New Zealand
2011 Article IV Consultation-Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for New Zealand
Author: International Monetary Fund
Publication Date:
09 May 2011
eISBN:
9781455274505
Language:
English
Keywords:
ISCR; CR; rate; exchange rate; inflation outcome; balance of payments; interest rate differential; debt growth; household debt; short position; headline inflation
Download PDF (1.5 MB)

New Zealand’s recovery has stalled since mid-2010. Spare capacity has helped contain inflation. The Reserve Bank of New Zealand (RBNZ) lifted its policy rate in two steps from a record low of 2.5 percent to 3 percent in mid-2010. The exchange rate appreciated and financial markets have largely recovered from the global financial crisis. The banking sector remains profitable and is dominated by four subsidiaries of Australian banks that performed well during the crisis. The 2010 Canterbury earthquakes have disrupted economic activity, reduced wealth, and weakened confidence.

Abstract

New Zealand’s recovery has stalled since mid-2010. Spare capacity has helped contain inflation. The Reserve Bank of New Zealand (RBNZ) lifted its policy rate in two steps from a record low of 2.5 percent to 3 percent in mid-2010. The exchange rate appreciated and financial markets have largely recovered from the global financial crisis. The banking sector remains profitable and is dominated by four subsidiaries of Australian banks that performed well during the crisis. The 2010 Canterbury earthquakes have disrupted economic activity, reduced wealth, and weakened confidence.

A BUMPY RECOVERY

1. New Zealand’s recovery has stalled since mid-2010. Domestic demand has remained soft, as cautious households and businesses look to strengthen their balance sheets by slowing debt accumulation amid a weak housing market and an uncertain outlook (Figure 1, Table 1). Moreover, two earthquakes have caused substantial damage and hurt confidence (Box 1).

Figure 1
Figure 1

Recovery From Recession

Citation: IMF Staff Country Reports 2011, 102; 10.5089/9781455274505.002.A001

Sources: Statistics New Zealand; Reserve Bank of New Zealand; UNIDO database; Haver Analytics database; World Economic Outlook and IMF staff estimates.
Table 1

Selected Economic and Financial Indicators, 2006–12

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Sources: Data provided by the New Zealand authorities; and IMF 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 2011 are for January.

Data for 2011 are for January-March.

IMF Information Notice System index (2000 = 100). Data for 2011 are for January.

A01ufig02

Consumer and Business Confidence

Citation: IMF Staff Country Reports 2011, 102; 10.5089/9781455274505.002.A001

1/ Percentage expecting improvement in general business conditions minus percentage expecting deterioration.

2. Spare capacity has helped contain inflation. The unemployment rate hovered between 6–7 percent during 2010, limiting labor cost growth. An increase in the goods and services tax (GST) in late 2010 (from 12½ percent to 15 percent) and higher food and fuel prices pushed up headline inflation to 4 percent y/y at end-2010, above the 1–3 percent target band (Figure 2). However, inflation, excluding food, fuel, and government charges, remained below 3 percent.

Figure 2
Figure 2

Inflation

Citation: IMF Staff Country Reports 2011, 102; 10.5089/9781455274505.002.A001

Sources: Reserve Bank of New Zealand; Statistics New Zealand; New Zealand Institute of Economic Research; Bloomberg; International Financial Statistics database.

3. Following signs of recovery, the Reserve Bank of New Zealand (RBNZ) lifted its policy rate in two steps from a record low of 2.5 percent to 3 percent in mid-2010 (Figure 3). As the recovery softened, policy rate was kept on hold in late 2010 and early 2011. In mid-March 2011, the RBNZ reduced the policy rate by 50 bps to limit downside risks as a result of the February earthquake.

Figure 3
Figure 3

Monetary Stimulus

Citation: IMF Staff Country Reports 2011, 102; 10.5089/9781455274505.002.A001

Sources: Reserve Bank of New Zealand; Statistics New Zealand; Bloomberg; International Financial Statistics database.

