New Zealand
2008 Article IV Consultation: Staff Report; and Public Information Notice on the Executive Board Discussion
Author:
International Monetary Fund
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Publication Date:
19 May 2008
eISBN:
9781451830361
Language:
English
Keywords:
ISCR; CR; rate; exchange arrangement; house price inflation; exchange; inflation pressure; crown debt; net error; bank bill; crown cashflow; containing inflation; Inflation; Global
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New Zealand has experienced a decade-long robust economic expansion, owing to its sound macroeconomic policies and structural reforms, but resource constraints have emerged. Executive Directors welcomed the policy settings, supported by the anticipated evolution of external and global developments. They noted that fiscal policy and tightened stance of monetary policy are appropriate. Directors noted that the financial sector remains sound. They also welcomed the steps taken by the Reserve Bank of New Zealand (RBNZ) to review its liquidity policy for banks to encourage the diversification of funding sources.

Abstract

New Zealand has experienced a decade-long robust economic expansion, owing to its sound macroeconomic policies and structural reforms, but resource constraints have emerged. Executive Directors welcomed the policy settings, supported by the anticipated evolution of external and global developments. They noted that fiscal policy and tightened stance of monetary policy are appropriate. Directors noted that the financial sector remains sound. They also welcomed the steps taken by the Reserve Bank of New Zealand (RBNZ) to review its liquidity policy for banks to encourage the diversification of funding sources.

I. Background

1. New Zealand has experienced a decade-long economic expansion, but capacity constraints have emerged in recent years. Sound macroeconomic policies combined with structural reforms in the 1990s resulted in growth averaging almost 3½ percent annually between 1998 and 2007. However, as the expansion continued, capacity utilization rose and unemployment fell to historical lows (Figure 1). This combined with rapidly appreciating house and share prices resulted in demand pressures. As resource pressures mounted, non–tradables inflation increased and domestic demand became increasingly satisfied with imports, widening the current account deficit to more than 8 percent of GDP (Table 1).

Figure 1.
Figure 1.

New Zealand: Prolonged Expansion Leads to Overheating

Citation: IMF Staff Country Reports 2008, 163; 10.5089/9781451830361.002.A001

Sources: Statistics New Zealand; NZIER; Bloomberg; and Fund staff estimates.
Table 1.

New Zealand: Selected Economic and Financial Indicators, 2004–09

Nominal GDP (2007): US$128.6 billion

GDP per capita (2007): US$30,245

Population (2007): 4.3 million

Quota: SDR 894.6 million

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

Contribution in percent of GDP.

Based on national accounts data.

Fiscal years ending June 30.

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

Data for 2008 are as of end-March.

IMF Information Notice System index (1990 = 100).

2. The authorities tightened monetary policy in response to rising inflation, but abundant international liquidity muted the impact. The RBNZ raised the official cash rate (OCR) from 5.0 percent in 2003 to its current level of 8.25 percent, with four 25 basis point increases in the first half of 2007 (Figure 2). However, competition in the mortgage market, in part reflecting banks’ access to abundant international liquidity until the recent turmoil in global markets, reduced the transmission into mortgage rates. As a result, the housing boom, initially coinciding with an immigration spurt, remained surprisingly resilient, supporting household wealth and domestic demand. Searching for yield, international investors responded to the wide interest rate differential, and inflows of foreign capital appreciated the exchange rate.

Figure 2.
Figure 2.

New Zealand: Monetary Policy Tightening

Citation: IMF Staff Country Reports 2008, 163; 10.5089/9781451830361.002.A001

Sources: Bloomberg; RBNZ; CEIC; and Fund staff estimates.1/ Nominal exchange rate, indexed at 1979=100.2/ Spread between bank bill 90 day futures rates in New Zealand and trade-weighted average of 90 day future rates in the United States, Euro area, Australia, Japan, and the United Kingdom.

