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Cablegate: New Zealand's Economy Faces Bumpy Road Ahead

This record is a partial extract of the original cable. The full text of the original cable is not available.





E.O. 12958: N/A


(U) Sensitive but unclassified -- please protect

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.

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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

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

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

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.

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.


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