The FINANCIAL — New Zealand is enjoying a solid economic expansion. Economic growth is expected to remain strong, close to or slightly above potential.
Housing-related macro-financial vulnerabilities have stabilized recently, but household debt remains high. Macroeconomic and macroprudential policy settings are broadly appropriate. The successful flexible inflation targeting regime has appropriately been maintained in Phase One of the Review of the Reserve Bank Act, while decisions related to areas in need of reform should be prioritized in Phase Two. The government’s ambitious policy agenda to restore housing affordability appropriately focuses on strengthening supply and lowering tax distortions. The structural policy agenda seeks to address key gaps in several areas, including in research and development, according to IMF.
New Zealand has enjoyed a solid economic expansion in recent years. Construction and historically high net migration have been important growth drivers. Accommodative monetary policy, increasing terms of trade, and strong external demand from Asia have supported activity more broadly. Unemployment has decreased despite high net migration, and the economy’s growth potential has increased along with GDP. The current account deficit has remained below longer-term averages despite a mostly domestic demand-driven expansion. Inflation has been either below or in the lower half of the Reserve Bank of New Zealand’s (RBNZ’s) 1 to 3 percent target range, partly reflecting downward pressures on prices for tradable goods and services in a weak global economy.
While the main macroeconomic imbalances have been addressed, managing housing-related risks has been challenging. Rising house prices were associated with rapid household credit growth through 2016 and household debt rising from already high levels. Affordability concerns have also become more pressing, especially for first-time home buyers.
Outlook and Risks
The baseline economic outlook is favorable. In the near term, growth is expected to remain at around 3 percent, with higher government spending offsetting slowing residential investment and weaker agricultural exports because of dry weather conditions. While net migration and potential output growth are expected to slow, the new KiwiBuild program should result in a gradual increase in residential investment growth, and economic activity is expected to remain strong. Inflation is projected to rise toward the mid-point of the 1-3 percent target range. The current account deficit remains below longer-term averages.
Household debt-related vulnerabilities are expected to decrease following recent stabilization. Macroprudential policy intervention contributed to slowing household debt growth, and momentum in house prices moderated last year. While housing demand fundamentals remain robust under the baseline outlook, the soft landing in the housing market should continue, reflecting increasing supply and, in the medium term, gradually rising domestic interest rates. The interest burden on household debt should remain low, given relatively small expected increases in interest rates.
Risks to growth are broadly balanced in the near term, although some downside risks remain a concern in the medium term. On the upside, stronger economic performance abroad in the near term would benefit New Zealand, or net migration could decrease more slowly than projected. On the downside, the demand stimulus from government spending might be weaker if policy implementation is more gradual. On the external side, in both the near and medium term, New Zealand is exposed to downside risks of tighter global financial conditions, structurally low growth in advanced economies, a significant slowdown in China, and more protectionist and inward-looking policies. Household debt remains high under the baseline outlook and would amplify the impact of large downside shocks, notwithstanding recent improvements in its risk structure after macroprudential policy intervention. Such shocks could also trigger a disruptive housing market correction.
Macroeconomic and Financial Policies
Current monetary policy is appropriately expansionary. The policy settings are robust to current uncertainties. A precautionary further easing would raise risks of a steeper tightening if inflationary pressures emerged sooner than expected, given that the economy appears to have been operating close to capacity for some time. On the other hand, a premature tightening could prolong price setting below the mid-point of the target range, given persistently low inflation in recent years.
The strong fiscal position provides space to accommodate the needs from strong economic and population growth. Compared to the time of the last Article IV Consultation, the updated baseline expenditure path already incorporates higher infrastructure spending and new growth-friendly measures, as discussed below. The continued political commitment to budget discipline and a medium-term debt anchor in New Zealand is welcome. With the country’s strong fiscal position, there is no need for faster debt reduction beyond that outlined in the 2017 Half Year Economic and Fiscal Update. Stronger structural revenues, such as from higher-than-expected population growth, should be used to increase spending on infrastructure and other measures that would strengthen the economy’s growth potential.
Macroprudential policies have contributed to reducing risks to financial stability and should continue to mitigate risks from high household debt. Bank and household balance sheets have become more resilient with a lower share of loans with high loan-to-value ratios (LVRs). With household debt still elevated, further relaxation of LVR restrictions beyond those that became effective on January 1, 2018 would not be helpful under the baseline outlook.
