Growth has moderated as tailwinds have waned: dairy prices have fallen sharply from historic highs and investment activity related to the Canterbury rebuild has reached a plateau. The short-term outlook is challenging with both external and domestic risks, the latter arising from rapid house price inflation in Auckland. However, New Zealand's flexible economy is resilient, and medium-term prospects remain positive. Monetary policy has been eased since June and the Reserve Bank stands ready to reduce rates further if warranted. Given the below-potential growth, measures of core inflation around the lower end of the target band, and a still strong exchange rate, the monetary policy stance is appropriate.

Abstract

Growth has moderated as tailwinds have waned: dairy prices have fallen sharply from historic highs and investment activity related to the Canterbury rebuild has reached a plateau. The short-term outlook is challenging with both external and domestic risks, the latter arising from rapid house price inflation in Auckland. However, New Zealand's flexible economy is resilient, and medium-term prospects remain positive. Monetary policy has been eased since June and the Reserve Bank stands ready to reduce rates further if warranted. Given the below-potential growth, measures of core inflation around the lower end of the target band, and a still strong exchange rate, the monetary policy stance is appropriate.

Recent Developments

1. The economy’s strong growth after the global financial crisis (GFC) has been supported by tailwinds: rising terms of trade (driven by high demand from China); and reconstruction activity after the 2010-11 Canterbury earthquakes. More recently, population growth driven by high net immigration also contributed, as the economy of Australia, New Zealand’s common labor market partner, has slowed. Growth peaked at 3.5 percent y/y in Q4 2014, bringing output slightly above potential. Due largely to the decline in oil prices, inflation has dropped to 0.1 percent (y/y) in Q4 2015.

2. However, the tailwinds have recently waned. In 2014, dairy prices began to fall from historic highs, leading to a sharp drop in income growth after the positive effect of declining oil prices had worn off, and post-earthquake rebuilding activity in Canterbury has reached a plateau.

  • Prices for whole milk powder (WMP), one of New Zealand’s key exports, declined from an average of around US$4,900/MT over 2013Q2-2014Q1 to US$1,700/MT in August 2015, partly on account of high inventories in China, decline in demand from Russia, and increased global milk supply after the European Union abolished its production quotas. Production cuts in New Zealand, which provides about 60 percent of global supply of WMP, have since supported a partial recovery of the price to just over US$2,300/MT in November 2015.

  • Post-earthquake reconstruction investment in the Canterbury region ramped up quickly, from NZ$1½ billion in 2011 to NZ$4½ billion in 2014, but is forecast to plateau at about that level during 2015-17.

A01ufig1

Export Prices

Citation: IMF Staff Country Reports 2016, 039; 10.5089/9781484398654.002.A001

Sources: Global Dairy Trade, and ANZ Bank.
A01ufig2

Canterbury Reconstruction Spending

(Bn constant 2012 NZ$)

Citation: IMF Staff Country Reports 2016, 039; 10.5089/9781484398654.002.A001

Source: Canterbury Earthquake Recovery Authority.

As a result, output growth began to slow in H1 2015, despite resilient consumption. Meanwhile, unemployment has been edging up, reaching 6 percent in Q3 2015 (well above pre-GFC levels) even as employment is growing, on account of stronger labor force growth.

3. Monetary policy has been eased. With inflation below target and the weakening outlook, the Reserve Bank of New Zealand (RBNZ) lowered its policy rate by a cumulative 100 bps since June 2015, to 2.5 percent, and has indicated its readiness to ease further if circumstances warrant in its December Monetary Policy Statement.

4. The exchange rate depreciation has cushioned some of the impact of the decline in dairy prices. The bilateral exchange rate against the U.S. dollar has depreciated as dairy prices fell and the RBNZ eased monetary policy. The depreciation has mitigated the impact of the international dairy price decline on farmers’ incomes, and supported exports of travel and education services. The trade-weighted exchange rate depreciated by 12 percent since its peak in July 2014, which has brought the REER closer to fundamentals, though some overvaluation likely remains (Annex I).

A01ufig3

Exchange Rates of Selected Commodity Exporters

(US$ per national currency; Jan 2014=100)

Citation: IMF Staff Country Reports 2016, 039; 10.5089/9781484398654.002.A001

5. House price inflation in Auckland has remained high. House prices in Auckland (where about one-third of the population lives) have continued their strong upward trend, rising by 22.5 percent (y/y) in December 2015, and the housing inventory available for sale remains low. Moreover, prices in neighboring areas are beginning to accelerate as buyers are priced out of the Auckland market. Supply shortages are a fundamental driver of house price inflation, exacerbated by high net immigration. On the demand side, macroprudential measures introduced in 2013 have led to a temporary slowdown in house price inflation. A package of additional macroprudential regulations and tax measures aimed at containing risks emanating from the Auckland housing market was announced in May 2015, but having become fully effective only in November, its effectiveness to cool rapid house price growth is yet to be seen (Box 1).