4. The exchange rate appreciated and financial markets have largely recovered from the global financial crisis (Figure 4). The nominal effective exchange rate appreciated by about 25 percent from the trough in early 2009 to February 2011, driven by higher commodity prices that pushed the terms of trade to 15 percent above the average of the past two decades. New Zealand’s positive interest rate differential with other advanced economies and a recovery in global risk appetite also contributed to the appreciation.

Figure 4
Figure 4

Recent Financial Market Developments

Citation: IMF Staff Country Reports 2011, 102; 10.5089/9781455274505.002.A001

Sources: Bloomberg; Haver Analytics database; International Financial Statistics database; APDCORE database; and IMF staff estimates.

5. Fiscal easing supported activity. Permanent income tax cuts and spending increases that were announced before the global financial crisis and introduced in late 2008 provided a stimulus, but worsened the fiscal outlook. The structural balance deteriorated from a surplus of 2 percent of GDP in 2007/08 to a deficit of 2¾ percent of GDP in 2009/10 (Figure 5, Table 2). Net government debt (core Crown) increased to 14 percent of GDP in mid-2010.

Figure 5
Figure 5

Fiscal Stimulus

Citation: IMF Staff Country Reports 2011, 102; 10.5089/9781455274505.002.A001

Sources: The New Zealand Treasury; Statistics New Zealand; World Economic Outlook and IMF staff calculations and projections.
Table 2

Summary of Central Government Budget, 2006/07–2011/12 1

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Sources: New Zealand Treasury; and Fund staff estimates and projections.

Fiscal years ending June 30.

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.

Excluding Reserve Bank settlement cash.

Excluding NZ Superannuation Fund and advances.

Includes financial assets of NZ Superannuation Fund.

Includes the Earthquake Commission’s payments of $NZ 3 billion.

6. The banking sector remains profitable and is dominated by four subsidiaries of Australian banks that performed well during the crisis. Nonperforming loans have increased to 2 percent of total loans, still low by advanced country standards, and sound regulation and supervision helped maintain stability. All banks currently meet the Basel III requirements for common equity, Tier 1 and total minimum capital ratios (Figure 6).

Figure 6
Figure 6

Domestic Banks

Citation: IMF Staff Country Reports 2011, 102; 10.5089/9781455274505.002.A001

Sources: Reserve Bank of New Zealand; Bankscope; APRA; Haver Analytics database; and IMF staff estimates.

The Economic Impact of the Canterbury Earthquakes

The Canterbury region, accounting for about 15 percent of New Zealand’s economy, was struck by severe earthquakes in September 2010 and February 2011. About 180 lives were lost and residential and commercial buildings in Christchurch, New Zealand’s second largest city, suffered extensive damage. Infrastructure and tourism assets were also damaged, but most of the manufacturing and agriculture sectors were largely unaffected. Estimates of the damage are still subject to considerable uncertainty, and staff assume the cost of reconstruction to be $NZ 15 billion or about 7½ percent of 2011 GDP, comprising residential buildings ($NZ 9 billion), commercial buildings ($NZ 3 billion), and infrastructure ($NZ 3 billion).

The cost of reconstruction is larger relative to GDP than for major earthquakes elsewhere. The 2010 earthquake in Chile and the 1995 earthquake in Kobe, Japan, inflicted damage of about 6½ percent and 2 percent of GDP, respectively. While the scale of damage from the recent Japan earthquake is still uncertain, it is likely to be less than the Canterbury earthquakes as a percent of GDP.

The Canterbury earthquakes have disrupted economic activity, reduced wealth, and weakened confidence. Staff marked down the growth projection for 2011 to about 1 percent from 3 percent projected in the WEO forecast of October 2010, largely because of the quakes. The earthquakes destroyed assets equal to about 2–3 percent of the nation’s productive capital stock, and will have temporarily reduced potential output.

