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Budget 2015 Home Page Budget Economic and Fiscal Update 2015

Economic Risks

The balance of risks to global growth continues to be skewed to the downside. Growth in China slowed in 2014 as housing demand weakened, and growth in Australia remained below trend. The US recovery remains on track despite moderating in early 2015, and US monetary policy settings are expected to tighten, which may have the unintended effect of increased volatility in emerging markets. Growth in euro area activity has picked up from a low level, but deflationary risks persist. Downside risks remain around the demand for New Zealand's key commodity exports, and global inflation may remain weak for longer. The realisation of any of these downside risks to the world economy would weigh on growth in the New Zealand economy.

The outlook for domestic demand continues to be solid, with household spending and high net migration presenting upside risks. High household confidence may facilitate a larger boost to consumption from the low inflation environment than in the central forecast. Stronger demand and GDP growth in New Zealand relative to other countries, compared to our central forecast, could sustain a longer period of elevated net inward migration, which would further boost domestic demand in the economy.

Risks to China's growth outlook continue to be tilted to the downside...

Risks to the growth outlook for China continue to be skewed to the downside, with GDP growth in 2014 (7.4%) just below the government's target (7.5%). Annual growth in the March 2015 quarter fell to the government's 2015 target of 7.0%. Housing demand has continued to weaken, resulting in house price falls across the major cities. The housing market slowdown reinforced concerns over the high level of informal banking credit and local government debt. China's growth could slow more sharply than in the central forecast if financial adjustment results in significantly tighter credit conditions.

The People's Bank of China has continued to ease monetary policy, but the extent of stimulus has been relatively limited so far. While policymakers want to prevent a sharp slowdown in the economy and stabilise the housing market, excessive stimulus would lead to the build-up of future risks. Structurally, China is rebalancing its economy away from investment- and export-led growth towards private consumption. Rebalancing is expected to lead to slower overall growth in the short term, but should deliver more sustainable growth in the long term. A successful rebalancing into more consumption-based growth would be positive for New Zealand by increasing Chinese demand for our primary products.

...which could hinder the recovery in the Australian economy...

A sharp slowdown in China's growth would weaken external demand for other Asian economies. Lower Chinese demand would also impact on Australia's export sector, particularly mining and agriculture. Iron ore prices have already fallen 50% since mid-2014. Growth in Australia is expected to be below trend in the near term, and risks to the Australian economy (apart from the flow-on effect from China) centre on a slower-than-expected rebalancing of growth from mining investment to investment in the non-mining sectors. Continued muted growth in labour productivity and firm profitability could dampen employment and wage growth, leading to weaker household demand than expected. Lower export earnings and a sharp depreciation in the Australian dollar would also reduce real incomes and spending. As one of New Zealand's largest trading partners, a more prolonged period of soft growth in Australia would clearly impact on the New Zealand economy.

...and US monetary tightening may expose emerging market vulnerabilities...

The US economy has continued to recover from the global financial crisis, driven by growth in consumption and investment. Despite a moderation in the recovery in early 2015, the US Federal Reserve is expected to raise its funds rate in the second half of the year. Thereafter, monetary tightening could be faster than in the central forecast if US domestic demand turns out to be stronger than expected. This could lead to the unintended consequence of a disorderly global financial market adjustment, especially in emerging markets.

In an environment of very low interest rates, global asset prices have risen to levels that may not reflect economic fundamentals. As monetary tightening begins in the US, higher US bond yields and a more entrenched recovery would raise the attractiveness of US assets. This could lead to large capital outflows from emerging markets including Asia, as well as tighter credit conditions and volatility in their exchange rates. Growth would fall in some of New Zealand's key trading partners, in turn reducing the demand for our exports.

...contributing to risks of prolonged weakness in global commodity demand

Risks to the outlook for global commodity prices are, on balance, skewed to the downside. Crude oil prices were down 50% in April 2015 from June 2014, and a key judgement underpinning the central forecast is a slow recovery in oil prices (see the box on “Commodity prices” in the Economic Outlook chapter). Oil prices would remain low for longer than in the central forecast if any international risks weaken demand, and/or competition intensifies between oil producers in the Middle East and North America. On the other hand, geopolitical uncertainty in the Middle East and Ukraine could lead to greater volatility in oil prices.

The prices of other hard commodities, such as iron ore and copper, and soft commodities including dairy, may fall further or remain at their current low levels for longer than expected. Lower commodity prices than in the central forecast would reduce key export prices and export revenues for New Zealand. Lower commodity prices would also dampen global inflation and increase deflationary risks in some of the major economies, particularly the euro area and Japan.

Euro area deflationary risks persist despite a pick-up in growth

The growth outlook for the euro area economy has improved from 2014, but significant risks remain around the high levels of sovereign debt and the robustness of the banking sector in the peripheral economies. In particular, the risk of a Greek default is assessed by the market to have increased as the Greek government and its EU partners experienced difficulty in agreeing on the terms of a further bailout programme.

