An International Monetary Fund (IMF) review of the New Zealand economy has found it rode out the global financial crisis "better than most" advanced economies, but said it considered its currency to be overvalued.

The IMF said New Zealand rode out the financial crisis thanks to strong demand from fast-growing Asian markets and the robust Australian economy, a flexible exchange rate, the absence of a banking crisis, and significant and effective policy easing.

"Nevertheless, the crisis highlighted long-standing vulnerabilities due to high household and external debt," it said.

Led by domestic demand, the economy emerged from the recession in mid-2009. A large output gap contained growth in labor costs and eased inflationary pressures, with the annual CPI inflation falling from the peaks of 4–5 percent in 2008 to about 2 percent in early 2009.

After cutting the official cash rate (OCR) by 575 basis points from mid-2008 to early 2009, the Reserve Bank of New Zealand (RBNZ) has kept it at a historical low of 2.5 percent. The IMF said a strong pre-crisis fiscal position also enabled the delivery of a large fiscal easing that was in train prior to the crisis, equivalent to almost 6 percent of GDP spread over the two years to June 2010.

The current account deficit narrowed sharply in 2009 to 3 percent of GDP, as both trade and income balances improved. Private capital inflows continued to finance the deficit, and net foreign liabilities increased marginally to 90 percent of GDP.

The exchange rate depreciated sharply at the onset of the crisis, but has appreciated by over 20 percent since early 2009, reflecting a recovery in commodity prices and global risk appetite, and a widening of interest rate differentials, it said.

"Directors noted that the exchange rate is overvalued from a medium-term perspective, while recognizing the uncertainty surrounding the estimates. The exchange rate would need to be significantly lower for an extended period of time for New Zealand's external liabilities position to be materially reduced."

The IMF said New Zealand Banks remain sound but faced some funding difficulties during the crisis, and it said banks remain exposed to highly-indebted households and house prices appear overvalued.

A gradual recovery is expected to continue, according to the IMF, with growth projected at 3 percent in 2010–11. The outlook was subject to downside risks related to the pace of global recovery and borrowing costs for countries with high external debt, such as New Zealand.

The IMF "commended" the Government for its decisive policy response, which helped cushion the impact of the global crisis on the New Zealand economy and is supporting a gradual economic recovery.

"Directors noted that the fiscal and monetary policy frameworks, including the flexible exchange rate regime, have served New Zealand well during the crisis. Key policy challenges are to lift sustainable economic growth and reduce the vulnerabilities associated with a deteriorated fiscal position and high private external debt."

The IMF said it considered the current accommodative monetary stance as appropriate and supported a measured withdrawal of the stimulus once the recovery is well established, given that spare capacity is expected to persist over the next few years, helping to keep inflation within the 1–3 percent target range.

"If downside risks to inflation materialized, there could be room to loosen monetary policy. Directors observed that the inflation-targeting framework performed well during the global crisis and saw no clear net benefits to increasing the inflation target."

The IMF said prudential and structural reforms would help reduce New Zealand's external vulnerabilities.

"They welcomed the introduction of a prudential liquidity policy, including a core funding ratio, which should reduce banks' reliance on short-term external funding. Directors also underscored the importance of structural reforms to raise productivity and labor force participation, including tax and benefit reform, to help lift potential growth and export capacity, and support economic rebalancing, thereby reducing vulnerabilities related to external debt," the IMF said in its report.

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