6. Fiscal consolidation is broadly on track. With significant expenditure control and solid revenue growth, an overall surplus of 0.8 percent of GDP was reached in 2014/15, well above the budget target (which had envisaged a deficit).1 Net debt declined slightly to 7½ percent of GDP.

7. The authorities broadly agreed with the staff’s policy advice in the last Article IV consultation. They have strengthened macroprudential policies to rein in risks from the housing market. Their flexible monetary policy has been supported by fiscal policy.

Measures to Contain Auckland House Price Risks

To contain risks arising from rapidly rising house prices to the financial sector, the RBNZ has used macroprudential policy tools proactively.

A01ufig4

House Prices

(Y/y % change)

Citation: IMF Staff Country Reports 2016, 039; 10.5089/9781484398654.002.A001

Sources: QV.co.nz and staff estimates.

First round (October 2013): The RBNZ placed a temporary ‘speed limit’ on high loan-to-value ratio (LVR) residential mortgage lending where banks must restrict new mortgages at LVRs over 80 percent to no more than 10 percent of their total residential mortgage lending. While house price inflation in Auckland initially moderated in response to the measures (and tighter monetary policy), it accelerated again during 2015.

Second round (May 2015): The RBNZ announced additional measures, which have taken effect in November 2015:

  • Residential property investors (though not owner-occupiers) in Auckland are required to have a deposit of at least 30 percent of the purchase price.

  • The existing 10 percent speed limit for loans at LVRs of greater than 80 percent is retained in Auckland, while it is increased outside of Auckland from 10 to 15 percent, to reflect the more subdued housing market conditions there.

  • A new asset class for loans to residential property investors has been established, which could attract a higher risk weighting than owner-occupier mortgages.

Tax measures announced in the 2015/16 budget presented in May also complemented the RBNZ’s second round. They effectively apply income tax on profits from property sales for non-primary residences if the house is bought and sold within two years. The government also announced a tightening of reporting and taxation rules for foreign buyers.

Outlook and Risks

New Zealand’s flexible economy, underpinned by strong policy frameworks, is well-positioned to weather the recent slowdown and manage risks, including to financial stability. Over the medium term, raising saving remains critical to address long-standing issues associated with New Zealand’s large net external liability position.

A. Outlook: Short-Term Challenges but Positive Medium-Term Prospects

8. The short-term outlook is challenging. The decline in dairy prices is still feeding through the economy, as investment and input decisions in the dairy sector continue to influence related sectors through the rest of the milk production season (until May 2016). While New Zealand’s milk production comprises less than 5 percent of GDP, its downstream and upstream footprint is estimated to be much larger.2 On the investment side, the plateauing of reconstruction in Canterbury and a relatively slow pick-up in infrastructure and housing construction in Auckland imply that the contribution of investment demand to growth will be significantly reduced (Figure 1, panel 3). More broadly, New Zealand’s main trading partners, China and Australia, have slowed, putting downward pressure on demand for and prices of New Zealand’s exports.

Figure 1.
Figure 1.

Output and Prices

Citation: IMF Staff Country Reports 2016, 039; 10.5089/9781484398654.002.A001

Source: Haver Analytics.

9. House price inflation has not given rise to a general credit boom. Credit to the private sector has accelerated recently but remains moderate at 7.1 percent in the year to November, with both housing loans and business credit growing at similar rates (Figure 2, panel 6). Going forward, house price growth is projected to moderate, as the impact of tighter macroprudential and tax measures sets in. This should lead to a slowdown in housing loans and an eventual decline of the household debt-to-disposable income ratio (Box 2). At the same time, business credit is expected to pick up further as investment accelerates in the medium term, supported by accommodative monetary policy and a recovery in domestic-currency export prices.

Figure 2.
Figure 2.

Considerations for Monetary Policy

Citation: IMF Staff Country Reports 2016, 039; 10.5089/9781484398654.002.A001

Sources: Reserve Bank of New Zealand; Haver Analytics; CoreLogic; and IMF staff estimates.

10. Fiscal policy is supportive of the economy in the short term, while consolidation is projected to resume in the medium term. In 2015/16 and 2016/17, weaker revenue growth and higher public investment are expected to return the budget to deficit (of about ½ percent of GDP each year), providing significant stimulus to the economy. In the medium term, the authorities’ fiscal plans envisage significant expenditure control through improvements in the efficiency of recurrent as well as capital spending, while maintaining revenue broadly constant as a share of GDP. In 2017/18, the budget is projected to be broadly in balance, and from 2018/19 in surplus which gradually increase to about 1 percent of GDP. Net debt is forecast to decline to about 5½ percent of GDP by 2019/20.