Updating The Reserve Bank Act
Phase One of the Review of the Reserve Bank Act updates elements of the monetary policy framework, while appropriately continuing with the successful flexible inflation targeting regime. The updates include a dual mandate, which adds maximum sustainable employment alongside price stability as the main monetary policy objectives, and the creation of a monetary policy committee as the decision-making body. The envisaged process for a regular review of the monetary policy goals led by the RBNZ would enhance the transparency and accountability of the framework. In the latest Policy Targets Agreement, the employment objective has already been operationalized through a qualitative description, which is consistent with operational monetary policy independence and should be maintained as the updated framework is legislated and fully implemented.
Phase Two of the Review, focused on financial stability and other policies, is expected to be ambitious in scope, and emphasis should be given to priority areas in need of reform. The work in this phase should consider the recommendations of last year’s Financial Sector Assessment Program (FSAP) by the IMF, which centered around strengthening the macroprudential framework, including by broadening the tool kit; the supervisory pillar of New Zealand’s three-pillar approach to banking regulation; and the financial safety net and crisis resolution regime. The FSAP identified an urgent need for reform in the first two areas, and the mission recommends that these reforms be prioritized in the deliberations, implementation, and addition of resources. It also called for a strengthening of the RBNZ’s operational independence in financial policy decision making.
Fostering Housing Affordability
The government has initiated an ambitious policy agenda to restore housing affordability, which appropriately focuses on strengthening supply and lowering tax distortions . The agenda includes several work streams. The KiwiBuild program aims to increase housing supply at affordable price points. The Urban Growth Agenda aims to address regulatory, planning and other policies that reduce development capacity for growth, along with the under-funding of local infrastructure development and maintenance. The government has already announced the extension of the bright-line test on sale of residential property from within two years of purchase to within five years and also proposes to limit negative gearing from rental properties. A Tax Working Group is considering possible additional reform, including a broader capital gains tax on real estate investment and land tax reform, although its mandate is narrow on the latter. These reforms are complementary, and the success of the housing policy agenda will depend on well-coordinated progress on all fronts.
A ban of residential real estate purchases by nonresidents is unlikely to have a significant impact on housing affordability. The proposed ban in the draft amendment to the Overseas Investment Act is a capital flow management measure (CFM) under the IMF’s Institutional View on capital flows. The measure is unlikely to be temporary or targeted, and foreign buyers seem to have played a minor role in New Zealand’s residential real estate markets recently. The broad housing policy agenda above, if fully implemented, would address most of the potential problems associated with foreign buyers on a less discriminatory basis.
Supporting Productivity and Inclusive Growth
The government’s structural policy agenda seeks to support productive, sustainable, and inclusive growth. The initial emphasis has been on minimum wages; productivity, including research and development (R&D) and education; tax reform; regional development; and trade policy. Many elements of the agenda are still under development.
The proposed minimum wage increases out to 2020 could help ease income inequality. But, as a result, New Zealand will have the second-highest minimum-to-median wage ratio in the OECD. In the current strong growth environment, the negative impact of higher minimum wages on employment growth, international competitiveness, and labor productivity are likely to be minimal, although there are risks that these impacts might turn out to be larger in a downturn.
Free tertiary-level education and training for at least one year could boost human capital. Given its potential fiscal cost, the program could include greater targeting based on needs, possibly beyond the current time horizon.
The agenda appropriately focuses on lifting R&D spending in New Zealand to 2 percent of GDP. An R&D tax credit, if well designed, would be an efficient instrument to support R&D spending in the business sector.
Tax reform could play an important role in shifting incentives toward broader business investment. Estimates of marginal effective tax rates published by the Tax Working Group suggest that investment in residential real estate is effectively tax-favored compared to other investment. In contrast, introducing progressive corporate income taxation is unlikely to be helpful, considering the relatively small size of businesses in New Zealand. New companies and startups can be supported more effectively through other instruments, such as R&D tax credits or grants. Broad tax bases will support corporate investment and productivity more generally.
The new Provincial Growth Fund should ensure project selection that helps regions to benefit from income gains more in line with the major urban centers. It can also be an appropriate tool to relieve pressures on the major urban areas by encouraging movement of population into the regions.
New Zealand’s continued support of open trade and the multilateral trade framework is welcome. As one of the initial signatories of Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CP-TPP), New Zealand will benefit from increased market access and new growth opportunities. Foreign direct investment complements the productivity benefits of international trade, and New Zealand would benefit from an improvement of the current policy regime. In particular, restrictions under the Overseas Investment Act could be clarified, while the administrative burden associated with direct investment approvals could be reduced.