3. Fiscal surpluses emerged well in excess of the 2 percent of GDP implied by the medium-term framework.1 Revenue consistently surprised on the upside in recent years, driven by the stronger-than-expected economy and surprising buoyancy in corporate tax revenue (Figure 3, Table 2). Most of the revenue over-performance was saved, moving the public sector into a positive net financial asset position. However, the strong fiscal performance has increased pressures to bring the fiscal position more in line with the medium-term targets by cutting taxes and increasing spending. Expenditure measures over the last three years have offset some of the restraint from automatic stabilizers, with the fiscal stance expected to be stimulative in 2007/08.

Figure 3.
Figure 3.

New Zealand: Fiscal Over-performance 1/

Citation: IMF Staff Country Reports 2008, 163; 10.5089/9781451830361.002.A001

Sources: New Zealand Treasury; and Fund staff estimates.1/ Fiscal year ending June with 2008 being a forecast.2/ Underlying spending adjusted for finance costs, irregular expenses and Government Superannuation Fund expenses.
Table 2.

New Zealand: Summary of Central Government Budget, 2003/04–2007/08 1/

article image
Sources: New Zealand Treasury; HYEFU (Half Year Economic and Fiscal Update, 2007).

Fiscal year ending June 30. From 2006/07, accounts follow the new version of New Zealand Generally Accepted Accounting Practices.

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

Net core Crown cashflow from operations after contributions to NZS Fund, purchases of physcial assets, and advances and capital injections.

Includes financial assets of the NZS Fund.

4. Large current account deficits have contributed to an increase in external liabilities. The trade balance worsened as the exchange rate appreciated while the income deficit widened to 7¼ percent of GDP in 2007 as domestic interest rates rose (Figure 4, Table 3). Consequently, net foreign liabilities increased to almost 90 percent of GDP, accumulating primarily as debt on banks’ balance sheets.

Figure 4.
Figure 4.

The Exchange Rate and External Liabilities

Citation: IMF Staff Country Reports 2008, 163; 10.5089/9781451830361.002.A001

Sources: CEIC; and Fund staff estimates.
Table 3.

New Zealand: Balance of Payments and External Debt, 2003–08

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

For 2008, actual number for end-February.

5. The banking sector is sound, but the rise in external debt has increased banks’ exposure to international capital markets. Traditional indicators—stable profits, high capitalization, and few nonperforming loans—suggest a healthy banking sector (Figure 5). However, the recent global financial market turbulence raised funding costs (Box 1) and highlighted the rollover risk associated with banks’ short-term funding from international wholesale debt markets. On the asset side, the large mortgage book (45 percent of assets) leaves banks exposed to households, whose debts exceed 160 percent of disposable income, while debt-servicing costs have risen to 14½ percent of disposable income. At present, nonperforming loans in the banking system amount to only 0.1 percent of total loans.

Figure 5.
Figure 5.

New Zealand: The Banking Sector

Citation: IMF Staff Country Reports 2008, 163; 10.5089/9781451830361.002.A001

Sources: RBNZ and Fund staff estimates.

II. Policy Discussions

6. Discussion focused on the macroeconomic policies needed to cool the economy and reduce external vulnerabilities, including:

  • the appropriate degree of monetary restraint to reduce inflationary pressures while balancing the risks associated with an uncertain external environment;

  • the fiscal restraint required to avoid placing undue pressure on monetary policy; and

  • the policy reaction to the fallout from global financial market turmoil.

What Was the Impact of the Global Financial Turmoil on New Zealand?

The direct effect of the U.S. sub-prime crisis was minimal as New Zealand banks report virtually no exposure to U.S. sub-prime investments or affected markets in other countries. In addition, securitization is not common in New Zealand, with less than 1 percent of banks’ mortgage loans funded through mortgage-backed securities.

