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Budget 2008 Home Page Budget Economic and Fiscal Update 2008

1 Economic and Tax Outlook

Introduction

This chapter outlines our view of the most likely path for the New Zealand economy and the expected impact on tax revenue over the next four years. The first part of the chapter discusses the recent course of the economy and focuses on what has happened since the Half Year Update. The second part of the chapter examines the external and domestic factors that are expected to influence the economy over the forecast period.

There is an unusual amount of uncertainty associated with the current economic and tax outlook. In addition to the usual upside and downside risks to any forecast, there are risks that have a low probability of happening but may have a significant negative impact on the economy should they eventuate. The key risks are introduced in this chapter and are discussed in more detail in the Risks and Scenarios chapter.

Recent Economic and Tax Developments

The economy picked up in 2007 ...

Figure 1.1 – Real GDP
Figure 1.1 – Real GDP.
Source: Statistics New Zealand

The New Zealand economy experienced an upturn in 2007. Quarterly real GDP growth averaged almost 1% in the five quarters to December 2007, up from ¼% in the previous five quarters, and annual average growth rose to 3.1% in 2007, the fastest pace since mid-2005 (Figure 1.1). The economy has now expanded in each of the nine years since the recession of 1997/98 and, with annual growth averaging 3.5% over this period, has outperformed the OECD average of 2.6%. The drivers of this strong performance have been well canvassed in the past (see pages 19-20 of the Half Year Update 2007).

The economy evolved broadly as expected in the second half of 2007 relative to the Half Year Update forecasts (finalised in early November 2007). Excluding data revisions, real expenditure GDP in the December 2007 quarter was 0.1% higher than expected as a result of higher business investment and exports, while both private consumption and residential investment slowed as expected.

… but appears to have slowed in early 2008 …

Economic growth had been expected to slow in the Half Year Update, but several factors have had a greater negative influence on the economy in early 2008. There are signs the slowdown in housing activity has been faster and larger than expected, drought conditions have affected agricultural production, the world economic environment has weakened, credit availability has tightened and oil prices have risen further. As a result, real GDP is expected to fall slightly in the March 2008 quarter and modest quarterly growth of 0.3% to 0.4% is forecast during the remainder of 2008.

… as the slowdown in the housing market has been faster and larger than expected …

Figure 1.2 – House prices
Figure 1.2 – House prices.
Source: Quotable Value New Zealand, The Treasury

The slowing of property activity has been faster and larger than forecast (Figure 1.2). House prices were forecast to rise 6% in the year to June 2008 in the Half Year Update, but are now forecast to fall 2% over this period and decline further the following year. These house price falls represent a correction after house prices nearly doubled since 2002. Weaker property activity was precipitated by higher mortgage interest rates, lower net migration inflows and declining affordability, and has already contributed to a slowing of consumer spending. Risks to house prices are mainly on the downside and are examined in the Risks and Scenarios chapter.

… drought conditions lowered agricultural production, especially dairy …

Another negative event since the Half Year Update is the emergence of drought conditions. The current climate setting, reflecting the influence of a strong La Niña weather pattern that appeared at the end of 2007, brought dry conditions to much of New Zealand through until April 2008.

Agricultural production in 2007/08 is expected to be around 1% lower than the year before because of the drought. The largest impact is likely to be on dairy production as dry conditions have been most severe in dairy regions such as Waikato, which accounts for around a third of the country’s dairy cattle. Drought has led dairy farmers to dry off poor-performing cows, use high-cost supplementary feeding and move to once-a-day milking, although greater use of irrigation has helped insulate dairy farmers from dry conditions in areas such as Canterbury. For sheep and beef farmers, the drought is expected to have increased culling and exports in early 2008, but exports will then fall away and remain subdued as farmers look to rebuild their stock.

Although rainfall in April has eased the drought situation significantly, the full impact of recent dry conditions on the economy is uncertain. The extent to which the drought will also impact on next year’s agricultural production, and on other aspects of the economy such as electricity generation, will be dependent on future rainfall and winter weather conditions.

… and the outlook for the world economy weakened amidst financial market turmoil

Other significant developments since the Half Year Update relate to world events. Data from the United States have been weak, with concern the United States economy may be in recession. Economic data have also been weak in other major economies, including Europe and the United Kingdom. In response to developments in the United States, the Federal Reserve has reduced its official interest rate by 225 basis points since January and the United States Congress passed a US$168 billion fiscal stimulus package.

Financial market turmoil in the second half of 2007, combined with continuing weakness in the United States housing market, has led to further difficulties in the financial sector of the United States. Some financial institutions have been exposed to losses from sub-prime mortgages (ie, loans made to people with poor credit histories) and the risk of credit downgrades increased the need for banks to raise and hold higher amounts of capital. Large losses have also been announced by European financial institutions.

Equity markets have reacted nervously to economic and financial market developments with stock markets down significantly from levels that prevailed late last year. The risk of flow-on effects from these developments in major developed economies to other parts of the world was highlighted by large falls in Asian and Australasian equity markets.

Figure 1.3 – Interest rates
Figure 1.3 – Interest rates.
Source: Reserve Bank of New Zealand

There are several channels by which recent developments in the world economy can affect New Zealand. The most immediate is through financial markets. Commercial interest rates have risen because of the risks associated with investments in sub-prime mortgages in the United States, raising the cost of credit globally. The borrowing costs of New Zealand banks have risen as a result, which, together with some restoration of margins by banks, has seen 2-year fixed term home loans in New Zealand rise by over half a percentage point since September 2007 to above 9.5% (Figure 1.3). There will be a larger increase in mortgage interest rates faced by those people rolling off existing lower mortgage rates (eg, the 2-year mortgage interest rate in March 2006 was around 7.8%). Higher interest rates are contributing to a slowing in consumer spending, housing activity and business investment. Other transmission channels by which developments in the world economy can affect New Zealand are less direct and immediate and are examined in the next section covering the economic outlook.

Some key factors have been, and will continue to be, positives for the economy

There are some positive factors that supported the economy in the second half of 2007 and in early 2008. The most important of these, the terms of trade, rose to a 33-year high in late 2007 mainly as a result of higher dairy prices. A number of factors lifted dairy prices in 2007 (eg, income growth in developing nations, drought in Australia, biofuel production competing for land use and rising grain prices) and they have held up well despite the weaker global economy. The boost to national income from high dairy prices is, in aggregate, expected to more than offset the negative impact on the economy from drought and the reduction in the spending power of households from higher food prices. The rising terms of trade have also contributed to a fall in the current account deficit from 8.6% of GDP in the year to December 2006 to 7.9% in the year to December 2007, as forecast in the Half Year Update, with a further fall to 6.7% expected in the year to September 2008.

The labour market has been another positive factor. With the unemployment rate falling to a 21-year low of 3.4% in late 2007, labour market conditions were slightly tighter than expected in the Half Year Update. Ongoing high wage growth and relatively low unemployment mean the labour market will likely remain a positive influence throughout most of 2008, although data released since the forecasts were finalised suggest there are downside risks to labour market conditions (see Risks and Scenarios chapter for more discussion).

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