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Budget 2013 Home Page Budget Economic and Fiscal Update 2013

Risks and Scenarios

Overview

  • Relative to the Half Year Update forecasts, the risks to the Budget Update central forecasts are more balanced, mainly owing to receding extreme global downside risks. However, significant global economic risks remain and are slightly skewed to the downside. The underlying euro area government debt problems still exist, there are risks around how the US manages its fiscal consolidation and the effects of developed-country monetary easing remain uncertain.
  • Domestically, uncertainties surround some of the key judgements in the economic forecasts and are slightly skewed to the upside. These judgements include the size and pace of the Canterbury rebuild, the path and pass-through of the exchange rate, the saving behaviour of households and the impact of the drought.
  • The more balanced profile of risks is demonstrated by the upside and downside scenarios being broadly symmetrical. In the downside scenario nominal GDP is $19 billion lower over the forecast period based on lower inflation internationally and domestically. The upside scenario results in nominal GDP being $19 billion higher over the forecast period and is driven by stronger-than-expected house prices which results in more complementary consumption spending, along with increased pricing pressures in the construction industry. The scenarios are based on their impact on nominal GDP and tax revenue over the forecast period.
  • If these economic risks or any significant deviations from the central forecast were to eventuate they would impact on the Government's fiscal performance and position. These economic uncertainties also pose risks to the Government's debt servicing costs. The fiscal uncertainties are illustrated by the downside and upside scenarios. Core Crown tax revenue is $5.4 billion lower over the forecast period in the downside scenario and the operating balance (before gains and losses) reaches surplus two years later, compared to the central forecast. Core Crown tax revenue is a cumulative $6.6 billion higher in the upside scenario and a larger surplus is recorded in the 2015 June year, compared to the central forecast.
  • The Crown's financial position is also exposed to risks from its balance sheet. The largest source of balance sheet risk is volatility in asset and liability values owing to movements in market variables such as interest rates, exchange rates and equity prices. These may result in operating balance impacts.

Introduction

The first part of this chapter outlines the key risks to the economic outlook. These risks mainly relate to the key judgements associated with the central forecast. In the second part of the chapter, upside and downside scenarios are presented which represent just two possible ways the New Zealand economy could deviate from the central forecast. The chapter then focuses on the established channels between the risks facing the economy and the Crown’s fiscal position.

Economic Risks

Risks to the forecasts have become more balanced…

In recent Economic and Fiscal Updates, risks around the central forecasts have been skewed to the downside, mainly owing to the relatively high probability associated with a negative global shock occurring as the euro area debt crisis evolved. The height of these elevated downside risks was shown in the Pre-election Economic and Fiscal Update 2011, where an upside scenario was not included in order to demonstrate that there was a much higher probability of a downside scenario occurring. Since then, downside risks have become less prevalent to the point where risks are now fairly symmetrical around the central forecast. The more balanced nature of risks is illustrated by the upside and downside scenarios having similar-sized impacts on nominal GDP and tax revenue.

…with extreme global downside risks receding…

The more balanced profile of risks mainly relates to a lower probability of a severe internationally-generated negative shock occurring. The euro area debt crisis has settled down somewhat, the US avoided the “fiscal cliff” and China is experiencing a relatively modest slowing in growth. Definitive decisions by officials have lessened the risk of disorderly default or break-up of the euro area. This has included Ireland, Greece and Portugal all receiving funding packages from the IMF and European organisations, while the European Central Bank (ECB) has pledged to “do whatever it takes” to keep the euro area together, including buying sovereign bonds.

More recently, Cyprus has participated in a partial “bail-in”, where large uninsured depositors have to take losses on their deposits in order for Cyprus to receive funding from the IMF and European Union. In the US, Congress was able to avoid the “fiscal cliff”; there will still be significant fiscal consolidation, including payroll tax increases and government spending cuts (“the sequester”), but not at the level feared by market participants if negotiations had failed. The Federal Reserve has also pledged to keep policy easing in place until the recovery becomes entrenched, reducing downside risks. Fears of a sharp slowing in growth in China have mostly been averted, with real GDP growth reaching a trough of 7.4% on a year earlier in the September quarter of 2012 and rebounding slightly to 7.9% and 7.7% in the December and March quarters respectively.