11. New Zealand’s economy is resilient and its financial sector sound. Business and consumer confidence indicators have recently picked up again, and consumption remains solid and net immigration strong.

  • The flexible exchange rate provides an important buffer. The depreciation of the NZ dollar is cushioning some of the impact of dairy price declines, and supports exports of education and tourism services, which constitute around one-fifth of total exports and continue to grow rapidly, as well as manufacturing.

  • In the agricultural sector, farmers are well-experienced and can employ a range of measures (e.g., delaying capital expenditure, using cheaper feed, reducing labor costs, culling cows) to adapt to lower prices, and banks continue to support the sector, taking a medium-term approach to borrower’s viability.

Macro-Financial Outlook and Risks

The housing sector is central in assessing New Zealand’s outlook and risks, considering risks stemming from high price inflation in Auckland, high concentration of mortgage loans in banks’ asset books, and high levels of household debt. Staff’s analysis, using a model of house prices based on economic fundamentals, suggests that house prices and household debt are to moderate over the medium term, containing financial sector risks in the baseline scenario.

Banking sector assets are around 180 percent of GDP, household debt is high, and much of household wealth is in housing. However, based on medium-term fundamentals, house price growth is likely to moderate, along with mortgage credit growth and the level of household debt (see also Tables 1 and 4).

A01ufig5

House Prices and Policy Rate

Citation: IMF Staff Country Reports 2016, 039; 10.5089/9781484398654.002.A001

Sources: RBNZ and Fund Staff calculations.
A01ufig6

Household Debt

Citation: IMF Staff Country Reports 2016, 039; 10.5089/9781484398654.002.A001

A01ufig7

Nominal GDP and Private Sector Credit

Citation: IMF Staff Country Reports 2016, 039; 10.5089/9781484398654.002.A001

  • House prices. The baseline projection is for a soft landing supported by effective macroprudential measures and tax policies, with house price inflation slowing to a sustainable 3-4 percent, based on medium-term fundamentals (interest rates, working-age population, and per capita income).

  • Household debt. Projected increases in house prices would further raise nominal household debt, but income growth should gather pace, resulting in the debt-to-disposable income ratio—which stood at 154 percent in 2014—initially rising further before falling gradually.

  • Household interest payments. The interest payments-to-income ratio is currently at historic lows. With RBNZ policy interest rates rising in the medium term, the household interest payment burden as a share of income is projected to rise, gradually approaching historical averages.

  • Credit to the private sector is assumed to grow as a weighted average of house price increases and business investment (broadly in line with recent historical patterns). This results in slightly slowing growth, and overall credit should remain broadly stable as a ratio of GDP. However, combined with deposits staying broadly constant as a share of GDP, this results in no significant reduction in banks’ use of wholesale funding.

  • Banks remain well capitalized and stress tests indicate hat the sector can withstand a sizeable shock to house prices, the terms of trade, and economic activity (Box 3). They have also reduced their reliance on foreign sources of funding.

A01ufig8

Potential Growth and Output Gap

Citation: IMF Staff Country Reports 2016, 039; 10.5089/9781484398654.002.A001

12. Medium-term prospects remain positive. Under the baseline scenario, dairy prices are expected to stabilize going forward at the current level. While the Chinese economy as a whole is expected to slow down, New Zealand’s main exports—agricultural consumer products and tourism—should benefit from the ongoing shift to a more consumption-oriented growth model in China. Consumer demand in other Asian countries is also expected to grow along with their income levels, and net exports to benefit from the weaker exchange rate. Overall, while output growth is estimated to have slowed to 2¼ percent in 2015, slightly below potential, it is projected to recover to its estimated potential rate of 2½ percent, based on total factor productivity (TFP) and capital input growth in line with long run historical averages, and moderately declining growth of labor input consistent with the projected slowing of working age population growth (with migration fluctuating in line with historical experience). With inflation expectations consistent with the midpoint of the RBNZ’s target range of 1-3 percent, inflation is forecast to rise to within the band in 2016, as the impact of the decline in oil prices drops out, the depreciation of the NZ dollar passes through, and fiscal stimulus is adding to demand, and then gradually converge to the center of the band.

B. Risks: Tilted to the Downside

13. While overall prospects are positive, risks are significant and tilted to the downside (Annex II).

  • Dairy prices. A renewed decline in dairy prices could threaten some higher-cost dairy producers. While New Zealand’s dairy sector as a whole has coped with significant price swings in the past, debt in the sector is concentrated among a relatively small group of farms. At the end of the 2013–14 season, 10 percent of farms accounted for around one-third of the total sectoral debt and these may constitute a pocket of vulnerability. The impact of this on financial stability, however, would likely be limited.

  • China spillovers. A sharper-than-expected slowdown in China that significantly affects consumer spending could reduce New Zealand’s exports and may lead to the exit of some farmers and attendant repercussions on the financial sector. In addition, it would also likely adversely affect Australia, New Zealand’s second-largest destination for exports.

