New Zealand: Staff Report for the 2005 Article IV Consultation Discussions

This 2005 Article IV Consultation highlights that New Zealand’s GDP growth was particularly strong in 2004, at 4.8 percent, led by a surge in domestic demand. Private consumption grew by 6 percent, reflecting high employment growth, strong commodity prices, and household borrowing against rising housing values. Business investment also increased rapidly, powered by robust sales, and strong profitability. Growth is projected to slow in the near term, to about 2¾ percent in 2005–06. Consumer spending is expected to moderate owing to a cooling of the housing market and the effects of higher interest rates.

Abstract

This 2005 Article IV Consultation highlights that New Zealand’s GDP growth was particularly strong in 2004, at 4.8 percent, led by a surge in domestic demand. Private consumption grew by 6 percent, reflecting high employment growth, strong commodity prices, and household borrowing against rising housing values. Business investment also increased rapidly, powered by robust sales, and strong profitability. Growth is projected to slow in the near term, to about 2¾ percent in 2005–06. Consumer spending is expected to moderate owing to a cooling of the housing market and the effects of higher interest rates.

I. Economic Developments and Outlook

A. Introduction

1. New Zealand has, in recent years, been one of the top performers among advanced economies. Growth in New Zealand averaged 4 percent a year over the past 6 years, compared to an annual average of 2½ percent in all OECD countries. Employment rose by 18 percent during this period, reducing the unemployment rate to the lowest in the OECD. CPI inflation has averaged 2¼ percent, consistent with the Reserve Bank of New Zealand’s (RBNZ) 1 to 3 percent target range, and the budget has recorded sizeable and growing current surpluses, that have permitted a significant reduction in government debt.

uA01fig01

Real GDP

(Percent change, y/y)

Citation: IMF Staff Country Reports 2005, 152; 10.5089/9781451830293.002.A001

2. During past Article IV consultations, there has been broad agreement on New Zealand’s economic policies. In recent consultations, Directors have attributed the strong performance of the New Zealand economy to the authorities’ astute management of macroeconomic policies and the ongoing benefits from the extensive structural reforms since the 1980s. Directors have also fully supported the sound medium-term frameworks guiding fiscal and monetary policies, and have generally endorsed the authorities’ macroeconomic policy initiatives. At the conclusion of the 2004 Article IV consultation on April 30, 2004 (IMF Country Report No. 04/128), Directors considered the decision to raise interest rates in early 2004 to have been prudent in the context of the high level of resource utilization. To support monetary policy in the near-term, Directors recommended that budgetary spending not be increased relative to the latest projections, and that unanticipated revenues be saved. Directors welcomed the partial prefunding of future pension liabilities through the New Zealand Superannuation (NZS) Fund. To fully contend with the long-term fiscal challenge of population aging, Directors emphasized that further reforms of the pension and health care systems should be adopted.

B. Recent Developments

3. Strong domestic demand was the main factor driving growth in 2004 (Table 1).GDP rose by an estimated 5 percent during the year, led by a surge in domestic demand. Private consumption was particularly strong, reflecting high employment growth, strong commodity prices, and household borrowing against rising housing values. Following a fall in net inward migration, house price increases eased to 13½ percent y/y in February 2005, from 25 percent in 2004, and residential investment slowed from the blistering pace set in 2002–03. 1 Nonetheless, overall investment growth accelerated as business capital spending rose rapidly, powered by robust sales, strong profitability, growing capacity constraints, and declining domestic prices for imported equipment.

Table 1.

New Zealand: Selected Economic and Financial Indicators, 2000–05

Nominal GDP (2003): US$ 78.8 billion

Population (2003): 4.0 million

GDP per capita (2003): US$ 19,603

Quota: SDR 894.6 million

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

Based on national accounts data.

Fiscal years ending June 30. Revenue and expenditure estimates from 2002 are not directly comparable with those for previous years.

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

Operating balance net of revaluations and accounting changes.

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

Data for 2005 are as of March 25.

Data from 2001 are not directly comparable with the historical data due to adoption of BPM5 methodology.

Residual maturity basis. Total Overseas Debt data until 2000, and International Investment Position data thereafter.

Includes debt that is unallocated in terms of foreign currency denomination.

IMF Information Notice System index (1990 = 100).

uA01fig02

Real GDP and Domestic Demand

(Percent change in annual total)

Citation: IMF Staff Country Reports 2005, 152; 10.5089/9781451830293.002.A001

uA01fig03

House Prices and Migration

Citation: IMF Staff Country Reports 2005, 152; 10.5089/9781451830293.002.A001

4. The current account deficit rose to 6.4 percent of GDP in 2004 (Table 2). Import volumes jumped by 16 percent, mirroring the strength of domestic demand. Despite the strong New Zealand dollar, export volumes grew by a relatively robust 5¼ percent. Exporters’ incomes were also aided by widespread foreign exchange hedging, and rising international prices for the country’s major commodity exports that pushed the terms of trade to a 30-year high. Overall, the trade deficit rose by 1 percentage point of GDP, and with the profits of foreign-owned companies rising sharply, the invisibles deficit increased by a similar amount. Net foreign liabilities rose to 84½ percent of GDP at the end of 2004.

Table 2.

New Zealand: Balance of Payments and External Debt, 2000–04

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

Based on IFS data, except for 2003 (where IFS data are unavailable as yet). For 2003, data are from Statistics New Zealand.

