”).

  • Multi-enterprise bargains could only come about through mutual agreement.

  • Compulsory and monopoly union powers were abolished, government registration of unions was terminated and “incorporated societies” lost their tax exempt status.

  • The right to strike or lock out was retained, but such actions were only possible after the expiry of a contract. If employers had agreed to a multi-enterprise contract, then strike action involving employees of other enterprises was legal after the expiration of the contract.

  • Protection against unjustified dismissal was retained, as were (under separate legislation) minimum wage laws, a minimum code of employment rights such as holidays, sick leave, and occupational hazards, etc.

  • All parties had the right to enforce their employment contract through an Employment Court and Employment Tribunal.

  • Employees had access to the Employment Court to have a contract set aside if it contained or was entered into under harsh or oppressive conditions. Government courts were restructured to provide quick and inexpensive means of mutual resolution of disputes.

Employment Relations Act (ERA), 2000

  • The ERA is based on the premise that there is an “inherent inequality of bargaining power in employment relationships,” and specifies that such relationships must be built on “good faith.” General principles of good faith bargaining are built into the legislation, but a code of good faith bargaining is to be developed by a tripartite committee for approval by the Ministry of Labor.

  • All collective bargaining must be undertaken through unions (which will be a signatory to any such employment contract) and only union members can be covered by a collective bargaining agreement.

  • The ERA retains the voluntary nature of union membership while protecting freedom of association. The ERA prohibits any preference or undue influence in decisions on union membership.

  • The legislation allows unions to have access to workplaces to recruit members, discuss union business, and to deal with any matters related to the terms and conditions of employment of union members.

  • The legislation establishes a collectively allocated right for those covered by collective agreements to take leave for training in employment relations, at the employers’ expense. The union allocates the use of this right to eligible employees who must be union members covered by the relevant agreement.

  • New institutions will be set up to promote resolution of problems: an independent (publicly staffed) Mediation Service as the first step of dispute resolution, and a new Employment Relations Authority (an independent statutory body) to investigate problems that have not been solved through mediation. The Employment Court will continue to exist to hear matters referred to it by the Employment Relations Authority.

19. Assessing the near- and medium-term outlook has been significantly complicated by the sharp fall in domestic confidence and international investor sentiment since April 2000. With signs that growth in the second and third quarters of 2000 slowed sharply, the staffs projections are for output growth of about 3¼ percent in calendar year 2000, falling to around 3¼ percent in 2001 and to 2½–3 percent over the medium term (Annex I). Given the strong trading partner outlook and the marked boost to competitiveness from the large real effective depreciation of the exchange rate, export growth is expected to remain strong. Imports are expected to be affected by higher interest rates and falling confidence which are expected to act as a dampener of domestic demand; higher oil prices which will boost the nominal import bill. All told, the current account deficit is expected to narrow to about 6 percent of GDP in calendar 2000, before tapering off gradually to around 4 percent by 2005. With little prospect of a strengthening of the New Zealand dollar in the near future, rising oil prices, and the long period of tightening margins, the pass–through to inflation of higher import prices should broaden, making it likely that inflation will get close to or even 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.

20. At this stage, the staff sees mostly downside risks to the growth outlook. Although the forecasts build in a weakening in domestic demand, the fall in confidence, if it persists, could foreshadow an even sharper slowing in the domestic economy. The lack of buoyancy in domestic activity would make growth—which is expected to be driven by exports—especially vulnerable to a weakening in global economic conditions.

IV. Policy Discussions

21. Discussions focused on demand management and the policy mix, structural policies to raise saving and growth, operational elements of monetary policy and on the degree of external vulnerability facing New Zealand. During the last Article IV consultation, Directors recommended structural reforms of the agricultural producer boards and of education to raise potential growth. They saw the need to address fiscal pressures from population aging, and to remove disincentives to household saving in the tax, welfare and pension schemes. Directors’ view was that although New Zealand was well–positioned to cope with shocks, the high current account deficit and net external liabilities left the economy vulnerable to adverse shifts in investor sentiment.

New Zealand—Recent Developments in Monetary Policy Operations

The second half of the 1990s saw some important changes in New Zealand’s approach to inflation targeting, all broadly aimed at moving to greater flexibility and efficiency in the framework.

  • In December 1996, the inflation target band was widened from 0-2 percent to 0-3 percent;

  • From March 1999, the Reserve Bank of New Zealand (RBNZ) began to use the Official Cash Rate (OCR) as its primary policy instrument, replacing the previous, more complicated, modus operandi when policy was conducted through periodic announcements about the desired level of the Monetary Condition Index (MCI);

  • At the same time as the switch to the OCR, the RBNZ extended its policy horizon (from 12-14 to 18-24 months);

  • The RBNZ has shifted from a “mark up” approach to projecting inflationary pressures (based on cost pressures and margins and, thus, on the direct effect of the exchange rate) to an “output gap” approach, that emphasizes the indirect effect of the exchange rate (via aggregate demand).

