Credit rating agency Fitch has downgraded the outlook for New Zealand's AA+ sovereign credit rating to negative from stable and has warned that severe economic imbalances mean the government should dramatically tighten its purse strings.

The downgrade to New Zealand's outlook, which is closely watched by foreign investors, surprised traders in the New Zealand dollar, who pushed it a full cent lower in afternoon trade to 64 US cents.

Fellow ratings agency Standard and Poor's shocked the new National-led coalition government into a budget tightening when it warned of a potential downgrade in January, but the government did enough in the May budget to convince Standard and Poor's to retract its warning. This latest move by Fitch ups the ante again for the Government just when it thought the worst might be over.

Fitch was scathing in its assessment of New Zealand's economic outlook and warned the Government would have to tighten its belt further to ensure New Zealand's foreign debts did not blow out any more.

"The revision in the outlook reflects the agency's concern about the medium-term growth outlook for New Zealand given its persistently large current account deficit and rising foreign indebtedness," Fitch said. "Despite the recession, the current account deficit remains large and is projected to remain above the level necessary to stabilise and reduce New Zealand's net foreign liabilities," it said.

New Zealand's current account deficit stood at 8.5% in the March quarter and New Zealand's net debt was a record high 98.2% of GDP.
"In Fitch's opinion, a stronger fiscal adjustment than currently planned may be required to raise national savings and reduce the current account deficit, as well as structural reforms to improve productivity," Fitch said.

"New Zealand could fall into a low-growth trap as foreigners demand higher returns to incentivise them to continue to lend to New Zealand so it can consume more than it produces, gradually eroding New Zealand's fundamental credit strengths, including strong public finances, and rendering it more vulnerable to future adverse shocks," said Ai Ling Ngiam, Director in the agency's Asia-Pacific sovereign team. Fitch said there were some positives in New Zealand, including the strength of the banking sector and timely policy action by the Reserve Bank of New Zealand, which helped New Zealand navigate turmoil in global financial markets without a crisis. 

"Nonetheless, severe macroeconomic imbalances, most notably the current account deficit and low household savings, remain in place and adjustment is further complicated by the volatility of the New Zealand dollar that appears more responsive to global financial conditions than to domestic economic fundamentals," Fitch said.

"Moreover, the reliance on short-term foreign funding by local banks remains a potential source of risk if a more abrupt adjustment was imposed at some future date on New Zealand by international markets and its creditors." Fitch said it estimated a 4.5 percentage points of GDP turnaround in the current account balance was necessary to bring the net international income deficit below 100% by 2011. 

"However, with historically low real interest rates and the current accommodative fiscal stance, there is a risk that the required balance sheet adjustment by households and, more generally the private sector, will be insufficient in reducing the current account deficit and foreign indebtedness to a more sustainable and safe level," Fitch said. "Against this backdrop of external vulnerability, more aggressive restoration of public finances through fiscal prudence will be needed to raise the national savings rate to counter weak private savings," it said.

Fitch said budget estimates for New Zealand's trend economic growth rate were too optimistic, "given falling labour productivity growth and evidence that the economy may have been persistently expanding above capacity in recent years as reflected in the large current account deficit." Fitch said the rating review could take up to 2 years and implied a greater than 50% chance the rating would be downgraded.