Rising house prices and a China slowdown could threaten New Zealand's economic recovery, the International Monetary Fund (IMF) says.
But the Government is playing down the risk of China's economy tanking, although it is concerned about Auckland's housing market.
In a report released overnight, the IMF said the risks of a sharp Chinese downturn and a housing market crash were the biggest internal and external threats to an otherwise strong economy.
It pointed to improved growth prospects, strong business and consumer confidence, high commodity prices for key exports and the prospect of the Government returning to surplus as positive factors.
The economic expansion is becoming "increasingly embedded and broad-based" with growth forecast to increase to about 3.5 per cent this year, the IMF said.
However, it warned New Zealand's growth prospects remained exposed to external developments, particularly a sharp slowdown in growth in China.
"About two-thirds of New Zealand's exports of goods go to China, Australia, and other parts of Asia," the report said. "As such, any adverse development in the region would have a substantial impact on New Zealand's terms of trade."
There was also the risk a bumpy exit by advanced economies from unconventional monetary policy could lead to "widespread contagion" and raise the cost of New Zealand banks' offshore borrowing.
The report also raised concerns about New Zealand's house prices, which it said appeared elevated by historical and international comparisons, as well as most measures of affordability.
"With house-price inflation running high, there remains the risk that expectations-driven, self-reinforcing demand dynamics and price overshooting could take hold," the IMF said.
The Government's steps to help alleviate supply bottlenecks, tighter standards for mortgage lending and an increase in mortgage rates should help ease price pressures.
"But a sudden price correction - possibly triggered by a shock to household incomes or borrowing costs - could reduce consumer confidence, impact overall economic activity, and hurt banks' balance sheets," the report said.
The IMF said the Reserve Bank's new macro-prudential policy framework, which included controversial limits on high loan-to-value mortgage lending, improved the central bank's ability to safeguard financial stability.
It also praised the Government's commitment to return to surplus, which it said would support monetary policy and ease pressure on the exchange rate.
Risks remained from the current account deficit, which had narrowed but was forecast to widen, while the New Zealand dollar appeared overvalued, the report said.
Prime Minister John Key said Auckland's housing market was a potential risk because net migration was strong in Auckland, so the population was rising.
"We need to build around about 13,500 homes a year, so that's quite a lot more than we've previously been building or consenting, and if Auckland house prices continue to rise that puts pressure on the Reserve Bank governor to raise rates," he said.
The Government was addressing the issue through special housing areas and by working with the Auckland Council in its planning process to get more houses built.
Key didn't think there would be a sharp slowdown in China but he said there was an issue with the credit build-up in China, which he raised with the Chinese President Xi Jinping.
"That's not inconsistent with what we've seen in other countries as they've been looking to stimulate their economy," he said.
"And the Chinese have an advantage many other countries don't have and that is they have more levers to pull."
Finance Minister Bill English said the report was a welcome endorsement of the Government's economic programme.
"As the IMF notes, the Government's steps to help alleviate housing supply bottlenecks and the Reserve Bank's measures to tighten mortgage lending and to raise interest rates should help to ease house price pressures," he said.
"The Government's fiscal deficit reduction programme is also expected to take some pressure off the exchange rate, as the IMF acknowledges."
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