Calculated as a residual.

Data from 2001 are not fully comparable with the historical data due to methodology changes to comply with BPM5.

Data based on Total Overseas Debt statistics until 2000, and on the International Investment Position thereafter.

Remaining term until interest rate adjustment of less than one year, rather than residual maturity.

5. Indicators of resource utilization suggest an economy that is operating at full stretch. Even as growth in the working age population slowed due to declining migration inflows, employment rose by 4½ percent during 2004, bringing down the rate of unemployment to 3.6 percent. Indicators of the difficulty of finding labor, both skilled and unskilled, have reached historical highs. At the same time, capacity utilization is at record levels, particularly in the construction sector.

uA01fig04

Labor Market Conditions

Citation: IMF Staff Country Reports 2005, 152; 10.5089/9781451830293.002.A001

6. The New Zealand dollar has appreciated further. Since end-2003, the New Zealand dollar has risen by 7 percent on a Trade-weighted basis, led by an 8 percent appreciation against the U.S. dollar. On a real effective basis, the exchange rate is estimated to be 16 percent above its post–float average at End-March 2005, a level similar to earlier peaks in 1988 and 1997.2 The appreciation reflects a combination of strengthening global commodity prices, U.S. dollar weakness, and a widening in interest rate differentials due to New Zealand’s relative cyclical position.

uA01fig05

Real Effective Exchange Rate

(Percent deviation from 1986-2004 average)

Citation: IMF Staff Country Reports 2005, 152; 10.5089/9781451830293.002.A001

7. Inflation stayed within the target range of 1 to 3 percent, but signs of inflationary pressure are emerging. Headline CPI inflation rose to 2¾ percent y/y by end 2004, from 1 ½ percent a year earlier, led by a rise in the inflation rate for tradable goods as the effects of the exchange rate appreciation diminished and oil prices rose. Nontradable inflation remained high at 4¼ percent y/y, with the cost of constructing new dwellings continuing to be a key contributor. While official data through 2004 show wage and salary growth remained moderate outside the construction sector, an experimental index of labor costs unadjusted for quality changes indicates that some acceleration has occurred. Rising labor turnover has reportedly increased the frequency of wage raises to recruit and retain staff, and labor unions in some sectors are also pressing for higher wage increases.

uA01fig06

CONSUMER PRICE INFLATION

(In percent change, y/y)

Citation: IMF Staff Country Reports 2005, 152; 10.5089/9781451830293.002.A001

8. Monetary policy has been further tightened. The RBNZ raised the official cash rate (OCR) six times between January and October 2004, bringing the OCR to 6.5 percent. The resulting rise in effective mortgage interest rates has been somewhat smaller than in previous tightening cycles—partly due to a mortgage lending “war” in late 2004—but a slowing in household credit growth began in the second half of 2004. In its March 2005 Monetary Policy Statement (MPS), the RBNZ noted that the economy had not slowed in line with earlier projections, and the near-term outlook for activity was also stronger, implying higher underlying inflation pressures than earlier expected. As a result, the OCR was raised by a further 25 basis points.

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INTEREST RATES

(In percent, end of period)

Citation: IMF Staff Country Reports 2005, 152; 10.5089/9781451830293.002.A001

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Credit Growth

(Percent change, y/y)

Citation: IMF Staff Country Reports 2005, 152; 10.5089/9781451830293.002.A001

9. The fiscal positio has strengthened, aided by stronger than expected growth. The operating surplus before revaluations and accounting changes (OBERAC) rose to 4¾ percent of GDP in 2003/04 (fiscal year ending in June), and gross government debt declined to 25¼ percent of GDP (Table 3). The December Economic and Fiscal Update (DEFU) released at end-2004 projected the 2004/05 OBERAC surplus at 4.3 percent of GDP, compared with a budgeted surplus of 3.9 percent, with higher projected tax revenues in 2004/05 only partly offset by higher spending plans. In the eight months to February 2005, the OBERAC was ¾ percent of GDP above the DEFU projections, owing to spending delays, and higher surpluses of state owned enterprises.

Table 3.

New Zealand: Summary of Central Government Budget, 1999/00–2004/05 1/

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Sources: New Zealand Treasury; DEFU (December Economic and Fiscal Update) 2004 and Fund staff estimates.

Fiscal year ending June 30. Changes have been made to the compilation of fiscal data starting in 2001/02; data prior to that date are not fully comparable.

The value for 1999/00 includes $NZ 0.519 billion corresponding to movements in ACC valuations.

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

Operating balance net of revaluations and changes in accounting rules.

Fund staff estimate; equals cash flows from operations less cash flows on investment.

Excludes contribution to the New Zealand Superannuation Fund.

Includes financial assets of the New Zealand Superannuation Fund, which are excluded from net core Crown debt.

Fund staff estimate; equals overall cash balance net of cyclical effects as a percent of potential GDP.

C. Economic Outlook and Risks

10. Real GDP growth is projected to slow in the near-term (Table 4). Growth is expected to moderate to about 2¾ percent in 2005 and 2006.3 The housing market appears to be cooling, so the fall in residential investment that began in the third quarter of 2004 is likely to continue, and lead in turn to a deceleration in consumer durable spending.4 Consumption growth will also be dampened by rising household debt service burdens associated with the recent OCR increases. In contrast, business fixed investment is expected to remain strong. CPI inflation will likely remain at the top of the target band through 2005, and the external current account deficit may widen slightly further in 2005–06 as the strong exchange rate weakens export growth.