The main impact of the turmoil was an increase in funding costs in offshore wholesale debt markets, which account for more than ⅓ of total funding for New Zealand banks. As a result, banks have competed more vigorously for funding in the domestic market since July last year, causing bank bill yields to increase relative to the overnight indexed swap (the market expectation of the OCR) by 25–50 basis points above the normal spread (see figure below). Also, in recent months the credit default swap (CDS) rates for the major Australian banks that own the four large New Zealand banks have widened sharply (see figure below), also indicating a higher cost of funding.

During the turmoil, banks had sufficient liquidity to meet payment obligations. The RBNZ provided interbank liquidity by increasing settlement cash and allowing banks to use a wider range of instruments in the overnight reverse repurchase facility. These measures were similar to actions taken by other central banks in late 2007.

While the banking system remains sound, several finance companies experienced difficulties in mid-2007 and were put into receivership. Liquidity pressures arising from the turmoil were the trigger for closure in some cases, but these failures were caused primarily by problems with asset quality, connected lending, and credit management. However, finance companies are a small segment of the financial system (3 percent of total assets), and the failures are not expected to undermine the stability of the system given that the failed companies comprise only 0.3 percent of total system assets.

uA01fig01

Bank Bill Rates and Overnight Index Swap Rates

Citation: IMF Staff Country Reports 2008, 163; 10.5089/9781451830361.002.A001

Sources: Bloomberg; and Fund staff calculations.
uA01fig02

Credit Default Swap (CDS) Spreads

(Average of 4 Major Australian Banks)

Citation: IMF Staff Country Reports 2008, 163; 10.5089/9781451830361.002.A001

Sources: Bloomberg; and Fund staff calculations.

A. The Outlook

7. There was broad agreement that activity is slowing. Staff projects growth to moderate to about 2 percent in 2008 and 2009. A cooling housing market, rising debt-servicing costs and weaker consumer sentiment should restrain private consumption and residential investment, despite continued strength in incomes (Figure 6). The rising cost of capital, owing to re-pricing of risk, should curb business investment. External demand is also expected to moderate as the U.S. downturn and tighter credit conditions flow through to activity in the rest of the world. In addition, an extended dry period in early 2008 will adversely affect farm incomes. CPI inflation is projected to remain above 3 percent over 2008, before easing in 2009.

Figure 6.
Figure 6.

New Zealand: Consumption Outlook

Citation: IMF Staff Country Reports 2008, 163; 10.5089/9781451830361.002.A001

Source: RBNZ.
Figure 7.
Figure 7.

New Zealand: Inflation Expectations

(Annual % change)

Citation: IMF Staff Country Reports 2008, 163; 10.5089/9781451830361.002.A001

Source: Statistics New Zealand; RBNZ; Alexander Consulting.

8. High commodity prices and slowing domestic demand will narrow the current account deficit, even under the assumption of a constant REER at end-2007 levels, which underlies staff forecasts. But, as inflationary pressures abate and the official cash rate returns to a more neutral level in 2009/10, a reduction in capital inflows should lead to an exchange rate depreciation and help the current account adjust further. In turn, this would slow the accumulation of external liabilities and help to contain vulnerability.

9. Uncertainty regarding the economy’s prospects, however, is greater than usual. The impact on incomes from high commodity prices and wage growth could maintain domestic capacity pressures. In contrast, the impact of the U.S. downturn on trading-partner growth could be larger than expected, sharply dampening external demand. Also, because of banks’ dependence on wholesale markets for funding, continued tightening in international credit conditions could increase further the servicing costs for heavily indebted New Zealand households, squeezing domestic demand

B. Monetary Policy

10. The persistence of inflation pressures argues for maintaining a firm monetary policy stance. The tight labor market, strong income growth (especially for dairy farmers), and the prospect of fiscal stimulus are keeping inflation high even with a cooling in the housing market.2 In addition, the authorities noted that rising energy and food prices, together with the introduction of an emissions trading scheme, is increasing inflation expectations and making it more difficult to reduce inflation. The authorities agreed on the need to respond if the slowing in trading partner growth or the fallout from financial market turmoil is worse than expected. However, given the uncertainties at present, the authorities and the staff agreed that monetary policy should remain on hold pending clearer indications of the future path of the economy.