The most recent change was the revision of the Policy Targets Agreement (PTA) in December 1999 following the change in government in November 1999. The new PTA confirms the primacy of the price stability objective and the 0-3 percent inflation target, but now states that “in pursuing its price stability objective, the bank shall implement monetary policy in a sustainable consistent and transparent manner and shall seek to avoid unnecessary instability in output, interest rates and the exchange rate”. This compares with the previous PTA, which stated that “the Bank shall implement monetary policy in a sustainable, consistent and transparent manner”.

Another recent development has been the commissioning of a review of the operation of monetary policy. The goal of the review is to ensure that the monetary policy framework and the RBNZ’s operations within that framework are appropriate to the characteristics of New Zealand’s economy and best international practice. The primacy of the price stability objective and the RBNZ’s autonomy in conducting monetary policy will not be subject to review. The review (which will be conducted by Lars Svensson and is due to be completed early next year) will consider the following issues:

  • Whether the way the RBNZ interprets the PTA with a view to ensuring that achieving price stability is consistent with avoiding undesirable instability in output, interest rates and the exchange rate;

  • Whether the RBNZ has an adequate range of instruments and is using them effectively in altering monetary conditions in the desired direction;

  • The range of sources, availability, type and timeliness of data and the impact of these variables on forecasting and decision making;

  • Whether the monetary policy decision making process and accountability structures promote the best outcomes possible;

  • The coordination of monetary policy with other elements of the economic policy framework;

  • Whether the RBNZ’s decisions are explained to the public and markets in the simplest, clearest and most effective way possible.

A. Macroeconomic Policies

22. The key challenge for near–term macroeconomic policy is to steer the economy pragmatically to support sustained growth while avoiding a build–up of inflationary pressures. Given the large external imbalances, an adverse shift in investor sentiment could—as in the past few months—lead to unsettled financial market conditions, and thus complicate the task of macroeconomic management. Thus, the mission stressed the need to reassure investors and markets that the overall economic strategy is clearly consistent with raising New Zealand’s productivity and that it is aimed at enhancing the economy’s competitiveness and growth prospects.

Monetary Policy

23. The mission supported the implementation of monetary policy to date. The staff agreed with the authorities that the very rapid pace of expansion of the economy in the second half of 1999 and the stimulus being provided by the depreciating exchange rate warranted the increases in interest rates that have taken place thus far. The staff also supports the authorities’ decision not to raise interest rates at the mid–August review, both because recent signs of slowing activity could suggest that the balance of risks may have shifted slightly away from a sustained build–up in inflationary pressures, and the possible salutary effects the pause in the tightening cycle may have on confidence.

24. For the period ahead, the authorities are of two minds about the direction of monetary policy, but agreed that any tightening should be gradual and continually reassessed. Indicators of activity paint a mixed picture of the strength of the economy going forward, with a marked difference in temperature across sectors. In these circumstances, the authorities’ view is that there is a plausible scenario for inflationary pressures that would necessitate further tightening. In particular, it is unclear whether there is much prospect for a strengthening in the $NZ in the near future; indeed, the significant volume of Eurokiwi bonds that are maturing in the next few months, and the market’s view that New Zealand is off global investors’ radar screens suggests further downward pressure on the exchange rate in the near term. The authorities agreed with the staff’s judgment that the decline in the New Zealand dollar could be a structural adjustment to the large current account deficits and that the currency may only be slightly below its medium–term equilibrium in real effective terms. On the other hand, there is also a plausible scenario which would call for no further tightening or even an easing of policy. The fall in confidence could be an early indicator of a sustained weakening in domestic demand. Moreover, in light of the high level of household indebtedness (estimated to be close to 110 percent of household disposable income),5 domestic demand may now be more interest sensitive, implying that the increase in interest rates to date may be impacting the economy more than previously estimated.

Fiscal Policy

25. The authorities explained that the overriding principle of this year’s budget was one of restoring balance between economic and social objectives. The key initiatives are aimed at strengthening the health and education sectors, promoting regional development, improving prospects for Maori and Pacific Islanders who make up some 20 percent of the population, and closing gaps between the rich and the poor, while still preserving a sustainable medium-term fiscal position. Specifically, the government’s fiscal objectives are to maintain an operating surplus across the economic cycle to allow for prefunding pension costs associated with an aging population (discussed further below) and to reduce and maintain net debt below 20 percent of GDP.

