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Budget 2014 Home Page Budget Economic and Fiscal Update 2014

Economic Risks

Domestic demand has grown faster than anticipated in the Half Year Update, with the economic expansion becoming more broad-based and embedded. Key areas of uncertainty remain, including the speed of the Canterbury rebuild and its wider economic implications, the reaction of households to higher debt servicing costs, and the scale of the current migration cycle and its impact on domestic demand.

Despite improvements in the prospects for some advanced economies, the balance of global risks remains skewed to the downside, with emerging economies having underperformed relative to expectations. Global economic developments may lead to adjustments in the demand for our main commodity exports and therefore affect the terms of trade (the prices of goods and services New Zealand exports relative to those that it imports) which were at a 40-year high in the December 2013 quarter. If a number of adverse global developments were to occur simultaneously, New Zealand could experience a rapid and sizeable negative adjustment in commodity prices and national income.

Other key assumptions made in the forecasts around the level and flow-through of the exchange rate, the amount of spare capacity in the economy and monetary policy developments all represent areas where deviations from forecast can exacerbate or dampen the current economic cycle.

The pace and scale of the Canterbury rebuild remain uncertain…

There is still some uncertainty around the timing and magnitude of the Canterbury rebuild. Key determinants continue to be the pace of the settlement of remaining insurance claims and the capacity of the construction sector.

While the resolution of insurance claims has continued to progress, there are risks that the greater complexity of remaining claims could slow the rate of settlement. The availability of skilled labour will also impact on the pace of reconstruction if specific skill shortages act as bottlenecks in the construction industry. If the rebuild were to progress more slowly, residential and non-residential investment and employment growth could all be weaker than reflected in the main forecast.

The Canterbury region will account for a greater share of GDP than in previous construction booms and regional resource pressures will act to crowd out activity in other parts of the economy. Inward migration and imports of capital and materials may help to alleviate local capacity issues and will mitigate some of the upward pressure on prices in both Canterbury and the wider economy.

...as does the sensitivity of households to increasing interest rates...

Figure 3.1 - Composition of residential mortgage lending
Figure 3.1 - Composition of residential mortgage lending.
Source: Reserve Bank

After a sustained period of historically low rates, the Reserve Bank has increased the OCR from 2.5% to 3.0% with the aim of returning it to neutral levels in the medium term and then increasing it even further by 2016. It is difficult to anticipate the sensitivity of households to higher debt servicing costs. This is in view of already elevated debt levels and high exposure to interest rate increases, with a large number of households on floating or fixed mortgages of less than one year (Figure 3.1). Households could exercise more or less spending restraint than is anticipated in the main forecast. If consumption growth were to outpace income growth, then the shortfall may have to be funded by increasing levels of debt. On the other hand, if households exercise more restraint, debt levels would be lower but consumption growth would be weaker.

…and net migration's effect on domestic demand remains uncertain

Stronger employment growth in New Zealand relative to Australia and a more positive outlook have reduced the number of New Zealand resident departures, while the Canterbury rebuild has contributed to more permanent and long-term arrivals. The annual net inflow of migrants is now forecast to peak at around 38,000 in the second half of 2014 compared to a forecast of around 26,000 in the Half Year Update. The impact on the wider economy of stronger rates of net migration will depend on the skill sets of the migrants and their geographic distribution. If the migration cycle is larger than forecast it would put additional pressure on the housing market and add further impetus to domestic demand. However, higher migrant inflows to Canterbury would mitigate some of the capacity risks associated with the rebuild.

If, for any reason, key factors such as those outlined above played out differently than assumed in the main forecast and impacted on the inflation outlook, then the Reserve Bank's setting of monetary policy would be responsive to those different conditions. Interest rates could rise by more or less and the pace of tightening could be faster or slower depending on the direction of change.