…but global risks remain…

While the extreme negative risks from the euro area debt crisis have receded, significant global risks remain and are still somewhat skewed to the downside. In the central forecast it is assumed that governments and officials continue to do what is necessary to avoid a disorderly default by a euro area country but that growth in the region remains weak as fiscal consolidation weighs heavily on activity. The probability that the crisis will worsen significantly has fallen recently owing to actions taken by organisations, including the ECB and IMF. However, escalation of the euro debt crisis would further dampen growth in the region and cause financial market turmoil, with spillover effects on the rest of the world.

More generally, the effects of fiscal consolidation and monetary easing by major advanced economies remain uncertain. The US and euro area must undergo significant adjustment to reduce government debt. Japan, the US and the UK are currently undertaking significant quantitative easing programmes to stimulate their economies through the purchase of financial assets. An example is the Bank of Japan pledging to double the size of its balance sheet over the next two years in order to achieve its 2% inflation target. This has driven the yen lower and boosted Japanese asset markets. How these changes flow through to the real economies remains uncertain.

…including for New Zealand's major trading partners…

One of the main risks associated with New Zealand's largest trading partner, Australia, is the source of growth after the peak in mining investment has passed this year. It will take some time for the exports associated with this investment to ramp up, requiring increased residential and non-mining business investment to maintain Australia's recent strength in economic growth.

China has grown in importance to the New Zealand economy, now being our second largest trading partner. The risk of a significant slowing in growth, as Chinese authorities tried to clamp down on rising asset prices, has eased recently. However, risks remain of a correction in the housing market, following the recent run up in prices, and the build up of poor quality debt over the recent investment boom. China is also attempting to rebalance its economy away from export- and investment-led growth, towards consumption. Faster progress towards this goal would benefit New Zealand as a major supplier of soft commodities, including dairy products.

…which, if they eventuate, would impact on the New Zealand economy

If any of the global downside risks eventuate, demand for New Zealand's exports would be lower; the opposite is true of upside risks which are considered now to be almost as likely. For products whose production is responsive to demand, including services and manufactured exports, lower world growth would depress demand and decrease export volumes; whereas for other products with supply constraints, including agricultural exports, the main impact would be through lower prices.

Downside global developments would also have a negative impact on domestic confidence and asset prices. Higher risk aversion in response to negative developments would result in more cautionary behaviour by households, which would be expected to lead to lower asset prices and less willingness by consumers to commit to major purchases. The result of these developments would be lower private consumption, while more caution on the part of firms would decrease business investment and employment as they are less willing to commit to expenditure in a more uncertain environment.

Negative global developments would increase the level of uncertainty faced by financial market participants and lower the amount of risk they are willing to take on. This would flow through to reduced availability, and higher cost, of credit for New Zealand. The effective repricing of risk would increase the borrowing costs of New Zealand banks, which they would pass on to customers. However, there is room for the RBNZ to provide liquidity as needed and lower the base interest rate to mitigate the impact of higher funding costs on the interest rates faced by households and businesses. This is different from the majority of other developed-country central banks that are at the zero lower bound of interest rates and are undertaking alternative policy (eg, quantitative easing) to ease monetary conditions.

Risks surround key judgements relating to the domestic economy…

Offsetting the somewhat negatively skewed global risks, upside risks are slightly more prevalent for the domestic economy. Domestic risks mainly relate to the key judgements that have been made in the forecasts about the size and timing of the Canterbury rebuild, the level and flow through of the exchange rate, household saving behaviour and the developments of monetary policy. In addition, the impact of the drought, the current amount of spare capacity in the economy and the current underlying strength of the labour market remain uncertain.

...including earthquake rebuilding...

The timing and extent of the Canterbury earthquake rebuild is difficult to forecast, as an event of this magnitude has never occurred before in New Zealand. The key determinants of the speed the rebuild can ramp up and be sustained include insurance settlements and the capacity and capability of the construction sector. These factors provide both upside and downside risks to the rebuild assumption influencing the central forecast (see the “Investment Associated with the Canterbury Rebuild” box [Chapter 1, page 15] for more information). If insurance settlements and construction capability progress faster than expected, residential and non-residential construction, imported goods volumes and employment would all be stronger than in the main forecast. There is also a risk that the Canterbury rebuild puts more upward pressure on prices, which is explored further in the upside scenario.