26. The mission took the view that the projected fiscal policy stance in 2000/01 and the medium–term is broadly appropriate but the risks are predominantly on the downside. From the point of view of demand management and raising public saving, the planned operating surpluses for the next four years are appropriate. Also, the fiscal provision covering new discretionary spending provides an additional dimension of accountability. The authorities acknowledge that, because about two–thirds of the fiscal provision has already been allocated, they face a very tight constraint on discretionary spending for the rest of this government’s term. In addition, the staff expressed concern that the revenue forecasts are based on optimistic growth projections. Thus, while the fiscal provision may be met, the baseline outcomes for revenues and expenditures may be worse than expected due to factors that may not be strictly exogenous, including negative macroeconomic effects of the policies of the new government. Given the recent shift in market sentiment and in light of the fact that a key driver of confidence is the market’s perception of whether the government has the ability to control its finances and to reduce the burden of demand management on monetary policy, the mission suggested the need to keep a very close watch on expenditures together with the formulation of well–specified contingency plans to offset possible slippages in achieving the targeted surpluses.

27. The authorities’ view is that the contentious history of superannuation reform in New Zealand makes it critical to have a period of stability in the scheme. One way to achieve this is to use part of fiscal surpluses to partially prefund future pension spending. The mission expressed broad support for the authorities’ prefunding plans, and the staff’s work on the macroeconomic impact of prefunding superannuation suggests that, relative to the counterfactual where superannuation expenses continue to be funded out of general revenues, there would be a small positive impact on national saving, and a net positive impact on labor supply and output.6 In response to the suggestion to consider additional parametric reform to reduce the generosity of the system, lower pension costs, and encourage private saving, the authorities explained that the proposed scheme to partially prefund future pension costs has the flexibility to incorporate some parametric reform such as a gradual increase in the retirement age. On the institutional arrangements, including the investment strategy, the mission recommended that consideration be given to running a tax-exempt fund using an index approach with both domestic and foreign investments. The authorities prefer to subject the superannuation fund to taxes on the grounds that this would be consistent with the tax treatment of all Crown entities. The authorities agreed that defining the institutional arrangements to safeguard the fund’s assets were important, but believe that regardless of the chosen arrangement, once the fund rises to a critical level, it will become increasingly difficult for future governments to tamper with it.

28. Finally, in addition to pension costs, the mission suggested that preparations be started to address health costs related to the aging population—conservatively estimated to be of a similar order of magnitude as pension expenses. In this context, the mission suggested that the authorities review the experiences of other industrial countries with progressively shifting a part of the costs to the private sector.

B. Structural Policies

29. As noted above, the new government’s view is that the relatively weak growth payoff to New Zealand’s reforms suggests the need for a “correction” in certain policies, while maintaining intact other aspects of the reforms. The authorities stressed that they remain committed to the fiscal policy framework and to the fundamental elements of the monetary policy framework, and that the changes being implemented in other areas should be seen as attempts to bring New Zealand in line with regimes in Australia and other comparable industrial countries. The authorities also took the view that there is a need for a more active role for the government in the economy to ensure greater consistency between sectoral policies.

Growth

30. The staff shares the authorities’ concern that, although there have been improvements in growth and productivity in the 1990s, there has not been a significant narrowing of the gap in per capita incomes with comparable countries (Box 1). The staff agreed with the authorities on the broad objectives of the growth strategy for New Zealand, namely (a) to leverage its traditional strengths in primary and commodity–based manufacturing; and (b) to put itself in a better position to take advantage of those aspects of globalization where physical remoteness may be of much less importance.7 Acknowledging that the experience of other countries (e.g., Australia and the U.K.) suggests that the full effect of reforms takes several years, and that important reforms were implemented only in the first half of the 1990s, the discussions focused both on areas where there is scope for additional reforms and those where there could be a risk of weakening the gains that have already been achieved through earlier reforms.

31. On the scope for further reforms:

  • First, the mission agreed with the authorities’ focus on upgrading human capital. In particular, the mission endorsed initiatives such as the modern apprenticeship program to supplement the on–the–job training provided by Industry Training Organizations; skills–targeted immigration policies; and the provision of grants to encourage R&D. An additional issue relates to retaining skilled labor in New Zealand and stemming the “brain drain”. In this context, the mission had some concern that measures such as the increase in the income tax on high–income earners could serve to exacerbate rather than alleviate the problem of emigration of skilled labor.

