Public Information Notice No. 99/89

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

September 15, 1999

On August 30, 1999, the Executive Board concluded the Article IV consultation with New Zealand.¹

Background

Since the mid-1980s, New Zealand has been engaged in a comprehensive reform effort designed to improve its economic performance. Reflecting the success of this effort, economic performance improved during the 1990s. Inflation averaged about 2 percent, compared to nearly 10 percent in the 1980s, while economic growth also picked up. And, thanks to strong budget surpluses, net public debt has been reduced by half, and has now reached relatively low levels by international standards. Despite these improvements, the current account deficit remains very high, increasing the economy's vulnerability to external shocks. And, while growth performance has improved, most estimates suggest that the potential growth rate remains too low to close the per capita income gap between New Zealand and the advanced-economy average.

Since mid-1997, New Zealand was hit by a string of unfavorable shocks which, combined with high real interest rates and a strong New Zealand dollar in 1996-97, served to push the economy into recession at the beginning of 1998. In addition to the collapse in demand from crisis-hit Asia, the economy was affected by severe drought, and by continued weakness in the terms of trade. Overlaid on these shocks was the impact of very firm monetary conditions that had been established in a period when forecasts portended continued strong demand growth.

Recession proved short-lived, however, and a recovery was underway by the second half of 1998, aided by both a significant easing in monetary conditions and tariff and income tax cuts.

The current account deficit narrowed in 1998, reflecting the weakness of the domestic economy and competitiveness gains, but remained well above the level that would stabilize the net external liabilities/GDP ratio. While the domestic recession dampened imports and dividend payments to nonresidents, other factors prevented a stronger improvement . These included weak cyclical conditions in trading partners; adverse terms of trade; supply constraints on agricultural exports; and poor returns on foreign investments. As a result, the net external liabilities ratio--already the highest among industrial countries--rose further.

Importantly, sizable current account deficits since the mid-1990s have coexisted with fiscal surpluses, consistent with a key tenet of the Fiscal Responsibility Act, which requires that public debt be reduced to "prudent" levels. In this vein, the authorities have run operating surpluses of 2-3 percent of GDP over the past five years, while net public debt has been reduced by some 15 percent of GDP over the same period, and stands at 22 percent of GDP, 7 percent above the authorities' stated long-term target for a "prudent" level of net Crown debt. Less progress has been made in respect of another long-term objective--to reduce government spending below 30 percent of GDP--mainly because of pressures to increase social expenditure.

The budgetary outturn for 1998/99 includes several one-off factors that boosted the operating surplus in that year, but that have no impact on the structural fiscal position. Adjusting for these, and for cyclical factors, the structural balance--while still in surplus--is much lower than its average level since the mid-1990s. The main factor explaining the fall in the structural surplus in 1998/99 is income tax cuts introduced in mid-1998, the second such tax cut since mid-1996.

Monetary policy has continued to be directed at achieving annual inflation (excluding credit services, CPIX) of between 0 and 3 percent. Monetary conditions began to ease in early 1997, and the easing gathered momentum in 1998. With recovery underway by the second half of 1998, a modest firming has taken place since late-1998, although the Monetary Conditions Index (MCI) remains significantly easier than at the beginning of last year. From March 1999, the Reserve Bank began to use the Official Cash Rate (OCR) as its primary policy instrument.

The near-term outlook is for recovery to continue, inflation to remain subdued, and the current account deficit to widen slightly in 1999 before coming down in 2000. Weak terms of trade and supply constraints on agricultural exports will limit the near-term adjustment in the current account, while the import of a navy frigate will boost imports by ½ percent of GDP in 1999. A more hospitable external environment, and the disappearance of one-off factors on the import side, should, however, see the external deficit significantly reduced in 2000. Inflation should remain near the midpoint of the target range throughout the forecast horizon, although this will imply some continued firming in monetary conditions as the output gap is reduced. Over the medium term, fiscal consolidation and some recovery in household saving should support the adjustment in the current account and a slow decline in the net external liabilities ratio.