11. A sharp slowdown in the housing market is underway (Figure 8). This is key to containing inflation as it will slow construction activity and dampen consumption through wealth effects and reduced availability of home equity financing. Earlier concerns about the lack of effectiveness of monetary policy in containing the housing boom in the face of the carry trade have lessened. The effective mortgage rate has risen by 160 basis points since the tightening cycle began in 2004, with the increased cost of funding arising from the global turmoil a contributing factor. At least another 50-basis points increase in the effective mortgage rate is in prospect through late 2009 due to interest rate resets for fixed mortgages (if new mortgage rates stay around current levels).3

Figure 8.
Figure 8.

New Zealand: Housing Sector

Citation: IMF Staff Country Reports 2008, 163; 10.5089/9781451830361.002.A001

Sources: CEIC; RBNZ and REINZ.

12. A parliamentary inquiry into the monetary policy framework is nearing completion. The inflation-targeting framework has evolved over time, and has been based since 2002 on a more flexible target of “1–3 percent on average over the medium term.” Despite the increased flexibility, concerns about an overvalued exchange rate sparked the inquiry, which provided a useful forum for discussing the benefits and costs associated with the inflation-targeting framework. The framework has delivered a prolonged period of relatively low inflation accompanied by economic growth, therefore the staff advised against any significant changes in the framework.

C. Competitiveness and External Stability

13. The staff and authorities consider that the overvaluation of the New Zealand dollar primarily reflects temporary factors. The authorities’ assess that the currency overvaluation is at the upper end of the staff’s estimate of 5–15 percent (Box 2). Much of the overvaluation arises from a wide interest rate differential that resulted in large capital inflows. The authorities noted that over the past year the response to the differential had been muted. The staff and the authorities expected that the overvaluation would unwind over time as inflation abated and the policy interest rate could be reduced. However, the equilibrium level of the currency is likely to remain above its historical average because a portion of the rise in commodities prices will likely be permanent.4

New Zealand’s Equilibrium Real Exchange Rate

Staff estimates suggest that the New Zealand dollar is overvalued by 5-15 percent.1 These estimates are based on the macroeconomic balance (MB) approach, the equilibrium real exchange rate (ERER) approach, and the external sustainability (ES) approach.

The baseline MB estimates suggest an overvaluation of 6–10 percent.2 But the estimates are subject to uncertainty, as shown by varying the projection for the underlying current account deficit and changing the assumption for the elasticity of the current account balance with respect to the exchange rate. This sensitivity analysis suggests that the overvaluation is in the range of 5–24 percent.

The baseline ERER estimates suggest an overvaluation of 12–15 percent. The models attempt to explain the exchange rate based on the terms of trade, relative productivity, and relative government consumption. An important determinant is the terms of trade, with the 14 percent improvement in the terms of trade over the past five years contributing to an increase in the equilibrium REER of about 5 percent.

The ES approach implies an overvaluation of 11 percent, if we assume that net foreign liabilities stabilize at their average level for the past 10 years of 82 percent of GDP. A smaller overvaluation would result if we assume net foreign liabilities stabilize at the end 2007 level of 87 percent of GDP.

Exchange Rate Assessment: Baseline Results 1/

article image
Source: Fund staff estimates.

All numbers are expressed in percent.

Based on a semi-elasticity of the CA/GDP with respect to the REER of –0.23.

Overvaluation is assessed relative to December 2007.

Based on a nominal GDP growth rate of 5.4 percent for the projection period.

WEO projection of the underlying CA/GDP in 2013.

MB Approach: Sensitivity Analysis 1/

article image
Source: Fund staff estimates.

REER overvaluation is expressed in percent.