  • Second, the mission saw considerable scope to improve agricultural sector performance through more rapid progress in deregulating key primary sectors. The mission welcomed the progress that has been made with the partial deregulation of the apple and pear, and kiwifruit boards and suggested that the authorities undertake an early review of experience with a view to further deregulation. As for the dairy industry, which accounts for 15–20 percent of New Zealand’s exports, the authorities agreed that notwithstanding the limits to expansion arising from partner country protectionist barriers, there remains scope for innovation and for achieving greater access to new markets through dairy board reform, but noted that they strongly prefer that a solution be generated from within the industry. The mission suggested that, since the dairy industry had failed to deliver a restructuring plan before the deadline of September 1, 2000, the authorities now take a greater leadership role in its reform, including through the commissioning of an external review similar to one for the wool board.

32. The mission also highlighted areas where there is a danger of weakening the gains that have already been achieved through earlier reforms. In this context, the mission took the view that the impact on confidence of changes in policy direction that are accompanied by a lack of clarity in the underlying economic rationale could be severe. As already noted, the economy’s increased resilience and flexibility in the face of shocks has largely been the result of labor and product market deregulation, which has improved competition and has significantly reduced the scope for rent–seeking activities. Thus, in the following areas, the mission suggested proceeding with caution and being prepared to change policies that prove detrimental to competitiveness and growth.

  • The first of these areas is the replacement of the Employment Contracts Act (ECA) by the Employment Relations Act (ERA). The ECA is widely acknowledged as having improved labor market flexibility and resulted in a much closer alignment of wages and productivity growth.8 The authorities’ view is that the ECA tipped the power balance in labor relations unduly in favor of employers and that the ERA is aimed at achieving a better balance. Private sector representatives expressed the view that there was no compelling reason for a reform of the industrial relations framework, that labor relations had improved greatly under the ECA, and that the new legislation would add to the cost of doing business. Moreover, they noted that although a code of “good faith” in employment relationships is being drafted, actual practice will depend on the body of case law that will take time to be built up. The authorities countered that business’ reaction is exaggerated and were confident that experience with the new legislation will show that business’ fears are unfounded. The mission noted that the new framework does raise the possibility of weakening wage and labor market flexibility, and that the authorities should be prepared to be flexible and pragmatic in its implementation.

  • The second is the restoration of the ACC as the monopoly, public–sector owned provider of workplace accident insurance after it was opened up for private sector participation only in mid–1999. Prior to the introduction of a competitive insurance market, the main concerns related to the scheme’s increasing cost and relative generosity. Since the introduction of the competitive regime, businesses had experienced substantial cost saving. Nevertheless, the authorities were concerned first, that private insurers’ focus on short–term profits would come at the expense of investment in injury prevention and rehabilitation; and second, that higher transactions and compliance costs associated with a multi–insurer environment would be transferred to employers and claimants. The mission noted that a competitive system could lead to greater incentives for employers to take preventive measures because of the link between firms’ risk ratings and their premiums, and suggested that the authorities remain open to reintroducing competition in this market, especially if risks of rising fiscal costs reemerge.

  • The third relates to changes in product market regulation. On the changes to the Commerce Act, the authorities explained that actual practice had tended to weaken the original intent of the legislation and that the amendments bring the legislation in New Zealand more closely in line with that in Australia. They also acknowledged that these amendments would be especially effective in the regulation of utilities. The staff was in broad support of these changes. However, in the telecommunications sector—where the authorities are considering the establishment of an industry–specific regulator with relatively far–reaching powers—the staff noted that this was a difficult area, and that there is no international consensus on “best practice.” Indeed, New Zealand’s current approach of relying on general competition law and industry self–regulation is, in many ways, an ideal. Moreover, there is evidence that competition in this sector has not been stifled in spite of light–handed regulation, and that costs have remained low, despite the disadvantages of low population density and lack of scale economies.9 This suggests the need to proceed with caution, especially with the establishment of additional regulatory apparatus that could prove difficult to dismantle if deemed unsatisfactory.

  • The fourth relates to industrial policies. The refocused and expanded role of the Ministry of Economic Development in coordinating, integrating and monitoring on–going economic and industry development programs is likely to be quite useful insofar as it minimizes duplication and could increase efficiency. On the role of the soon to be established entity Industry New Zealand, the mission acknowledged that only a small amount has been allocated for this purpose in the budget, but suggested that its role be carefully designed and tightly circumscribed from the start, so as to prevent drift into the type of activist industrial policy that characterized pre–reform New Zealand. In particular, caution is warranted in the use of public intervention in promoting regional development policies. First, these policies could restrict the benefits of agglomeration—critical in a country of New Zealand’s size. Second, there is the risk of creating opportunities for rent seeking behavior and associated resource allocation distortions.

