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New Zealand is seeing what could be the beginning of another

housing boom. The course of events in the housing market will

have a profound impact on the New Zealand economy in the

year ahead. A resurgent housing market will be supportive for

economic growth, but will also have implications for inflation

and the way the RBNZ implements policy in the medium term.

Investors should note that these factors all have implications for

New Zealand asset classes.

The house price picture

The New Zealand housing market has steadily gained

momentum over the past year with annual house price

growth rising above 5%, house sales volumes growing strongly,

construction showing signs of accelerating and household credit

growth also starting to accelerate (albeit well below the 10-15%

level of the early to mid 2000s). The key driver of national level

house price growth has been Christchurch and Auckland, butthere is emerging evidence of this strength spilling over into

other regions.

House prices, credit and construction trend up

-15

-10

-5

0

5

10

15

20

25

30

0

500

1000

1500

2000

2500

3000

3500

4000

93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

NZ Dwelling ApprovalsREINZ House Prices YoY [RHS]

Household Credit Growth YoY [RHS]

Source: AMP Capital, Statistics New Zealand, RBNZ, REINZ

The Reserve Bank of New Zealand (RBNZ) is concerned about the

trends depicted in the chart above. This is because during the

mid 2000s a credit-fuelled housing boom emerged and the RBNZ

could do little about it except for raising interest rates. There are

two reasons the RBNZ should be concerned:

1. Price stability. Housing related price rises flow through to

specific components of inflation directly and indirectly as

construction activity comes up against capacity constraints

and the wealth effect boosts aggregate demand, lifting

generalised inflation.

2. Financial stability. Excess credit growth, particularly when

driven by asset booms, presents risks to the financial system

as banks aggressively expand their balance sheets, exposing

themselves to falling asset prices and lending to potentially

poor credit risks.

Auckland housing market: supply and demand

While the reason for the rise in house prices in Christchurch

is quite straightforward (ie the earthquake destroyed

or degraded a significant part of the housing stock), the

Auckland situation is not as immediately obvious. In Auckland

fundamental demand (basically net growth in population,

specifically households) has consistently grown, driven by

three factors:

> natural population growth (births minus deaths);

> net migration (more people coming to NZ and living in

Auckland than leaving); and

> domestic migration (with a one-off rise from people leaving

Christchurch, and people following jobs as a number of

companies have relocated their head offices to Auckland).

Auckland demand growth has outstripped supply

-5,000

-

5,000

10,000

15,000

20,000

97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

No.

Dw

ellings

Demand vs Supply mismatch Demand Supply

NB: Demand = population growth divided by average household size i.e. no. new

households, Supply = number of dwellings approved.

Source: Statistics New Zealand, AMP Capital estimates

The problem is the supply side has yet to catch up, with the

key dwelling consents numbers showing Auckland building is

still well below the mid 2000s building boom.

A number of factors are restricting supply, some of theseare regulatory but theres also the psychological aspect. For

example, there needs to be a greater willingness and ability to

go up, ie more and better quality apartments, which is how

many big cities around the world accommodate population

growth, and/or smaller houses. The trend has been for

average house sizes to rise, this impacts on affordability and

demand for land.

Other factors are more structural. There are limits on how

fast a city can expand, such as the consenting process,

infrastructure upgrades and build outs, zoning and land

availability, etc. Theres also the important matter of capacity

in the construction industry. New Zealand is currentlyundertaking an unprecedented level of construction in the

Canterbury rebuild, with estimates that it will cost as much as

$30 billion.

MARCH 2013

New Zealand Outlook:Housing and Inflation

Investment insights

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While some amount of price appreciation is needed to

stimulate a supply response, too much price appreciation

could turn fundamental demand into speculative demand.

Thats the risk. Its also rightly been identified1 as an

impediment to productivity growth as it encourages

overinvestment and enthusiasm in an unproductive sector,

crowding out resources that could have gone into things like

building businesses or investing in skills.

1 The New Zealand Productivity Commission recommended addressing theseissues in its Housing Affordability Enquiry. Key areas recommended foraddressing were: urban planning, infrastructure costs, building consent costs,building costs, social housing, and Maori housing.

The inflation picture

Going back to price stability, what is the present trend in inflation?

We are at cyclical lows in consumer price inflation and we already

know inflation will increase. Looking ahead, the inflation outlook

will be driven by underlying trends in aggregate demand in

relation to potential growth (ie the output gap) and capacity.

We expect the housing market to be a key contributor to seeing

inflation head towards 2% by year end as a result of rising housing

related inflation and stronger aggregate demand.

Housing related inflation starting to rise

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

7%

8%

00 01 02 03 04 05 06 07 08 09 10 11 12

NZ CPI Headline Inflation

Housing and household utilities

Non-Tradeable

Source: AMP Capital, Statistics New Zealand, RBNZ

The RBNZs options

On the inflation outlook, the RBNZ probably still has some time up

its sleeve before it has to hike rates (our base case is for an interest

rate increase in December this year). But with the housing market

gaining momentum, will the RBNZ be forced to move earlier? The

current trends in the Auckland housing market are top of mind

when the RBNZ thinks about price stability. The question on what

can be done depends whether the pace of activity, particularly

credit growth, starts making the RBNZ more worried aboutfinancial stability.