A01ufig03

Assumed Timing of Rebuilding (2011-16)

(In percent of GDP)

Citation: IMF Staff Country Reports 2011, 102; 10.5089/9781455274505.002.A001

The earthquakes also had an impact on the financial sector. One insurance company, AMI Insurance, is facing significant financial uncertainty because it has ⅓ of the residential insurance market in Canterbury and has a concentration of risk in the region. The government has subscribed for called but unpaid preference shares in AMI of up to $NZ 500 million (¼ percent of GDP) to ensure that claims for damage are paid out in case AMI cannot, and to maintain confidence in the insurance sector. The authorities believe that the insurance sector in general is sound and has adequate resources, including offshore reinsurance arrangements, and that the impact of the earthquakes on the banking system is limited.

Over the medium term, reconstruction is expected to boost investment and aggregate demand. Aftershocks, demolition and land stabilization work suggest that reconstruction will not start until late 2011 or early 2012. Staff assumes that four-fifths of residential and infrastructure rebuilding will be completed by 2016, while commercial rebuilding continues beyond this.

A01ufig04

Fixed Investment

(In percent of GDP)

Citation: IMF Staff Country Reports 2011, 102; 10.5089/9781455274505.002.A001

7. The current account deficit narrowed to 2¼ percent of GDP in 2010, well below the levels of about 8 percent of GDP in 2005–08. This reflects weak domestic demand, terms of trade gains, low world interest rates, and re-insurance inflows following the first earthquake (Figure 7, Tables 3 and 4). Net foreign liabilities have declined since 2008 but remained high at 82 percent of GDP at end-2010.

Figure 7
Figure 7

External Developments

Citation: IMF Staff Country Reports 2011, 102; 10.5089/9781455274505.002.A001

Sources: Reserve Bank of New Zealand; Statistics New Zealand; Haver Analytics database; World Economic Outlook; International Financial Statistics database; and IMF staff estimates.
Table 3

Balance of Payments and External Debt, 2005–10

(In percent of GDP)

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

The large net errors and omissions in 2008 and 2009 mainly reflect financial account data issues, as extreme volatility in exchange rates and market prices during that period made it difficult to separate out valuation effects from financial account transaction. A project is underway to investigate how balance of payments statistics can better capture transactions in financial derivatives.

IIP balance sheet positions arise from transactions and valuation changes. The large net errors and omissions in 2008-09 do not lead to large under-estimation of net foreign liabilities.

Table 4

Balance of Payments and External Debt, 2005–10

(In billions of U.S. dollars)

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

The large net errors and omissions in 2008 and 2009 mainly reflect financial account data issues, as extreme volatility in exchange rates and market prices during that period made it difficult to separate out valuation effects from financial account transaction. A project is underway to investigate how balance of payments statistics can better capture transactions in financial derivatives.

IIP balance sheet positions arise from transactions and valuation changes. The large net errors and omissions in 2008-09 do not lead to large under-estimation of net foreign liabilities.

OUTLOOK AND RISKS

8. Large uncertainty surrounds the economic outlook, particularly related to the size and timing of reconstruction from the earthquakes. In the near term, the earthquakes will slow activity, with growth projected at 1 percent in 2011, supported by elevated terms of trade and the Rugby World Cup later this year. Assuming that the bulk of reconstruction takes place during 2012–16, staff projects growth to rise to 4 percent in 2012 and converge to the potential rate of 2⅓ percent in outer years (Table 5).

Table 5

Medium-Term Scenario, 2008–16

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

Contribution in percent of GDP.

Converted from March year basis for historical data. Public saving covers general government.

Fiscal years ending June 30.

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

Data for end-December.