33. On trade issues, the authorities stressed that protectionist barriers in industrial countries for its exports have had substantial detrimental effects on New Zealand’s GDP. Thus, while they remain committed to trade liberalization through the WTO, they are pursuing regional and bilateral agreements as second best options. The authorities made the point that the recent decision to freeze unilateral tariff reductions on textiles, footwear and clothing would make the regime no different from that in Australia. The vast majority (95 percent) of goods entering New Zealand are not subject to any tariffs, and New Zealand remains committed to APEC agreements to eliminate all tariffs by 2010 and to other bilateral trade agreements. The staff welcomed the authorities’ commitment to trade liberalization but noted that the decision to freeze unilateral tariff reduction, because it reverses earlier plans, could have an adverse impact on confidence.

Saving

34. In light of the steady decline in saving, the staff have, in the past, argued strongly in favor of policies that provide appropriate incentives for private saving. With respect to private saving, the staff noted that some of the recent changes in the tax and social transfer systems could go in the wrong direction to this objective. First, the increase in the income tax rate on high income earners further increases the reliance on direct taxation which studies (both by the staff and the authorities) have found to be a significant disincentive to private saving. Second, the increase in the replacement ratio from New Zealand Superannuation together with some of the welfare system reforms tend to increase the generosity of social transfers, which, in turn, could dull private saving incentives. In this context, the staff welcomed the comprehensive review of the tax system planned for 2001 and urged that priority be given to efforts to eliminating disincentives in the tax regime and in the social transfer and welfare system to private saving and productive investment. The authorities pointed out that the key reason for the low saving rate was the low rate of income growth rather than tax and transfer policies and thus the focus of policies should be on generating higher growth.

Household Saving Ratio

(In percent of disposable income)

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Source: OECD.

C. Review of Monetary Policy Operations

35. The government has implemented a change in the Policy Targets Agreement (PTA) and has commissioned a review of monetary policy operations to assess “its effectiveness in contributing to broader social and economic objectives” (Box 5).10 The authorities were of the view that the new PTA merely formalizes the changes that are already being implemented by the RBNZ since the mid–1990s as part of the move from a relatively strict to a more flexible inflation targeting framework. The staff agreed with this view, but made several points. First, in light of the favorable early assessment of the experience with the switch to the Official Cash Rate (OCR), the rationale for altering the PTA was not entirely clear.11 Second, the inclusion of additional words and conditions in the PTA reduce the simplicity and clarity that were strong points of New Zealand’s inflation targeting framework and could, over time, complicate monetary policy formulation. Third, there could now be a need for additional discussion of implementation issues to ensure that the public understands fully the rationale for monetary policy decisions and their likely implications for output, interest rate and exchange rate variability. Indeed, some of the gains in moving from the MCI to the OCR regime in terms of a reduction in the public’s attention to implementation issues may be lost with the new PTA. Fourth, modifications to the PTA, particularly when coincident with the political cycle, could unduly politicize monetary policy implementation. In this context, any actual or perceived reduction in the instrument independence of the central bank could weaken policy credibility. The authorities stressed that there were sufficient checks and balances in the framework to ensure the independence of the central bank: the governor has the right to decline to sign the PTA which would require the Treasurer to activate the “override” clause and begin dismissal procedures. Moreover, any change to the objectives of monetary policy would be a very open and public process and not one that would be entered into lightly.

36. On the monetary policy review, the authorities emphasized that the terms of reference for the review clearly state that the goal of price stability and the operational autonomy of the RBNZ are not open to review. Their view is that the time is right for a broad review of the operation of the monetary policy framework over the past ten years. The mission’s discussions focused on the decision-making process and accountability structure used in New Zealand and whether these are likely to promote the best outcomes for monetary policy. Formally, the implementation of monetary policy rests in the sole hands of the governor, and he is solely accountable for inflation outcomes as specified in the contract embodied in the PTA. The performance of the governor in the implementation of monetary policy is assessed by the Board of Directors, of which the governor himself is a member.

  • Notwithstanding theoretical arguments in favor of delegation of responsibility for monetary policy to a formal committee, the authorities cited the loss of parallels with the accountability structures in the rest of the public sector, the operational complexity arising from signing several individual contracts, and the shortage of potential candidates to constitute such a decision–making body as possible stumbling blocks to moving to a committee structure in New Zealand. Another factor is the possible adverse impact on monetary policy credibility as the new committee members establish their reputations and the market and the public learn how the committee will function. The mission agreed that there did not appear to be a compelling reason to move to a monetary policy committee structure at this time.

  • However, regardless of whether changes are made to the current decision–making structure, the authorities agreed on the need to modify an element of the accountability structure, namely the board of directors which assesses the performance of the governor, either by replacing the governor as the chairman, or by dropping him from the board altogether.

