US embassy cable - 05WELLINGTON849

UNCLAS SECTION 01 OF 03 WELLINGTON 000849 
 
SIPDIS 
 
SENSITIVE 
 
STATE FOR EB/TPP AND EAP/ANP 
STATE PASS USTR-LCOEN 
COMMERCE FOR ABENAISSA/4530/ITA/MAC/AP/OSAO 
 
E.O. 12958: N/A 
TAGS: ECON, ETRD, PREL, NZ 
SUBJECT: NEW ZEALAND'S ECONOMY FACES BUMPY ROAD AHEAD 
 
REF: (A) WELLINGTON 695; (B) WELLINGTON 342 
 
(U) Sensitive but unclassified -- please protect 
accordingly. 
 
Summary 
------- 
1. (SBU) After enjoying five years of strong economic 
growth, New Zealanders are awakening to the sober reality 
that the party may be over.  The sign posts for a rough 
patch ahead have multiplied in recent weeks.  Yawning 
deficits have appeared in the country's trade balance and 
current account.  Inflation and interest rates are pointed 
upward.  The Labour Party campaigned for re-election by 
taking credit for the recent good times and touting its 
prudent management of the economy over the last six years. 
But a new, more fragile Labour-led government, announced 
October 17, faces the unenviable task of talking down the 
public's expectations for tax cuts and more government 
spending promised during the campaign.  Meanwhile, the 
central bank governor has sternly warned the government to 
hold the reins on new expenditures and admonished the public 
to quit its debt-fueled spending binge. 
 
En route to a fall? 
------------------- 
2. (SBU) New Zealand's economy is slowing.  Exports are 
suffering from the impact of a high exchange rate and rising 
shipping costs, and firms are unable to expand production 
because of labor and infrastructure shortages. 
Concurrently, inflation is rising.  Household spending is at 
record levels despite high interest rates, and fuel prices 
are up.  These factors have fed into a current account 
deficit, whose record expansion has raised the likelihood of 
an imminent correction.  There is growing concern that the 
Kiwi dollar could fall sharply, making for a disruptive 
adjustment.  There also is growing concern that even higher 
interest rates will be required to cool domestic spending, 
which could sharpen the economic slowdown. 
 
3. (U) That slowdown comes at the end of a five-year 
economic roll.  Since 2000, real GDP growth averaged 3.6 
percent annually, with a peak performance of 4.8 percent in 
2004.  Now, the New Zealand Treasury, which has been 
criticized for overly rosy forecasts in the past, predicts 
real GDP growth of 2.2 percent in the March 2006 year and 
2.6 percent in the March 2007 year. 
 
The signposts 
------------- 
4. (U) Inflation is on the rise, increasing to 3.4 percent 
for the year ended September 30, breaching for the first 
time since June 2001 the inflation target range that the 
central bank is charged with maintaining.  The Reserve Bank 
is required by law to hold inflation between 1 and 3 percent 
on average over the medium term.  It tries to do so by 
adjusting the official cash (prime) interest rate. 
 
5. (U) Wielding that tool, the Reserve Bank governor, Alan 
Bollard, on October 27 raised the official rate by 25 basis 
points to 7 percent -- the highest of any nation with a top 
credit rating.  With the last increase in March, the bank 
had gradually raised the rate a total of 1.75 percentage 
points over the past 21 months, to little effect. 
 
6. (SBU) Bollard's critics, many of them economists working 
for commercial banks, have warned in recent days that a hard 
turn by the Reserve Bank in raising the official cash rate 
could slow business borrowing more than its intended target: 
consumers.  So far, any worries that the rate increases 
would send New Zealand reeling into a severe recession 
appear unjustified, as the economy hums along close to 
capacity.  However, capacity restraints -- evidenced in both 
a tight labor market and infrastructure, notably the 
transportation needed to get goods to market -- are creating 
inflationary pressures.  Some industries that use a large 
amount of domestic content are already feeling a slowdown, 
including forestry, tourism and fishing.  New housing 
construction has tapered off, and building consent issuances 
-- a good forward indicator -- have fallen this year for 
both residential and non-residential construction. 
 
7. (SBU) It is the changing shape of New Zealand's recent 
economic expansion that appears to most worry both Bollard 
and even his critics.  In its early stages from 1999 to 
2002, New Zealand's expansion was largely driven by export 
growth, as the country enjoyed favorable terms of trade on 
its mix of commodity-based export products.  However, 
economic growth in the last three years has been powered by 
a worrisome jump in household and business spending, spurred 
by the rising value of the Kiwi dollar that has made import 
prices more attractive.  The economy also is drawing a 
declining, but still important, dividend from efficiencies 
arising from the painful structural reforms that New Zealand 
undertook between 1985 and 1999. 
 
8. (SBU) The bigger picture of the New Zealand economy is 
looking more cloudy.  The nation's current account deficit - 
- measuring the difference between what New Zealand earns 
overseas from exports and investments and what it pays for 
its imports and the investments foreigners have made in New 
Zealand -- is widening.  The deficit reached a record NZ 
$11.9 billion (US $8.3 billion), or 8 percent of GDP, for 
the year ended in June 2005.  New Zealand has run a deficit 
for years, resulting in net liabilities to the rest of the 
world that are equivalent to 81 percent of GDP, higher than 
in virtually any other developed country. 
 
