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Budget 2007 Home Page Budget Economic and Fiscal Update [2007]

Economic Risks

There is uncertainty about the strength of domestic demand in the near term …

Figure 3.2 – Real gross national expenditure
Figure 3.2 – Real gross national expenditure
Source: Statistics New Zealand, The Treasury

Domestic demand was the major driver of growth in the New Zealand economy from 2002 to 2004, but its contribution to GDP growth has decreased in the past two years. However, growth in domestic demand – particularly private consumption – picked up in the final quarter of 2006, but the outlook depends on the reasons for the resurgence. Petrol prices fell nearly 15% in the final quarter of 2006 as oil prices fell and the NZ dollar strengthened, increasing disposable income and giving private consumption growth a boost. Although the level of consumption might be maintained, further falls in fuel prices would be required to lift growth in consumption again.

Another uncertainty is the impact of past interest rate increases on domestic demand. From late 2003 until recently, the effective mortgage interest rate has not increased by as much as the Official Cash Rate and 90-day rates. However, longer term rates have increased recently, affecting new borrowers, and the effective mortgage rate will continue to increase as borrowers re-finance at higher rates. It is uncertain when the effect of these changes will be felt and what impact they will have on domestic demand.

… and the sustainability of the recent increase in the terms of trade

The impact of the recent increase in the terms of trade (largely as a result of increases in dairy prices) is a further uncertainty. International dairy prices have increased by nearly 50% since late 2006, but it is not certain how sustainable these increases are and what effect they will have on the exchange rate, real incomes and consumption.

The future rate of growth in house prices is another uncertainty for domestic demand. In the past six years house prices have approximately doubled, boosting household wealth and supporting private consumption growth and encouraging further residential investment. There has also been an increase in household liabilities, leaving the household sector exposed to a slowdown in house price growth as well as increases in debt servicing costs.

There are both positive and negative risks associated with the strength of domestic demand, but the greater risk is that it will continue to be stronger or continue for longer than in the central forecast. A scenario is developed below which illustrates this risk, combined with a stronger terms of trade, and shows the consequent developments in the economy and the implications for tax revenue.

The exchange rate is an important influence on the economy …

In the central forecast we have assumed that the exchange rate will remain around its current level until early 2008 when it will begin to fall in response to lower interest rates and slower economic growth. However, the exchange rate is always a major uncertainty in economic forecasts and recent volatility has shown that sentiment can change quickly.

There are a number of factors which help to explain the recent strength in the NZ dollar and which are likely to continue to influence it in the forecast period. The large positive interest rate differential between New Zealand and some other countries (particularly Japan, but also the United States) has encouraged offshore investment in New Zealand. Recent increases in commodity prices have also sustained the NZ dollar. The rebound in domestic demand in the final quarter of 2006 and first quarter of 2007 is an additional factor supporting the NZ dollar currently.

… but its future path is uncertain

Figure 3.3 – TWI exchange rate
Figure 3.3 – TWI exchange rate
Source: Reserve Bank of New Zealand, The Treasury

The NZ dollar could appreciate further, especially against the US dollar if growth slows in the United States, or could remain strong for longer than assumed in our central case if export commodity prices remain strong or domestic demand remains robust. Such an outcome would further postpone the export recovery and narrowing of the current account deficit, and likely bring stronger domestic demand and higher non-tradables inflation.

It is also possible that the NZ dollar could fall sooner than assumed in our central forecast, most likely because of international developments. A scenario which explores the implications of a sharp fall in the currency sooner than in the central forecasts, in conjunction with weaker domestic demand, is developed below. Its effect on other parts of the economy and tax revenue is also explored.

The pace of growth in the world economy is a potential risk …

The world economy is currently in the mature phase of an expansion which began in 2002 with the recovery from the bursting of the “tech bubble” in the United States. Our central forecast assumes that trading partner growth will average 3.6% per annum over the forecast period, similar to its average for the past three years. However, there are risks to this outlook, mostly on the downside.

Interest rates are being tightened in most developed economies as inflation pressures emerge. Consequently there is a risk that growth might be weaker than assumed in our central forecast if, for example, inflation pressures become greater and further monetary tightening is required in the major developed economies. In addition, the housing market in the United States has slowed over the past year and problems have emerged in the sub-prime mortgage sector.