Table 4.

New Zealand: Medium-Term Scenario, 2002–10

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

Fund staff estimates; based on national accounts data.

Fiscal years ending June 30. Figures from 2002 are not directly comparable with the historical data.

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

Operating balance net of revaluations and accounting changes.

Fund staff estimates; equals cash flows from operations less cash flows on investment.

Includes the financial assets of the New Zealand Superannuation Fund, which are excluded from net Crown debt.

Data for end-December. Data from 2001 comply with BPM5 and are not directly comparable with prior data.

uA01fig09

Household Interest Payments

(In percent of disposable income)

Citation: IMF Staff Country Reports 2005, 152; 10.5089/9781451830293.002.A001

1/ The high and low scenarios use RBNZ projections for the effective mortgage rate from the Dec. 2004 Monetary Policy Statement, which assumes that the OCR remains at 6.5 percent. Projections assume household debt remains at the 2004Q4 level of 137

11. However, upside risks to domestic demand remain. Clear signs of the long-awaited slowing in the economy have yet to emerge. Growth in real GDP slowed to 0.4 percent q/q, s.a., in the fourth quarter of 2004, partly reflecting one–off factors that may be reversed in early 2005. Moreover, consumer confidence is still near the ten-year highs reached at the end of 2004, with rising employment increasing disposable incomes and job security. Prices for New Zealand’s export commodities have remained high in early 2005, so income growth could be larger if these prices do not ease as projected. Business investment could also be higher than expected owing to the increasing need to substitute capital for labor.

uA01fig10

Consumer Sentiment and Domestic Demand

Citation: IMF Staff Country Reports 2005, 152; 10.5089/9781451830293.002.A001

12. The possibility of a further appreciation of the exchange rate, particularly if pressure on the U.S. dollar intensifies, counterbalances some of the upside risks. The impact of such an appreciation on export sector incomes could be felt more rapidly than has recently been the case, as RBNZ surveys indicate that the extent of foreign exchange hedging of exports has declined somewhat due to the already appreciated level of the exchange rate. An associated rise in U.S. bond yields would affect long-term interest rates in New Zealand, also tending to dampen demand.

13. In the medium-term, real GDP growth is projected to average about 3¼ percent. As New Zealand’s relative cyclical position unwinds in coming years, the external current account deficit will tend to narrow, thus stabilizing net foreign liabilities as a share of GDP.5 The inflation rate is also expected to decline to about 2 percent. Given New Zealand’s historically high level of labor force participation, at 67¾ percent of the population over 15 years old, employment growth is likely to moderate in the medium-term. Hence, a rise in trend productivity growth will be needed to sustain strong growth (as discussed in section II.C). The risks to these medium economic prospects are cushioned by past structural reforms, macroeconomic policy flexibility, and generally healthy balance sheets, which have proven to be resilient to large swings in exchange and interest rates in the past.6

II. Policy Discussions

The authorities and staff were in general agreement on the settings for macroeconomic policies in the period immediately ahead, and the discussions focused on the policy priorities for sustaining strong growth in the medium term.

A. Monetary Policy and the Exchange Rate

14. With the economy continuing to show considerable momentum, the RBNZ recognized that current monetary settings might not be sufficient to contain inflationary pressures. At the time of the December MPS, the RBNZ considered that a further tightening might not be necessary given that the full effects of interest rates increases in 2004 had yet to work their way through the economy. In particular, increased competition between mortgage lenders in late 2004 had probably extended the usual lags with which interest rates affected activity. An additional drag on the economy would also emerge during 2005 as foreign exchange hedges rolled off and exporters became more exposed to the appreciated exchange rate. Nonetheless, given that inflation was already at the top of the band, the RBNZ considered there to be little headroom to absorb additional inflationary pressures should the data continue to surprise on the upside.

15. The staff agreed with the RBNZ’s diagnosis that further monetary tightening would probably be required. Staff noted that the stage was set for the economy to slow, with the high exchange rate already appearing to affect export industries like forestry and seafood. Substantial interest effects were also in the pipeline. Nonetheless, the timing of the slowdown was highly uncertain, particularly given the difficulty of predicting the behavior of consumers who are experiencing strong income growth and record high job security. Indeed, in the staff’s view, inflation might edge above the 3 percent band in 2005. This was not inconsistent with the medium-term inflation objective providing that inflation fell back within the band fairly quickly, thus underscoring the importance of monetary policy retaining a tightening bias.

16. Continued strong data led to another interest rate increase in March. Economic activity has continued to be buoyant in 2005, further increasing inflation prospects, and in the March MPS, the RBNZ pushed out the timing of the expected slowdown to late 2005. In deciding to raise the OCR again, the authorities carefully weighed the risk of unduly exacerbating the eventual slowing of activity against that of a rise in inflationary expectations that would make the task of containing inflation more difficult in future. With inflation expected to remain near the top of the target band in the medium-term, the authorities judged there to be little scope for an easing of monetary policy in the foreseeable future, a view with which staff concur.

