Country Report New Zealand
New Zealand is still facing the consequences of the Canterbury earthquakes in 2011. Government finances deteriorated further due to increased reconstruction-related government spending. The economy fared relatively well in 2012 amid the reconstruction activities, favourable weather conditions and high commodity prices. The strong exchange rate is hindering growth in other tradable sectors. The country has a large negative net international investment position and a large persistent current account deficit. A welcome development is that private deleveraging is on-going. Despite relatively high commodity prices, though, the agricultural sector has not been able to decrease debt levels. Also the housing market is a risk: prices continue rising and credit standards are weakening.
Economic overview and outlook
The New Zealand economy fared relatively well during the global financial crisis, but the recovery was frustrated by the damaging Canterbury earthquakes. The first earthquake occurred on 4 September 2010, and was followed by more than 11,000 aftershocks, of which the one in February 2011 was the most damaging. Even so, GDP growth was 1.5% in 2011, and is estimated at 2.5% in 2013 by the IMF. Growth in 2012 was driven by agricultural exports (due to the favourable weather conditions and high commodity prices) and the construction sector as earthquake reconstruction finally got going. Private consumption and business investment is still subdued, also fiscal consolidation measures are negatively affecting growth. The government strives for an operational budget balance  in the fiscal year 2014-2015 .The export of services (mainly tourism) is hampered by the strong currency.
The outlook for 2013 is stable, the IMF expects 2.7% GDP-growth. Earthquake related reconstruction efforts are gathering pace, though the positive impact will be offset by the on-going budget deficit reduction, the strong currency, the private sector deleveraging process and the severe drought that hinders agricultural output growth.
 ^ New Zealand uses the concept of ‘operational budget balance’ which equals the operational revenues minus operational expenses.
 ^ Fiscal deficits are still high as a result of extra government spending in response to the Canterbury earthquakes.
Impact of Canterbury earthquakes on public finances
Government finances are strong in an international perspective, but are exposed to future ecological risks. As the Canterbury earthquakes showed, New Zealand is exposed to natural disasters. The financial impact of the earthquakes was reduced by the Earthquake Commission (EQC), a government agency that provides insurance against natural disasters to owners of residential properties, and reinsurance abroad. More than half of the estimated NZD 13bn cost to the government will be covered by the EQC. Most assets of the EQC will thereby be exhausted and will need to be replenished (homeowner premiums are increased to do this more rapidly). Any earthquakes in the near term will, therefore, directly affect government finances.
The two-speed economy
The country very much depends on the exports of agricultural commodities, which make them exposed to adverse weather conditions (like the recent drought) and the volatility in commodity prices. The main export partner remains Australia (export share is broadly stable over the last 10 years), but trade with China is increasing fast. This is the result of the free trade agreement between China and New Zealand that entered into force on 1 October 2008. Since then, exports to China grew fourfold. This makes New Zealand vulnerable to negative economic developments in China, especially since their main trading partner, Australia, is also strongly exposed to the country . Moreover, less demand from China could significantly affect commodity prices.
The terms-of-trade gains resulting from the increase in commodity prices resulted in an appreciation of the exchange rate. Since interest rates in New Zealand are also relatively high, the appreciation is amplified by increased foreign holding of New Zealand government debt. The strength of the exchange rate has a negative impact on other tradable sectors, like manufacturing and tourism and thereby lead to a widening of the current account deficit. Efficiency gains are needed to preserve employment in these sectors. Unemployment is still relatively high compared to pre-crisis levels, since the labour market suffers from a skills mismatch. A high number of construction workers is needed for the reconstruction efforts, whereas many workers in the tourism sector are unemployed.
 ^ According to the IMF, Australian GDP shocks are transmitted almost one-to-one to New-Zealand mainly through the financial linkages between the two countries. The Fund estimates that a 1% growth slowdown in China would give a negative shock to Australian GDP by 1/3%.
High external debt levels
New Zealand has a long history of current account deficits (figure 1), causing a large negative net international investment position (NIIP) (the largest among the AAA-rated countries). The foreign liabilities reflect the low amount of private savings in New Zealand, which was negative over a long period. Households are currently in a process of deleveraging that constrains private consumption in the short term. Whilst the private sector is busy repairing its balance sheet, the government is increasing its borrowing to finance the budget deficit stemming from the earthquake rebuilding efforts. Part of this debt build-up will be offset by foreign reinsurance, lowering the effect of the Canterbury earthquakes on external debt levels. Going forward, tightening of fiscal policy (in light of the government’s wish to return to a balanced budget in 2014-2015) will improve the overall savings rate in the country, thereby reducing imports and improving the country’s balance sheet.
The risks involved in having a strongly negative NIIP is somewhat reduced by the characteristics of the external liabilities of NZ, like its composition and currency denomination. Most external debt is, either directly or through hedging, denominated in the local currency. In the case of an adverse shock, the exchange rate will act as a first buffer by rebalancing resources towards the tradable sector, while the local currency value of the debt is almost unchanged and so the country’s ability to service its debt will be less affected. In the meantime, the depreciation of the currency will lead to an increase in the value of foreign assets. A tail-risk event would be a ‘sudden stop’, in which investors decide to not rollover existing external debt. The likelihood of a ‘sudden stop’ is reduced by the composition of the foreign liabilities. In the fourth quarter of 2012 New Zealand had foreign liabilities equivalent to 149% of GDP, of which 34% of GDP is in the form of equity and 81 % of GDP is in debt & loans (mainly government debt and debt of New Zealand banks, which almost all are subsidiaries of Australian banks).
Since the New Zealand banking sector is still reliant on offshore wholesale funding, although somewhat reduced in the recent years, the country is exposed to a possible worsening of global financial conditions and market sentiment. This could be the case if the European sovereign debt crisis were to escalate once again. It could cause a reversal of financial flows, thereby increasing liquidity and funding risk. Moreover, the financial sector is highly exposed to the greatly indebted agricultural sector, thereby increasing banks’ credit risks. Even though agricultural commodity prices are relatively high, the sector has not been able to decrease debt levels. A terms-of-trade shock will deteriorate the financial position of this sector, possibly increasing the amount of non-performing loans. This could trigger a funding problem for the banks, which in its turn will cause a rationing of credit and higher loan rates.
Another key risk for the New Zealand banking sector is its exposure to the domestic housing market. House prices remain elevated, whereby the major surge in the price level occurred in the period 2000-2008. Housing affordability is poor on all measures. During 2012 prices started to rise again, especially in regions with supply shortages. In Auckland and Christchurch, residential property prices picked-up particularly strongly, whereby the amount of high loan-to-value ratios increased as well. This signals a current easing of mortgage lending standards, which could lead to a housing bubble. The Reserve Bank of New Zealand is investigating the possibility of using macroprudential measures to restrict these developments. Since an income- or interest rate shock could trigger an undesired sharp correction in house prices, which would in turn weaken consumption and bank balance sheets, it is a development to monitor closely.