D. External Vulnerability

37. Indicators of external vulnerability and the adjustment to recent shocks supports the staff’s earlier assessment that New Zealand is generally well placed to absorb shocks without undue economic or financial distress.12 As identified during the last Article IV consultation, key factors mitigating the vulnerability associated with the high external liabilities are the freely floating exchange rate; the near–complete natural or derivative based hedging of interest and exchange rate risks by banks and corporates; the

38. sound financial position of banks with capital ratios well in excess of the Basle minimum standards and low levels of impaired assets;13 the relatively low share of short–term external debt subject to rollover risk; and the high degree of policy transparency and accountability of policy makers. The series of adverse shocks over the past 2–3 years—the shift in market sentiment, volatility in commodity prices, and loss in external markets associated with the Asian crisis; the droughts; the weakness in housing and equity markets; and the recent renewed slide in the exchange rate—have, thus far, been absorbed quite smoothly. That said, the authorities agreed that the high degree of external exposure means that policy makers have to be especially mindful of the impact of their actions on confidence, and that the best course to reduce the economy’s external vulnerability over the medium term is to implement policies that are clearly aimed at removing disincentives to saving and ensuring that investment is allocated more productively.

New Zealand--Key External Vulnerability Statistics

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Source: Statistics New Zealand.

For 2000, data are for end-June.

Goods only.

V. Staff Appraisal

39. The fact that the wide-ranging economic reforms have not yet brought strong rewards in terms of growth may be a legitimate reason to reexamine elements of the reform process. However, in light of New Zealand’s vulnerability to external investor sentiment, it is particularly important that the economic rationale for policy changes be well understood both domestically and internationally. Changes in policies that are undertaken in the absence of convincing evidence of the shortcomings of the existing regime could be interpreted by markets as a step backwards, with negative short–and medium–term consequences.

40. The resilience displayed by the New Zealand economy through the turbulence of the past 2–3 years is clear testimony of the benefits of the economic reforms of the past 15 years. Growth recovered strongly in 1999 and early 2000, owing to favorable weather conditions and appropriate macroeconomic management, while inflation remained relatively subdued. The widening of the current account deficit, in large part, reflected the effects of the drought on exports; in recent months, exports have picked up strongly and the current account deficit looks set to narrow despite the adverse impact of higher oil prices. The financial system has fully absorbed the impact of the adverse shocks and remains well capitalized with low levels of impaired assets.

41. The key challenge for near–term macroeconomic policy is to steer the economy pragmatically to support sustained growth while avoiding a build–up of inflationary pressures. In this context, in the absence of steps to reassure markets that the authorities’ overall economic strategy is clearly aimed at enhancing competition and growth, the burden on macroeconomic policies in maintaining stability could be very high.

42. The recent conduct of monetary policy has been appropriate but monetary management in the period ahead is likely to be challenging. Although signs of slowing activity would suggest that the balance of risks may have shifted slightly away from a sustained build–up in inflationary pressures, there remain some indications of a need for further tightening of monetary policy over the coming year. However, any tightening should be gradual and continually reassessed in light of the uncertainty surrounding the sustainability of the economic expansion.

43. The targeted near–and medium–term fiscal operating surpluses are appropriate from a demand management point of view and are reasonably ambitious, but the risks are mainly on the downside. These risks arise from the fact that two–thirds of the fiscal provision has already been allocated leaving a very tight constraint on discretionary spending for the rest of this government’s term. Moreover, at this stage, it is not clear that the optimistic growth forecasts underlying the revenue projections will be realized, in part because of the impact of the direction of government policies on confidence. With a key driver of sentiment being the market’s perception about the government’s ability to control public finances and to reduce the burden of demand management on monetary policy, the staff sees the need to keep a very close watch on expenditures together with the formulation of well–specified contingency plans to offset possible slippages in achieving the targeted surpluses.

44. The authorities’ focus on New Zealand’s growth performance is appropriate—the staff would suggest 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 through earlier reforms. In this context, the authorities’ focus on human capital development is appropriate, but there is concern that increase in tax rates on high income earners could exacerbate the “brain drain.” The staff welcomes the reforms implemented to partially deregulate parts of the agricultural sector, and recommends more rapid progress in deregulating the dairy sector, where notwithstanding the limits to expansion arising from partner country protection in dairy products, there remains scope for innovation and higher value added.

45. The mission also cautioned against reforms that could reduce labor and product market flexibility and suggested that the authorities be flexible and pragmatic in their implementation. Chief amongst these are the ERA, the restoration of the ACC as the monopoly provider of workplace accident insurance, and the regulatory reforms of the hitherto lightly regulated telecommunications sector. Likewise, while efforts to coordinate and integrate ongoing economic and industry development programs are useful, the mission would recommend that the role of the soon to be created Industry New Zealand be tightly circumscribed from the start so as to prevent a drift into activist industrial and regional development policies.