Another risk to the forecasts is how much the Canterbury rebuild crowds out activity in other parts of the economy. New Zealand has limited construction capacity, which will be added to through inward migration and the importation of capital goods, a significant part of which will be taken up by Canterbury. So while the Canterbury rebuild is a major driver of growth over the forecast period, in its absence other parts of the country would use some of the construction industry's capacity to increase activity.

...as well as the exchange rate...

A major change in judgement between the Half Year Update and the Budget Update is the evolution of the exchange rate. Previously, it was assumed that a significant fall in the New Zealand dollar (NZD) would occur over the forecast period owing to most measures suggesting a large over-valuation. However, this depreciation has not occurred yet and other factors, including looser monetary policy in major advanced economies and a positive growth outlook for New Zealand relative to other developed economies, have supported the NZD. The forecast for the NZD has therefore been held higher for longer on a trade-weighted basis. A risk to this forecast is that the over-valuation of the NZD leads financial market participants to sell the currency, resulting in a lower exchange rate than in the central forecast. A lower exchange rate would increase tradables inflation, as imported goods would become more expensive, and discourage consumption of imported products. On the other hand, exporters and import-competing businesses would become more competitive, boosting manufacturing and services exports and production of import substitutes for the domestic market.

…and household saving behaviour

In the central scenario it is assumed that households are fairly comfortable with the current state of their balance sheets and spend close to what they earn, resulting in a saving rate around zero over the forecast period. There is a risk that households show less restraint than anticipated; for example, households use the increased house prices that are forecast to fund consumption through housing equity withdrawal as occurred over the early-to-mid 2000s. This sort of behaviour is explored further in the upside scenario. This would result in consumption rising faster than disposable income, with the shortfall being funded by rising debt, and cause the saving rate to be more negative over the forecast period. While this would be positive for GDP growth in the near term, owing to a boost to private consumption, it may require a sharper negative adjustment in the medium term as households become more indebted and may need to repair their balance sheets.

Policy developments could turn out different than expected…

Macroeconomic policy developments remain uncertain, with macro-prudential policy being added to the uncertainty surrounding interest rates. The central forecast assumes that short-term interest rates begin rising in the June quarter of 2014, in line with market pricing at the time the forecasts were finalised. If recent strong growth in house prices were to spill over into more generalised price increases through wealth effects, an earlier increase in interest rates may be required. This could put further pressure on the exchange rate to appreciate and dampen domestic demand. On the other hand, if rising credit growth in order to finance house purchases and related consumption pose a threat to financial stability, macro-prudential tools may be used to stem the credit growth.

…as could the drought…

The effects of the recent drought on the economy are uncertain, particularly its impact on nominal GDP. Previous droughts have coincided with adverse global events such as the late-1990s Asian financial crisis and the late-2000s global financial crisis, which make it difficult to isolate the impact of each drought episode on the economy. The impact of this summer's drought on the economy is discussed in the “Economic Impacts of the Drought” box (Chapter 1, page 17). While rainfall has recently increased, given the weakened condition of the dairy herd going into the winter, a return to drought conditions would be particularly damaging and would impact on growth in the 2014 calendar year. A cold, dry winter could also reduce lambing rates next season to a greater extent than assumed, and may also negatively affect hydro-electricity generation which would be negative for GDP if producers switch to more costly thermal generation. The impact of the drought on prices is also a key uncertainty. If global dairy supply conditions remain tighter than assumed, dairy prices may be supported at a higher level next season than anticipated. There are also potential second round impacts to consider if changes in incomes resulting from the drought alter spending behaviour.

 …and other key judgements

Labour market data have been volatile recently and movements in the Household Labour Force Survey have appeared at odds with other indicators. For more information see the “Recent Labour Market Conditions” box (Chapter 1, page 21). If the assumption that modest employment growth will resume in the first half of 2013, following recent labour market weakness, is incorrect and employment remains weak, the unemployment rate could rise rather than be flat as is forecast. This would result in more spare capacity and lower wage pressures in the economy, creating less domestically-generated inflation. Related to this, the current amount of spare capacity in the economy (the output gap) is uncertain. If the output gap is more negative than the 1.0% of potential GDP estimated in the December quarter of 2012, there will be less domestically-generated inflation, but a greater cyclical increase in real GDP, than we have incorporated in the central forecast.

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