New Zealanders still carry too much debt and an overvalued housing market is not helping, Reserve Bank governor Graeme Wheeler says.
In the central bank's six-monthly financial stability report, released this morning, Mr Wheeler says that while debt has been reduced since 2009 it is still too high and the country remains vulnerable because of this.
The report cites over-investment in housing as a key factor in the country's ongoing economic vulnerability.
"House prices are already elevated relative to fundamental metrics, such as income and rents, and a property market rebound would exacerbate the risk of a sharp property price correction at some point in the future," the report says.
"Household debt is largely secured on property assets and a substantial property price correction could result in significant strain on household and bank balance sheets."
Credit growth has begun to pick up over recent months and banks have been reducing their lending requirements to encourage borrowers, mostly for competitive reasons.
"House prices are rising, particularly in Auckland, in the face of housing supply constraints.
"Excessive credit growth could worsen housing market imbalances, given that house prices appear overvalued on a number of measures."
Household and farm debt are still too high, although business debt levels remain comparatively low, the report says.
"Leverage in the agricultural sector remains high, especially among some dairy farmers, leaving the sector vulnerable to a fall in incomes. Households are also relatively indebted due to the substantial rise in borrowing over the past two decades."
Bank lending is matched by bank deposits, something which has not happened for more than 20 years. That period saw the increase in debt funded by borrowing from offshore wholesale markets.
The ability to return to that sort of debt expansion is not likely be repeated, the report says.
"The difficult external funding environment, along with both regulatory core funding requirements and banks' own efforts to place a greater emphasis on retail deposits, may place a brake on future upswings in credit expansion."
Mr Wheeler also cites the New Zealand currency as a constraint on the economy.
"The high New Zealand dollar and weak global demand are hampering prospects for some firms.
"New Zealand's comparatively high interest rates compared to other economies are leading to increased foreign holdings of New Zealand portfolio debt, putting pressure on the currency."