Global economic prospects have improved this year after a sharp slowdown at the end of 2011. There is growing evidence global activity is set to strengthen in the second half of 2012 as financial conditions ease and risk appetite rebounds following the aversion of imminent crisis in the eurozone.
Growth in Asia is also expected to gain momentum over the year. Although activity slowed markedly across the region in the last quarter of 2011, mainly due to weakening external demand, domestic demand has generally remained strong as reflected in low unemployment, high capacity utilisation, and robust credit growth.
In the first months of this year, leading indicators of activity strengthened, inflations picked up in some countries, and capital inflows into emerging Asian economies rebounded.
Growth for the Asia and Pacific region as a whole is projected to be at 6 per cent this year, broadly unchanged from last year, before rising to about 6 per cent next year.
However, the global economy remains fragile, exposing Asia to serious downside risks.
The European debt crisis remains unresolved, and financial turmoil could still reignite and spread globally while heightened geopolitical risks could push energy prices sharply higher.
So far, stronger economic and policy fundamentals have helped buffer Asian economies against external shocks. But a collapse in demand from advanced economies and a reversal of foreign capital flows would severely impact activity in Asia, both directly and through knock-on effects on domestic demand.
Moreover, a shock to commodity prices could create difficult trade-offs between inflationary pressures and budgetary risks from energy and food subsidies.
In this regional context, the pace of New Zealand's economic recovery is likely to remain modest. Output growth should pick up this year to 2 per cent as earthquake reconstruction spending gains pace, although the size and timing of this spending is still uncertain.
Other sources of demand will remain soft, however, as global growth prospects are still weak and households are still highly leveraged and will need to save to strengthen their balance sheets.
The spare capacity and elevated unemployment will contain wage and inflation pressures in the near term.
Emerging weaknesses in the global economy and a possible upheaval in the global financial system pose risks, which could impact through trade and financial channels.
There could be lower export demand, especially if the outlook weakens in Australia and China, which are the top two destinations for New Zealand exports.
And the terms of trade could fall, as prices for New Zealand's commodity exports are largely underpinned by demand from global markets.
As in other countries in the region, financial turmoil presents a risk to the New Zealand economy.
While New Zealand banks have little direct asset exposure to European borrowers, they do rely heavily on offshore wholesale funding.
A worsening of global financial conditions could raise the cost of this funding, putting upward pressure on interest rates for domestic firms and households, and banks are vulnerable to the tail risk of a temporary shutdown of global funding markets.
That said, banks are less vulnerable than during the market disruption in late 2008, as the share of retail deposits and the average maturity of bank liabilities have been steadily increasing over the last three years and the source of funding is diversified across different regions and products.
Officials have policy space to respond to near-term shocks, monetary policy serving as a first line of defence.
New Zealand's Reserve Bank has the scope to lower interest rates and loosen monetary conditions to help against a downside scenario.
As evident during the crisis, the free-floating New Zealand dollar is an extra cushion against external shocks.
The authorities would also be able to provide emergency liquidity support to banks, a measure which proved effective when wholesale markets shut down in the wake of the 2008 crisis.
New Zealand's relatively modest public debt is widely regarded as a strength, and the Government's planned budget deficit reduction will play an important role in limiting the country's external vulnerability by increasing national savings and reducing its persistently high net foreign liabilities.
At the same time, the favourable debt situation would leave the Government some scope to slow down their planned deficit reduction path if the economic outlook dropped sharply.
Anoop Singh is a director of the IMF's Asia and Pacific Department.By Anoop Singh