Executive Board Assessment

Executive Directors commended the authorities for their skillful economic management, noting that--despite the impact of recession in key Asian export markets and severe drought--economic outcomes in New Zealand had nonetheless been relatively favorable. While the economy experienced recession in the first half of last year, a recovery was underway by the second half, and has gathered momentum. Directors considered that other aspects of New Zealand's strong economic performance, including low inflation, low public debt, and the absence of distress in either the corporate or financial sectors, were further testimony to the economy's resilience under adverse circumstances. In the view of Directors, this resilience was itself a key payoff from 15 years of economic reform that had completely transformed the New Zealand economy.

Directors noted, however, that New Zealand continues to face some difficult economic challenges that warranted the continued attention of policy makers: first, the vulnerabilities associated with the large external deficit and debt; and second, the need to sustain the recent improvement in productivity growth.

Directors considered that near-term macroeconomic policies were broadly appropriate in light of the external risks. The relatively easy level of monetary conditions--especially the fall in the New Zealand dollar since mid-1997--combined with the authorities' intention to adhere to a path of rising budgetary surpluses through 2001/02, should help to support external adjustment without compromising the economic recovery.

At the same time, with the output gap expected to narrow somewhat more rapidly than was foreseen several months ago, Directors endorsed the Reserve Bank's readiness to tighten monetary conditions earlier than was envisaged at that time, if necessary.

Directors noted that monetary policy could be faced with a number of shocks in the period ahead, including a possible shift in market sentiment that would exert downward pressure on the currency and push up the risk premium. In these circumstances, Directors considered that the authorities should continue to be guided by their monetary policy framework, which allowed for some near-term volatility in inflation, while remaining firmly focused on medium-term price stability.

Directors considered that near-term fiscal policy should also continue to be set with both the external risks and long-term fiscal objectives in mind. In this regard, they emphasized the importance of avoiding a budget deficit this fiscal year, and of gradually building up surpluses over the subsequent two years, both in order to enhance the credibility of the authorities' commitment to their stated long-term fiscal objectives for expenditure and debt, and in order to bolster market confidence during a period in which the current account deficit is expected to remain at very high levels. Directors underscored the desirability of achieving a path of fiscal consolidation that will be at least as ambitious as that envisaged in the latest Fiscal Strategy Report.

Directors observed that the key long-term budgetary issues were those associated with population aging, and commended the authorities' early consideration of such issues. In this regard, Directors saw merit in building up the operating surplus over the medium term through continued expenditure control, as recommended by the staff. Not only was such a strategy essential for achieving the authorities' long-term objective for government expenditure before significant demographic pressures emerged, it was also a prudent course to follow pending decisions being taken on whether and how to reform the pension system.

Directors noted that, although New Zealand was relatively well positioned to cope with exchange rate or interest rate shocks that might occur as a result of an adverse shift in market sentiment, its vulnerability to such shocks called for caution and a continued implementation of strong macroeconomic policies. In addition, Directors suggested that active consideration be given to other measures that could underpin market confidence and external adjustment over the medium term. In this context, they endorsed efforts in train to reduce welfare dependency and the generosity of the state pension scheme. These efforts, in their view, were likely to improve the environment for private saving in New Zealand by encouraging self-provision for retirement and reducing a possibly excessive degree of social insurance provided by the welfare system. In addition, some Directors advised further consideration of tax reforms to remove potential disincentives to private saving, including those associated with the still relatively high proportion of revenue levied through direct taxes.

Directors strongly supported the authorities' structural reforms aimed at boosting the economy's sustainable growth potential, including recent education reforms aimed at helping to improve the skill level of the work force, tariff reductions, and producer board reform.

Directors noted that New Zealand publishes an array of high-quality economic and financial statistics that are adequate for surveillance.