17. The authorities have not intervened in the foreign exchange market since the recent review of intervention policy. Although the RBNZ remains committed to a freely floating exchange rate, it announced in March 2004 that it would contemplate intervention if the exchange rate was exceptionally and unjustifiably high or low, and if an opportunity existed that would ensure such intervention would be effective. The RBNZ noted that the exchange rate was high by historical standards—IMF staff estimates the New Zealand dollar to be some 15 percent above medium-term equilibrium levels according to a macroeconomic balance methodology. Nonetheless, the RBNZ considered that the strength of the currency was largely attributable to the relatively high level of commodity prices and interest differentials. It was also unclear that current foreign exchange market dynamics were such that intervention would be effective. Staff viewed the criteria guiding foreign exchange intervention to be well–considered, and likely to have the intended effect of making intervention an effective, but rare, occurrence.

B. Fiscal Policy

18. New Zealand’s strong fiscal position stems from its implementation of sound policy in a transparent and predictable medium-term framework. In the May 2004 Fiscal Strategy Report (accompanying the 2004/05 Budget) the government set out its longer-term fiscal objectives, which are to: (i) maintain government debt at prudent levels, with gross debt to be brought below 20 percent of GDP before 2015; (ii) run operating surpluses on average over the economic cycle sufficient to meet contributions to the NZS Fund; and (iii) meet capital spending pressures and priorities. The debt target is more stringent than the 30 percent of GDP specified in previous budgets and a specific timeframe for its achievement has been introduced in order to strengthen the anchoring role played by this objective.

uA01fig11

Net Government Debt, 2004

(in percent of GDP)

Citation: IMF Staff Country Reports 2005, 152; 10.5089/9781451830293.002.A001

19. The current fiscal projections are consistent with these medium-term objectives, while meeting the authorities’ economic and social priorities. The authorities noted that there were significant underlying pressures to raise spending, especially in health and education, along with the implementation of the Working for Families (WFF) package. 7 They explained that the projected phased increase in operating spending over the budget horizon—by about 2 percentage points of GDP from its 2004/05 level—would help to address these priorities. Revenues were projected to remain broadly stable relative to GDP, as earlier increases in the revenue ratio have proven to be persistent suggesting they are largely structural, while downside revenue risks were more limited than in the past, due in part to unutilized tax losses being at low levels. Consistent with the medium-term objectives, the OBERAC surplus is projected to decline to 3 percent of GDP by 2007/08, and gross debt is projected to fall below 20 percent of GDP in 2008/09, with net debt including the NZS Fund becoming negative at that time.

uA01fig12

Central Government Operations

(In percent of GDP)

Citation: IMF Staff Country Reports 2005, 152; 10.5089/9781451830293.002.A001

20. Staff agreed with the authorities that despite the current strength of the fiscal position, there were limits on the scope for expansionary fiscal policy. Staff noted that the latest DEFU projections involved a moderate stimulus in coming years, and that a more expansionary path (whether through additional spending or tax cuts) could aggravate existing short-term strains on resources.8 Moreover, spending growth in a number of categories, including health and education, had been rapid in recent years, and if such growth was sustained, the objective of keeping the ratio of debt–to–GDP on a gradually declining path would not be achievable in the longer run. In the Budget Policy Statement 2005 (accompanying the DEFU), the Minister of Finance expressed the government’s intention to avoid a fiscal expansion that would put undue pressure on interest and exchange rates, and also noted that it was prudent not to spend an increase in revenues that resulted from cyclical factors. Staff fully endorsed these policy intentions, and encouraged the authorities to maintain the fiscal prudence that has served New Zealand well.

21. New Zealand faces significant long-term spending pressures owing to rising health care costs and population aging. Per capita health spending has risen at an average annual rate of 5 percent in real terms in the last five years. Recent estimates suggest that the demographic changes in prospect, which are broadly typical of OECD countries, could push government spending on pensions and health care from the current level of around 11 percent of GDP to some 19 percent of GDP by 2051. 9 Moreover, allowing for higher cost assumptions, pension and health spending could rise to as much as 34 percent of GDP. The budgetary impact of anticipated pension–related pressures is expected to be partially smoothed over time by the use of the NZS Fund to prefund a portion of future pension liabilities. While this was an important step, staff noted that the challenges of keeping public spending on a sustainable path remained substantial. Among measures that would need to be considered were parametric changes in the pension and health care systems. The authorities have recently decided to start publishing long-run fiscal reports at least every four years to help inform the public debate about these issues.

uA01fig13

Projected Change in Population Aged over 65 by 2050

(Change in percentage share from 2000)

Citation: IMF Staff Country Reports 2005, 152; 10.5089/9781451830293.002.A001

Source: UN Population Projections: Medium Variant

C. Growth and Structural Policy Issues

22. New Zealand is aiming to sustain strong growth to raise living standards and ensure the economy is better placed to manage population aging. 10 Despite the economy’s dynamism in recent years, New Zealand’s per capita income remains some 20 percent below the OECD median level. In 2002, the government set the objective of closing this gap, and has begun monitoring progress on factors that will contribute to this goal.11 The key finding is that labor productivity is at the lower end of the OECD range, and while labor productivity growth has increased from the second half of the 1990s, it remains below the OECD median.

uA01fig14

Per Capita GDP, PPP basis, 2002

(In percent of OECD mean)

