But the expansion in Asia should remain healthy, supported by robust domestic demand, and inflation is expected to recede modestly. Downside risks dominate.
In particular, an escalation of the eurozone turbulence and a renewed slowdown in the United States could exert extreme economic and financial pressures across the Asia region.
We expect New Zealand's economy to grow by about 2 per cent and the recovery to gain pace with growth of 3.75 per cent, boosted by earthquake reconstruction.
Annual headline inflation should fall within the target band of 1-3 per cent. However, uncertainties are unusually large.
New Zealand's large net external liabilities expose it to a possible rise in funding costs if global financial conditions continue to deteriorate. Although short-term external debt has fallen, it remains sizeable at about 50 per cent of GDP and presents relatively high rollover needs.
Moreover, a faltering of emerging Asia's rapidly growing demand for commodities could adversely affect exports.
Domestically, households could become less cautious in their spending behaviour as the recovery progresses, and capacity bottlenecks from earthquake reconstruction could arise.
In Asia, the downside risks to growth amid persistently high inflation present policymakers with a delicate balancing act.
They need to guard against risks to growth but also limit the adverse effects of prolonged easy financial conditions on inflation and balance sheet vulnerabilities of corporates and households.
Depending on the extent of inflationary pressures, some countries may need to continue macro-policy normalisation, while a pause in tightening may be warranted in others.
The Reserve Bank has kept its policy rate at a record low of 2.5 per cent since March. Nonetheless, an appreciation of the New Zealand dollar has tightened financial conditions over the past six months, helping contain inflation.
With heightened global risks, the current pause is appropriate. Should the recovery remain on track, monetary policy normalisation will be needed to anchor medium-term inflation expectations.
Higher-than-expected earthquake reconstruction costs have contributed to an estimated 2010/11 budget deficit of about 9 per cent of GDP. Nevertheless, if the recovery proceeds as expected, the Government's plan to return to a budget surplus by 2014-15 and keep net public debt below 30 per cent of GDP remains feasible and desirable.
Fiscal consolidation will also help contain the current account deficit over the medium term. In addition, large net foreign liabilities (70 per cent of GDP) call for fiscal prudence. In an upside scenario, there is scope for faster fiscal consolidation.
New Zealand is in a relatively good position to respond to a downside scenario of sharply lower global growth. In such a scenario, the exchange rate would likely depreciate and there is some room for the Reserve Bank to cut the policy rate.
We should not lose sight of the challenge to improve productivity and raise national saving over the medium term. Continued fiscal consolidation, tax and welfare reform, and rationalising regulation will go a long way in that direction.
This article has been corrected from an earlier version. That said the IMF's economic growth forecast for New Zealand was 3 per cent. It is, in fact, 3.75 per cent.