WEO projection of the underlying CA/GDP in 2013.

uA01fig03

ERER Approach

(Index base = 1.0, 1985)

Citation: IMF Staff Country Reports 2008, 163; 10.5089/9781451830361.002.A001

Source: Fund Staff estimates.
1 The corresponding range for the equilibrium value of the RBNZ’s real trade weighted index (TWI) is 63 to 70, assessed relative to the December 2007 level of 74.3. 2 For both the MB and ERER approaches, the CGER methodology applies the OLS estimation technique over the period 1970–2004. The desk methodology is outlined in Appendix I.

14. The exchange rate could fall sharply if there were a disruption in capital inflows arising from the global financial market turmoil. The RBNZ was concerned that a sharp depreciation would boost inflation. While acknowledging that a depreciation would affect tradable goods inflation, the staff noted that a disruption to capital inflows would most likely slow domestic demand because of tighter credit conditions. In turn, this would reduce underlying inflationary pressures and might leave scope for the RBNZ to ease monetary policy. In these circumstances, fiscal policy could provide support through the operation of automatic stabilizers.

15. A number of exporters were concerned that the currency overvaluation is damaging the tradable goods sector. Although the magnitude of the exchange rate appreciation has been large, staff analysis suggests that it has not hurt tradable goods manufacturing significantly.5 The authorities noted that this could reflect the stability of the cross rate with Australia, its most important trading partner for manufactures.

16. The RBNZ considered that their foreign exchange market intervention in mid-2007 achieved its intended objective. They believed that their selling of New Zealand dollars introduced some two-sided risk that helped relieve some temporary and unwarranted upward pressure on the exchange rate.

D. Fiscal Policy

17. The authorities’ strategy is to transition to lower budget surpluses over time, conditional on the state of the economy. The government plans to reduce the surplus from 3½ percent of GDP in 2007/08 to less than 2 percent of GDP over the medium-term (Figure 9). As a result, the fiscal impulse is expected to be expansionary in 2008/09 with the stimulus abating thereafter. This plan includes a conditional allowance of 0.8 percent of GDP for personal income tax cuts together with increased spending. The Minister of Finance has stated publicly that the scope and shape of personal tax cuts would be such that they do not exacerbate inflationary pressures, increase public borrowing, or require a cut in public services. In line with previous Fund advice, the stimulus emphasizes tax cuts rather than spending increases, to limit pressure on resources. In addition, spending plans focus on improving productive capacity by addressing infrastructure bottlenecks. However, in recent years, the stimulus projected in the budget has not materialized because of stronger-than-expected revenue growth.

Figure 9.
Figure 9.

New Zealand: The Fiscal Plan 1/

Citation: IMF Staff Country Reports 2008, 163; 10.5089/9781451830361.002.A001

Sources: New Zealand: Half Year Economic & Fiscal Update 2007, December; Fund staff estimates.1/ Fiscal year ending June, with 2008 and beyond being a forecast.
Figure 10.
Figure 10.

New Zealand: External Debt Sustainability: Bound Tests 1/

(Gross external debt in percent of GDP)

Citation: IMF Staff Country Reports 2008, 163; 10.5089/9781451830361.002.A001

Sources: Fund staff estimates and projections.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ The historical scenario assumes that real GDP growth, inflation, current account deficit, and nominal interest rate are equal to ten-year historical averages from 2008 onward.3/ Permanent 1/4 standard deviation shocks applied to interest rate, growth rate, and current account balance.4/ This scenario assumes foreign exchange hedging covers 91 percent of foreign currency debt, consistent with the findings of hedging surveys conducted by Statistics New Zealand.

18. The staff endorsed the authorities’ fiscal strategy, including the transition to a lower surplus, but stressed the need for caution in the near term. Staff pointed to uncertainty regarding the durability of higher corporate tax revenues, and noted it would be prudent to delay spending the revenue surprises which have added to surpluses in recent years until it was clear that they were structural. Therefore, the staff encouraged the authorities to maintain flexibility in the magnitude and the timing of the easing so that the fiscal stimulus will not occur until inflation pressures are expected to have abated and it is clear that fiscal resources exist to deliver the tax and spending measures.