9. Risks are tilted to the downside.

  • On the external front, a faltering of emerging Asia’s rapidly growing demand for commodities could adversely affect exports, directly through lower commodity prices and indirectly through spillovers from Australia. Moreover, New Zealand’s large net foreign liabilities expose it to a possible rise in long-term interest rates as a result of high funding requirements of banks and sovereigns in advanced economies. The Japan earthquake, unrest in the Middle East and North Africa, and volatile oil prices add uncertainty to the global outlook.

  • Domestically, the recent earthquakes may have a greater-than-expected negative impact on confidence and growth. In addition, a sharp fall in house prices, which appear overvalued, would hit household balance sheets, likely depressing domestic demand and encouraging further deleveraging (Box 2). Similar falls in Australian house prices, which also appear moderately overvalued,1 could spill over to New Zealand, given the strong links in the business cycle (see selected issues paper).

  • Upside risks stem from a faster-than-expected recovery in major advanced economies pushing up commodity prices or stronger spillovers from Australia. Faster-than-expected reconstruction in Canterbury could create bottlenecks and push up inflation.

Are House Prices Overvalued?

Real house prices rose by 150 percent in the fifteen years to 2007, one of the strongest increases among advanced countries. Real house prices have since fallen by more than 10 percent.

House prices appear overvalued by about 15–25 percent, using a combination of simple metrics and models. However, some of these measures have weaknesses which add to the uncertainty of the estimate.

A01ufig05

House Price to Income Ratio

(1990 = 100)

Citation: IMF Staff Country Reports 2011, 102; 10.5089/9781455274505.002.A001

Source: OECD database.

The OECD’s house price-to-income ratio in September 2010 suggests an overvaluation of about 15 percent when compared with the average of the past twenty years. However, the income measure used by the OECD does not take account of Statistics New Zealand’s recent upward revision to household income.

The OECD’s price-to-rent ratio shows a much higher overvaluation relative to the past twenty years of 43 percent. However, the measure includes government subsidized rents which has pushed up the ratio over time as subsidized rents decreased, most noticeably in 2001. An alternative measure excluding subsidized housing suggests an overvaluation of 15–27 percent when compared with historical averages.

A01ufig06

House Price to Rent Ratio

(1990 = 100)

Citation: IMF Staff Country Reports 2011, 102; 10.5089/9781455274505.002.A001

Source: OECD database.

Model based estimates that take account of income, demographics and interest rates suggest an overvaluation of 15–25 percent. A model developed by Igan and Loungani (see forthcoming IMF working paper) shows an overvaluation in September 2010 of 20–25 percent. An alternative model that includes demographics, mortgage interest rates, and the terms of trade as a proxy for future income indicates that house prices are overvalued by about 15–20 percent, from a medium term perspective (based on Tumbarello and Wang, IMF WP/10/291).1 The model, however, is sensitive to assumptions about the terms of trade (a proxy for future income) and interest rates. The models suggest that a 10 percent fall in the terms of trade could result in an 8 percent fall in house prices over the medium run.

New Zealand Deviation of House Prices from Medium-Term Averages

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Source: OECD.
1 Assuming real mortgage interest rates return to the average of the past 15 years.

Authorities’ Views

10. The authorities shared staff’s assessment of the economic outlook and risks. They noted the difficulty in assessing the impact of the earthquakes and that confidence has deteriorated.

SECURING A SUSTAINABLE AND BALANCED RECOVERY

A. Monetary Policy

11. The weakening of the economic outlook gave scope for the recent reduction in the policy interest rate. Staff agreed that the reduction was appropriate given that the earthquake means that the output gap will likely remain about negative 2½–3 percent of GDP through mid 2012. Moreover, inflation expectations are below 3 percent, the upper end of the RBNZ’s target band, despite a series of shocks to headline inflation including the increase in the GST and higher global oil and food prices.

