Public Information Notice No. 02/35

Public Information Notice: IMF Concludes 2001 Article IV Consultation with New Zealand

March 27, 2002

On March 22, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with New Zealand.¹

Background

Between late 1999 and early 2001, the performance of the New Zealand economy was very strong, with real GDP expanding at almost a 4 percent annual rate. Net exports provided a significant stimulus to the economy, reflecting favorable prices for New Zealand's main exports, a recovery in agricultural production from droughts in 1999, and increased competitiveness from a depreciating exchange rate. The contribution from domestic demand during this period was more uneven, owing to large swings in business and consumer confidence that were triggered by initial concerns about the policy changes introduced by the Labor government and the rise in rural incomes on the back of strong export performance. Since early 2001, domestic demand growth has recovered and contributed to sustain GDP growth in the wake of weaker net exports, owing to the economic slowdown in the rest of the world. Low interest rates, strong net inflows of migrants, increased employment, and higher incomes associated with the surge of agricultural export over the last two years all contributed to consumption and bolstered the housing market in 2001. An improvement in business and consumer confidence in the first months of 2002 suggests that domestic demand is likely to maintain its momentum in the first half of the year.

The sharp rise in economic activity pushed the economy to a high level of resource use, as capacity utilization rates rose markedly in 2001. Conditions in the labor market also tightened considerably, and the unemployment rate, which declined to a 13-year low of around 5¼ percent in the second quarter 2001, but rose slightly to nearly 5½ percent in late 2001 owing to higher labor force participation.

Inflation has remained relatively well contained despite the increases in resource utilization and the depreciation of the exchange rate. Following a brief spike to 4 percent in the fourth quarter of 2000, inflation decelerated to about 3 percent in the first half of 2001 and declined further to 1¾ percent in the fourth quarter of 2001, near the mid-point of the official target range of 0-3 percent. After the sharp depreciation in 2000, the New Zealand dollar remained relatively stable during most of 2001. Spurred by more upbeat prospects for global growth, the value of the currency appreciated by about 5 percent against the U.S. dollar in early 2002, reaching a six-month high in March, and it is now back to its pre-September 11 level.

A strong performance in exports contributed to a substantial narrowing of the current account deficit. The current account deficit declined from almost 7 percent of GDP in 1999 to around 3½ percent of GDP in the third quarter of 2001. Export growth has been remarkably strong since early 2000, particularly in the primary sector and tourism, reflecting favorable terms of trade, a recovery in farm output from the effects of the 1999 drought, and a boost to competitiveness from the fall in the real effective exchange rate. However, export volumes and the terms of trade deteriorated in late 2001, largely on account of the weak global economic environment and some increases in export subsidies by other industrialized countries on key New Zealand's commodities.

With mounting evidence in 2001 of a marked weakening of global demand, the Reserve Bank of New Zealand (RBNZ) eased monetary policy cautiously, reducing its Official Cash Rate (OCR) by a total of 75 basis points between March and August 2001. Following events of September 11, the pace of monetary policy easing was stepped up, with the OCR cut in two steps by a total of 100 basis points to 4¾ percent in November 2001 to help arrest the deflationary risks stemming from a weak world economy. With the pace of domestic economic activity remaining strong in late 2001 and into 2002 and the external environment appearing more favorable, the RBNZ decided to raise the OCR by 25 basis points to 5 percent at its scheduled review in March 2002.

Following a strong performance through 2000/01 (July-June), the short-term fiscal outlook was marked down considerably in late 2001. The operating surplus was 1¼ percent of GDP in 2000/01, and the overall cash balance posted a surplus of ½ percent of GDP. An anticipated deterioration in the external outlook, especially after the events of September 11, prompted the government to revise downwards the fiscal projections in the December Economic and Fiscal Update. At that time, the operating surplus in 2001/02 was projected to be ¾ percent of GDP, while the overall balance is expected to be in deficit by 1¾ percent of GDP, mainly reflecting the government's investment in Air New Zealand and increased capital spending on health and education. Nonetheless, in the first seven months of the fiscal year (June 2001-January 2002), the operating surplus was larger than projected in the December Economic and Fiscal Update, mainly as a result of higher than expected revenues.

Over the medium-term, operating and overall surpluses are projected to rise steadily to 2¾ percent and 1 percent of GDP, respectively, in 2006/07. The ratio of gross government debt to GDP is expected to fall slightly from 32¼ percent in 2000/01 to 30¾ percent in 2006/07, and the net debt ratio would be unchanged at 17½ percent of GDP.

As for the near- and medium-term outlook, the staff's projections are for output growth of about 2 percent in 2002 and of 2½ -3 percent over the medium term. However, in light of the continued buoyancy of domestic demand over the last few months and the recently improved prospects for a marked turnaround in global economic activity, there appears to be scope for an upward revision of New Zealand's growth forecast for 2002. Following some deterioration in 2002, the current account deficit is expected to stabilize at around 3 percent of GDP over the medium-term, assuming that the real effective value of the New Zealand dollar remains near its depreciated level in late 2001. CPI inflation in 2002 is expected to be slightly above the mid-point of the target range and to remain around the mid-point over the medium-term.