19. The authorities recognized the need for fiscal policy to support monetary policy, but considered that the supply side benefits of lower income taxes and improved infrastructure were also important. Nonetheless, they acknowledged the downside risks to revenue if the economy slows more than expected. Therefore, delaying the tax cuts somewhat and perhaps scaling them down remain under consideration. They added that further tax cuts may be phased in over the medium-term once it was clear that revenue gains in recent years are permanent.

20. The authorities saw some merit in staff’s advice to save revenue surprises until they can reasonably be determined to be structural. Staff noted that pre-announcing the intention to save surprises could help deflect political pressures for additional spending or tax cuts in the near-term that work against the operation of the automatic stabilizers.

E. Financial Sector

21. The large external refinancing needs of banks are a source of vulnerability. One-third of banks’ funding comes from nonresidents, of which two-thirds matures in one year or less. While banks’ external debt is hedged against currency movements, the tightening in international credit markets has increased funding costs and highlighted rollover risk.6 Banks have contingency plans to deal with potential liquidity difficulties and are lengthening the maturity of their funding and diversifying the sources.7 In addition, the RBNZ is looking at instituting new liquidity guidelines for banks in late 2008 but no decision on the nature of the guidelines has been taken as yet, given the ongoing consultations with interested parties. The higher cost of medium-term funding compared with short-term funding is an obstacle to lengthening the maturity of funding.8 However, banks have been able to pass on some of the higher costs to borrowers, which limits the impact on bank profits.

22. The RBNZ’s action in late 2007 to provide additional domestic liquidity helped ease pressures in money markets. Owing to continued unsettled conditions in global markets, the staff suggested that the RBNZ prepare a contingency plan to provide additional domestic liquidity in case of further disruption of New Zealand banks’ access to liquidity.

23. Banks are exposed to mortgages, but the RBNZ considered that they could withstand sizable adverse shocks. Most conventional metrics indicate a modest degree of house price overvaluation (Box 3). However, the authorities pointed to factors that suggested banks’ asset quality would not deteriorate seriously in the event of a correction in house prices. First, sub-prime mortgage lending, securitization, and off-balance sheet credit provision are very limited. Second, average loan-to-value ratios remain low at around 60 percent at end-2007. Third, a large portion of the debt is held by high-income groups.9 The authorities noted that for mortgage asset quality to deteriorate significantly, house prices would need to decline sharply, combined with sizable adverse shocks to unemployment and debt servicing costs.

How Overvalued are New Zealand House Prices?

House prices in New Zealand increased on average by 15 percent per annum during 2003–07. As a result, the ratio of house prices to average household incomes and the ratio of house prices to rents have increased substantially, and it would take a 40 percent fall in house prices to bring them back to historical averages. In addition, a Fitch Ratings study notes that New Zealand house prices are now the fourth most overvalued in a sample of 16 advanced countries, with France, the United Kingdom, and Denmark registering greater overvaluation.

Staff estimated a model of house price inflation for New Zealand, based on the extended version of Terrones (2004).1 The model uses an updated data set, and substitutes more appropriate New Zealand-specific variables for those used in earlier cross-country studies (in particular, migration is used instead of population growth, and a mortgage rate is used instead of a short-term interest rate). Estimation results show that 60 percent of variation in house price inflation in New Zealand can be explained by changes in interest rates and migration. Other variables that are typically important in other countries (such as affordability of houses, growth of real incomes, real credit growth, and stock prices) are not statistically significant in New Zealand. In 2003–07, house prices grew by a cumulative 90 percent, exceeding the model’s prediction of 70 percent growth. This implies that house prices were overvalued by about 12 percent in the third quarter of 2007.

