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Budget 2011 Home Page Budget Policy Statement 2011

Economic and Fiscal Context

When this Government was elected in late 2008 we inherited an economy in recession. This put considerable stress on the fiscal position. Projections showed that public debt, although low in 2008, was set to increase substantially - largely as a result of a decade of projected operating deficits. The Government's key aims in Budget 2009 were to ensure that jobs and economic activity were supported and that the expected ballooning of debt was controlled and then brought back down. In Budget 2010 we focused on tax reform, strengthening the economic recovery, helping families get ahead and maintaining sound public finances. Budget 2011 will continue our focus on ensuring balanced and sustainable economic growth while delivering on our commitment to responsible fiscal management. A key focus will be on reducing our economic imbalances and further building confidence in the economy.

New Zealand's rate of economic growth from the mid-2000s proved to be unsustainable. It was an economic boom that was increasingly fuelled by debt and consumption. Domestic and external imbalances emerged. Although there are important offsetting factors, such as low government debt and a floating exchange rate regime, our net external liabilities increased from 75% of GDP in 2004 to around 85% of GDP in 2010. This increase has been caused by persistent current account deficits, which reflect a shortfall between our level of saving and our level of investment.

Figure 1 - Change in 10-year government bond yields, January 2010 to November 2010
Figure 1 - Change in 10-year government bond yields, January 2010 to November 2010.
Sources: Reuters, the Treasury

These imbalances leave New Zealand exposed to potential adverse changes in investor sentiment. Figure 1 shows the recent change in 10-year government bond yields in Australia, Germany, Greece, Ireland, New Zealand, Portugal, Spain and the United States. It highlights the extra interest cost that countries face when investors begin to lose confidence in a country’s ability to meet its foreign debt obligations. While the level of New Zealand’s net external liabilities is similar to at-risk or distressed countries, the contribution of government debt is much lower. Ireland was in a similar position prior to the global financial crisis. This underlines the need to maintain a strong fiscal position if the confidence of financial markets is to be maintained, as emphasised by the recent decision of Standard and Poor’s to revise its outlook on their foreign currency sovereign credit rating for New Zealand from stable to negative.

Policy settings need to support a shift in the drivers of our economic growth. In Budget 2010 the Government announced a significant, and broadly fiscally-neutral, tax package that was designed to shift incentives towards saving and investment through a change in the tax mix. The first round of the changes was implemented smoothly in October 2010. Further changes announced in Budget 2010 are scheduled for April 2011, including a lower company tax rate.

The issue of saving and investment in New Zealand is currently being investigated by the Savings Working Group, which is due to report back in January 2011. This is an important issue which has an impact on the imbalances in our economy. It is an area where the Government can play a role in creating an environment with better incentives towards saving and investment. Reducing the imbalances New Zealand faces means that although growth may be slower initially than after previous recessions, a more solid foundation will be laid for the future.

Figure 2 - Sectoral credit growth
Figure 2 - Sectoral credit growth.
Source: Reserve Bank of New Zealand

Fiscal policy also plays a key role in supporting economic growth and reducing the imbalances in the economy. We have reprioritised over $4 billion of spending in the last two Budgets, helping us to meet our election commitments and slow the projected rise in debt, and in turn assisting the reduction of imbalances in the economy. We expect to identify further opportunities in Budget 2011 and beyond.

The process of reducing these imbalances has already begun, with households and businesses continuing to be cautious. Household balance sheets had become overstretched during the last economic boom, as households relied heavily on debt to fund their consumption and investment. Figure 2 shows that the household, business and agriculture sectors have all begun to shift away from debt-fuelled consumption and investment, with credit growth slowing or falling across the board.

The current outlook

Annual average real GDP growth is forecast to pick up over the coming year, increasing from 2.2% in the year to March 2011 to 3.4% in the following year. Real GDP growth in the first half of 2010 was more subdued than expected. In addition, growth in the September 2010 quarter is likely to have been held back by the Canterbury earthquake. Despite the impact of the earthquake on New Zealand's asset base, economic growth is expected to lift during 2011 as household and business spending growth picks up, reflecting higher labour income growth and the terms of trade remaining high.

Earthquake rebuilding activity will also boost growth in 2011. Both monetary policy and fiscal policy will continue to provide stimulus. Exports will benefit from robust trading partner growth, especially in Australia and emerging Asia, although the high New Zealand dollar will limit the ability of some exporters to take advantage of this.

While the recovery is expected to strengthen, its overall pace is expected to be more muted than in many past recoveries. The cautious approach of households and businesses is likely to continue for some time yet. The Government is also being cautious with its spending decisions and from 2011/12 the fiscal deficit will start to narrow. Fiscal policy, which has been stimulatory for several years, will be altered to a more neutral position.

Figure 3 - Global imbalances: current account balances in major economies
Figure 3 - Global imbalances: current account balances in major economies.
Source: Organisation for Economic Co-ordination and Development (OECD)

Globally, the economic picture remains fragile and patchy. While China and Australia are currently recording solid growth, the majority of the developed world economy is struggling to recover the output lost during the financial crisis. In many countries, the damage done to financial systems and household and government balance sheets means the global recovery is likely to be more drawn out than we have become accustomed to over the past few decades. As a result, global imbalances remain large and may even increase further (Figure 3). This poses a risk to future growth, including in China and Australia. Any slowdown in global growth would impact on New Zealand.

These global imbalances are showing up in significant exchange rate movements, particularly in countries with floating exchange rate regimes. This is one reason why the New Zealand dollar is being held up at relatively high levels. The mix of uneven growth and the high exchange rate is limiting the ability of New Zealand's exports to fill the gap left by weak domestic spending.

Figure 4 - Revenue and expenses
Figure 4 - Revenue and expenses.
Source: The Treasury

The economic outlook is a little weaker than expected at Budget 2010. Growth is lower this year on the back of a slower than expected rebound in household spending. Underlying economic growth is weaker over the 2011 and 2012 March years, although this is partially offset by earthquake-related rebuilding activity which pushes up growth in the June 2011 and June 2012 years. Nominal GDP is expected to be a cumulative $5.2 billion lower over the 2011 to 2014 period than expected at Budget 2010.

The revision to the nominal GDP forecasts, combined with a higher than expected build up of corporate tax losses, has resulted in the revenue that the Government receives from tax being lower than forecast at Budget 2010 by a cumulative $3.2 billion from 2011 until 2014. This will flow through to net debt, which peaks at a higher level than previously forecast. Figure 4 shows the forecasts of both core Crown revenue and core Crown expenses compared with Budget 2010. Core Crown expenses fall from 2010/11 and core Crown revenue steadily increases from 2010/11. The total Crown operating deficit, before gains and losses, is initially larger than expected at Budget 2010, and is now forecast to be 5.5% of GDP in 2010/11. This is largely explained by lower tax revenue in the near term, and one-off events, such as the recognition of expenses associated with the recovery from the Canterbury earthquake and the re-phasing of expenses associated with the Weathertight Homes package. Despite this, the operating balance, before gains and losses, is forecast to break even in 2014/15, with the first surplus of note being forecast for 2015/16.

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