Public Information Notice No. 05/60

Public Information Notice: IMF Executive Board Concludes  2005 Article IV Consultation with New Zealand

May 5, 2005

On May 2, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with New Zealand.¹

Background

New Zealand's economy has performed well, recording real GDP growth of 4 percent on average since 1999, due to the extensive structural reforms undertaken in the 1980s and 1990s and the sustained implementation of sound macroeconomic policies. High net migration inflows in 2002-03 also contributed to strong growth in recent years. Unemployment has fallen to the lowest rate in the Organization for Economic Cooperation and Development Countries, public debt has been declining, and inflation has remained within the central bank's target range.

GDP growth was particularly strong in 2004, at 4.8 percent, led by a surge in domestic demand. Private consumption grew by 6 percent, reflecting high employment growth, strong commodity prices, and household borrowing against rising housing values. Business investment also increased rapidly, powered by robust sales, strong profitability, growing capacity constraints, and declining domestic prices for imported equipment.

The current account deficit rose to 6.4 percent of GDP in 2004, as import volumes jumped by 16 percent, mirroring the strength of domestic demand. At the end of March 2005, the New Zealand dollar had appreciated 7 percent on a trade-weighted basis since end-2003, to stand about 16 percent above its twenty year average on a real effective basis. Export volumes nonetheless grew by a robust 5¼ percent in 2004, aided by widespread foreign exchange hedging that shielded exporters from the full effect of the stronger exchange rate. Meanwhile, rising international prices for the country's major commodity exports pushed the terms of trade to a 30 year high. Net foreign liabilities rose to 84½ percent of GDP at the end of 2004.

Inflation rose to near the top of the 1 to 3 percent target range as the economy reached a very high level of resource utilization. The Reserve Bank of New Zealand (RBNZ) raised the official cash rate (OCR) six times between January and October 2004, bringing the OCR to 6.5 percent. But the economy did not slow in line with earlier projections, and with the near-term outlook for activity remaining strong, the OCR was raised by a further 25 basis points in March 2005.

The fiscal position is strong, with actual budget surpluses exceeding targets consistently in recent years. The operating surplus before revaluations and accounting changes (OBERAC) rose to 4¾ percent of GDP in 2003/04 (fiscal year ending in June), and gross government debt declined to 25¼ percent of GDP. The OBERAC surplus for 2004/05 is expected to be larger than budgeted, with higher projected tax revenues only partly offset by increases in spending plans.

Growth is projected to slow in the near-term, to about 2¾ percent in 2005-06. Consumer spending is expected to moderate due to a cooling of the housing market and the effects of higher interest rates, while, with the hedges rolling-off, export growth is likely to be dampened by the high exchange rate. Nonetheless, there are upside risks to domestic demand due to high levels of job security; and, the RBNZ has indicated that there is little scope for an easing of monetary policy in the foreseeable future. As the cyclical position of the economy unwinds, the external current account deficit and inflation are expected to decline. Real GDP growth is expected to average about 3¼ percent over the medium-term, requiring a rise in productivity growth as recent gains in labor utilization will be difficult to replicate going forward.

Executive Board Assessment

Executive Directors welcomed New Zealand's strong economic growth in recent years, which has reduced the unemployment rate to the lowest in the OECD. Directors considered these commendable economic achievements to have been underpinned by the sustained and skilful implementation of sound monetary and fiscal policies and the wide-ranging structural reforms.

Directors noted that, since the beginning of 2004, domestic demand has been consistently stronger than envisaged, partly due to continued strong export commodity prices. In this environment, the potential pressure on prices has not come off as expected, and Directors endorsed the authorities' tightening of monetary policy. Directors observed that, even though resource utilization has risen to record high levels, inflation has remained inside the target range. Strong upward pressures on nontraded goods prices have been offset by low inflation in non-oil traded goods prices, due in large part to the appreciation of the New Zealand dollar.

Looking forward, Directors considered that monetary policy faces a difficult balancing act of responding to inflationary pressures while avoiding an unduly sharp slowing of activity. On the one hand, growth is expected to moderate and resource pressures to ease, once the effects of higher interest rates and the more appreciated exchange rate come into play, and a decline in net migration inflows translates into a further cooling of the housing market. On the other hand, high consumer confidence, strong investment intentions, and the most favorable terms of trade in 30 years, together pose a risk that domestic demand again exceeds expectations. On balance, Directors considered that the risks to inflation are predominantly on the upside, and supported the authorities' recent decision to maintain a tightening bias in monetary policy. On the exchange rate, Directors supported the authorities' approach of limiting foreign exchange market intervention to exceptional cases that met clearly specified conditions.