  • El Niño. The El Niño weather pattern is well entrenched. While irrigation is spreading, some agricultural areas are reliant on rainfall. Should a drought occur there, agricultural output could be significantly affected.

  • House prices. If the authorities’ measures fail to cool house price inflation in Auckland, the housing market could be increasingly driven by self-reinforcing demand dynamics which could eventually lead to a sudden sharp correction in house prices, with adverse effects on the financial sector (residential mortgages represent about 50-60 percent of banks’ assets) and the wider economy. High levels of household debt—with a large share of mortgages carrying adjustable rates—also imply that a rise in interest rates could strain their ability to service debts, squeeze disposable income and consumption, and trigger declines in house prices.

  • Financial market volatility. U.S. monetary policy normalization may lead to unexpected bouts of higher global financial market volatility. This could lead to an abrupt depreciation, higher financing costs and/or a period of very poor liquidity in international financial markets.

14. There are also upside risks. A stronger-than-anticipated supply response to housing demand could pave the way for a smoother deceleration of house price inflation while supporting growth, and a recovery in dairy prices would boost incomes and investment. Continued high net immigration could pose challenges for short-term economic management, but in the longer run would boost growth.

15. There is ample policy space to respond. Should downside risks materialize, the RBNZ has scope to ease interest rates further. The low level of public debt would allow even more supportive fiscal policy if warranted. The flexible exchange rate provides an important buffer, and the financial system is less vulnerable than before the GFC. Broadly, financial system stress tests suggest it is able to withstand—at least in the short term—adverse developments related to China spillovers, dairy prices, and the housing market (Box 3), even though public support may be needed in an extreme scenario.

16. More broadly, with chronically low national saving, New Zealand’s economy is dependent on borrowing from abroad. Its persistently negative saving-investment balance has led to the accumulation of a large net negative international investment (IIP) position (65 percent of GDP in 2014), and requires to a significant extent financing by bank borrowing from abroad. While the net IIP position has improved from a negative 85 percent of GDP in 2009—supported by the payouts from international reinsurers after the Canterbury earthquake as well as strong deposit growth—this still renders the economy susceptible to swings in international financial markets (even though foreign exchange exposures are mostly hedged or in domestic currency), and is estimated to lead to higher capital costs.

Authorities’ Views

17. The authorities broadly concurred with the staff’s assessment of the outlook and risks, though they viewed risks as more balanced. They emphasized that at the current juncture the degree of uncertainty, including with regard to dairy prices, immigration, and the impact of El Niño was unusually high.

Stress Testing the New Zealand Financial Sector

Over the past years, the RBNZ has conducted regular stress tests of the New Zealand banking system, focused on housing price busts, interest rate spikes and a protracted decline in dairy prices. The Australian Prudential Regulatory Authority collaborated on the subsidiaries of Australian banks, which play dominant roles in New Zealand.

House price bust and interest rate spike. In the house price decline scenario, a sharp slowdown in economic growth in China triggers a severe double-dip recession. Real GDP declines by around 4 percent, and unemployment peaks at just over 13 percent. House prices decline by 40 percent nationally, with a more marked fall in Auckland. The agricultural sector is also hit by a combination of a 40 percent fall in land prices and a 33 percent fall in commodity prices. The RBNZ also considered a scenario where the interest rate is sharply higher, resulting in increased unemployment and higher borrowing costs.

In these scenarios banks face higher funding costs and credit losses, with a significant adverse impact on profitability and capital ratios. Losses on residential mortgages account for around one-third of total credit losses. The aggregate Common Equity Tier 1 (CET1) ratio falls by around 3 percentage points though all banks remain above the minimum CET1 capital requirement of 4.5 percent. Losses are greater than the capital held for housing for the internal ratings based risk weight banks and almost all banks would use capital conservation buffers and face constraints on dividend and bonus payouts. Even though CET1 requirements are not breached, it is unlikely that New Zealand would have a fully-functioning banking system as banks with substantially reduced capital ratios would be severely constrained in their ability to raise funding (both in availability and pricing), and hence in their ability to advance credit. In such a scenario, the lower credit extended by banks would also have an adverse impact on real GDP growth and would likely lead to higher fiscal deficits.

Low dairy prices. In the stress scenarios, milk prices are substantially below recent averages and farm gate prices are assumed to fall by around 40 percent by 2018-19. This will result in higher loss rates, estimated around 2-14 percent of all dairy lending. The banks would incur losses amounting to 2-18 percent of pre-tax profits, highlighting the need for increased provisioning, but the impact would be manageable from a financial stability perspective.

  • Dairy prices: the authorities noted that dairy markets had a history of volatility. They stressed, however, that the dairy industry has gone through rounds of structural changes coping with the volatility, and has become more competitive and resilient, with increasingly professional management and new investment.

