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Briefing to the Incoming Minister of Finance: Increasing Economic Growth and Resilience [2011]

5 Policy Priorities: A Resilient and Stable Macroeconomic Environment

The short-term focus should be on reducing fiscal risks and rebalancing growth

Returning to fiscal surplus and rebuilding fiscal buffers by lowering government expenditure relative to GDP is the most direct and immediate contribution that the Government can make to reducing New Zealand's macroeconomic imbalances. It will also allow room for Canterbury rebuilding to take place without putting undue pressure on the tradable sector.

The total Crown operating balance before gains and losses has deteriorated in each of the past six years, even after excluding one-off earthquake-related expenditure. Assuming the economy broadly develops in line with current expectations, our advice is that the Government's fiscal strategy commits to returning the total Crown operating balance before gains and losses to surplus in 2014/15. This strategy is in line with our PREFU forecasts (figure 12), but would commit the Government to a faster return to surplus than implied by the fiscal strategy outlined in Budget 2011. Committing to a return to fiscal surplus in 2014/15 is a credible fiscal strategy and should provide financial markets with sufficient assurance about the sustainability and resilience of the New Zealand Crown's financial position. If economic growth turns out to be temporarily weaker, there could be a case for allowing automatic fiscal stabilisers to operate.

Figure 12: Total Crown operating balance before gains and losses: 1994-2020
Figure 12: Total Crown operating balance before gains and losses: 1994-2020.
Source: Pre-election Economic and Fiscal Update 2011, the Treasury

The fiscal tightening required to return the operating balance before gains and losses to surplus in 2014/15 is expected to coincide with the pick-up in economic recovery. The tightening will therefore reduce the upward pressure on interest and exchange rates that is likely to come as labour and capital become fully employed.

It is possible that further discretionary fiscal tightening may be necessary if global developments deteriorate to such an extent that the Government's fiscal credibility is at risk and becomes the focus of adverse financial market attention. In these circumstances, policy changes would need to be aimed at minimising negative short-term demand effects while generating credible fiscal savings over time. In the event that New Zealand's economic growth surprises on the upside, the Treasury recommends that any positive revenue surprises be applied to strengthening the fiscal position more quickly.

Steps should also be taken to increase the resilience of the wider financial system ...

In addition to restoring fiscal buffers, introducing further measures to improve the resilience of the wider financial system will help to reduce the macroeconomic risks associated with potential future financial shocks. Higher bank capital requirements and an effective resolution regime, such as the Open Bank Resolution, could increase the resilience of the financial sector. Any further increase in bank capital would need to take account of its impact on growth. Internationally, reforms in response to the Global Financial Crisis are evolving and it will be important that overseas developments continue to inform New Zealand's approach (box 3).

Box 3: Lessons from the Global Financial Crisis for financial stability

In many developed economies, the Global Financial Crisis almost caused financial sector collapse. Internationally, a process of financial sector re-regulation and tighter supervision is under way to address the most obvious problems that led to the crisis.  Although there is agreement on the broad principles that should underpin new frameworks, the implementation of policy is progressing slowly.  Some fundamental questions, such as the value of a large financial sector and how best to resolve systemic institutions, remain unresolved.    

New Zealand has maintained financial stability through the crisis.  At the same time, high levels of household and corporate debt, reliance on external sources of financing, and elevated house and farm price levels, all point to the need for us to incorporate lessons from countries seeking to ensure financial sector stability. 

Given uncertainty about the most appropriate policy responses, New Zealand should generally aim to be a fast follower - adopting quickly those policies that prove to be effective.  However, given the long lags involved and the infrequent nature of financial instability, it may be costly to wait for additional evidence before acting. Any policy responses will need to carefully balance likely effects on the accessibility and cost of credit.  Key areas for policy consideration include:

  • Liquidity risks associated with short-term external financing: New Zealand has moved quickly, via new Reserve Bank prudential requirements, to reduce the liquidity risk associated with New Zealand's relatively high levels of short-term external financing.  Further choices remain about how quickly to increase liquidity buffers and their final level.
  • Basel Committee recommendations: New Zealand will need to decide how to implement the Basel Committee recommendations for bank capital and whether we should go further in some aspects given our current vulnerabilities.
  • Resolution of systemic financial institutions: Countries are currently revising frameworks to resolve systemic financial institutions without large fiscal costs and in a way that reduces moral hazard.  The Reserve Bank is in the process of consulting on a process for resolving banks in a manner that maintains the operation of the financial system (Open Bank Resolution).  We will need to monitor and assess resolution options put in place in other jurisdictions and their applicability to New Zealand.
  • Macroprudential policies: Frameworks for macro-prudential policies are being developed, including in New Zealand. Clarity around the objectives, governance, and accountabilities of such a framework is important.
  • Financial Market Supervision: New Zealand will also need to further embed steps taken prior to the crisis to widen the population of entities subject to supervision to include non-bank deposit-takers and insurance companies.

... and to reduce future cyclical rises in interest and exchange rates

There is also an opportunity to make institutional changes now to help reduce future cyclical rises in interest and exchange rates. In particular, we recommend adding to the current fiscal responsibility principles in the Public Finance Act:

  • A fiscal structure dimension relating to the level and composition of government revenue and expenditure. This could help to improve the impact of government revenue and expenditure decisions on economic performance over time.
  • An explicit macro stability dimension. Such an amendment would help to reduce the risk of procyclical fiscal policy during economic upturns, such as occurred between 2005 and 2008, and the related additional upward pressure on interest and exchange rates.

Policy changes to improve the responsiveness of housing supply are another key way in which future cyclical pressures could be reduced. A more responsive housing supply could reduce house price cycles and the related negative consequences for household saving, interest rates, and the exchange rate.

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