Directors commended the authorities on their sound fiscal management, cast in a transparent and predictable medium-term framework, which has led to a strong fiscal performance and a substantial reduction in gross government debt. They welcomed the decision in the 2004/05 budget to lower the debt target from 30 to 20 percent of GDP, to be achieved before 2015. Directors endorsed the government's objectives of achieving operating surpluses over the economic cycle, sufficient to cover contributions to the New Zealand Superannuation (NZS) Fund, while meeting capital spending requirements and maintaining government debt at prudent levels.

Directors stressed that current fiscal projections imply a small macroeconomic stimulus over the next few years, and that a more expansionary policy would risk adding to current resource pressures. Against that background, they supported the intention not to spend the cyclical component of higher-than-expected operating surpluses. Moreover, Directors noted that the recent rapid growth in a number of spending categories, including health and education, is unlikely to be sustainable. Directors therefore encouraged the government to maintain the prudence and discipline that it has shown in the past several years in making its expenditure decisions.

Directors reaffirmed that the creation of the NZS Fund to prefund part of the future pension liabilities has been an important step toward meeting the significant long-run demands on the budget posed by population aging. While noting that health care also represents an important source of long-run pressure on fiscal resources, they emphasized the need for further parametric changes in the pension and health care systems. Directors urged that such measures be adopted sufficiently early to help smooth fiscal costs over time and allow individuals time to adapt. In this context, Directors welcomed the planned publication of long-run fiscal reports at least every four years to help inform public debate about the policy options.

Directors agreed that New Zealand has the potential for continued strong economic growth in the medium-term. They observed that New Zealand's per capita income remains about four-fifths of OECD median levels, and that narrowing this gap would leave the New Zealand economy better positioned to manage the problems of population aging. With limited scope for further increases in labor utilization, Directors agreed with the authorities that increasing labor productivity is the key policy challenge.

Directors noted that higher labor productivity growth appears feasible if business investment remains high, thereby deepening the capital used by workers, and promoting the adoption of new technologies, and research and development. To enhance the investment environment, Directors supported plans to upgrade the transportation and energy infrastructure, and endorsed recent steps to enhance the skills of the workforce by raising the quality and relevance of tertiary education. Directors were of the view that improving the Resource Management Act would also help facilitate investment.

Directors judged New Zealand's flexible labor market to have contributed to strong employment growth and low unemployment, and recommended that this flexibility be carefully preserved. In this context, Directors advocated that close review be kept of the effects of the range of labor market measures that have been adopted in recent years, including the Holidays Act and minimum wage increases. Directors agreed that the adequacy of existing arrangements for probationary periods of employment should be reviewed.

While overall labor participation is already relatively high, Directors saw scope for increasing participation among certain groups. Directors welcomed the intention to promote participation of women by expanding access to child care, and the government's plans to use more active case management to help people make the transition from welfare to work, and recommended that these efforts be reinforced by strengthening requirements for those on benefits to participate in appropriate training or work programs.

Directors endorsed the authorities' emphasis on minimizing the administrative costs of the schemes being developed to facilitate household savings that would be operated at the workplace level. Directors recommended that any savings incentives that are offered be designed so as to contain the budgetary impact. Directors considered that such schemes can help to improve the financial resilience of households.

Directors strongly welcomed the authorities' recent efforts to strengthen the banking regulation and crisis management framework at a time when the financial sector is fundamentally sound. They considered the planned review of the regulation and disclosure of nonbank financial institutions to be an important step. Directors observed that substantial progress in addressing the recommendations of the 2004 Financial System Stability Assessment is being made, including by enhancing cooperation and coordination between the financial supervisors in Australia and New Zealand. In the discussions currently under way between the two countries on the closer integration of banking regulation, Directors urged that priority be given to ensuring that adequate safeguards for financial stability in New Zealand remain in place.

Directors recognized that New Zealand continues to face substantial trade barriers in key areas, including agricultural products, and welcomed the authorities' commitment and efforts to promote an open international trading system, not only at the bilateral and regional levels, but also at the multilateral level under the Doha round. Directors commended the authorities' generous response to the recent tsunami and encouraged the authorities to continue to make progress towards their goal of raising overseas development assistance.