46. On saving, the mission noted that recent proposals and changes in the tax and social transfer systems may not go far enough to have a significant impact on saving or, in some cases, may actually reduce saving. The staff expressed broad support for the authorities’ plan to prefund a part of future pension liabilities through the building up of a separate trust fund, and would suggest that consideration also be given to parametric reforms to lower pension costs. The staff also suggests that more rapid progress be made with defining the institutional arrangements and the investment strategy to safeguard the fund’s assets. As for private saving, the staff’s view is that recent increases in top income tax rates and in the replacement rate for superannuation are likely to lower private saving; the staff would therefore suggest that the forthcoming comprehensive review of the tax and transfer regimes focus on removing disincentives to private saving and to productive investment.

47. On recent reforms and the forthcoming review of monetary policy operations, the staff agrees that a review of monetary policy operations may be timely and welcomes the fact that the primacy of the price stability objective and the autonomy of the RBNZ are not subject to review. However, the inclusion of additional conditions in the contract could reduce the clarity of the framework and, over time, could complicate monetary policy formulation. Moreover, the changes imply a need for monetary policy announcements to focus on implementation issues. Finally, the staff would caution against actions that could unduly politicize monetary policy implementation and could undermine the actual or perceived instrument independence of the RBNZ.

48. The mission’s assessment of New Zealand’s external vulnerability is that the country is generally well placed to absorb shocks without undue economic or financial distress. While the extent of external imbalances remains very large, suggesting a high degree of vulnerability to sudden changes in investor sentiment, mitigating factors including the high degree of hedging and the experience of adjustment to shocks over the recent past support this assessment. The staff, however, stressed that the large degree of external exposure means that policy makers have to be especially mindful of their actions on confidence, with the focus being on policies that are clearly aimed at reducing disincentives to saving and productive investment so as to narrow the current account deficit over the medium term to more sustainable levels.

49. New Zealand publishes an array of high–quality economic and financial statistics that are adequate for surveillance. The staff welcomes the authorities’ efforts to improve the frequency, timeliness and coverage of these statistics (Annex IV).

50. The staff would encourage the authorities to give favorable consideration to requesting an FSAP. The authorities have tentatively indicated that if they do, it will be in 2001, after the completion of the on-going monetary policy review.

51. It is proposed that the next Article IV consultation with New Zealand take place on the standard 12–month consultation cycle.

FIGURE 4
FIGURE 4

NEW ZEALAND: MONETARY AND FINANCIAL INDICATORS, 1995-2000

Citation: IMF Staff Country Reports 2000, 138; 10.5089/9781451830163.002.A001

Sources: Reserve Bank of New Zealand; and IMF International financial Statistics.
FIGURE 5
FIGURE 5

NEW ZEALAND: FISCAL INDICATORS, 1994/1995-2000/01

(In percent of GDP)

Citation: IMF Staff Country Reports 2000, 138; 10.5089/9781451830163.002.A001

Sources: Data provided by the New zealand authorities; and staff estimates.

ANNEX I New Zealand—Medium-Term Scenario

Background

This scenario illustrates the medium-term dynamics of key economic variables such as growth, inflation, and the current account. In particular, it takes into account the impact of the authorities’ medium-term fiscal consolidation plans and the real effective depreciation of the New Zealand dollar since 1997 on the dynamics of the current account deficit and net external liabilities.

Given the strong dependence of the New Zealand economy on the external environment, the economic outlook is largely conditioned by future regional and global developments. The scenario presented here is consistent with the latest global WEO projections of partner-country demand and world prices for New Zealand’s exports and imports.

Near-term outlook

  • Following the sharp acceleration of growth in the second half of 1999, activity weakened in the first half of 2000 with a slowdown in domestic demand.

  • Relatively sharp differences have recently emerged between the domestically-oriented sectors and the external sector. Domestic demand growth and the urban, nontradeables sector are slowing as a result of successive interest rate hikes, the generally moribund stock market, and a sharp fall in business confidence, related in part to government policy changes which is reflected in lower investment intentions. On the other hand, the rural sector and exporting industries have been buoyed by a recovery from 2 years of drought, the very competitive exchange rate as well as strong demand in key export markets. Consequently, the composition of growth has shifted sharply toward net exports and away from domestic demand.

  • Growth is projected at 3¾ percent in 2000, with the quarterly growth momentum is projected to slow sharply through the year. The annual average growth rate reflects the carryover effect of the rapid growth in the second half of 1999.

  • The current account deficit is projected to narrow to 6 percent of GDP in 2000, down from 6¾ percent of GDP (adjusted for a large one-off defense-related import item) in 1999.

  • Inflation in 2000 is expected to get close to and could even breach the 0–3 percent target band at end-2000, with increasing pass-through of the exchange rate depreciation but will remain at 2½ percent on average.