Global downside risks persist…

In addition to the migration channel, global developments can also impact the New Zealand economy through both trade and financial channels. For example, strong Chinese demand for our key commodity exports has contributed to the terms of trade reaching a 40-year high, improving incomes and supporting the exchange rate at high levels. Risks posed to the outlook for key trading partners, and global financial settings in general, are all factors that can lead to rapid changes in the economic outlook for New Zealand. Overall, the balance of global risks remains skewed to the downside. Geopolitical risks have also increased, with Russia's annexation of Crimea creating ongoing diplomatic tensions with the West and greater uncertainty in financial markets.

…as weak emerging-market fundamentals exposed…

In January, the US Federal Reserve began the tapering of its asset purchase programme. Expected rises in US bond yields contributed to capital outflows from emerging market economies and sizeable depreciations in exchange rates. Generally, borrowing costs for countries that have become accustomed to favourable global lending conditions in recent years have increased. Both the monetary policy responses (that are likely to magnify the higher costs of capital) and the higher capital cost itself, will act to constrain growth in emerging economies. The most fragile countries, with the largest imbalances and high inflation, account for only a small share of New Zealand's export demand. Contagion to other emerging market economies could impact New Zealand more significantly.

Importantly, Asian economies have larger foreign exchange reserves than they did prior to the Asian financial crisis in the late 1990s, as well as floating exchange rates, which make them more resilient to these market pressures.

…and risks to New Zealand's key trading partners remain

Our largest trading partner, China, would largely be immune to the risks outlined above because of its capital account restrictions. However, domestic risks to the growth outlook for China remain. The property investment and construction boom that stimulated Chinese growth following the global financial crisis was fuelled by rapid credit growth. Concerns around the high level of local government debt, the quality of lending in the shadow banking sector and exposure of financial institutions to housing market vulnerabilities persist. Chinese growth could slow more quickly than in the main forecasts if financial market disruption resulted in significantly tighter credit conditions.

Structurally, China is looking to rebalance its economy away from investment-led growth towards private consumption. Rebalancing could lead to slower growth in the short term, particularly if this transition is disorderly. As consumption's share of output increases and the purchasing power of Chinese consumers improves, demand for New Zealand's soft commodities, such as dairy, will strengthen and help maintain prices at high levels.

Australian data continue to show signs that demand is picking up as the economy transitions from growth in mining investment to growth in the non-mining sectors and exports. However, the labour market remains subdued and the unemployment rate has remained steady at around 5.8% for the past year. Australia remains exposed to a slowdown in China and emerging market economies, which would reduce demand for its hard commodities, such as iron ore. This channel could be a source of indirect effects on the New Zealand economy.

Upside risks to US growth are also apparent with the recent weakness in US data largely a result of the harsh winter. A large amount of investment activity has been deferred since the global financial crisis and the stock of capital has aged. A more rapid movement to capital investment could be a source of upside surprises to growth. Likewise, households have deferred purchases of durable goods over this time. That said, a stronger US economy would further exacerbate the risks to emerging economies if expectations of a faster withdrawal of monetary stimulus were to develop.

Euro area recovery exposed to deflationary risks

Inflation in the euro area has been on a declining trend since late 2011 as peripheral economies rebalance and attempt to achieve renewed competitiveness. Large negative output gaps also mean that pricing pressures remain subdued. In the absence of adequate policy responses, Europe could enter a period of sustained low inflation, increasing the risk of deflation. If long-term inflation expectations fall, demand and output would follow, stifling the euro area recovery.

Other risks around key judgements

Economic relationships are complex and judgements need to be made about key economic variables such as the exchange rate. For example, a higher exchange rate relative to forecast would decrease tradables inflation, as imported goods would become less expensive, and encourage the consumption of imported products. On the other hand, exporters and import-competing businesses would become less competitive, hindering manufacturing and service exports and production of import substitutes.

Recently, pasture conditions have been drier than usual in the North Island, with feed yields down from last year. Although there has been ample rain in most of the country in April, if dry conditions return, agricultural production could again act as a drag on gross domestic product as it did in the first half of 2013. Feed prices and availability amongst New Zealand's international competitors will also influence global supply and have a strong bearing on global commodity prices and the path of the terms of trade.

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