(Adds detail, quotes, market reaction)
By Gyles Beckford
WELLINGTON, Nov 13 - A surging and overvalued New Zealand housing market is the main threat the country's financial system, but tighter lending rules for banks are starting to reduce riskier lending, the central bank said on Wednesday.
The Reserve Bank of New Zealand (RBNZ) said house prices are overvalued in some areas, which along with increasing demand, a lack of supply and low interest rates, have lead to households becoming more indebted and more vulnerable.
"The main threat to the financial system is the risk associated with imbalances in the housing market," RBNZ Governor Graeme Wheeler said in the bank's six-monthly financial stability report.
However, he said limits on the amount banks can lend for low deposit-high value (LVR) house mortgages, which came into force last month, seem to be having an effect.
"The early evidence shows that banks have significantly reduced high LVR lending approvals, while increasing the cost of high LVR loans."
Real estate industry data earlier this week showed prices at record levels, but with some hints that the new rules are weighing on sentiment and making buyers and sellers uncertain and more cautious.
Wheeler said it would take a few months to assess the impact on house price inflation, which would also be dampened as the official cash rate was raised to counter more widespread price pressures in the strengthening economy.
The RBNZ repeated that the LVR limits would be temporary, but without them the record low 2.5 percent cash rate could be expected to rise higher than the two percentage points between 2014 and 2016 forecast in its September rates statement, putting upward pressure on the New Zealand dollar.
It said the still elevated New Zealand dollar continued to hurt exporters by dampening sales volumes, margins and revenue.
The New Zealand dollar fell after the release of the report, touching a two-month low around $0.8168 before rebounding above $0.8200.
The report said New Zealand's banks were in strong financial shape, with adequate reserves and capital, and low levels of bad loans.
Other risks to the financial system highlighted by the RBNZ included the high debt levels in the dairy sector, and New Zealand's high level of foreign debts.
"While the dairy sector is currently enjoying record export prices, its high level of indebtedness makes it vulnerable to a fall in commodity prices or an increase in interest rates," deputy RBNZ governor Grant Spencer said.
Dairy produce accounts for about a quarter of New Zealand's NZ$46 billion annual export earnings.
The RBNZ said the improvement in New Zealand's domestic savings rate and reduction in government debt needed to be sustained to constrain the country's high external debt levels, as seen in the current account deficits.
The euro zone's long running fiscal problems, a sharp slowdown in the Chinese economy, and the United States' government funding problems, were seen as the main external risks.
(Editing by Lincoln Feast)
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