Country Report New Zealand
New Zealand experiences relatively high, domestic-driven, economic growth. A major risk to the outlook is the deterioration of the terms-of-trade. Meanwhile, the central bank successfully slowed down the potentially overheating housing market.
Strengths (+) and weaknesses (-)
(+) Stable and reliable public institutions
Governance, rule of law and transparency indicators confirm the stability of the government. There is a strong motivation across all political parties to pursue fiscal consolidation. The central bank is highly credible in its inflation mandate and its supervisory role.
(+/-) Strong position as agricultural commodities producer
The primary sector is just 7% of GDP, but accounts for more than 50% of export earnings. Dairy and meat alone consists of 42% of export values. The dependence on primary exports makes the country subject to volatility in the global commodities market.
(-) Large external debt
New Zealand has a long history of current account deficits resulting in a large negative international investment position. This is mainly financed through debt, with net external debt at 59.9% of GDP in the third quarter of 2014. The persistent gap between private savings and investment induces higher domestic interest rates and thereby an elevated exchange rate.
(-) Banking sector is highly concentrated and dependent on foreign funding
The four biggest banks together have a market share (in loans) of 84%. The low private savings rate makes the banks reliant on foreign wholesale markets for funding, though tighter regulations have reduced the dependence to 32% of total funding, down from 39% in 2008.
1. Favourable economic conditions
New Zealand experiences relatively high growth, the central bank (RBNZ) estimates that the economy grew by 3.4% in 2014 and forecasts growth to be 3.5% in 2015. Growth has been primarily domestically driven. Private consumption growth has been strong, on the back of the solid income growth during the past years as a result of high commodity prices. In contract to the years before the Global Financial Crisis, household credit growth is still relatively low. Private sector investment has also been extremely strong and in particular the amount of residential investments expanded quickly. This is partly caused by the ongoing reconstruction activities in the Christchurch area that will continue in the coming years. Also demand for new housing in the Auckland will remain high for the coming years. Net exports has been weak over the past year, due to the strong exchange rate and reduced demand for dairy products from China. The strong exchange rate in combination with the low oil prices led to an inflation level below target (0.8% y-o-y in the fourth quarter of 2014). In response to the robust economic situation, the RBNZ increased the policy rate from 2.5% to 3.5% during 2014. The government is keeping progress in returning to a budget surplus. According to its latest budget update, the New Zealand Treasury expects a small surplus in the 2015-2016 fiscal year. The current monetary and fiscal policy stance gives the country ample opportunity to respond to a weakening of the economy if needed.
2. Deterioration of dairy prices due to reduced demand from China
The terms of trade deteriorated significantly during 2014, due to a decline of world dairy prices by about 50%. The exchange rate is a first cushion against a terms of trade shock, but, nevertheless, also dairy prices in NZD dropped considerably during the last year (figure 1). Fonterra, the biggest dairy company in New Zealand lowered the milk payout forecast to NZD 4.90 for the 2014/2015 season (from NZD 8.40 in the previous season). Also the milk volume forecast is lowered somewhat, due to dry weather conditions. The combination of both negative price and volume developments puts the dairy sector at risk. Dairy NZ estimates that 1/4 of all farmers will struggle to pay interest and working expenses at the forecasted payout. The RBNZ expects financial stress in the dairy sector to rise markedly if prices do not recover in the next season. A mitigating factor is that over the last couple of years, farm debt has risen only slightly, while the prices were high. Part of the strong incomes has been used to build up cash reserves and to repay debt. A risk is that the prices of farms and land will be negatively affected by the lower incomes. During the Global Financial Crisis, falling farm incomes led to lower liquidity in the market and to a sharp decline in farm prices. In addition, since the dairy sector provides 30% of the country’s exports, the decline in the value of the exports can spill over in the rest of New Zealand’s economy.
3. Current account deficit is expected to widen over the coming years
One of New Zealand’s structural weaknesses is the persisting gap between domestic savings and investments that leads to current account deficits and a large negative net international investment position (NIIP). After the Global Financial Crisis, increased private savings led to an improvement of the current account, although partly undone by the higher financing needs of the government. In 2013, the high commodity prices led to a lower current account deficit, though in 2014 both the deteriorated terms-of-trade and the negative growth of net imports led to a widening of the current account. Going forward, a further widening of the current account deficit is expected due to the strong growth in private consumption and investment, and increased imports to fund the rebuilding of the Christchurch area. These deficits will likely be financed through offshore borrowing by banks.
4. Introduction of the LTV-policy reduced house prices growth
House prices in New Zealand are high from a historical perspective. The price-to-income ratio is 29.5% above the historical average and the price-to-rent ration is 64.2% higher than the historical average. This is primarily the result of a regional supply side problem in the Auckland and Christchurch regions, in which about half of the national population lives. In the former area, housing supply is restrained by land availability and council regulations. In the latter area, the Canterbury earthquakes caused considerable damage to the housing stock. To lower the risks associated with excessive growth of house prices, the RBNZ introduced a cap on the maximum amount of high loan-to-value (LTV>80%) lending. This ‘speed limit’ is set on 10% of new mortgage commitments. This reduced the amount of new high LTV-lending significantly (figure 2). Together with the increase in mortgages rates (as a result of the higher monetary policy rate), the increase in the house prices has moderated significantly.
The public institutions of New Zealand have a good reputation. The government ranks high on themes like democratic institutions, government transparency and lack of corruption. The central bank is independent and highly credible. GDP per capita (at PPP) is 88% of the OECD average or 73% of the Australian income level, reflecting below-average productivity, distance to export markets, and the small size of the economy which limits opportunities for scale advantages. Economic growth was and still is mainly based on private-sector borrowing and terms-of-trade gains. In the future, the economy needs to rebalance towards more sustainable growth, for which productivity increases are necessary. This structural challenge is reflected in the long history of current account deficits, which has resulted in a large, negative net international investment position. The shortfall of private savings has generated higher interest rates than in comparable countries, and therefore led to an overvalued exchange rate. The exports of New Zealand are highly concentrated both in products (food & agri) and destinations (China and Australia).
The banking sector is also highly concentrated. The four biggest banks have a market share (in loans) of 84%, making each of them too-big-to-fail. These banks are subsidiaries of the biggest Australian banks, but in general do not get funding from their parents. Historically, the banking sector has been highly reliant on foreign wholesale markets, but tighter regulations have reduced this dependence. Higher than average capital ratios make the banking sector more resilient to economic stress. According to the IMF, the banking sector can withstand a shock to either its residential mortgages or its corporate lending book. A combined shock, though, would pose problems to their capital position, of which the risks are ultimately borne by the government.