  • Immigration: they noted that the current situation, in which net emigration to Australia was at an all-time low, was unusual, and that they expected it to pick up as growth in Australia rebounds. However, should high net immigration continue, this would support growth in the longer run even if it posed challenges—notably by increasing pressure in the housing market—in the short run.

  • El Niño: the authorities indicated that the El Niño weather pattern was well established, but its impact as yet uncertain. The spread of irrigation had reduced the risk associated with drought.

  • House prices: they pointed to stress tests that suggested banks would be able to withstand a severe shock to house prices, output, and dairy prices, but noted that in a severe scenario credit supply could become constrained.

  • Financial market volatility: while acknowledging the risks, the authorities noted that New Zealand’s banking system had weathered the GFC relatively well, and stressed that capital ratios have improved and the use of wholesale funding was significantly reduced since then.

18. The authorities broadly shared the staff’s assessment of longer-term vulnerabilities and higher capital costs arising from low saving. While they pointed out that this is a longstanding feature of the economy and that net external liabilities had been reduced substantially after the GFC, they shared the staff’s concerns and indicated that they would consider measures to raise savings.

Policies

Monetary and fiscal policy settings are broadly appropriate. Automatic stabilizers have been allowed to operate, and public investment is accelerated where possible. Prudential and tax measures should be used to increase the maneuvering room for monetary policy. In the medium term, steps to raise national savings, boost productive investment, and further strengthen the financial sector should be considered.

A. Short-Term Macroeconomic and Risk Management

19. A strong public sector balance sheet ultimately underpins confidence in New Zealand’s economy. In this regard, while public debt is already low (Annex III), the authorities’ planned medium-term fiscal consolidation path is broadly appropriate, envisaging an improvement of the cyclically adjusted balance by about 1/3 percent of GDP annually from 2016/17 onward over the next few years. However, in the short run, with the economy below potential and ample fiscal policy space, the authorities’ planned fiscal stimulus through automatic stabilizers and increased public investment is timely. In particular, investments to support a boost in housing supply in Auckland, and infrastructure improvements to address bottlenecks would also help ease house price inflation, and improve the productivity of the economy. This should be facilitated by the recently completed national 30-year infrastructure investment plan, which provides a strategic framework for infrastructure investment decisions.

20. Monetary policy should focus on price stability while paying due regard to economic growth. With the below-potential growth, measures of core inflation around the lower end of the target band, and a still strong exchange rate, the RBNZ’s recent easing and its continued readiness to ease further are appropriate. Using monetary policy to ‘lean against the wind’ could be considered as part of a broader strategy to rein in financial stability risks only if financial stability risks become broad based and prudential policy is insufficient to contain them. Even in this case, the benefits would need to be weighed against the output costs and the risk of policy reversals, though further prudential and tax measures to reduce incentives to invest in housing could ease these trade-offs.

21. For monetary policy to be able to focus on the real economic cycle, the risks arising from further house price inflation in Auckland need to be managed through other policy measures. The underlying issue is a supply/demand mismatch. Intensifying efforts already underway to boost higher-density housing, and increase the supply of land and infrastructure in the city would be welcome, including through better local/central government coordination and measures to discourage land hoarding (which could include higher land taxes), but even then the supply response will be slow. Therefore, in the interim, to buy time, other measures can usefully be employed:

  • Prudential measures: Housing market risks are serious, and need to be proactively addressed. While the impact of the newly introduced macroprudential and tax measures will need to be evaluated, the authorities should prepare further steps in advance, should they be needed. This could include targeted higher risk weights on housing loans, higher down payments, and a formal debt serviceability test, as deployed in other advanced economies in the Asia-Pacific region that have experienced rapid house price growth.

  • Tax measures: The newly introduced measures to deter speculative investment are welcome, and further steps in this direction (e.g., by widening the scope within which a resale of real estate is deemed for a business purpose and the proceeds taxable) could be envisaged. In addition, the incentives for buying real estate increase when real estate investors can write off interest payments against their other taxable income. This ‘negative gearing’ encourages investment that would otherwise be loss making, and thereby acts as an amplifier of price movements in the real estate market. Ring-fencing housing losses to within real estate earnings would therefore weaken an important price driver.

22. The financial system has markedly improved its capital and liquidity buffers since the GFC, but challenges remain. The major banks have a large proportion of their assets in residential mortgages and rely on broadly similar business models. Banks have continued to reduce their reliance on short-term offshore funding markets, resulting in a rise in the core funding ratio from 78 percent in 2010 to 86 percent in 2015, mainly through increased deposit funding. With regard to capitalization, all banks currently exceed Basel III capital requirements, with strong profitability. Stress tests indicate that even under very adverse scenarios, banks’ CET1 capital remains above the minimum requirement. Nonetheless, a reduction in collateral values and loss absorbing capital could prompt banks to rebuild buffers, leading to reduced credit provision to the economy. To improve the resilience of the sector and reduce vulnerabilities stemming from the reliance on offshore funding, it is important to continue strengthening capital buffers and moving toward more stable sources of funding. Staff welcomes the planned review of financial sector capital levels in 2016. Moreover, the planned FSAP in 2016 will also assess financial sector resilience. Even after the recent growth in size and depth, New Zealand’s capital markets remains small by international standards and the banking system continues to dominate funding for firms. Further development of both equity and bond markets, including retirement products, should remain a policy priority.