Executive Board Assessment

Executive Directors agreed with the thrust of the staff appraisal. They complimented the New Zealand authorities for persisting with comprehensive structural reforms over the past 15 years and a sound macroeconomic policy framework, which have increased the economy's resilience to economic shocks and allowed it to perform relatively strongly despite the slowdown in world economic growth since 2001. Directors acknowledged that buoyant export prices, good agricultural conditions, and the absence of imbalances in asset markets also have been important factors underpinning the favorable economic performance during the current slowdown in world economic growth.

Directors endorsed the supportive stance of macroeconomic policies during 2001. They agreed that monetary policy should be the main line of defense against inflation and economic slowdown. Thus, with inflation well within the official target range, Directors endorsed the easing of monetary policy during 2001 to help support economic activity. In light of the recent forecast of a quicker-than-expected global economic recovery in 2002, and the strong growth of domestic demand in recent months, Directors supported the central bank's move to tighten monetary policy in March 2002.

Directors praised the skillful conduct of monetary policy in New Zealand and considered that the inflation targeting framework has served the country well. They welcomed the conclusions of the independent review of monetary policy and the authorities' decision to further strengthen the central bank's decision-making and governance structures.

Directors agreed that the modest fiscal support provided to the economy in the short run through the full play of automatic stabilizers is sufficient in the present circumstances. In any event, they noted the scope for a more proactive fiscal policy is limited by the country's net external liability position, the difficulty of timing the fiscal stimulus so that it is effective, and the need to ensure that medium-term fiscal objectives are not compromised.

Directors noted that potentially large pressures on the budget have been building up, and that those associated with pension and health care expenditures are likely to intensify over the long term. In line with the authorities' intentions, they emphasized that expenditure restraint will be important, if the medium-term objective of maintaining a fiscal surplus over the business cycle to prefund the future pension liabilities and contain the size of the public debt is to be achieved. While welcoming the plan to prefund part of future pension liabilities, Directors noted the need for reforms in the public pension system, including raising the retirement age, lowering the replacement rate, and changing the indexation of pensions to prices from wages. They stressed also the need for health care reform to improve the efficiency of the delivery of services and to control costs. Given New Zealand's good track record of prudent fiscal management, Directors expressed confidence in the authorities' ability to meet the challenges in the period ahead.

Directors agreed that New Zealand remains well placed to absorb adverse external shocks, as demonstrated by the economy's ability to absorb these shocks over the past few years without undue economic or financial distress. While the rapid growth of foreign currency-denominated external debt and the shortening of its maturity structure might suggest an increase in New Zealand's external vulnerability, Directors acknowledged that several factors mitigate the foreign exposure risk to the financial system, including the credibility and soundness of economic policies, the robustness of the banking sector, the absence of corporate and household sector financial imbalances, and the high degree of hedging. At the same time, Directors supported the authorities' efforts to better understand the implications of recent developments for the exchange rate and other asset prices, and to identify the ultimate holders of risk. They also welcomed the efforts to develop a set of macroprudential indicators and the decision to participate in the Financial Sector Assessment Program in 2003.

Directors pointed to a number of structural reforms that have enhanced economic incentives and improved the growth performance of the economy, including fiscal reform, the elimination of major distortions in the economy, the deregulation of product and labor markets, and the opening up of the economy to foreign trade and capital. They emphasized that, to create conditions conducive to lifting New Zealand's growth potential, additional reforms will be required to reduce disincentives to work, save, and invest, while building the social consensus necessary to ensure their success.

Directors welcomed the authorities' focus on innovation and skill development, and on efforts to attract high-skilled workers and strengthen New Zealand's international trade linkages through multilateral trade agreements. In this context, Directors commended New Zealand for its exemplary policy of providing quota- and duty-free access to all products from least developed countries. Some Directors also noted that trade restrictions imposed by partner countries continue to significantly hamper growth in New Zealand.

While acknowledging that the tax system is basically sound, Directors accorded high priority to certain changes that could spur labor force participation, saving, and productive investment. These include aligning the top marginal personal income tax rate with the corporate rate, reducing the tax bias in favor of residential investment, and reassessing replacement rates and the duration of social benefits. Directors raised doubts about the long-term effectiveness of lowering tax rates in attracting foreign investment and cautioned that such a measure would likely create new opportunities for tax arbitrage.

Directors urged the authorities to closely monitor the operations of the newly-established dairy cooperative, Fonterra, to ensure that it remains subject to effective competition domestically. Similarly, they welcomed the authorities' intention to allow Air New Zealand to operate on a commercial basis, but recommended that the company be privatized at the earliest opportunity. Directors also welcomed the authorities' intention to run Kiwibank on a strictly commercial basis and recommended that the bank's activities be kept under close scrutiny. In addition, they advised that the role of Industry New Zealand be tightly circumscribed so as to prevent drift into activist industrial and regional development policies.

Directors welcomed the significant progress made in dealing with anti-money laundering initiatives and the introduction of legislation to suppress the financing of terrorism.

It is expected that the next Article IV consultation with New Zealand will be held on the standard 12-month cycle.