12. Staff stressed, however, that monetary policy will need to be tightened once it becomes clear that the recovery is underway. Staff estimates that the output gap will close by around 2013/14 as reconstruction proceeds, putting upward pressure on inflation. Staff also noted that a shift toward floating rate mortgages in recent years and high household debt means that consumer demand is more sensitive to interest rate hikes. Therefore, the effect of monetary stimulus could be removed relatively quickly. Higher marginal bank funding costs relative to the policy rate imply a lower neutral policy rate of around 4½ percent compared to 5½–6 percent in the past. Moreover, with inflation projected to be in the upper range of the target band for several years, staff pointed out that the RBNZ needs to guard against medium-term inflation expectations becoming anchored at too high a level.

13. If growth falters or global financial markets are disrupted, staff noted that the RBNZ has scope to cut the policy rate and provide liquidity support for banks if necessary. This proved effective in the recent crisis. The flexible exchange rate also provides an important buffer.

Authorities’ Views

14. As indicated in their own public statements, the RBNZ shared the view that monetary accommodation would need to be removed if the recovery proceeds as expected. They noted that the recent policy rate cut should be seen as an insurance measure designed to offset the negative economic effects of the earthquake until such time as rebuilding—and a recovery in the broader economy—act to draw on the economy’s surplus resources. The mobilization of resources required to rebuild could have a persistent inflation impact which would likely require a material increase in the policy rate.

B. Fiscal Policy

15. Reflecting the impact of the earthquakes and slower-than-expected economic recovery, staff projects the 2010/11 fiscal deficit to reach about 8 percent of GDP, much larger than budgeted. The earthquakes could increase public expenditure in the current fiscal year by $NZ 5.5 billion (on accrual basis), including $NZ 3 billion funded by the Earthquake Commission.2 The sharper-than-expected increase in the deficit is an unavoidable consequence of the earthquakes and will raise net government debt to 22 percent of GDP by June 2011.3

16. Staff advised returning to fiscal surpluses as soon as feasible, if the economic recovery proceeds as expected. Prior to the February earthquake, the Prime Minister announced the intention to return to a small surplus by 2014/15, one year ahead of the government’s earlier plan (Figures 8 and 9). The earthquakes have worsened the deficit in the near term, but it would be desirable to return to surpluses by 2014/15 or earlier if feasible for the following reasons:

  • Fiscal consolidation would create a buffer against future shocks.

  • It would relieve pressure on monetary policy and thereby the exchange rate, helping rebalance the economy and contain the current account deficit over the medium term.

  • Although government debt is projected to remain low by advanced country standards, New Zealand’s large net foreign liabilities calls for fiscal prudence. If global interest rates rise, low government debt would help contain the rise in New Zealand’s cost of funds.

  • In a tail risk scenario where the asset quality of banks deteriorates sharply, bank liabilities present a potential fiscal liability that limits the extent to which public debt can be raised without hurting investor confidence.

  • Reducing net government debt to below 20 percent of GDP over the next ten years would put the budget in a stronger position to deal with the fiscal costs of aging.

Figure 8
Figure 8

Exit from Fiscal Stimulus

Citation: IMF Staff Country Reports 2011, 102; 10.5089/9781455274505.002.A001

Sources: The New Zealand Treasury; Statistics New Zealand; and IMF staff calculations and projections.
Figure 9
Figure 9

Comparison of Fiscal Outlook

Citation: IMF Staff Country Reports 2011, 102; 10.5089/9781455274505.002.A001

Sources: World Economic Outlook, IMF staff estimates.

17. Staff encouraged the government to take concrete measures to control spending. Even excluding earthquake-related expenses, government expenditure has risen significantly in recent years (up by 6 percent of GDP over the six years to 2010/11). Reducing expenditure relative to GDP would be needed to return to structural surpluses. To this end, there is considerable scope to trim transfers to middle-income households, rationalize capital spending (which is high by advanced country standards), and improve the efficiency of public service provision.

A01ufig07

Government Investment, 2004-09

(Averages; percent of GDP)

Citation: IMF Staff Country Reports 2011, 102; 10.5089/9781455274505.002.A001

Source: Organisation for Economic Co-operation and Development.