23. Should any of the risks outlined above materialize, macroeconomic policy responses would need to be adjusted. A sharp slowdown in the economy driven by key export markets could warrant a monetary and, if severe enough, a coordinated fiscal policy response. A severe downturn in the housing market may also call for supportive demand policies. Similarly, a period of extremely low liquidity in financial markets or an excessive risk premium required by international investors could call for both monetary and fiscal support.

Authorities’ Views

24. The authorities emphasized their commitment to reducing net debt. While low compared to other advanced economies, they felt that a small open economy like New Zealand needed particularly strong buffers and that the government has an important role to play given the economy’s net external liabilities. While keeping its fiscal strategy unchanged, the government has updated some of its short-term intentions and long-term objectives to provide scope for the fiscal position to fluctuate in response to changing economic circumstances. The intention is to reduce net debt in national definition to around 20 percent of GDP by 2020, and to within a range of 0 to 20 percent of GDP over a longer time horizon. The authorities also emphasized their efforts to enhance the efficiency of both capital and current spending, the latter through a ‘social investment’ approach which takes into account costs and benefits of social policy interventions over a 20-year horizon. The authorities were ready to let automatic stabilizers—which largely work on the revenue side—operate fully, and have announced an additional NZ$1 billion of capital spending given the pipeline of high-quality investment priorities. This could help alleviate housing market and infrastructure pressures in Auckland.

25. The RBNZ reaffirmed its accommodative stance. While they expect interest rates to now be on hold for some time, they stand ready to ease further should circumstances warrant. They confirmed that monetary policy was focused on price stability, with due regard to output growth, but at the same time, they pointed to the limits of monetary policy in fine-tuning the economy. With regard to house price inflation, they indicated that they were strengthening their collection of data to enhance analysis of mortgage lending, and suggested that they would need to assess the impact of the most recent macroprudential and tax measures on the housing market and mortgage lending before deciding on possible additional measures. While pointing to stress tests indicating that banks can withstand a sizeable shock to house prices, the terms of trade, and economic activity, the authorities agreed on the importance of maintaining strong capital and stable sources of funding buffers.

B. Medium-Term Policies: Increasing Resilience and Raising Incomes

26. Raising national saving is key to reducing external vulnerabilities and raising potential growth. With government saving broadly adequate and higher than those of peers, policy measures would need to concentrate on raising private savings. Higher savings would, through lower capital costs, raise potential growth over time due to higher productive capital investment and increased TFP, and would improve the IIP, rendering the economy less susceptible to external developments.

27. Comprehensive measures to encourage long-term private financial saving should be considered. Such measures would need to be embedded in the current tax system, which epitomizes the principle of ‘broad-base low-rate’ taxation, but need not be confined to tax measures. A key instrument could be modifications to the Kiwisaver scheme, which was introduced in 2007. Options include broadening coverage, changing default settings to nudge participants toward higher contributions, restricting access to funds before retirement (including for buying a first home), raising employer contributions, raising the minimum level of employee contributions, reduce taxation of contributions or returns, and promote a wider variety of financial investment options. This could also help deepen New Zealand’s capital markets and broaden options for retirement planning. In addition to changes to the Kiwisaver scheme, modifications to the universal pension system could also be considered, including the introduction of a means test.

28. Incentives to invest in real estate assets should be reduced. The tax-preferred treatment of housing diverts savings into real estate assets, increasing costs for business investment. In this regard, the measures outlined above to reduce the tax advantage of real estate investment (reducing the scope for ‘negative gearing’ and widening the scope of applicability of income taxation on profits from property sales for non-primary residences) would also help promote financial savings.

29. New Zealand’s living standard is very high but incomes lag those of other advanced economies. Its income per capita remains at the low end of advanced OECD economies. While New Zealand’s small size and distance from markets likely play a role in limiting gains from trade (Box 4), there is some room to alter other structural factors to increase investment in productive capital, thereby increasing the currently low capital intensity and TFP.

A01ufig9

Better Life Index

Citation: IMF Staff Country Reports 2016, 039; 10.5089/9781484398654.002.A001

Source: OECD Better Life Index.

