Public Information Notice No. 98/1

Press Information Notice: IMF Concludes Article IV Consultation with New Zealand

January 12, 1998

The IMF Executive Board on November 7, 1997 concluded the 1997 Article IV consultation¹ with New Zealand.

Background

Over the past decade, innovative policy reforms have resulted in an outward-oriented, competitive, and dynamic economy. Since 1991, GDP has grown by an average of 3½ percent per annum, unemployment has been reduced from 10½ percent to 6¾ percent, and inflation has been kept close to 2 percent. Further, the government operating budget has been in surplus for four consecutive years, reducing net debt by half, to 27 percent of GDP.

During 1995 and 1996, the prolonged expansion, together with unexpected shocks, caused underlying inflation to breach the ceiling of the 0–2 percent target band. In response, the Reserve Bank moved to reinforce an already tight monetary policy stance. High real interest rates and a sharp appreciation in the New Zealand dollar have resulted in underlying inflation declining from an annual rate of 2.4 percent in December 1996 to 1.8 percent in September 1997. Meanwhile, output growth has slowed, to an annualized rate of only 1½ percent in the first half of 1997, as private investment and consumption—the motors of the expansion—decelerated, and output has now fallen slightly below its potential. Employment growth has also stagnated, and the unemployment rate has risen to 6¾ percent, from 6 percent at the end of 1996.

Despite the slowdown in domestic activity, the current account deficit has widened markedly, to 6½ percent of GDP (national definition) in the June 1997 year. Three factors have been responsible: the goods and services surplus has declined as the exchange rate has appreciated and competitiveness has deteriorated; the investment income deficit has risen as payments on external liabilities have increased significantly and earnings on New Zealand’s overseas assets have fallen; and migrant transfers have declined following a tightening of immigration policy.

In December 1996, the inflation target band was widened to 0–3 percent, and the Reserve Bank refocused its policy on the new 1½ percent inflation point target. With inflationary pressures declining, the Reserve Bank has been able to ease monetary conditions since the beginning of the year. This has occurred mainly through the exchange rate, with the real effective rate depreciating by 6 percent during April–September, although it still remains above its longer-term trend. Short-term interest rates have also fallen, but remain above 6 percent in real terms.

The fiscal surplus has narrowed from 3½ percent of GDP in the 1995/96 fiscal year (July–June), to 2 percent in 1996/97. While part of this reflected the cyclical slowdown, there was also a structural deterioration as income taxes were cut (by the equivalent of 1 percent of GDP). The 1997/98 budget projected a further decline in the surplus to 1½ percent of GDP. This reflects, in part, a further decline in the structural budget position in response to increased expenditures on health, education, and pensions.

Executive Board Assessment

Executive Directors commended the authorities for implementing rigorous macroeconomic policies and innovative reforms, including a transparent macroeconomic policy setting process and public sector accounting framework, that had transformed the economy into one that is outward-oriented and dynamic. For the past several years New Zealand has been reaping the benefits of reforms—economic expansion has been generally robust, the unemployment rate is among the lowest in the industrialized world, and inflation is low.

Directors observed that the economy is now facing several challenges. Growth has slowed, the structural fiscal surplus has been reduced, private savings is low, competitiveness has deteriorated, and the current account deficit has widened. While noting the continuing international confidence, Directors considered that the sizable external imbalance posed risks, given New Zealand's already high stock of external liabilities and its vulnerability to external shocks. Directors generally believed that it would be advisable for the authorities to tighten policies to minimize the risks, particularly in light of current regional uncertainties, with a number of Directors considering that fiscal tightening could be achieved by scaling back medium-term expenditure plans. A tighter fiscal position would also enable a more balanced policy mix and allow the monetary stance to be eased somewhat further, alleviating the strain on the export sector.

Directors noted that the aging of the population would put pressure on the fiscal position over the longer term, and commended the authorities for their forward-looking efforts to meet those pressures. Noting the recent referendum result rejecting the government's proposal to privatize the pension system, Directors encouraged the early consideration and implementation of measures to reduce the fiscal cost of the public pension scheme, noting that a number of possibilities had been under discussion in New Zealand, including raising the retirement age, reducing the replacement rate, and means-testing benefits. Directors also noted the advantages of moving quickly to implement the health-care reform policy, and hoped that it would provide more scope for competition between the public and private sectors.

Directors observed that the current monetary policy framework has successfully maintained price stability. In particular, the requirement that the Reserve Bank bring inflation back to target quickly, following deviations from a narrow target band, has built credibility and reduced inflation expectations. A number of Directors agreed with the staff that there might be scope to adopt a more gradualist approach to correcting inflation deviations, so as to better allow for the long lags of monetary policy; but Directors also cautioned that this approach must be supported by an appropriate fiscal policy, to preserve credibility. Some other Directors believed that the current approach taken by the Reserve Bank was appropriate. Directors thought that the recently adopted monetary conditions index provided a useful additional signaling device, but cautioned that it should not be used as a rigid intermediate target.

Directors endorsed the authorities' efforts to raise potential growth by improving educational quality, encouraging labor force participation, and further deregulating the economy. However, the level of dependency on government benefits remains high, and Directors encouraged further efforts to tighten eligibility criteria and to enhance incentives for work. Directors also called for a careful review of government support for the monopoly agricultural export boards, as deregulation could improve export competitiveness. In that context, some Directors noted the need for the liberalization of agricultural trade in other countries.