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Budget 2013 Home Page Budget Economic and Fiscal Update 2013

Downside Scenario

Prices weaker over the forecast horizon…

While there are a number of downside risks to real GDP growth, as outlined in the Economic Risks section, the downside scenario is based primarily on weaker inflation, both internationally and domestically. In this scenario it is assumed some of the judgements made in the central forecast turn out different than expected. In particular, it is assumed that the high exchange rate places more downward pressure on tradables inflation, inflation expectations are lower than anticipated resulting in decreased non-tradables inflation, and the terms of trade are lower than assumed in the central track owing to weaker global demand and a greater global supply response to expected growth in emerging market demand. These developments lower nominal GDP and tax revenue over the forecast period.

In the central forecast it is assumed that the deflationary impact of the recent appreciation of the exchange rate dissipates and becomes inflationary as the exchange rate begins to depreciate. This results in rising tradables inflation over the forecast period. In the downside scenario it is assumed that the deflationary impact of the high exchange rate is more persistent and keeps tradables inflation lower for a longer period than in the central forecast (Figure 3.1). The positive outlook for the New Zealand economy relative to other developed countries and an increase in monetary easing by advanced-economy central banks holds the NZD up, despite a lesser increase in short-term interest rates over the forecast period in response to the weaker inflation outlook.

In the central forecast it is assumed that the labour market partially recovers in the first half of 2013 from the weak employment results in the second half of 2012. In the downside scenario employment remains weak in the first half of 2013 as firms are still not confident enough in the recovery to take on permanent staff and the unemployment rate rises. This weaker labour market and subsequent lower wage growth, along with the current low headline inflation rate, help to contain inflation expectations. Lower inflation expectations, along with marginally weaker real GDP growth, result in less domestically-generated inflation.

Figure 3.1 - Tradables CPI inflation
Figure 3.1 - Tradables CPI inflation.
Sources: Statistics New Zealand, the Treasury
Figure 3.2 - Merchandise terms of trade (SNA)
Figure 3.2 - Merchandise terms of trade (SNA).
Sources: Statistics New Zealand, the Treasury

In the central forecast it is assumed that the goods terms of trade increase sharply over 2013. This increase occurs as the price of the commodities New Zealand exports, especially dairy products, rises with global supply being constrained owing to dry conditions in New Zealand and adverse weather conditions and increased feed costs overseas. Over the medium term it is assumed that growth in emerging market demand results in a slight upward trend in the merchandise terms of trade. In the downside scenario a lesser recovery in New Zealand's export commodity prices in 2013 is assumed as the price of dairy products is not as affected by adverse global weather conditions as first thought and a re-emergence of global risks dampens demand for commodities. It is also assumed that the global supply response to increasing emerging market demand is strong enough to contain price increases, resulting in a flatter merchandise terms of trade in the medium term (Figure 3.2).

…causing weaker nominal GDP…

The combination of lower tradables and non-tradables inflation, as well as weaker terms of trade over the forecast period, result in lower inflation compared to the central scenario. These weaker prices, along with slightly lower real GDP, reduce nominal GDP by $19 billion over the forecast period, compared to the central track. The lower terms of trade in the downside scenario weaken the goods trade balance over the forecast period which, along with the lower nominal GDP, increases the current account deficit as a percentage of GDP relative to the main forecasts. The current account balance reaches a deficit of 7.0% of GDP by March 2017, compared to 6.5% in the central track. The assumption of a weaker labour market mentioned earlier only reduces the unemployment rate to 5.6% by March 2017, compared to 5.2% in the central scenario.

…as well as lower tax revenue and operating balance

Core Crown tax revenue is a cumulative $5.4 billion lower over the forecast period in the downside scenario. A weaker inflationary environment means that nominal consumption and residential investment are lower, which reduces GST revenue by a cumulative $800 million over the forecast period. The weaker labour market and less inflationary pressure mean that worker incomes are also lower, which reduces source deductions revenue by $2.4 billion over the forecast period. The economy's weaker nominal activity means that business profitability is reduced, resulting in corporate taxes being a cumulative $700 million lower. Resident withholding tax is $600 million lower over the forecast period with interest rates needing to increase less than in the central forecast as inflation remains in the bottom half of the target band.

Core Crown expenses are slightly lower than in the central forecast as an increase in debt servicing costs is more than offset by a reduction in welfare payments. The reduction in welfare payments, despite incorporating a higher number of recipients of unemployment-related benefits, is driven by lower rate adjustments to benefits and superannuation, reflecting both lower inflation and wage growth. In this scenario, the return to surplus of the operating balance (before gains and losses) is delayed by two years until the June 2017 year (Figure 3.3) and, consequently, net core Crown debt as a proportion of GDP is still rising at the end of the forecast period (June 2017), reaching 30.3% at that time.

Figure 3.3 - Operating balance (before gains and losses)
Figure 3.3 - Operating balance (before gains and losses).
Source: The Treasury
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