30. Despite the implementation of successful structural reforms in the 1980s, productivity levels have remained low compared to OECD peers. To raise productivity, the government’s Business Growth Agenda has identified a number of policy priorities. Specifically, the Productivity Commission has highlighted the need to raise productivity in the services sector (which comprises 70 percent of GDP). Measures include boosting competition in key sectors such as finance, real estate, retail, and business and other professional services; and leveraging ICT technology more intensively, including by enhancing skills. With New Zealand ranked 2nd in the World Bank’s 2016 Doing Business report, there is limited scope for simple measures to boost productivity, but the authorities’ focus on the services sector as well as on ICT as a means to reduce the costs of distance is appropriate. Higher saving (see above) may also boost long-term growth by lowering capital costs for businesses, thus supporting higher productive investment. This would be reinforced if incentives for investing in real estate were to be reduced and options for financial savings broadened.

The Impact of Distance

New Zealand’s distance from markets has limited productivity, resulting in below-OECD average incomes, even though its sound institutions and policies could have made it a top performer Enhanced efforts would be needed to overcome this handicap.

From the 2000s, New Zealand has lagged behind top OECD countries in output per worker by 20–25 percent. This gap can be explained by both substantial productivity gaps and lower levels of capital. While the latter may be partly influenced by the low savings rate (and higher interest rates), the productivity gap is striking, particularly when taking into account New Zealand’s sound institutional and policy settings: New Zealand’s per capita should be 20 percent above the OECD average based on structural policy settings, not 20 percent below (NZPC, April 2014).1/

A01ufig10

GDP Per Worker

(1984 = 100; 5yma)

Citation: IMF Staff Country Reports 2016, 039; 10.5089/9781484398654.002.A001

Sources: OECD Productivity database; and IMF staff calculations.

New Zealand’s distance from markets appears to be a key factor. It could affect productivity through limits on the potential to exploit scale economies and agglomeration effects, higher transport costs, and by reducing trade intensity. These factors may explain more than half of New Zealand’s productivity gap compared to 20 selected OECD countries and is estimated to cost around 12 percent of GDP relative to other developed countries (Boulhol and de Serres, 2010). 2/

A01ufig11

Trade and Market Access

Citation: IMF Staff Country Reports 2016, 039; 10.5089/9781484398654.002.A001

Sources: Baulhol and de Serres (2010) for index of market access; IMF WEO database; and IMF staff calculations. Trade intensity is defined as sum of exports and imports over nominal GDP in percent.

Overcoming the disadvantages of distance may require enhanced efforts. Integration into global value chains in industries and services with fast-paced innovation, particularly in high-value added (and less location-dependent) aspects such as design and R&D would be required. Further easing telecom and air transport regulation may help reduce the distance disadvantage, including for service exports, for which New Zealand is relatively well positioned.

1/ New Zealand Productivity Commission: An International Perspective on the New Zealand Productivity Paradox, Working Paper 2014/01.2/ “Have countries escaped the curse of distance?” Journal of Economic Geography 2010 (1).

Authorities’ Views

32. The authorities agreed that raising national saving was an important policy objective. They indicated that they had explored this issue in depth, and would consider measures to boost private saving—without jeopardizing their solid fiscal position—in the future. They also pointed to measures already taken to reduce incentives for investing in real estate, and indicated that consideration could be given to expanding these. At the same time, they were keen to protect the integrity, simplicity and ‘broad base, low rates’ approach of the tax system, and were skeptical about the effectiveness of fiscal incentives. They were also concerned about transitional issues and the distributional impact of changes to the tax system, but agreed that such issues could at least partially be addressed through a comprehensive approach to reform. Moreover, they pointed out that key tax measures to significantly disincentivize investment in housing were politically difficult.

33. They concurred that raising productivity was critical. With New Zealand among the most business-friendly economies in the world, they saw little scope for ‘big bang’ reforms, but explained that they were advancing a broad-based Business Growth Agenda to strengthen skills and innovation, as well as investment and infrastructure, while using natural resources sustainably. They also aimed to boost exports, as a means to foster competitiveness. The authorities also saw improvements in the efficiency of both recurrent and capital public spending as a key tool to contain fiscal costs while improving outcomes.

Staff Appraisal

34. Outlook. As tailwinds wane, the short-term outlook is challenging. Dairy prices have fallen from historic highs and the investment associated with the Canterbury rebuild is plateauing, while trading partner growth has slowed. However, New Zealand’s resilient and flexible economy is well positioned to weather the recent slowdown. The flexible exchange rate is an important buffer to help the economy adjust. Underpinned by strong policy frameworks, medium-term prospects remain positive.

35. Risks. There are significant downside risks, including a renewed decline in dairy prices, spillovers from a sharper-than-anticipated slowdown in China, the impact of El Niño on agriculture, a sharp correction in house prices, and financial market volatility related to monetary policy normalization in the U.S. However, the well capitalized banking system, under strong RBNZ supervision, is assessed to be able to withstand severe stress scenarios, although it continues to face long-standing structural issues related to reliance on offshore funding and a large share of mortgage lending. Moreover, there is ample monetary and fiscal policy space to respond, should it become necessary.