18. The government plans to better manage its balance sheet and is considering selling a stake in state-owned enterprises. Staff noted that consideration should also be given to selling other assets, which would help reduce gross government debt and may limit the increase in New Zealand’s borrowing costs.

19. Staff supported the government’s intention to save excess revenue. Higher-than-expected growth, possibly arising from higher commodity prices, could boost tax revenue. In a downside scenario of lower growth, there is some limited space to delay the exit from budget deficits, while taking credible measures to return to structural surpluses over the medium term.

20. Tax reforms announced in the 2010/11 budget should help boost growth and saving (WP/10/128). The package included increasing the GST rate, cutting personal and corporate income tax rates, and reducing tax incentives to invest in properties.

21. In the long term, the budget faces considerable pressure from aging and rising health care costs. To contain the public share of costs in these areas, policy action will be needed. Health care spending growth could be reduced by improving the efficiency of delivery and the public pension cost increases could be contained by raising the retirement age and moving away from full indexation of benefits to wage increases.

A01ufig08

Public Health Spending: Projected Increases Over 2010-30

(In percent of GDP)

Citation: IMF Staff Country Reports 2011, 102; 10.5089/9781455274505.002.A001

Source: IMF Fiscal Monitor database.
A01ufig09

Pension: Projected Increases Over 2010-30

(In percent of GDP)

Citation: IMF Staff Country Reports 2011, 102; 10.5089/9781455274505.002.A001

Source: IMF Fiscal Monitor database.

Authorities’ Views

22. The authorities reiterated their intention to return to fiscal surpluses as soon as possible, despite the near-term cost of the earthquakes. They plan to reduce the Budget 2011 allowance for spending on new initiatives with any increases in spending in areas like health and education offset by savings in other areas. They also plan to streamline government service provision and prioritize capital spending. A key aim is to cap government net debt at 30 percent of GDP over the medium term and reduce it to the publically stated long-term objective of no higher than 20 percent of GDP by the early 2020s. Consideration is being given to funding more of planned capital spending from the government’s own balance sheet, including the partial sale of some state-owned enterprises, which would help limit the build-up in net debt.

MAINTAINING FINANCIAL STABILITY

23. Banks’ key vulnerabilities are their exposure to highly indebted households and farmers together with their sizable short-term offshore borrowing. While household net wealth (mainly housing) exceeds 500 percent of disposable income, household debt exceeds 150 percent of disposable income (Figure 10). Residential house prices are estimated to be 15–25 percent overvalued, while a large fall in commodity prices would impair the quality of agricultural loans.

Figure 10
Figure 10

Household Vulnerabilities

Citation: IMF Staff Country Reports 2011, 102; 10.5089/9781455274505.002.A001

Sources: Reserve Bank of Australia; Reserve Bank of New Zealand; Eurostat; OECD; Haver; and IMF staff calculations.

24. The potential risks associated with household lending are mitigated by a number of factors. In implementing the Basel II framework, the RBNZ required banks to assume higher rates of loss-given-default than in many other countries. At the same time, banks were relatively conservative. They limited their exposure to low-income earners, with less than one-fifth of bank loans to households in the lowest two income quintiles. Moreover, data from the Household Economic Survey for 2007 suggest that less than 5 percent of owner-occupied mortgages had loan-to-value ratios greater than 80 percent and debt-service ratios greater than 30 percent. The full recourse nature of mortgage lending also helped limit strategic loan defaults. Nonetheless, staff encouraged the RBNZ to review assumptions regarding probability-of-default and loss-given-default for mortgages and commercial lending in light of recent experience in countries where banks incurred large losses.

A01ufig10

Loss Given Default on Residential Mortgages1/

(In percent)

Citation: IMF Staff Country Reports 2011, 102; 10.5089/9781455274505.002.A001

S