The New Zealand economy has grown modestly in the past three years but remains vulnerable to a downturn in global economic and financial conditions, Reserve Bank governor Alan Bollard says.
Releasing the May 2012 Financial Stability Report, Dr Bollard said financial market sentiment had improved since the start of the year, largely reflecting policy measures in Europe.
The policy measures had helped mitigate the effects of softening economic growth, stretched sovereign debt positions and weak balance sheets.
However, the situation remained fragile, given limited progress in addressing Europe's underlying issues.
In New Zealand, households remained cautious and had been saving more, while business investment had been weak.
Private sector indebtedness had declined, although that had largely been offset by rising public debt, he said.
There was a risk that part of the rise in private savings proved cyclical and that stronger demand for credit would re-emerge as the economic recovery strengthened.
"It seems unlikely that credit would resume the growth rate of the previous decade, but a milder upward trend in credit relative to GDP - as seen throughout the last 20 years - would be enough to intensify concerns about indebtedness."
Households had benefited from steady income growth, partly assisted by tax cuts, and relatively low growth in retail prices stemming from reduced import prices and discounting by retailers, Dr Bollard said.
Also, households' efforts to save more and consolidate their balance sheets had been supported by developments in the labour market.
Unemployment had not reached the levels experienced in previous recessions, in either short-term or long-term unemployment.
Increases in unemployment, especially long-term, could generate financial instability as households became unable to maintain debt repayments.
"The labour market resilience seen in the recent downturn has helped keep financial stress in the household sector contained, with non-performing housing loans peaking at just above 1%."
Additionally, while household debt in New Zealand was "fairly high", generally sound lending practices meant the relatively large loans were concentrated in the higher household income brackets.
