Fitch Affirms New Zealand at 'AA' with Positive Outlook

Fitch Ratings has affirmed New Zealand's Long-Term Foreign and Local Currency Issuer Default Ratings (IDRs) at 'AA' and 'AA+' respectively. The issue ratings on New Zealand's senior unsecured foreign and local currency bonds are also affirmed at 'AA' and 'AA+' respectively. The Outlooks on the Long-Term IDRs remain Positive. The Country Ceiling is affirmed at 'AAA' and the Short-Term Foreign Currency IDR at 'F1+'.

KEY RATING DRIVERS

The affirmation and the Positive Outlook reflect the following factors:

New Zealand's general government deficit continues to narrow, albeit at a slower pace than our projections last year. Weak inflationary pressures have reined in nominal growth, reducing the pace of consolidation as a proportion of GDP growth.

New Zealand's general government (central and local government) debt to GDP ratio - as measured by Fitch - was 35.7% in 2014, similar to the 'AA' median, but well below the OECD median of 71.8%. Under Fitch's baseline scenario, the government debt ratio will fall from 2017 onwards.

New Zealand's status as a high-grade sovereign credit is underpinned by a credible and flexible economic policy framework, supportive business environment and high standards of governance. External finances are a longstanding weakness to the sovereign credit profile, made more vulnerable by dependence on agricultural commodities and exposures to China, both directly and indirectly through economic and financial linkages with Australia.

The sovereign's ability to borrow freely in local currency and the country's holding of net foreign currency assets help to mitigate some external risks. Fitch expects the current account deficit to widen to 5.4% of GDP in 2016 from 3.3% in 2014 as growth in investment, spurred by construction activity, outpaces domestic savings. Foreign investors continue to be willing to finance the deficit, at long maturities or through direct investment, and in local currency. However Fitch projects a gradual build-up of external indebtedness that could increase longer-term vulnerabilities and sensitivity to external shocks.

The current account deficit could widen by less than Fitch projects if net exports respond more strongly to weaker exchange rates than expected. The New Zealand dollar has depreciated sharply since the Reserve Bank of New Zealand (RBNZ) cut the Official Cash Rate by 25bp to 3.25% in June.

Real GDP growth (expenditure measure) was 3.3% in 2014, outperforming most 'AA'-category peers, which posted median growth of 2.5%. Fitch expects high levels of net immigration, rebuilding efforts in Christchurch and construction activity in Auckland to continue supporting economic growth and facilitating further fiscal consolidation. However lower agricultural production due to drought, and weaker demand following a fall in dairy prices, has slowed New Zealand's economic momentum.

Fitch expects the economy to expand 2.8% in 2015. Fitch expects some recovery in dairy prices over the 2015-2016 seasons, but a prolonged period of low dairy prices could have a substantial impact on the economy. Many leveraged dairy farmers are currently facing negative cash flows, but have been able to manage their finances by drawing on savings from more profitable years and through overdraft facilities. However another season of low dairy prices could find farmers struggling to make debt repayments and maintain production, especially combined with another shock such as poor weather.

The New Zealand banking system is rated 'a' by Fitch, the second highest score. Development of the Open Bank Resolution framework and backing from Australian parent banks should limit contingent liabilities on the sovereign to support the system during times of stress. However there is a risk that potential problems in the Australian banking sector would spill over to the New Zealand financial system.

A sharp fall in Auckland house prices could pose a downside risk to the economy, although Fitch thinks a scenario that will lead to substantial mortgage losses for banks is unlikely. Auckland house prices are rising at potentially unsustainable levels, with average prices at over seven time's average income (compared with four times in the rest of New Zealand). The RBNZ has proposed tighter macro prudential policies for Auckland to slow the build-up of risks, but monetary policy easing could act in the opposite direction. Fitch would view a more sustainable pace of house price appreciation relative to income as a credit positive.