If these financial difficulties spill over to other sectors, perhaps combined with further monetary tightening, growth could slow dramatically. Although the performance of the Asian economies, particularly China, may not be as dependent upon the US economy as previously, there are doubts about the sustainability of the growth in the Asian region as inflation pressures develop there too.

… as are other international developments

Changes in international commodity markets can have a major impact on the New Zealand economy. The recent emphasis on bio-fuels in the United States has placed upward pressure on stockfeed prices with flow-on effects on dairy prices. To the extent that these price increases are sustained, they point to higher terms of trade for New Zealand and a higher equilibrium exchange rate with consequent benefits for real incomes.

International events can also affect the prospects for the New Zealand economy. Recent fluctuations in oil prices have shown the continued influence of political events, as well as the usual supply and demand factors. Changes in oil prices are directly reflected in local fuel prices and affect household disposable income and private consumption, as well as inflation. Increased costs also affect firm profitability and investment and hiring decisions.

Employment and investment decisions by firms are a key factor …

The response of firms to higher costs (including labour costs) and steady or lower profits will also be a key factor in the forecast period. In the central forecast we have assumed that employment growth will ease. However, continuing tight labour market conditions and a pick-up in domestic demand may lead firms to seek to expand employment further.

If employment levels or labour incomes were higher than in the central scenario, private consumption and residential investment would also be stronger. If firms are unable to find the labour they are seeking, they may increase their investment in plant and equipment even more than already assumed in order to increase productivity and output.

Similarly, the response of firms to the Business Tax Reform in this budget is an uncertainty. The impact of the changes on business costs is a key dimension likely to affect employment and investment decisions.

… and so are the responses of households to labour market conditions

The response of households to labour market conditions is also important. The fall in participation from its peak in the second half of 2006 may be related to weaker employment growth at that time, but may also reflect the effect of income support policies which impose high effective marginal tax rates. Lower labour force participation, for a constant employment level, would bring lower unemployment and a tighter labour market and may lead to faster wage growth than assumed in the central forecasts. While this might support total labour income – and private consumption – in the short term, it would adversely affect firm profitability. Lower participation also implies a lower potential growth rate for the economy as a whole and greater inflation pressure for a given rate of growth above that trend.

Underlying assumptions concerning productivity are an uncertainty …

The central forecast assumes that labour productivity growth will recover in the forecast period. Productivity growth has been weak recently as output growth has fallen without a commensurate change in labour input, typical of the mature phase of the economic cycle. In addition, unemployment has been below 4% since September 2004 and so the productivity of the latest workers hired may be lower than the existing workforce, detracting from aggregate productivity. Some firms may also be holding onto existing labour despite a fall in output, adversely affecting measured productivity.

However, we consider that labour productivity growth is likely to strengthen in the forecast period as a result of a reversal of these cyclical factors, as well as the beneficial effects of recent business investment. If these assumptions are not correct and productivity growth turns out to be lower than assumed, the potential growth rate of the economy will be lower and inflation pressures will be higher for a given level of output.

… as are assumptions concerning population growth

Another key assumption in our central forecast is the rate of population growth, with the net gain from external migration the main uncertainty. In the central forecasts we have assumed that net migration will decline gradually to its long-run average of 10,000 per annum by March 2010. There is a risk that migration will be lower in the short term as increasing departures of New Zealanders lowered the net gain to only 6,400 on an annualised basis for the March 2007 quarter. Lower net migration gains would affect both the potential growth rate (through its effect on labour supply) and short-term demand via consumption and residential investment.

There are also risks associated with some other types of events

There are also a number of non-economic risks which might impact on the development of the economy. Climatic events can affect agricultural production levels, both in New Zealand and in competing supplier countries with adverse or beneficial effects on returns to New Zealand producers. Similarly, agricultural diseases can have adverse or beneficial consequences for New Zealand producers, depending on how they affect them. Market perceptions arising from concerns about long-term climate change and environmental concerns may also affect the demand for New Zealand products.

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