New Zealand: IMF Staff Concluding Statement of the 2015 Article IV Mission
An IMF mission led by Mr. Chikahisa Sumi visited Wellington, Auckland, and Christchurch during October 28-November 10, 2015, and met with Deputy Prime Minister and Minister of Finance English, Reserve Bank of New Zealand Governor Wheeler, other government officials, private-sector analysts, and business and labor representatives. The mission thanks the New Zealand authorities and other counterparts for engaging discussions and their hospitality.
New Zealand’s flexible economy, underpinned by strong policy frameworks, is well-positioned to weather the recent slowdown of the economy and manage financial stability risks. Over the medium term, raising savings remains critical to address long-standing vulnerabilities arising from New Zealand’s large net external liability position.
Tailwinds that helped the economy after the Global Financial Crisis have waned. Dairy prices have fallen sharply from historic highs and the investment associated with the Canterbury rebuild is plateauing. As a result, output growth has slowed, and unemployment edged up. At the same time, inflation has declined, partly due to the drop in oil prices, while house prices in Auckland have continued to rise rapidly.
In response to these developments, the Reserve Bank of New Zealand (RBNZ) has cut its policy rate by a cumulative 75 bps to 2.75 percent since June. The authorities also introduced a package of tighter macroprudential regulations and tax measures aimed at containing risks emanating from the Auckland housing market. With the 2014/15 government operating balance in surplus, fiscal consolidation is progressing broadly in line with the authorities’ plans to reduce net debt to no higher than 20 percent of GDP by 2020.
The short-term outlook is challenging. The decline in dairy prices is still feeding through the economy. More broadly, New Zealand’s main trading partners, China and Australia, are slowing. Output growth is expected to slow in 2015 and remain somewhat below potential in 2016. Inflation is projected to rise to within the RBNZ’s target range of 1–3 percent in 2016, as the impact of the decline in oil prices drops out and the depreciation of the NZ dollar passes through.
But New Zealand’s economy is resilient:
- The flexible exchange rate provides an important buffer. It has depreciated over the past year, though it still remains somewhat overvalued.
- In the agricultural sector, farmers are employing a range of measures to adapt to lower prices, and banks continue to support the sector.
- Banks remain well-capitalized and stress tests indicate that the sector can withstand a sizeable shock to house prices, the terms of trade, and economic activity. They have also reduced their reliance on foreign sources of funding.
Business and consumer confidence have recently picked up again, net immigration remains strong, and medium-term prospects remain positive. New Zealand’s main exports, including of dairy, tourism and education services, 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.
However, risks are significant and tilted to the downside.
• Dairy prices: A renewed decline in dairy prices could threaten some higher-cost dairy producers, though the impact on financial stability would likely be limited.
• China spillovers: A sharper-than-expected slowdown in China that significantly affects consumer spending could reduce New Zealand’s exports. In addition, it would also likely adversely affect Australia, New Zealand’s second-largest destination for exports.
• El Ni?o: The El Ni?o weather pattern is well entrenched. Should a drought occur in areas reliant on rainfall, agricultural output could be significantly affected.
• House prices: The Auckland housing market could be increasingly driven by self-reinforcing demand dynamics which could eventually lead to a sudden sharp correction in house prices. High levels of household debt also imply that a rise in interest rates could strain their ability to service debts, squeeze disposable income and consumption, and possibly 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.
On the upside, 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.
A strong public sector balance sheet ultimately underpins confidence in New Zealand’s economy. In this regard, the planned medium-term fiscal consolidation is broadly appropriate, but in the short term automatic stabilizers should be allowed to operate fully. In addition, investment in infrastructure and housing (in high-quality projects) should be accelerated where possible to support higher housing supply in Auckland, and infrastructure improvements.
Monetary policy should focus on price stability while paying due regard to economic growth. With weak growth and core inflation in the lower half of the target band, the RBNZ’s easing bias is appropriate.
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, but even then the supply response will be slow. Therefore, in the interim, to buy time, other measures can usefully be employed:
• Prudential measures: The impact of the new measures to reduce financial stability risks will need to be evaluated, but the authorities should be prepared if further steps are needed. This could include targeted higher risk weights on housing loans, higher down payments, and a formal debt serviceability test.
• Tax measures: The newly introduced measures to deter speculative investment are welcome, and further steps in this direction should be envisaged. In addition, a more comprehensive reform to reduce the tax advantage of housing over other forms of investments could be warranted. This could include reducing the scope for negative gearing.
Responses to Risks
Should risks highlighted above materialize, the authorities have ample monetary and fiscal policy space, while the flexible exchange rate would be expected to act as a buffer. 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. 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. Nonetheless, 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.
Monetary policy has been focused on the primary objective of price stability. Only if financial stability risks become broad based and prudential policy is insufficient to contain them, then using monetary policy to ‘lean against the wind’ could be considered as part of a broader strategy to rein in financial stability risks. Even in this case, the benefits would need to be weighed against the output costs and the risk of policy reversals.
The banking sector continues to face long-standing structural issues related to reliance on offshore funding and a large share of mortgage lending. To improve the resilience of the sector, it is important to continue strengthening capital buffers and moving toward more stable sources of funding.
A long-standing source of vulnerability is New Zealand’s dependence on borrowings from abroad (albeit mostly hedged or in domestic currency). With chronically low national saving, the savings-investment balance is persistently negative and has led to the accumulation of a large net negative international investment position which requires to a significant extent financing by bank borrowing from abroad, and may have raised capital costs.
Raising saving is key to addressing this vulnerability. Higher private and in particular household saving would improve the international investment position, render the economy less susceptible to external developments, and help long-term growth by lowering capital costs for businesses, incentivizing productive investment which would lead to capital deepening. In this regard, comprehensive measures to encourage private long-term financial saving should be considered, including through reform of retirement income policies. Options include changing the parameters of the Kiwisaver scheme—e.g., default settings, access to funds, and taxation—to increase coverage and contributions while containing fiscal costs, and adjustment of parameters of the public pension system. This could help deepen New Zealand’s capital markets and broaden options for retirement planning.
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 accounts for 70 percent of the economy). 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.