Medium-term outlook

  • Growth is projected to fall to 3¼ percent in 2001 and then gradually slow to its medium-term potential rate of about 2½ percent.

  • The current account deficit is projected to fall steadily (reaching about 4 percent of GDP in 2005), mainly due to a sustained improvement in the trade balance. This is based on a projected firm recovery in import demand in trading partners, and the lagged impact of stronger competitiveness as a result of the large real effective depreciation of the New Zealand dollar.

  • Net foreign liabilities are projected to stabilize at about 99 percent of GDP in 2000.

  • Inflation is projected to remain above 2 percent over the next two years with the negative output gap having been closed in 2000 while gradually approaching the midpoint of the authorities’ 0–3 percent target band. Further out in the medium term it is projected to remain close to the midpoint of the band.

Saving-Investment balance

  • The improvement in the current account is projected to occur as a result of higher national saving, which more than offsets the cyclical recovery in investment rates from their depressed levels in 1998–99.

  • Higher national saving rates are expected due to increases of roughly the same magnitude of both public saving (in line with the authorities’ medium-term fiscal projections) and private saving.

  • The projected increase in private saving reflects both the impact of high household debt levels and the leveling-off of household net worth since 1997, following sizable increases during the 1990s.

Sensitivity analysis

The staff has conducted sensitivity analysis of the illustrative baseline scenario to examine the impact of:

  • A 100 basis point increase in the risk premium on foreign liabilities.

  • A deterioration of terms of trade by five percent through higher import prices. In both these scenarios, the current account adjustment is much smaller with the deficit remaining above or at about 6 percent of GDP through 2005—the end of the projection period—when net foreign liabilities would increase to 107 percent of GDP.

  • A 2 percentage point drop in external demand. The reduction in the current account deficit is again slower than in the central scenario, reaching 5 percent of GDP by 2005. Net foreign liabilities would increase gradually over the period projection to 104 percent of GDP.

  • A 10 percent depreciation of the trade weighted exchange rate from its level in Q3,2000. By the end of the projection period the current account deficit would fall to 2¾ percent of GDP and net foreign liabilities would decline to 88 percent of GDP.

  • Lower growth caused by weak domestic demand. The reduction in the current account deficit would be faster than in the baseline scenario, reaching 3 percent of GDP by 2005 while net foreign liabilities would decline to 96 percent of GDP.

Each scenario assumes a single shock. It is, of course, possible to envisage a situation where more than one of these shocks take place at the same time. In these circumstances, in some cases (e.g., if there is a deterioration in the terms of trade coupled with an increase in the risk premium), external imbalances could deteriorate significantly. In other cases, (e.g., a further depreciation of the exchange rate coupled with weaker domestic demand), there could be a substantial improvement in external balances.

New Zealand: Medium-Term Scenario, 1996-2005

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Sources: Data provided by the New Zealand authorities; and staff estimates and projections.

Staff estimates; based on national accounts data.

Fiscal years ending June 30.

Staff estimates; equals operating balance net of cyclical effects, revaluations and changes in accounting rules.

End of calendar year.

ANNEX II New Zealand—External Vulnerability Assessment

This Annex updates the staff’s assessment of New Zealand’s external vulnerability provided in SM/99/196 (August 3,1999). On the whole, the assessment remains broadly unchanged. That is, while the extent of external imbalances remains very large, suggesting a high degree of external vulnerability to sudden changes in investor sentiment, several mitigating factors, including evidence from recent large movements in the exchange rate, lead the staff to conclude that the external risks remain manageable. However, the staff notes that some of the mitigating factors—such as the relatively benign currency and maturity composition of the debt—have deteriorated somewhat since the previous Article IV consultation, but that others—such as increases in debt to related parties—have helped to offset this somewhat.

The Annex is structured as follows: Section A decomposes New Zealand’s gross external debt along sectoral, currency denomination, maturity and related party lines. Section B reports on the extent to which external exposures are hedged. Section C looks at the balance sheets of the household, banking and government sectors. Section D covers some remaining factors that come into play in assessing New Zealand’s external vulnerability. Section E concludes.

A. Decomposition of External Debt1

New Zealand’s gross external debt remains very high, and continues to rise rapidly. At end–March 2000, external debt totaled $NZ 109 billion, equivalent to 105 percent of GDP, up from 101 percent of GDP two years ago and 82 percent of GDP at end–March 1996 (Table 1). 2

Table 1.

New Zealand--Decomposition of Gross External Debt 1/

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Source: Statistics New Zealand; and Fund staff estimates.

Based on an “Overseas Debt Survey” comprising all official organizations known to have external debt, and corporate enterprises with external debt greater than SNZ 50 million.