9. (U) A slowdown in export growth is a big contributor to 
New Zealand's current account woes.  The nation's trade 
balance, which stood at a NZ $419 million (US $294 million) 
surplus in August 2001, turned negative in 2002, with the 
trade deficit growing in both 2003 and 2004.  It reached a 
record $5.8 billion (US $4 billion) deficit in the year 
ended in August 2005, equivalent to 19 percent of New 
Zealand's exports.  A stronger Kiwi dollar is partly to 
blame.  Finance Minister Cullen warned October 26 that the 
New Zealand dollar was trading at an unsustainable level. 
Since August 2004, the Kiwi dollar has gained 5 percent in 
value as measured by the central bank's trade-weighted 
index. 
 
10. (U) In the short term, the Reserve Bank's interest-rate 
hikes will drive up the Kiwi dollar's value.  Longer term, 
Bollard hopes that foreign investors in New Zealand assets, 
particularly debt securities, will sell their investments as 
they reassess their exchange-rate risk.  Such sell-offs 
should reduce the Kiwi dollar's value, although there is 
some risk that if this happens too quickly, it could be 
destabilizing. 
 
11. (U) Meanwhile, New Zealand -- which last year enjoyed 
the lowest unemployment rate among OECD countries -- saw its 
jobless rate inch down to 3.7 percent in the June quarter, 
reflecting the continuation of a tight labor market. 
However, that decline followed the first rise in the 
unemployment rate in more than two years, to 3.9 percent in 
the March quarter.  With the economy slowing, economists 
expect the jobless rate to climb.  As if to drive home the 
point, Air New Zealand, the majority government-owned 
national air carrier, announced October 19 plans to trim 600 
maintenance staff -- marking the nation's largest layoff in 
at least six years. 
 
Pressure on government spending 
------------------------------- 
12. (U) The timing of the Air New Zealand announcement was 
inauspicious for the new government, formed just two days 
before.  Labour's horse-trading to secure the support it 
needed from three minority parties to form the new 
government produced a new set of demands on government 
spending, including generous pensions and more police. 
These demands come on top of the minimum $1.5 billion (US 
$1.1 billion) a year that would be needed if Labour 
fulfilled the spending pledges it made to voters before the 
September 17 election.  Those promises included increased 
support payments for low- and middle-income families and 
waiving interest on tertiary education loans for students 
who remain in New Zealand after graduation (ref A).  Amid 
these planned spend-ups, Bollard warned October 14 that 
hikes in government expenditures might provoke even higher 
interest rates. 
 
13. (U) In addition, the government faces escalating costs 
in public services.  Increases in health and education 
spending are outstripping the economy's rate of growth.  The 
country is in desperate need of more and improved roads. 
Faced with declining sources of natural gas, little 
remaining untapped hydroelectric capacity and other energy 
options limited by its participation in the Kyoto Protocol, 
New Zealand also has yet to figure out how it will meet 
electricity demand in the next five years. 
 
14. (U) These spending commitments, coupled with the likely 
slowdown in tax revenues as the economy slows, means that 
the government's vaunted budget surplus is in jeopardy.  At 
NZ $6.7 billion (US $4.7 billion) in mid-2005, the surplus 
is among the largest for OECD countries as a percentage of 
GDP -- 4.2 percent. 
 
Sheep, but no piggy banks 
------------------------- 
15. (U) To help New Zealand weather the expected slowdown, 
the government needs to address two factors that affect New 
Zealand's economy to an unusual degree: savings and 
immigration. 
 
16. (U) Increasing national savings relative to national 
investment would be key to reducing the current account 
deficit.  But New Zealanders do not save money.  Rather, 
they borrow to spend it faster.  In recent years, personal 
borrowing has stood at the equivalent of 12 percent of 
household income per year.  Already at the low end of OECD 
countries for personal savings, New Zealand's situation has 
actually worsened during the recent economic expansion. 
Rising housing prices, up 15 percent in the year to 
September, have convinced many New Zealanders of their 
newfound wealth, and many have borrowed against their homes 
to purchase cars, televisions and other imports.  Bollard 
warned October 14 that home prices were ready for a fall and 
that the current level of consumer spending was 
unsustainable.  In a slowing economy, many highly leveraged 
borrowers will face financial strain. 
 
17. (U) The growing number of New Zealanders who leave the 
country for better opportunities offshore contributes to New 
Zealand's labor shortage and hinders the economy's growth. 
The so-called brain drain became an issue in the recent 
election campaign.  Whereas gains in net annual migration 
previously had been a key driver of the strong domestic 
economy, New Zealand's population growth has flattened from 
its peak annual gain of 1.7 percent in 2002.  Arrivals have 
decreased largely due to tougher requirements: greater 
English-language ability and priority to those with job 
offers.  Meanwhile, the number of departing Kiwis has risen 
since mid-2003, ironically at a time when New Zealand's 
economy has been buoyant.  Since last year, the number of 
Kiwis leaving for greener pastures increased 15 percent. 
Estimates of the number of Kiwis living overseas range up to 
1 million, or one in five citizens.  Most have gone to 
Australia for its higher wages, wider job opportunities and 
better standard of living. 
 
Comment 
------- 
18. (SBU) Faced with the prospect of slower economic growth 
-- and possibly a recession -- it is difficult to gauge how 
the new Labour government will respond.  Its claim to fiscal 
prudence during the expansion is largely true, but its 
recent politically-driven commitments to new government 
spending may prove hard to resist.  Also, Labour will need 
to stifle its impulse to pour money into job-creation 
schemes and instead encourage productivity in the workplace 
(ref B). The Reserve Bank's remedy to higher inflation is 
already certain:  higher interest rates. 
 
BURNETT