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

Economic Scenarios

The following scenarios show how the growth path of the economy might evolve if some of the key judgements underlying the central forecast are altered. The scenarios are two of a large number of possible examples, and do not represent upper or lower bounds for the central forecast, with more extreme paths possible. They represent what are assessed to be two key risks to the central forecast and serve to illustrate the impact which relatively small changes in the assumptions underlying the forecasts have on some key variables, especially the fiscal aggregates.

In the first scenario, entitled “Higher terms of trade and stronger domestic demand”, a stronger terms of trade (in the form of higher export prices) in the near term, accompanied by stronger consumption and residential and market investment, raises real GDP growth in the near term but also increases inflationary pressures and postpones the current account adjustment.

The second scenario is entitled “A sharper fall in the TWI and weaker domestic demand”. The NZ dollar falls sooner than in the central forecast and domestic demand is weaker, leading to lower growth in GDP initially and an increase in tradables inflation. Subsequently, inflation is weaker, interest rates are lowered and the current account deficit adjusts sooner than in the central forecast.

Table 3.1 – Alternative scenarios: summary
  2006 Actual 2007 Estimate 2008 Forecast 2009 Forecast 2010 Forecast 2011 Forecast
Production GDP (annual average % change, year ending 31 March)            
Central forecast 2.0 1.7 2.6 1.6 2.8 3.1
Higher terms of trade and stronger domestic demand 2.0 1.7 2.9 2.3 2.6 2.8
Sharper fall in TWI and weaker domestic demand 2.0 1.7 2.2 1.3 2.7 3.4
Nominal expenditure GDP (annual average % change, year ending 31 March)            
Central forecast 4.6 4.4 5.6 3.5 4.2 4.8
Higher terms of trade and stronger domestic demand 4.6 4.4 6.4 4.6 4.2 5.0
Sharper fall in TWI and weaker domestic demand 4.6 4.4 4.8 3.4 3.9 4.5
OBEGAL ($billion, year ending 30 June)[1]            
Central forecast 8.6 5.5 5.0 4.0 3.5 3.3
Higher terms of trade and stronger domestic demand 8.6 5.6 5.6 5.0 4.4 4.1
Sharper fall in TWI and weaker domestic demand 8.6 5.5 4.4 3.4 3.0 2.7

Sources: Statistics New Zealand, The Treasury

NOTE:

  • [1] Operating balance before gains and losses. See Chapter 2 above for an explanation. The figures for 2006 are the OBERAC.

Higher terms of trade and stronger domestic demand

In the central forecast, the terms of trade (on an overseas trade index basis) are forecast to increase 3.6% in annual average terms in the March 2008 year. Most of this increase is an upward revision from the Half Year Update forecasts; in this scenario, the terms of trade are assumed to increase by a further 2% in the March 2008 year. The reason for this could be a more sustained increase in international dairy prices or a greater flow-through from the recent increases to the price received by New Zealand producers. As a result of the increased export prices, the exchange rate is assumed to be 3% higher in the March 2008 quarter. It is also assumed that there is greater confidence as a result of the higher terms of trade and more momentum in the economy than in the central scenario.

Table 3.2 – Higher terms of trade and stronger domestic demand scenario
(Annual average % change, year ending 31 March) 2006 Actual 2007 Estimate 2008 Forecast 2009 Forecast 2010 Forecast 2011 Forecast
Private consumption 4.3 1.7 3.6 2.8 1.2 1.0
Residential investment -4.7 -2.3 5.8 -1.3 -5.1 -0.0
Market investment 7.5 -4.6 6.6 5.5 1.3 0.8
Gross national expenditure 3.9 0.6 5.0 3.1 1.2 1.3
Exports of goods and services -0.3 3.1 0.4 3.4 3.8 4.2
Imports of goods and services 4.1 -1.2 5.5 5.2 -0.3 -0.2
GDP (production measure) 2.0 1.7 2.9 2.3 2.6 2.8
Employment growth 2.6 1.6 1.1 1.7 1.2 1.3
Unemployment rate[1] 3.9 3.8 3.9 4.1 4.0 4.0
90-day bank bill rate[2] 7.6 7.8 8.5 8.3 7.2 6.9
TWI[2] 68.3 68.8 72.0 62.8 55.6 52.8
CPI[3] 3.3 2.6 2.7 3.1 3.3 2.7
Current account balance (% GDP) -9.6 -8.6 -7.2 -8.1 -8.7 -7.3
Nominal GDP (expenditure measure) 4.6 4.4 6.4 4.6 4.2 5.0

Sources: Statistics New Zealand, Reserve Bank of New Zealand, The Treasury

NOTES:

  • [1] Percentage of labour force, March quarter, seasonally adjusted.
  • [2] Average for March quarter.
  • [3] Annual percentage change, March quarter.

In this scenario, private consumption growth is assumed to be stronger in the March 2008 and 2009 years than in the central forecast, as households respond to their higher real incomes and increased confidence; higher real incomes also lead to stronger residential investment in the first two years of the scenario. With stronger demand from households, firms increase their investment relative to the central forecast in the same period.

As a result of the stronger domestic demand, employment growth is approximately half a percentage point higher in the March 2009 and 2010 years and the unemployment rate approximately half a percentage point lower. Wage growth is higher than in the central forecasts and the greater strength in the labour market reinforces the stronger domestic demand.

Export volume growth in this scenario is assumed to be slightly lower than in the central forecast because of the effect of the higher exchange rate inhibiting growth in non-commodity and services export volumes. Import volume growth responds rapidly to the increased private consumption and business investment to be slightly higher in the March 2008 year and 3.0% higher in the March 2009 year. GDP growth is higher in the first two years of the forecast period.

The stronger domestic demand leads to higher inflation and more persistent inflation pressures. Consumer price inflation is 0.7% higher in March 2009 and 1.0% higher in the following year. Increased inflation pressure results in tighter monetary policy and 90-day interest rates are half a percentage point higher in the March 2008 quarter and do not fall as rapidly in the following year, remaining at 8.3% in March 2009, 1.6% points higher than in the central scenario. Even with this monetary tightening, inflation remains half a percentage point higher in the final year of the forecasts.

The monetary tightening, however, brings about a slowing in domestic demand. Private consumption, residential investment and market investment all grow more slowly in this scenario in the final two years of the forecast than in the central forecast. Import growth is also lower in this period, but so is real GDP growth. Nominal GDP growth receives a boost of approximately 1% in each of the first two years of the projection period as the higher real GDP is boosted by higher inflation, but is practically unchanged from the central forecast in the last two years as lower real GDP growth offsets the higher inflation.

The stronger domestic demand, especially increased demand for imports, leads to a slower adjustment in the current account deficit. Net investment income outflows also increase as firm profitability increases with the stronger domestic demand. The deficit increases in the March 2009 and 2010 years, reaching 8.7% of nominal GDP in March 2010, 1.8% points higher than in the central forecast. It declines slightly in the following year as GDP growth falls below the central forecasts, but remains at least one percentage point higher at 7.3% of GDP. A continuation of current account deficits at such a level is unsustainable, suggesting that further adjustment will be necessary in the future.

Figure 3.4 – Current account
Figure 3.4 – Current account
Source: Statistics New Zealand, The Treasury

Because of the stronger growth in nominal GDP in the early part of the forecast period, the level of nominal GDP is higher throughout the whole forecast period. The cumulative increase over the period to March 2010 is $11.6 billion, with an increase in the final year of $3.7 billion. This higher level of nominal GDP leads to higher tax revenues throughout the period.

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