Citation: IMF Staff Country Reports 2005, 152; 10.5089/9781451830293.002.A001

23. Hence the authorities intend to make the promotion of productivity growth a focus of future policy. Even though rapid growth in employment has probably depressed the average skill level of the workforce, New Zealand’s labor productivity growth has averaged 1½ percent per annum in recent years (Box 1). Nonetheless, the RBNZ has estimated that trend productivity growth would need to rise to about 2 percent in order to maintain the recent pace of growth in per capita incomes. Sustaining the recent strength of business investment would be crucial to achieving stronger productivity growth, and staff highlighted the importance of implementing planned improvements in the transportation and energy infrastructure on schedule, and of continuing to upgrade education and training to ensure the availability of people with the necessary skills. Staff welcomed proposed amendments to the Resource Management Act, since reducing uncertainties in the resource consent process would also be beneficial for investment.

uA01fig15

Labor Productivity 1/

(Percent change, 3-year average)

Citation: IMF Staff Country Reports 2005, 152; 10.5089/9781451830293.002.A001

1/ Real GDP per hour worked.

24. Maintaining New Zealand’s labor market flexibility is a critical element in sustaining high medium-term growth. Amendments to the Employment Relations Act come into effect in 2005, including requirements to bargain in good faith, to limit “free–riding” of individual agreements on collective negotiations, and to facilitate increased use of multi–employer collective agreements. Significant minimum wage increases and the Holidays Act, which includes an extension in annual paid leave from three to four weeks by 2007, have also been adopted. While the authorities did not expect the functioning of the labor market to be impeded by these changes, staff recommended that the effects be reviewed after a suitable period. As the pool of available workers declines, the risk of making a poor employment match may become a higher barrier to hiring, and staff encouraged the authorities to review the adequacy of current arrangements for probationary periods.

25. Current strong labor market pressures present an ideal opportunity for reforms to further expand labor participation. The authorities explained that while New Zealand has relatively high overall labor participation, there are still some groups for whom reducing barriers to participation would help meet the pressing labor needs of employers. Hence staff welcomed recent measures to increase the opportunity for women to participate by expanding access to childcare. Staff noted that the WFF package had been carefully designed to avoid significant adverse impacts on labor participation, and by making returning to work more worthwhile for those on welfare benefits, it also provided a platform for other reforms to boost labor participation.

26. The authorities outlined how more active case management was being used to help people make the shift from welfare to work. The government was seeking to help people on benefits move back into work within their abilities by increasing resources for case management, including by simplifying benefit administration. It had also introduced trial employment periods for persons on the invalids benefit and pilot projects taking a case–by–case approach to addressing the health needs of those on sickness benefits. Staff welcomed these steps, especially as the sharp fall in unemployment has been partly offset by a 21 percent increase in the number of people receiving invalids and sickness benefits in the last three years. Staff suggested that the authorities’ efforts could be reinforced by utilizing elements of Denmark’s “right and duty” welfare model, where the right to benefits comes with the duty to participate in suitable training or work programs. This system has enabled Denmark to combine a strong welfare system with high labor participation.

uA01fig16

Welfare Beneficiaries

(Thousands of persons)

Citation: IMF Staff Country Reports 2005, 152; 10.5089/9781451830293.002.A001

1/ Primarily paid to single parents.

27. The authorities were developing a program to facilitate household savings. A recent report proposed that employers should offer access to a savings plan, with voluntary employee participation via an‘opt–out’ system.12 The authorities were refining this proposal, with the aim of reducing the costs associated with saving, especially for those on lower incomes. Staff suggested that any budgetary incentives for saving should be time limited and income targeted. The authorities recognized that large saving incentives were not affordable, and indicated that the focus would likely be on offering “sweetners” to join and stay in the scheme for a reasonable period. The staff noted that for many employees, such a program would not increase their saving, and even if total household savings rose, this was unlikely to much affect investment and growth, as the financial system has access to international capital.

28. The authorities have long recognized the importance of an open international trade regime in promoting competition, innovation, and growth. As New Zealand faces substantial foreign trade barriers in agricultural exports, it has a significant stake in the success of the Doha round, and has been active in discussions across the full range of issues. On the bilateral front, New Zealand concluded a closer economic partnership with Thailand in November 2004, and recent studies of bilateral free trade agreements (FTAs) with China and Malaysia reached positive conclusions. Current trade negotiations include those concerning a four–way partnership with Brunei Darussalam, Chile, and Singapore. Negotiations on an ASEAN–Australia and New Zealand Free Trade Area will commence in 2005.

29. New Zealand’s official development assistance is focused on the Pacific. Overall, New Zealand provided 0.23 percent of Gross National Income for ODA in 2003, close to the average for industrial countries, but well below the 0.7 percent United Nations target, which New Zealand remains committed to achieve.

D. Financial Sector Issues

30. The RBNZ has been working to strengthen the regulatory framework for the banking system. The banking sector has remained sound in recent years, with strong capital, low nonperforming assets, and well–managed risks. Policy initiatives in banking regulation include: (i) strengthening the RBNZ’s ability to monitor banks’ risks by adopting a framework for independent reviews of banks’ systems and controls, with the first use of this tool already made; (ii) reviewing the disclosure regime, particularly in light of Basel II, which includes a framework for strengthening market discipline that goes beyond the current New Zealand disclosure requirements; and (iii) enhancing the capacity to manage financial stresses, by operationalizing the RBNZ’s lender of last resort role and finalizing options for responding to bank failures. Furthermore, to ensure banks can operate on a stand–alone basis in a crisis, the RBNZ has developed a policy to limit the outsourcing of key functions. Staff welcomed these policy developments, which also represented substantial progress in addressing the main recommendations of the FSSA (IMF Country Report No. 04/126).

