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Budget 2008 Home Page Budget Economic and Fiscal Update 2008

3 Risks and Scenarios

Introduction

The forecasts presented in the Economic and Tax Outlook chapter incorporate a number of judgements about how both the New Zealand and the world economies evolve. Some judgements relate to the cyclical drivers of activity, others to the structural characteristics of the New Zealand and the world economies. These judgements have a number of risks surrounding them. In balancing these risks we have arrived at our view of how the economy is going to evolve, as presented in the Economic and Tax Outlook chapter.

The risks to our forecasts can be characterised as two types. The first are the risks we traditionally identify that could lead to more or less nominal GDP – examples of such risks include different profiles for the terms of trade, domestic demand and the exchange rate (see the 2007 Half Year Update, for example). Associated with this forecast, there is a second set of more extreme risks, albeit with a smaller probability, that would arise if recent financial market developments were more prolonged and severe than we have assumed in the main forecast.

The first part of this chapter, Economic Risks, focuses on describing both sets of risks around our forecasts and describing the possible impact on the economy if these risks were to occur. Given the significance of more prolonged and severe weakness in financial markets on the New Zealand economy and the Government's fiscal position, we consider such a scenario in the second part of the chapter. In such an environment, with high levels of risk aversion prevalent and confidence low, a significant gap would exist between the interest rates faced by borrowers and official policy rates both in New Zealand and abroad, slowing domestic demand and trading partner growth relative to our main forecast.

The third part of this chapter, Fiscal Scenarios, considers the implications of the alternative scenario for the fiscal position, while the fourth part, Fiscal Sensitivities, examines how sensitive the fiscal position is to changes in specific variables.

Economic Risks

A longer and deeper financial crisis poses downside risk to our forecasts …

As stated in the Economic and Tax Outlook chapter, the turmoil in international financial markets has worsened since the Half Year Update, with financial markets characterised by increased risk aversion and investor uncertainty. In our main forecasts, we have assumed a reasonably orderly resolution of the financial crisis in the year ahead. Figure 3.1 shows the Chicago Board Options Exchange Volatility Index. It represents one measure of the market’s expectation of volatility over the next 30-day period (a higher number means more volatility is expected). Since mid-March the index has been falling – consistent with the assumption in our main forecasts – but, as Figure 3.1 indicates, in the past year uncertainty has come in cycles with stresses intensifying and easing in waves. With risk appetite being so volatile in the current environment, further write-downs of debt and bank funding problems internationally could see the markets become even more risk averse. If the period of financial market uncertainty and risk aversion is more protracted and severe than expected, New Zealand could be affected in two main ways – a higher cost of credit to firms and households and a lower exchange rate.

Figure 3.1 – Chicago Board Options Exchange Volatility Index
Figure 3.1 – Chicago Board Options Exchange Volatility Index.
Source: Chicago Board Options Exchange

Banks operating in New Zealand have passed on some of the increased costs of funding their loans to New Zealand households and firms in the form of higher interest rates. Banks have also become more reluctant to lend to some firms in some sectors. In our main forecasts this contributes to the slowing in domestic demand which began late 2007, continuing throughout 2008. A further rise in interest rates (or in the more extreme case if credit availability becomes severely restricted) would mean the easing in domestic demand is sharper and longer than we have forecast.

Rising global risk aversion could exacerbate any depreciation of the currency. If, as assumed in our forecasts, the official cash rate moves towards a more neutral position, heightened risk aversion could cause large exits in carry trade positions.[4] A lower exchange rate would boost exports but would also likely slow consumption and business investment relative to our main forecasts as imports become more expensive.

Notes

  • [4]The carry trade is an investment strategy in which an investor sells a certain currency with a relatively low interest rate, eg, the Yen, and uses the funds to purchase a different currency yielding a higher interest rate, eg, the NZD. These transactions are leveraged, so a small movement in exchange rates can result in large losses.
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