Meanwhile, deflationary risks remain high as lower petrol prices drove headline inflation below zero, which may reinforce low inflation expectations. A flare-up of debt concerns or a fall into deflation could stifle the euro area recovery. It remains uncertain how effective the European Central Bank's quantitative easing programme will be at boosting inflation and growth.

Weak global demand would reduce key commodity export prices...

The effect of lower commodity prices on New Zealand's terms of trade would depend on the relative size of price declines between commodity exports (especially dairy) and imports (primarily crude oil). Given a larger weight for commodities in exports than in imports, and the possibility of weaker demand from Asian markets, the risks to the terms of trade are tilted to the downside. Lower terms of trade than in the central forecasts, owing to weakness in export prices, particularly dairy, would reduce export receipts and weigh on incomes and spending in the agricultural sector. Agricultural production beyond 2015 may also be negatively affected to an extent. Lower spending by the agricultural sector could lead to second-round impacts on other sectors, suppressing consumer confidence and demand in the wider economy.

...and global inflation may remain low for longer and suppress domestic prices further...

The inflation outlook is weak over the year ahead in spite of solid growth in domestic demand. If prices for crude oil and other commodities remain at a low level for longer, this would flow through to lower domestic petrol prices and inflation. A more prolonged period of low inflation in the major economies than expected, including the euro area and Japan, would suppress global price pressures, which could put further downward pressure on the prices of tradable goods and services in New Zealand.

A separate risk for inflation originates from the estimation of the economy's productive capacity (the maximum level of activity that can be achieved while maintaining stable inflation). If potential output is higher than estimated, the output gap (the difference between real GDP and potential output) would be smaller. As a result, inflationary pressures would be weaker than anticipated. Under these circumstances, the Reserve Bank may hold stimulatory monetary policy settings in place for longer than currently expected. If potential output is lower than estimated and fast growth continues, inflation could pick up earlier, prompting the Reserve Bank to increase rates sooner.

Scenario one explores the above risks further, through simulating the economic impacts of lower terms of trade for longer than in the main forecast as a result of weaker world demand. Weak global demand is also reflected in a prolonged period of low inflation in this scenario.

...but higher net migration than forecast would boost domestic demand...

Net migration gains remain elevated and judgements around the extent of the cycle play a key role in the forecasts. The annual net inflow of migrants is forecast to peak at around 57,000 in June 2015, up from a forecast peak of around 52,000 in March in the Half Year Update. A stronger domestic labour market than forecast or weaker conditions in the countries to and from which significant migration occurs could result in a higher peak level of net migration than in the central forecast, which may also last for longer. Higher net migration would be likely to continue to include fewer departures to Australia.

The impact of higher migration inflows on the wider economy will depend on the balance between increased arrivals and reduced departures. The contribution of new arrivals to net migration gains has increased over the past year, which points to a larger initial boost to demand than to supply in the economy. This development contrasts with 2014, when reduced departures drove net migration gains. New migrants are likely to require time to adjust to the New Zealand labour market. At the same time, higher migrant arrivals than in the central forecast would put additional pressure on the housing market and boost private consumption.

...and low inflation environment may provide larger boost to consumption

Low inflation also poses some upside risk to the central forecast of domestic demand through lifting the purchasing power of households. The extent of the demand boost would depend on the magnitude of the impact on real incomes, the response from the Reserve Bank and household decisions on saving and spending. Should firms' wage-setting behaviour remain relatively unchanged despite low inflation, real wage growth would be higher, contributing to a larger boost to household consumption. The Reserve Bank may hold the Official Cash Rate (OCR) at an historically low level for longer than in the central forecast, or even reduce the OCR. Lower interest rates and higher consumer confidence would also lead to a larger boost to household spending and business investment, which would flow through to faster growth in real and nominal GDP than in the central forecast.

Potential housing market adjustment and risks around the Canterbury rebuild

Housing demand is expected to be supported by net migration and low mortgage rates in the year ahead. However, housing demand might be weaker or stronger than in the main forecast, particularly given the risks around migration inflows. Declining nationwide house prices would reduce growth in residential investment and erode some households' wealth. Faster nationwide house price growth than in the central forecast would boost residential investment, as well as household wealth and consumer confidence.

The Canterbury rebuild may provide a smaller contribution to growth than in the central forecast. The size of the residential rebuild may be smaller than expected, as uncertainty persists over the number of households leaving Christchurch after settling their insurance claims. At the same time, housing supply may be gradually catching up with demand. The commercial rebuild may also be slower over the next couple of years than expected, as the commencement of large commercial buildings is taking longer than anticipated despite the basic infrastructure rebuild being well underway.

Uncertainty on labour productivity presents risks for the medium-term outlook

The assumptions on labour productivity growth have significant implications for the medium-term real GDP forecasts. Slower labour productivity growth over the medium term than in the central forecast would result in lower real income growth in the later years of the forecast period. This would result in lower domestic demand than projected, and slower growth in both real and nominal GDP. Conversely, faster labour productivity growth would lead to higher GDP growth.

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