WELLINGTON, May 8 (Reuters) - A surging New Zealand housing market is raising the risks to the country's financial system, prompting a move to tighten lending rules for major banks, while an overvalued currency is hindering the rebalancing of the economy, the central bank said on Wednesday.
The Reserve Bank of New Zealand (RBNZ) repeated warnings that house prices are overvalued in some areas and banks have loosened their lending rules, which is leading to households becoming more indebted and more vulnerable.
"Housing pressures are increasing risk in the financial system," RBNZ Governor Graeme Wheeler said in the bank's six-monthly financial stability report.
"Further price escalation will worsen the potential damage that could result from a housing downturn following an economic or financial shock."
He said the credit cycle appeared to be passed the low point, with low interest rates and buoyant global markets, resulting in credit growing faster than incomes.
House prices in some parts of the country, notably the biggest city Auckland and the earthquake-damaged Canterbury region have hit record levels, prompting the RBNZ to warn several times this year about inflation and financial stability risks.
"Demand is being underpinned by easier credit conditions, both in terms of lower mortgage rates and an increased willingness to by banks to lend at high loan-to-value ratios (LVR)," Wheeler said, adding that a shortage of supply and low interest rates would likely boost prices.
The RBNZ said that from Sept. 30 it would require the country's four major banks, which have around 80 percent of the banking market, to raise the risk weighting for new high LVR loans, which would see capital held to back house lending rise by around 12 percent.
The move was flagged by the RBNZ in March when it put out a consultation paper on macro-prudential tools to control lending and asset bubbles.
Wheeler said the RBNZ expected to agree soon with the government on key policy elements of the tools, which include forcing banks to increase their reserves for certain types of lending, requiring bigger housing deposits, and capital buffers.
However, households were seen in better shape than before the global crisis, although the pace of reducing debt and raising savings had slowed.
The bank also repeated its concern about a significantly overvalued New Zealand dollar, boosted in part by loose money policies in some economies, which was hindering a rebalancing of the economy.
"There's the potential for the exchange rate to keep appreciating and that's a ... concern," Wheeler told reporters.
The New Zealand dollar eased to $0.8440 from $0.8460 on the comments, although it remains in range of a 20-month high of $0.8676 hit in April.
External fiscal risks from the euro zone and the United States were seen to have eased but there remained a significant risk of renewed turbulence in offshore funding markets.
The financial stability report did not touch on monetary policy. The RBNZ has held its cash rate at a record low 2.5 percent for the past two years, and said it expects to hold it there through the end of the year as annual inflation remains at a near 13-year low, below the bottom of its 1-3 percent target band.
Reporting by Gyles Beckford