Estimation Results

Dependent variable: Quarterly house price inflation

Time Period: 1990:Q1 to 2007:Q3

article image
Sources: RBNZ; and Fund staff calculations.

** denotes significance at 5 percent level, *** at 1 percent level.

uA01fig04

House Price Inflation: Actual and Predicted Values

(Y/Y Percentage Change)

Citation: IMF Staff Country Reports 2008, 163; 10.5089/9781451830361.002.A001

Sources: RBNZ; and Fund staff calculations.
1 See October 2007 World Economic Outlook.

24. Good progress has been made on implementing Basel II. The four large banks have been accredited to use internal models to assess credit risk and the RBNZ is working closely with these banks to improve their models, particularly those related to housing and agriculture loans. In the meantime, banks must maintain capital at no less than 90 percent of what would be required under Basel I.

25. The authorities outlined a range of measures to strengthen oversight of nonbank financial institutions. The RBNZ will take over regulation of nonbank deposit takers in 2009, setting requirements for such things as governance, risk management, and licensing. The Securities Commission will approve and monitor the trustees which supervise these institutions. The Securities Commission is also tightening oversight of financial advisors and investment funds and insurance companies will come under the regulation and supervision of the RBNZ in 2010.

III. Staff Appraisal

26. Sound macroeconomic policies and structural reforms have resulted in 10 years of robust economic expansion. However, capacity constraints have emerged in recent years and inflation pressures have increased, especially with the rise in world commodity prices. Current policy settings and external prospects appear poised to deliver the required easing of constraints.

27. The current stance of monetary policy is appropriate. During 2007, retail mortgage rates became more responsive to the official cash rate, and this is having the desired effect of moderating house price inflation and slowing overall activity. More recently, tightening international credit conditions have also contributed to mortgage rate increases that should help ease capacity pressures. With significant risks present, monetary policy should remain on hold pending clearer indications of the future path of the economy.

28. Although inflows of foreign capital, attracted by wide interest rate differentials, have contributed to the appreciation of the currency, the strength in commodity prices has also been an important factor. As inflation pressures moderate and the policy rate normalizes, capital inflows are expected to ease and the exchange rate depreciate. However, the equilibrium level of the REER is likely to remain above its historical average because a portion of the rise in commodities prices will likely be permanent.

29. A reduction in budget surpluses over time is consistent with prudent fiscal policy, but caution is needed in the near term to avoid potentially adding to inflationary pressures. The focus of fiscal policy on sound medium-term objectives has delivered low public debt and a positive net financial asset position. With surpluses still in excess of the level required within the medium-term framework, the authorities’ broad strategy for a gradual transition to a lower surplus, conditional on the state of the economy, is appropriate. Flexibility should be maintained in the magnitude and the timing of the easing so that the fiscal stimulus will not occur until inflation pressures are expected to have abated and it is clear that fiscal resources exist to deliver tax and spending measures.

30. The financial sector remains sound but vulnerabilities exist. Banks are profitable, well capitalized, and asset quality appears to be high. However, banks’ assets are concentrated in residential mortgages, and banks have significant short-term international wholesale funding. The current tightening in international capital markets is putting upward pressure on bank funding costs and highlighting rollover risks.

31. The vulnerabilities in the banking sector present some policy challenges. A further disruption to capital inflows that raises demand for domestic liquidity would need to be accommodated by the RBNZ. In addition, steps taken by the RBNZ to develop and implement guidelines aimed at improving banks’ liquidity management are welcome. These guidelines should encourage banks to diversify funding sources as well as lengthen maturities to help reduce the risk of restricted access to funding.

32. Staff recommends the next Article IV consultation be on the standard 12-month cycle.

Table 4.

New Zealand: Medium-Term Scenario, 2007–13

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

Contribution in percent of GDP.

Fund staff estimates; calculated as residual from gross national investment and external current account balance.

Fiscal years ending June 30.

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

Includes the financial assets of the NZS Fund.

Data for end-December.

