Public Information Notice No. 06/50

Public Information Notice: IMF Executive Board Concludes 2006 Article IV Consultation with New Zealand

May 4, 2006

On April 28, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with New Zealand.¹

Background

Following a vigorous expansion in recent years, a cyclical slowing in New Zealand's economy commenced in 2005, with growth declining to 2¼ percent. Economic growth had averaged 4¼ percent annually in 2002-04, with domestic demand boosted by large migration inflows, wealth effects from rising house prices, and income effects from high commodity prices. Unemployment fell to 3½ percent, but resources became increasingly stretched. In this environment, CPI inflation rose slightly above the medium-term target range of 1 to 3 percent by end-2005, although higher international oil prices also played a role.

The slowdown in 2005 fell most heavily on the tradable sector, and domestic demand growth remained strong for much of the year, hence the external current account deficit rose to 9 percent of GDP, double its 20-year average. The New Zealand dollar reached a post-float record high in December 2005, supported by large capital inflows associated with exceptional demand for New Zealand dollar denominated bonds from retail investors in Japan and Europe. The appreciated exchange rate was a key contributor to the decline in export volumes in 2005 despite strong global growth. At the same time, domestic demand was sustained by an unexpected revival of the housing market in 2005, with annual house price inflation of about 15 percent facilitated by mortgage rates remaining relatively low despite rising official interest rates.

Monetary policy has been on hold so far in 2006, after being tightened in 2005, while the fiscal position remains strong. The official cash rate (OCR) was raised by 75 basis points during 2005 to 7¼ percent. The central government's operating surplus before revaluations and accounting changes (OBERAC) climbed to 5½ percent of GDP in 2004/05 (fiscal year ending in June), and gross government debt declined to 23 percent of GDP. The OBERAC surplus is expected to fall to 4 percent of GDP in 2005/06 (excluding write-downs of student loans), partly reflecting an expansion in support for low income families.

Domestic demand has slowed more recently and the exchange rate has declined substantially. The downturn in domestic demand is expected to continue, reflecting the upward repricing of mortgage rates in 2006, and also owing to an expected leveling out of house prices. Hence growth is likely to be sluggish in 2006, at around 1 percent. Nonetheless, growth is projected to recover to about 2 percent in 2007, led by exports, which will benefit from the adjustment underway in the exchange rate, which has so far retraced 16 percent on a trade-weighted basis from its December 2005 peak.

With slower growth easing resource pressures, inflation is expected to moderate, allowing an eventual easing in monetary policy. A substantial narrowing of the external current account deficit should occur over time as the economy rebalances. In the medium term, growth is expected to return to 3 to 3½ percent, underpinned by the extensive structural reforms undertaken in the 1980s and 1990s, and the sustained implementation of sound macroeconomic policies.

Executive Board Assessment

Executive Directors commended the New Zealand authorities on their continued implementation of sound macroeconomic policies during a challenging phase in the business cycle. Directors noted that following a number of years of strong economic growth, New Zealand's economy slowed in 2005. The external current account deficit widened markedly as the exchange rate appreciated, and with resources stretched, a strong housing market, and higher oil prices, inflation edged to the top of the medium-term target range. Nonetheless, inflation expectations going forward remain well contained, and underlying inflation is expected to decline as resource pressures ease. Accordingly, Directors agreed that the current stance of macroeconomic policies should be appropriately supportive of a soft landing for the economy, although downside risks remain.

Looking ahead, Directors noted that the recent depreciation of the exchange rate will help rebalance demand in the economy and contribute subsequently to a pick-up in growth. They also considered that the government's budgetary plans will help cushion downside risks to the outlook. Directors fully endorsed the government's farsighted conduct of fiscal policy, which has allowed the operating surplus to rise substantially during the years of strong growth. The expected decline in the operating balance in coming years is consistent with the government's prudent medium-term fiscal objectives, as the balance will remain in surplus, and net assets will continue to increase relative to GDP. Directors judged that the associated fiscal stimulus should not exacerbate inflationary pressures in view of the expected slowing in activity. In the case of a sharper-than-expected downturn, Directors supported allowing full play of the automatic fiscal stabilizers.

Directors considered that following the significant tightening over the past two years, monetary policy should continue to steer a steady course in the near term. They regarded the current pause in official interest rate adjustments to be appropriate. Directors also considered monetary policy to be well placed to accommodate the one-off effects on headline inflation from the recent exchange rate depreciation and the jump in international oil prices, particularly as the slowing economy helps anchor inflation expectations. At the same time, with the labor market remaining tight, they saw little room to cut interest rates in the near term, but noted that there is scope for monetary policy easing if the economy slows more abruptly.

Directors welcomed the recent advances in the financial sector regulatory framework, which will help to entrench financial and macroeconomic stability. They considered New Zealand's financial sector to be fundamentally sound, and supported the authorities' efforts to strengthen the monitoring of households' debt service capacity, in view of the notable rise in household indebtedness in recent years. Directors welcomed the agreement with Australia to lay the legislative foundations for enhanced cooperation in banking supervision between the two countries. They also supported the government's decision to develop a new regulatory framework for non-bank financial institutions.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.