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Budget 2008 Home Page Budget Economic and Fiscal Update 2008

Economic Scenario

In this section, a scenario is presented to represent a situation where the downturn in financial market developments is more severe and protracted than in our main forecast and this impacts on the growth path of economies worldwide. In the scenario, the severity of the financial downturn leads to a lack of confidence and a high level of risk aversion in financial markets, meaning a significant gap exists between the interest rates faced by borrowers and official policy rates in both New Zealand and abroad. Monetary measures in key global economies, especially the United States, are therefore not successful in their attempts at boosting real economies. While this is a relatively extreme scenario, with a low but not negligible probability, such a development would have significant impacts on the global economy and New Zealand and would have major implications for the New Zealand Government's fiscal position.

Figure 3.4 – Real GDP
Figure 3.4 – Real GDP.
Source: Statistics New Zealand, The Treasury
Figure 3.5 – Real GNE
Figure 3.5 – Real GNE.
Source: Statistics New Zealand, The Treasury
Figure 3.6 – Nominal GDP
Figure 3.6 – Nominal GDP.
Source: Statistics New Zealand, The Treasury
Figure 3.7 – Inflation
Figure 3.7 – Inflation.
Source: Statistics New Zealand, The Treasury

Such a scenario could have the following consequences (expressed relative to the main forecast):

  • As a result of investor uncertainty and risk aversion remaining higher in financial markets until the March 2011 year, banks operating in New Zealand face significantly higher funding costs. These increased funding costs are passed on to firms and households as higher borrowing costs. Financial markets begin to normalise again in the March 2012 year.
  • Key trading partners experience slower growth for longer, including slower growth in emerging Asia, which has so far been largely unaffected by developed country weakness. Trading partner growth is about 1 to 2 percentage points lower in each year until the March 2011 year than currently assumed in our forecasts, before recovering to similar levels as in our main forecasts in the March 2012 year. Lower trading partner growth reduces demand for exports, particularly commodities and tourist services.
  • The heightened uncertainty means New Zealand households become more cautious in their spending behaviour and firms are reluctant to invest.

Domestic demand is weak in this scenario …

Relative to the main forecast, higher interest rates – owing to a longer period of more pronounced risk aversion in financial markets – make mortgage debt servicing difficult for a larger number of households and property investors. For the majority of households, higher debt servicing costs reduce disposable incomes, lowering consumption. However for some households (and more than in the main forecast) the strain of servicing this debt would mean they are forced to sell their home or investment property. More houses on the market would lower house prices and lower the demand for the construction of new housing. Residential investment is therefore weaker for longer in this scenario, falling cumulatively by 23% in the forecast period until the March 2011 year.

Figure 3.8 – Real private consumption growth
Figure 3.8 – Real private consumption growth.
Source: Statistics New Zealand, The Treasury

Real private consumption undergoes a period of weak growth (around 1%) throughout the forecast period owing to higher mortgage servicing costs reducing discretionary incomes, falling house values lowering perceptions of wealth and collateral, households engaging in more precautionary saving (particularly of the tax cut) as the result of global uncertainty and a lower exchange rate making imports more expensive.

In this scenario, firms face less demand for their products as a result of weak domestic and international markets. Lower demand, coupled with higher borrowing costs, a lower exchange rate (increasing the cost of importing plant and machinery) and heightened uncertainty mean business investment is cumulatively 14 percentage points lower across the forecast period than in our main forecast.

Slower domestic demand means that firms lower their demand for labour, resulting in a contraction in employment, slower wage growth and a higher unemployment rate than the main forecast. The weaker labour market reinforces the slowdown in the domestic economy.

Domestic demand recovers in the March 2012 year as financial markets recover lowering the risk premium on interest rates. A lower risk premium, combined with looser monetary policy, results in lower market interest rates, which boost private consumption and investment.

… as is the export response, leading to slower real activity …

Weaker domestic demand and a lower exchange rate slow import growth until the March 2010 year resulting in a narrowing of the current account deficit to 4.5%. The narrowing of the current account deficit is somewhat muted by increased debt servicing costs as higher world interest rates result in a larger investment income deficit.

From 2010 the lower exchange rate helps to drive the rebound in exports of goods and services but a softer world economy than in our main forecasts means the response of exports to the lower exchange rate is somewhat muted (see Figure 3.9). The response of exports of services (including tourism receipts) to the lower exchange rate is particularly weak as the slower global economy reduces discretionary incomes available for travel.

Figure 3.9 – Real exports
Figure 3.9 – Real exports
Source: Statistics New Zealand, The Treasury

The weak domestic economy means real GDP growth is sub 1% in the March 2009 and 2010 years. Real GDP growth does rebound to 2.8% in the 2012 March year – although still below trend – owing to lower market interest rates boosting domestic demand and stronger exports as the world economy recovers and the exchange rate is lower.

… lowering inflation …

CPI inflation averages 2% across the forecast period in this scenario as opposed to around 2.9% in the main forecast. Lower inflation is mainly driven by a weaker domestic economy lowering non-tradables inflation. While the sharp depreciation of the exchange rate does lead to an increase in tradables inflation, it is limited somewhat by a weaker economy, meaning firms facing increased import prices are not able to fully pass through cost increases. The lower inflation pressures see official interest rates cut significantly more than in the main forecast but this does not fully translate into lower market interest rates owing to the heightened risk aversion in the financial markets. The exchange rate depreciates more sharply than in the main forecasts as slower economic growth and relatively lower domestic interest rates make the New Zealand dollar less attractive.

… leading to less nominal GDP

Lower consumer price inflation, coupled with a weaker real economy, results in slower nominal GDP growth throughout the period and therefore the level of nominal GDP is a cumulative $34.4 billion lower, resulting in lower tax revenues across the whole period. See the Fiscal Scenarios section for more details.

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