Appendix I. Exchange Rate Assessment Methodology

The desk estimates of the equilibrium value of the REER for the macroeconomic balance (MB) and the equilibrium real exchange rate (ERER) approaches are based on panel econometric techniques using a generalized method of moments (GMM) estimator. To control for endogeneity, lagged explanatory variables are employed as instruments, where appropriate. The tables and figures below summarize the results. Further details are available in a forthcoming working paper.

MB Estimation Results for 55 Economies, 1973–2007

article image
uA01fig05

MB Approach: Contributions to Current Account/GDP Norm

(In percent)

Citation: IMF Staff Country Reports 2008, 163; 10.5089/9781451830361.002.A001

ERER Estimation Results for 55 Economies, 1973–2007

article image
uA01fig06

ERER Approach: Contributions to Equilibrium REER

(Log scale)

Citation: IMF Staff Country Reports 2008, 163; 10.5089/9781451830361.002.A001
1

A surplus of about 2 percent of GDP is consistent with the authorities’ objective of maintaining a prudent level of debt (gross debt of less than 20 percent of GDP) and accumulating assets in the publicly managed superannuation fund to help address long-term pension costs.

2

Higher world dairy prices should boost dairy farmer incomes by 1½–2 percent of GDP in 2007/08.

3

Half of fixed mortgages will reset within the next 20 months, with fixed mortgages comprising four-fifths of mortgages.

4

A selected issues paper analyzes the impact of higher commodity prices on the exchange rate.

5

A selected issues paper uses the IMF’s Global Economy Model to analyze this issue.

6

A selected issues paper examines the impact of a disruption in capital inflows.

7

The four major banks accredited to use internal models under Basel II assess the impact of changes in funding costs as part of their stress tests. However, the banks are not required to hold regulatory capital against these risks. The RBNZ intends to review banks’ experience with modeling this risk by early 2009.

8

For the four large Australasian banks, the 5-year credit default swap rate (CDS) averaged 126 basis points in March 2008 compared with 76 basis points for the 1-year credit default swap rate. The CDS rates, however, are not an accurate measure of the actual cost of funding.

9

Households in the top two income quintiles held 72 percent of the debt identified in a 2004 household survey, while households in the bottom two income quintiles held just 8 percent of the debt, and had the lowest debt-to-asset ratios (less than 25 percent). Results from the 2007 survey are not yet available.

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Cover IMF Staff Country Reports
New Zealand: 2008 Article IV Consultation: Staff Report; and Public Information Notice on the Executive Board Discussion
Author:
International Monetary Fund
Volume/Issue:
Volume 2008: Issue 163
Publisher:
International Monetary Fund
ISBN:
9781451830361
ISSN:
1934-7685
Pages:
34
DOI:
https://doi.org/10.5089/9781451830361.002
Figure 1.

New Zealand: Prolonged Expansion Leads to Overheating
Figure 2.

New Zealand: Monetary Policy Tightening
Figure 3.

New Zealand: Fiscal Over-performance 1/
Figure 4.

The Exchange Rate and External Liabilities
Figure 5.

New Zealand: The Banking Sector

Bank Bill Rates and Overnight Index Swap Rates

Credit Default Swap (CDS) Spreads

(Average of 4 Major Australian Banks)
Figure 6.

New Zealand: Consumption Outlook
Figure 7.

New Zealand: Inflation Expectations

(Annual % change)
Figure 8.

New Zealand: Housing Sector

ERER Approach

(Index base = 1.0, 1985)
Figure 9.

New Zealand: The Fiscal Plan 1/
Figure 10.

New Zealand: External Debt Sustainability: Bound Tests 1/

(Gross external debt in percent of GDP)

House Price Inflation: Actual and Predicted Values

(Y/Y Percentage Change)

MB Approach: Contributions to Current Account/GDP Norm

(In percent)

ERER Approach: Contributions to Equilibrium REER

(Log scale)