31. The potential for closer integration of banking regulation with Australia is being discussed. The New Zealand banking system is dominated by four large Australian-owned banks which account for some 85 percent of banking assets, and as a result, the RBNZ and the Australian Prudential Regulation Authority (APRA) have undertaken to build an enhanced home–host supervisory relationship.13 In addition, the Australian and New Zealand authorities have recently established a high–level council on banking supervision to coordinate trans–Tasman regulatory issues and guide the development of policy advice to the respective governments. While staff welcomed these efforts to strengthen supervisory coordination, it nonetheless stressed that it would be crucial that the final regulatory scheme adopted incorporate adequate safeguards for financial stability in New Zealand in the event of a crisis.

32. Staff welcomed the publication of the first Financial Stability Report . The October 2004 report notes that a slowing in the housing market could pose some difficulties for those nonbank financial institutions which have exposure to speculative developments, and staff supported the planned review of the regulation and disclosure of this class of institutions. Household debt has risen to 137 percent of disposable income, double its level 12 years ago, and household interest payments are projected to rise above previous highs in 2005–06 (Box 2). The stress–tests conducted as part of the FSSA found that the banking system was robust in the face of shocks to the household sector, including a substantial decline in housing prices. Nonetheless, staff endorsed the RBNZ’s plans to use household–level data to further analyze the potential vulnerability of the household sector to higher interest rates or other shocks.

III. Staff Appraisal

33. New Zealand has maintained its recent record of outperforming other advanced economies. Over the last 6 years, growth has averaged 4 percent a year, compared to an annual average of 2½ percent across the OECD. Job creation has continued at a rapid pace, reducing unemployment to the lowest in the OECD. These macroeconomic achievements are underpinned by the sustained implementation of sound monetary and fiscal policies and the wide–ranging structural reforms undertaken in the past.

34. Growth has continued to surprise on the upside. Activity was expected to slow in 2004 as a result of the appreciation of the New Zealand dollar, combined with a substantial fall in net migration inflows that was expected to reduce pressures in the housing market and slow durable consumption as residential investment declined. However, exporters’ incomes have held up, aided by strong commodity prices and widespread foreign exchange hedging. The strength of the labor market has also supported consumption, while promoting strong business investment to help overcome capacity pressures and the difficulty of finding labor.

35. Clear signs of the anticipated decline in inflationary pressures have yet to emerge. Since the beginning of 2004, domestic demand has been consistently stronger than envisaged, and with the potential pressure on prices not coming off as expected, the RBNZ has appropriately raised rates seven times. Yet even though resource utilization has risen to record high levels, inflation has remained inside the target range with strong upward pressures on nontraded goods prices being offset by low inflation in non-oil traded goods prices. However, labor markets are now exceptionally tight and inflation, already near the top of the band, may rise above 3 percent in 2005.

36. In this environment, monetary policy faces a difficult balancing act. While there continue to be upside risks to the inflation outlook, a further tightening could exacerbate a slowdown that may already be underway. It is expected that resource pressures will ease once lower net migration translates into a decisive cooling of the housing market, and the lagged effects on activity of higher interest rates and the more appreciated exchange rate come into play. On the other hand, high consumer confidence, strong investment intentions, and the highest terms of trade in 30 years, together pose a risk that domestic demand could again exceed expectations, in which case, resource pressures would not abate. On balance, given the underlying momentum in household consumption and business investment, staff agree with the RBNZ that the risks to inflation are predominantly on the upside and that monetary policy should retain a tightening bias.

37. Fiscal performance has been very strong and prospects remain favorable, but there is limited scope for expansionary fiscal policy. Policy objectives are to achieve operating surpluses over the economic cycle sufficient to cover contributions to the NZS Fund, and to meet capital spending requirements while bringing gross government debt down below 20 percent of GDP by 2015. The Treasury’s December 2004 forecasts show operating surpluses over the next few years that are larger than previously anticipated. The higher than expected fiscal surpluses reflect buoyant revenues, and staff strongly endorse the authorities’ intention not to use the cyclical component of these revenues to raise spending. The new projections already imply a small stimulus over the next few years, and a more expansionary policy would risk adding to current resource pressures, while potentially complicating the attainment of the government’s medium-term fiscal policy objectives. Moreover, the recent rapid growth in a number of spending categories, including health and education, is unlikely to be sustainable for much longer. In this light, the prudence and discipline that the government has shown over many years in making its expenditure decisions should be maintained.

38. Rising health care costs and population aging will pose significant long-term challenges for fiscal policy. Estimates made by the Treasury suggest that demographic changes over the next half century are likely to double or triple government spending on pensions and health care from the current level of 11 percent of GDP, depending on cost assumptions. The creation of the NZS Fund to prefund part of the future pension liabilities has been an important step to smooth out the effect on the budget of expected increases in pension obligations. However, if public spending is to be kept on a sustainable path, the challenges remain substantial, and parametric changes in the pension and health care systems will need to be considered. In this context, staff welcome the decision to start publishing long-run fiscal reports at least every four years since this will help inform public debate about the need for reforms.

