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Budget 2008 Home Page Budget Economic and Fiscal Update 2008

External Factors (continued)

Higher terms of trade as world dairy prices hold much of their recent gain …

Figure 1.6 – SNA goods terms of trade
Figure 2: A strong labour market.
Source: Statistics New Zealand, The Treasury

Despite developments in the world economy, the terms of trade follow a similar profile to the Half Year Update, with dairy continuing to dominate (Figure 1.6). As expected, the terms of trade rose sharply in late 2007 to their highest level since 1974 as dairy prices rose sharply. The outlook for the terms of trade became much more positive in 2007 as spot dairy prices rose by 120% in the year to August 2007. In April 2008, the ANZ dairy price index was down 10% from its peak in November 2007, but was still more than double its level of 20 months earlier.

World dairy prices for New Zealand products are expected to peak in the June 2008 quarter before declining from late 2008. The levelling off and decline in prices reflects increasing production from the United States (high dairy prices have more than covered the higher feed costs caused by increasing biofuel production), Europe (as production quotas have increased), Australia (recovery from drought), and “newer” producers (eg, Argentina, Uruguay, Brazil, Ukraine for export markets and China for the domestic market). High prices for consumer products will also reduce demand, leading in turn to lower prices. However, continuing strong demand for protein products from developing countries is expected to help maintain dairy prices, and thus the terms of trade, at high levels throughout the forecast period.

Prices for some other New Zealand exports are also expected to rise. World meat prices are expected to recover over the forecast period largely because of income growth in developing countries leading to demand for protein and supply reductions in Europe and Australasia. Prices for non-commodity exports are forecast to continue their upward trend in the forecast period as New Zealand manufacturers move out of low-end manufacturing into high-end or niche products, although this rise will be dampened by other countries such as China also broadening their manufacturing base towards the higher end.

… will be partially offset by higher oil prices throughout the period …

Figure 1.7 – WTI oil prices
Figure 1.7 – WTI oil prices.
Source: Datastream, The Treasury

West Texas Intermediate (WTI) oil prices are expected to be around 35% higher than in the Half Year Update across the forecast period (Figure 1.7). Based on futures prices, we expect oil prices to still be relatively high at US$100 per barrel at the end of the period. Income growth in China, the Middle East and other developing countries continues to underpin demand for oil, despite the recent slowdown in parts of the developed world. In addition, oil supply remains tight and geo-political events pose risks to prices. There are still upside risks to this forecast, at least in the short term, as oil prices rose over US$125 in May 2008, after these forecasts were finalised.

Higher oil prices will offset some of the increase in dairy prices on the terms of trade and, as discussed below, will lower the spending power of households. However, high oil prices are also a factor supporting world demand for dairy products owing to strong demand from oil-exporting countries, and have also been a positive for New Zealand exports of oil.

… and will bring a temporary reduction in the current account deficit

The higher terms of trade, particularly high dairy prices, are expected to bring a fall in the current account deficit to 6.7% in the year to September 2008. However, this fall will be temporary as the current account deficit will rise back to 7.4% of GDP once the terms of trade begin to fall. Although an export recovery leads to a fall back towards 6% of GDP by the end of the forecast period, this remains a large deficit and the main risk is of a smaller narrowing of the deficit. In particular, financial market turmoil has raised the funding costs of debt acquired overseas and, if it persists, higher funding costs could result in a wider investment income deficit.

Exports recover as drought eases and the world economy picks up …

Figure 1.8 – Export volumes
Figure 1.8 – Export volumes.
Source: Statistics New Zealand, The Treasury

The high exchange rate, the impact of drought conditions and weak trading partner growth are all expected to weigh on export volumes in the coming year (Figure 1.8). Export volumes in the year to March 2009 are expected to be down nearly 1% from the year before compared with a forecast rise of almost 3% in the Half Year Update. As dairy areas were particularly affected by drought, this fall will be driven by a fall in the volume of dairy exports. Services export growth is picked to remain relatively low with the high exchange rate making New Zealand a more expensive destination for overseas visitors.

Exports are expected to be a key driver of the rebound in economic growth over the year to March 2010. The turnaround in exports occurs as agricultural production recovers from the recent drought, with a strong rebound in dairy exports as dairy production was particularly affected by drought and will also benefit from further dairy conversions. Another positive for export growth will be higher economic growth among our trading partners of 3.6% per annum from the calendar year 2010. Export volumes are expected to rise by 4.0% over the year to March 2010 and this robust pace of growth will continue in the final two years of the forecast period, also helped by a decline in the exchange rate.

… and the exchange rate of the New Zealand dollar declines …

Figure 1.9 – TWI exchange rate
Figure 1.9 – TWI exchange rate.
Source: Reserve Bank of New Zealand, The Treasury

The TWI is expected to remain around 70 over the course of 2008 and depreciate from 2009 onwards (Figure 1.9). The exchange rate is expected to fall by around 20% over the forecast period as a result of a projected fall in soft commodity prices, a slowing in the New Zealand economy and a reduction in interest rate differentials versus the United States and Japan (as interest rates rise in those economies as they recover from weak growth and interest rates fall in New Zealand).

… as interest rates ease from 2009

Despite a slowing in the economy, short-term (90-day) interest rates are expected to remain around their current level of 8.8% until early 2009 because of ongoing inflation pressures in the economy and funding difficulties arising from turmoil in global financial markets. After a period of lower economic growth, resource constraints are expected to have eased sufficiently for the Reserve Bank to begin easing monetary policy in early 2009. Interest rates are also expected to be lower as we assume that financial market turmoil and credit constraints will gradually unwind over the year ahead.

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