Price stability vs financial stability

The RBNZ has specific mandates and targets under the Reserve

Bank Act and as agreed with the Minister of Finance. Price stability

is set out in the Policy Target Agreement (PTA) as keeping CPI

inflation between 1% and 3% on average over the medium term,

with a focus on average inflation near the 2% midpoint. On

financial stability, the RBNZ is responsible for oversight of the

banking system, non-bank deposit takers, the insurance sector

and payment system. Essentially this means maintaining a sound

and efficient financial system.

On the one hand, the RBNZ could move to act now by lifting

interest rates early, but this would risk setting back non-housing

related economic activity. On the other hand, if it waits too long it

could risk falling behind like it did during the mid 2000s. For now

the potential costs of lifting rates too early probably outweigh

the potential benefits. If the RBNZ starts to become particularly

worried about financial stability in relation to the housing market,

the use of macro-prudential tools could be a viable option in

curbing the impact of housing market excesses on financial

stability.

The RBNZ is currently accepting public submissions on its

proposed macro-prudential tools, and these tools could certainly

be implemented to offset the risks that an overheated housingmarket would have on financial stability. But thats the key point

macro-prudential policy is designed to support financial stability.

While these tools would likely have some impact on the aggregate

demand picture, they are more of a complement than a substitute

for the cash rate.

Its also worth asking whether taming house prices is worth

doing. Higher prices should encourage more development, with

this supply response potentially fulfilling the usual self-regulating

feature of the free market. However, as noted previously, there is

a real risk that a fundamental supply/demand mismatch can be

self-perpetuated as fundamental demand turns to speculative

demand, and panic buying as buyers seek to avoid missing out.Indeed, looking to history, many asset bubbles could be soundly

justified in the early stages.

The outlook and investment implications

Factors specific to the Auckland and Christchurch housing markets

have led to increased prices, credit growth and construction

activity. As for the rest of New Zealand, record low mortgage rates

have been broadly supportive for house prices, and there is the

possibility that elevated activity spills over from Christchurch and

Auckland to the broader market. We know that higher prices and

activity in the housing market flows through to higher housing

related inflation, puts pressure on construction sector capacityand boosts aggregate demand through the wealth effect. We

expect this strength in the housing market to eventually flow

through to higher inflation over the year which will likely prompt

the RBNZ to act.

This will result in winners and losers when it comes to the

financial markets:

> Bonds will likely see lower returns as the improving outlook,

higher inflation and prospects of interest rate increases drive up

market yields, reducing total returns.

> Currencies continue to be dominated by offshore drivers, but

a surge in credit growth will reinforce the structural currentaccount deficit. In the immediate term however a rise in rates

will likely be supportive for the New Zealand dollar(NZD),

directly and indirectly, in that it reflects improved economic

conditions.

> Cash may begin to see higher returns if interest rates begin to

rise, but inflation will be a hurdle to real returns.

> Property may see support as economic conditions improve, and

historically it has acted as an inflation hedge. However, rising

interest rates may put downward pressure on valuations, and

put pressure on the reach for yield.

> Equities will be faced with opposing forces. On the one hand,

earnings will be supported by improved demand from the

wealth effect and from construction activity. On the other,

valuations could come under pressure if interest rates rise,

while a small increase in inflation can be supportive (see Equity

valuations, inflation and interest rates).

2

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Appendix: Property prices around the world

Prior to the financial crisis many countries around the world saw

strong gains in property prices, which transmitted through to

excessive credit growth and overheating economies. This was a

major contributor to the financial crisis, and is a key reason why

increasing attention is being placed on the housing market as a

potential driver of financial instability.Global property prices - YoY%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

01 02 03 04 05 06 07 08 09 10 11 12 13

US

China

New Zealand

Australia

UK

Source: AMP Capital, REINZ, NBS, Bloomberg

But rising house prices are not all bad the issue is how far

things go. Indeed, improving house prices in the US and UK have

turned the housing market from a headwind to a tail wind for

growth as the negative impact on wealth reverses and credit

quality improves as collateral values increase.

Callum Thomas

Research Analyst

Contact us

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Ground Floor, PwC Tower

113 - 119 The Terrace

PO Box 3764 Wellington

Telephone: +64 4 494 2200

or visit ampcapital.co.nz

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AMP Capital Investors (New Zealand) Limited

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188 Quay Street

PO Box 5346, Wellesley Street, Auckland

Telephone: +64 9 927 1600

Important note: While every care has been taken in the preparation of this document, AMP Capital Investors (New Zealand) Limited makes no representation or warranty as to theaccuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document hasbeen prepared for the purpose of providing general information, without taking account of any particular investors objectives, financial situation or needs. An investor should,before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investors objectives,financial situation and needs. This document is solely for the use of the party to whom it is provided