39. New Zealand has the potential for continued strong economic growth in the medium-term. Despite the strong performance of the economy in recent years, per capita income remains some 20 percent below the OECD median. The challenge for New Zealand is to sustain high growth that will narrow this gap, while positioning the economy to manage the problems of population aging. In this endeavor, increasing labor productivity will be key, since there is no longer scope for the substantial gains in labor utilization that have occurred over the past decade. Indeed, the task for the next decade is to maintain high GDP growth in a period when the labor input is set to grow more slowly.

40. Higher productivity growth will be crucial to sustaining medium-term growth. A rise in productivity growth appears to be feasible if business investment remains high, thereby deepening the capital used by workers and bringing in new technology. The government can facilitate continued high investment by upgrading transportation and energy infrastructure, and ensuring that the education system equips the workforce with the requisite skills. Improving the Resource Management Act to reduce investor uncertainties will also assist in this regard.

41. New Zealand’s labor market flexibility is a key advantage that should be carefully preserved. A range of measures affecting the labor market have recently been adopted, including the Holidays Act, amendments to the Employment Relations Act, and increases in the minimum wage. These measures are generally not expected to impair labor market flexibility, although the effects should be kept under close review. Given the tightness of the labor market, the risk of making a poor employment match may be deterring some firms from hiring new staff. The adequacy of existing arrangements for probationary periods should therefore be reviewed.

42. Using more active case management to help people transition from welfare to work is a promising approach to expand labor participation. Although participation is already relatively high, there appears to be scope for increasing participation among certain groups, thus helping to meet the pressing labor needs of employers and cushion the impact of slowing net immigration. Recent measures to increase the opportunity for women to participate by expanding access to childcare are welcome, and the Working for Families package provides a useful foundation for further reforms to raise participation rates. The government has adopted significant new initiatives aimed at helping people on benefits back into work within their abilities, including trial employment periods for recipients of invalids benefit and taking a case–by–case approach to addressing the health problems of those receiving sickness benefit. These efforts could be reinforced by strengthening requirements for those on benefits to participate in training or work programs.

43. The main benefits from schemes to promote savings probably lie in improving the resilience and economic opportunities of households. Even if the proposals currently being debated do lead to an increase in aggregate savings, the effects on investment and growth are unlikely to be large as New Zealand already has easy access to international capital. Nonetheless, workplace savings systems can help households build financial assets that provide a buffer against shocks and expand their opportunities to invest in education, housing, small business, and retirement. As the authorities well recognize, the design of such schemes should take account of the administrative costs, while the incentives offered should be carefully designed so as to limit the impact on the budget.

44. Reforms to banking regulation are underway. The adage that roof mending is best done while the sun shines has been taken to heart in the reforms being made to New Zealand bank regulation. The financial sector is fundamentally sound, and the banking sector is blessed with strong capital, low nonperforming assets, and well–managed risks. In these favorable circumstances, the authorities’ efforts to strengthen their regulatory and crisis management capacity are especially commendable. The planned review of the regulation and disclosure of nonbank financial institutions is also an important step. At this stage, it is unclear how discussions with Australia on the closer integration of banking regulation will progress, but the priority should be to ensure that adequate safeguards for financial stability in New Zealand remain.

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

Rapid Employment Expansion and Productivity Growth

New Zealand’s growth over the last decade has been primarily a labor utilization story, as the table below summarizes. With the employment ratio already at a historical high, labor input growth is set to decline in coming years, and New Zealand will need to increase productivity growth to sustain strong rates of GDP growth. Since labor input can be expected to rise by only about 1¼ percent a year over the medium-term, compared to 2½ percent over 1992–2004, productivity growth will need to increase to 2 percent a year (from about 1¼ per during 1992–2004) for the economy to achieve annual growth in potential output of 3¼ percent. To some extent these data overstate the required jump in productivity growth, since productivity growth has been higher in recent years than in the first half of the 1990s, at some 1½ percent.

Sources of Growth in New Zealand

(annual averages, percentage points)

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Source: IMF staff calculations, adapted from OECD (New Zealand 2003 Economic Survey).

However, a significant increase in employment, as recently experienced in New Zealand, can itself lead to lower measurements of average productivity. When the employment rate increases, the newly employed workers tend to be less productive than existing workers, which mechanically reduces average productivity. Bélorgey et al. (2004) estimate the impact of the employment rate on labor productivity for a panel of 25 industrial economies. 1 They find that a 1 percent increase in the employment rate decreases average productivity by ½ percent.

The increase in productivity growth required to maintain high GDP growth thus may be less daunting than it appears. The employment rate in New Zealand rose from 57 percent in 1992 to 64 percent in 2004, implying an average increase in the rate of about 1 percent a year. Extrapolating the results of Bélorgey et al. (2004) to New Zealand suggests that this rapid growth in employment may have lowered measured average labor productivity growth by as much as ½ percent a year. This would suggest that in the absence of further growth in the employment ratio in the period ahead, measured productivity growth should be boosted by the end of the dampening effect on average productivity noted above. Moreover, the productivity of newly–hired workers can be expected to rise as they gain work experience, and it might do so more rapidly than the average worker given their lower initial level of productivity on average.