36. Macroeconomic management. Given low inflationary pressures, output below potential, and unemployment edging up, the RBNZ’ accommodative monetary stance, including its readiness to ease further if warranted, is appropriate. With regard to fiscal policy, continued strengthening of the public sector balance sheet with a firm commitment to the medium-term objective of reducing debt further should help underpin confidence in New Zealand’s economy. The authorities’ fiscal easing this year and next, including through an acceleration of public investment in infrastructure, combined with a resumption of a gradual fiscal consolidation path thereafter, is broadly appropriate to support the economy in the short term while bolstering the public sector balance sheet in the longer term. If risks were to materialize, macroeconomic policies would need to be adjusted: a sharp slowdown in the economy could warrant a monetary and, if severe enough, a coordinated fiscal policy response.

37. Financial stability. Risks stemming from the housing market are serious, and staff welcomes the proactive macroprudential measures to address them. While the underlying cause of the housing market boom in Auckland is a supply/demand mismatch, self-reinforcing price dynamics may emerge and eventually lead to a sudden sharp correction in house prices, with adverse effects on the financial sector. Intensifying efforts to boost housing and the supply of land and infrastructure in the city is therefore critical. But since such measures, even if accelerated, will take time, other policy steps are needed for monetary policy to be able to focus on the real economic cycle.

  • Prudential: While some time will be needed to fully assess the impact of the recent macroprudential and tax measures, additional steps should be prepared in advance, in case they are needed.

  • Tax measures: The newly announced measures to strengthen the applicability of income taxation on profits from property sales are welcome, but more comprehensive steps to reduce the tax advantage of housing over other forms of investments should be considered, including by reducing the scope for ‘negative gearing’ and increasing taxation of land.

38. Saving and investment. Raising national saving is critical to reducing external vulnerabilities. In particular, higher private and especially household saving (which are low compared to peers) would improve the IIP. At the same time, higher saving may also reduce capital costs by lowering the risk premium and thereby support productive investment and long-term growth. Comprehensive policy measures to encourage private long-term financial saving should be actively considered, including through reform of retirement income policies. Options include changing the parameters of the Kiwisaver scheme—e.g., default settings, access to funds, contributions, and taxation—to increase coverage and contributions while containing fiscal costs, and adjustment of parameters of the public pension system. This could also help deepen New Zealand’s capital markets and broaden options for retirement planning.

39. Productivity. Notwithstanding high living standards, New Zealand incomes lag those of other advanced economies, due to relatively low capital intensity and TFP. The economy’s small size and distance from markets likely limit gains from trade, but leveraging ICT technology more intensively, including by enhancing skills, could mitigate the impact of this handicap. Moreover, measures to boost competition in key sectors such as finance, real estate, retail, and business and other professional services should help raise productivity and incomes. In addition, public investment to address key infrastructure bottlenecks should help improve productivity. These steps should effectively supplement the macro-economic measures to reduce the longstanding saving-investment imbalance described above.

40. It is recommended that the next Article IV consultation be held on the standard 12-month cycle.

Figure 3.
Figure 3.

External Developments

Citation: IMF Staff Country Reports 2016, 039; 10.5089/9781484398654.002.A001

Sources: The Reserve Bank of New Zealand; Haver Analytics; and IMF staff calculations and projections.
Figure 4.
Figure 4.

Fiscal Developments

Citation: IMF Staff Country Reports 2016, 039; 10.5089/9781484398654.002.A001

Sources: The Treasury, Budget 2015; and IMF staff estimates.
Table 1.

New Zealand: Main Economic Indicators, 2010-2020

(Annual percent change, unless otherwise indicated)

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Sources: Authorities’ data and IMF staff estimates and projections.

Calendar year.

Table 2.

New Zealand: Fiscal Accounts, 2009/10–2019/20

In percent of GDP, unless otherwise indicated)

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Sources: Authorities’ data and IMF staff estimates and projections.

The fiscal year runs from July to June.

Accrual basis; GFS. Comprises Core Crown (excl. Reserve Bank of New Zealand) and Crown entities. Includes New Zealand Superannuation Fund.

Table 3.

New Zealand: Balance of Payments, 2010-2020

(In percent of GDP, unless otherwise indicated)

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Sources: Authorities’ data and IMF staff estimates and projections.
Table 4.

New Zealand: Monetary and Financial Sector, 2014-2020

(In billion NZ$, unless otherwise indicated)

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Sources: RBNZ and IMF staff calculations.
Table 5.

New Zealand: Financial Sector Indicators, 2009-2014

(In percent of GDP, unless otherwise indicated)

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

Data for 2014 are for end-June.