Low interest rates and windfalls from escalating house prices have household debt sitting at higher levels than before the 2007-08 global financial crisis, highlighting the economy's vulnerability to unfavourable changes.
While New Zealand's household debt levels have continued to break records, the debt servicing costs remain low, most lending is secured against assets and lenders have been independently tightening access credit, Westpac senior economist Satish Ranchhod said.
"One of the key issues confronting the New Zealand economy is a build-up of debt in the household sector. Over 2015, household debt rose to levels higher than those reached prior to the financial crisis,'' he said.
The latest Reserve Bank figures showed the trend had continued in early 2016 and household debt was now at levels equivalent to 163% of annual household disposable income, Mr Ranchhod said.
"A key contributor to this trend has been historically low interest rates.
The present low interest rates had provided a powerful boost to asset prices, particularly for housing, he said.
"And as has historically been the case, strength in the housing market has seen home owners spending some of the windfall they perceive when the value of their house rises, while aspiring buyers must borrow more,'' Mr Ranchhod said.
The net effect was an increase in both borrowing and spending, he said.
Compared with other developed economies, household debt-to-GDP in New Zealand was "relatively high'' and was consistent with strong growth in house prices.
Contributing factors to the debt trend include record-low interest rates, which have boosted housing demand, and a housing supply that has not kept up with population growth, especially in Auckland.
"These conditions have made it very attractive for investors to purchase residential property using debt,'' Mr Ranchhod said.
The strong growth in house prices also meant owner-occupiers were having to borrow more to purchase housing.
Mr Ranchhod said "trends in debt levels over time can alert us to the build-up of risk''.
Some pick-up in debt levels was not a problem for an economy and was actually a sign monetary policy was operating as expected, he said.
The Reserve Bank had set interest rates at low levels to boost domestic activity, which was helping offset headwinds in externally focused parts of the economy and households' appetite for debt would continue to support economic activity for the next few years, he said.
However, rising household debt raised important concerns for the longer-term economic outlook.
Firstly, increases in debt could not boost growth indefinitely and households eventually needed to repay debt, and interest rate increases would require them to commit a greater proportion of income to service the debt, Mr Ranchhod said.
Secondly, higher debt levels meant the economy was more vulnerable to unfavourable changes in economic or financial conditions.
"In this respect, there are some red flags on the economic horizon,'' Mr Ranchhod said.
The recent Brexit vote and nervousness in financial conditions added to negative risks for global economic growth. As well, New Zealand's migration cycle was turning down and the Canterbury rebuild would wind down, he said.
"With higher debt levels, the slowdown in economic growth could be even more pronounced due to the impact on households' debt-servicing abilities,'' Mr Ranchhod said.