1/ Bélorgey, N., Lecat, R., and T. Maury, 2004, “Determinants of Productivity per Employee: an Empirical Estimation Using Panel Data,” Bulletin de la Banque de France Digest, No. 123, March 2004, pp. 59-84.

Rising Household Indebtedness and Monetary Policy1

As in other advanced economies, household debt levels have risen strongly in the last two decades in New Zealand. Following financial deregulation in the mid–1980s, and aided by the decline in nominal interest rates permitted by disinflation, the ratio of household debt to income in New Zealand doubled to 100 percent by the end of the 1990s. Borrowing accelerated in 2002–04, primarily due to the rise in housing prices, lifting the debt ratio to an estimated 137 percent at the end of 2004, a level broadly similar to the U.S., U.K., and Australia.

uA01fig17

Household Debt to Disposable Income 1/

(In percent)

Citation: IMF Staff Country Reports 2005, 152; 10.5089/9781451830293.002.A001

Sources: Reserve Bank of New Zealand and Reserve Bank of Australia.1/ Only data for Australia and USA exclude unincorporated enterprises.

Higher indebtedness could increase the sensitivity of household spending to interest rates, potentially allowing monetary policy to achieve its goals with smaller interest rate adjustments. The negative impact of interest rates on the incomes of households that are debtors will be greater at higher debt levels (see Debelle, 2004). New Zealand households are relatively exposed to interest rate effects on their disposable income; at the end of 2004, some 85 percent of mortgage loans were at interest rates fixed for less than two years, or were at floating rates.

An analysis of consumer spending in New Zealand supports the hypothesis that interest sensitivity has increased. Real interest rates on housing mortgages are found to have a negative impact on consumption, and a model allowing this effect to depend on the level of household indebtedness has greater explanatory power. With household debt at 50 percent of disposable income, a 1 percentage point rise in the interest rate is estimated to reduce consumption by some ¾ percent after 2 years. With the household debt ratio near 140 percent, as at the end of 2004, the same interest rate increase is estimated to lower consumption by 2¼ percent.

Nonetheless, the recent rise household’s equity in housing could moderate the interest rate sensitivity of consumption looking forward. Recent U.S. research finds that households can better hedge income shocks when collateral for borrowing is more abundant (Lustig et al, 2004). Housing equity has risen by some 100 percentage points of income in recent years in New Zealand, so the scope for households to smooth income shocks from interest rate changes may have risen significantly.

1 This topic is discussed further in Chapter IV of the forthcoming selected issues paper.Debelle, Guy, 2004, “Macroeconomic implications of rising household debt,” BIS Working Paper No. 153.Lustig, Hanno and Stijn Van Nieuwerburgh, 2004, “Housing Collateral and Consumption Insurance Across US Regions,” NBER Working Paper 10505.
Figure 1.
Figure 1.

New Zealand: Selected Real Economic Indicators, 1996–2004

Citation: IMF Staff Country Reports 2005, 152; 10.5089/9781451830293.002.A001

Sources: Statistics New Zealand; and staff estimates.1/ Based on staff estimate of potential output.2/ 1999Q4 excludes purchases of naval frigate equipment, equivalent to 0.6 percent of GDP.
Figure 2.
Figure 2.

New Zealand: Balance of Payments and External Indicators, 1996-2004

Citation: IMF Staff Country Reports 2005, 152; 10.5089/9781451830293.002.A001

Sources: Statistics New Zealand; IMF, World Economic Outlook; and staff estimates.
Figure 3.
Figure 3.

New Zealand: Inflation and Labor Market Indicators, 1996-2004

Citation: IMF Staff Country Reports 2005, 152; 10.5089/9781451830293.002.A001

Sources: Statistics New Zealand; Reserve Bank of New Zealand; and staff estimates.1/ Based on Quarterly Employment Survey (QES).
Figure 4.
Figure 4.

New Zealand: Monetary and Financial Indicators, 1996-2005

Citation: IMF Staff Country Reports 2005, 152; 10.5089/9781451830293.002.A001

Sources: Statistics New Zealand; and staff estimates.
Table 5.

New Zealand: External Debt Sustainability Framework, 2000–10

(In percent of GDP, unless otherwise indicated)

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Derived as [r - g - ρ(1+g) + εα(1+r)]/(1+g+ρ+gρ) times previous period debt stock, with r = nominal effective interest rate on external debt; ρ = change in domestic GDP deflator in US dollar terms, g = real GDP growth rate, ε = nominal appreciation (increase in dollar value of domestic currency), and á = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [- ρ(1+g) + εα(1+r)]/(1+g+ρ+gρ) times previous period debt stock. ɛ increases with an appreciating domestic currency (ρ > 0) and rising inflation (based on GDP deflator).

For projection, line includes the impact of price and exchange rate changes, which is large in 2005 due to the exchange rate appreciation during 2004. The impact of price and exchange rate changes falls to negative 1 percent of GDP in later years.

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year.

ANNEX I Economic Vulnerability Assessment

1. New Zealand does not appear to face major economic vulnerabilities.14 Overall, the economy remains well placed to manage adverse economic shocks. While net foreign liabilities remain high, they have declined from their peak. Foreign debt has become more concentrated in the banking sector and its maturity has shortened, reflecting increased intermediation of capi