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Budget 2016 Home Page Budget Economic and Fiscal Update 2016

Economic Risks

The key judgements underpinning the economic forecasts are subject to risks (see Key economic forecast assumptions box in the Economic Outlook chapter).

Global uncertainty has increased since the 2015 Half Year Update, reflected in heightened financial market volatility in the first months of 2016, and risks to growth in both emerging market and advanced economies remain skewed to the downside. Growth is expected to slow in China, other Asian economies, the US and the euro area.

There is risk of a sharper-than-expected slowdown in China, further impairing growth in other economies, particularly in the Asia-Pacific region, with a risk that growth in Australia remains below trend for longer. While recovery in most advanced economies, such as the US and euro area, is expected to continue, albeit at a slower pace, there are risks that global growth moderates further and slower growth becomes entrenched with a more prolonged period of low inflation and interest rates.

The realisation of any of these downside risks to the world economy would weigh on economic growth in New Zealand, materialising as lower demand and prices for New Zealand's exports as well as adversely affecting confidence. Economic stability, as well as financial market stability, faces risks from multiple sources, including the possibility of a British exit from the European Union, geopolitical tensions in the Middle East and elsewhere, terrorist attacks in Europe and uncertainty regarding the impact and efficacy of highly accommodative monetary policy, particularly in the euro area and Japan.

Risks to the domestic outlook are more balanced. Risks around high net migration, tighter labour market conditions, faster growth in house prices and ongoing resilience in consumption are balanced by uncertainty around inflation dynamics, and the continuation of rapid tourism growth which has provided significant offset to weakness in goods exports, particularly dairy.

Sharper slowdown in China a key risk to the outlook…

Annual GDP growth in China has fallen from over 10% in 2010 to 6.7% in the March 2016 quarter as the composition of growth shifts from investment towards consumption. Heightened concerns about growth in China contributed significantly to elevated global financial market volatility in early 2016. In addition, falls in the Chinese stock market and the depreciation of the Renminbi in mid-2015 and early 2016 increased concerns that the Chinese economy is weaker and more fragile than headline GDP indicates.

While global financial markets have calmed recently, risks remain skewed towards a sharper slowdown in China, which carries with it the flow-on impact of slower growth in other trading-partner economies, particularly in the Asia-Pacific region. A slowdown in China may be exaggerated if authorities do not support activity in order to avoid creating further imbalances, especially if the key risks of high levels of local government debt and a sharp downturn in the housing market increase.

Slower growth and heightened uncertainty about the outlook have been reflected in lower commodity prices, international trade flows, confidence and financial market volatility. A sharper slowdown would be expected to be transmitted as a more severe deterioration through these channels.

Over the medium term, risks around slower growth in China relate to how the transition from investment-led to consumption-led growth continues to evolve. The direct effect on New Zealand of a slowdown in China may be offset to some extent by the rebalancing towards consumption as the main driver of growth, as a successful transition could be positive for New Zealand by increasing Chinese demand for our mostly consumer-orientated primary products. That said, a sharp slowdown in China’s investment-led growth would weaken demand for hard commodities from Australia, lowering demand for their exports and in turn their income, directly affecting New Zealand.

…as well as further moderation of growth in advanced economies…

The outlook is for moderate growth in advanced economies. In addition to the flow-on impacts of slowing growth in China to other trading partners, risks to the Australian economy centre on a more gradual-than-expected transition in investment from mining to non-mining sectors, resulting in a longer period of below-trend growth. There is also some uncertainty about Australia's trend growth rate with slower population and productivity growth.

While the US recovery remains underway, the outlook is for more moderate growth in both 2016 and 2017, and consequently a more gradual tightening path for monetary policy. There remains some uncertainty around the possible unintended destabilisation of emerging market economies from tighter US monetary policy, but this has abated somewhat following the signalling of more gradual interest rate increases.

Likewise, the growth outlook for Japan and the euro area is for ongoing low and moderate growth respectively, with both economies facing policy challenges to stimulate demand.

…and with global inflation low…

Falls in oil and other commodity prices, as well as weak economic growth, have kept inflation low in most economies. Inflation excluding food and energy (ie, direct commodity price effects) remains below target in the major advanced economies, including the US. As interest rates in advanced economiesare close to zero (or below), in the event of further weakness in growth there is limited or no scope for further conventional monetary stimulus to provide a boost to demand.

Both the Bank of Japan and the European Central Bank have adopted quantitative easing and negative interest rate strategies in order to combat low inflation. However, there is much debate over the efficacy of negative interest rates as they are relatively untested and can lead to financial sector distortions.

…there is a higher risk that slower global growth becomes entrenched…

An outlook for slower growth leaves the global economy more exposed to negative shocks as it reduces the scope for fiscal and monetary stimulus (owing to a weaker fiscal position and/or lower policy rates than otherwise), and raises the risk that slow growth over the medium term becomes self-reinforcing. The combination of low inflation, low interest rates and slow growth over a prolonged period is sometimes referred to as “secular stagnation”.[13]

…and translates to weaker demand for key exports

The outlook for key exports, such as dairy and tourism, continues to be marked by uncertainty. Within the dairy sector prices are at low levels and are expected to recover only gradually. However, there is uncertainty about how international production will respond to lower prices, as there has been an increase in European production following the removal of the EU quotas, possibly owing to EU intervention prices distorting price signals. Global dairy production growth has been further supported by lower input costs from low oil and stockfeed prices and the strength of the US domestic dairy market. There is also uncertainty around the outlook for demand, particularly from China, and the removal of Russian import bans.

Visitor arrivals from China have been at all-time highs, supported by the depreciation of the New Zealand dollar in the middle of 2015 and the gradual loosening of travel restrictions in China, leading to robust growth in travel services exports. Similarly, arrivals on student visas from Asian countries are at high levels, although they have moderated slightly in recent months. A shift in travel preferences, significantly slower income growth and/or heightened uncertainty abroad pose risks to the outlook for both tourism and education services exports.

Weak inflation also a risk to the domestic economy…

The low inflation environment that characterises many advanced economies also characterises New Zealand. If weakness in global inflation continues, tradables inflation in New Zealand is likely to remain low. While the exchange rate depreciation in the middle of 2015 has provided a boost to tradables inflation, its impact is transitory. Over the medium term, tradables inflation is forecast to pick up to around 1% on average. However, this is heavily dependent on international developments as low global inflation will keep tradables inflation muted, all else equal.

In recent times, non-tradables inflation has been weaker than the long-term relationship with the output gap would suggest. In addition, inflation expectations are lower than previously, with persistent weak inflation weighing on expectations, offsetting the impact of a narrowing output gap to non-tradables inflation (see the box on Inflation in the Economic Outlook chapter).

While interest rate settings are considered stimulatory, it is not clear how far below neutral rates are. This is further compounded by possible changes in the sensitivity of businesses and consumers to low interest rates owing to heightened uncertainty in the current environment.If businesses and consumers are less sensitive to monetary policy than in the past, the boost to investment and consumption growth from low interest rates would be smaller than in the main forecast. In addition, heightened global financial market volatility, which characterised the early part of 2016, has increased funding costs for New Zealand banks accessing funds offshore. If global financial market volatility were to persist at high levels it would limit the pass-through of easier monetary policy settings, all else equal.

…and risk remains around the extent of the current migration cycle...

Annual net migration gains are assumed to begin declining from a forecast peak of 70,700 in June 2016 as labour market conditions in Australia improve and the New Zealand unemployment rate rises. However, it is difficult to gauge the strength and timing of these effects. If, for example, the Australian labour market materially improves in the near term, net migration inflows could decline more sharply than in the main forecast. On the other hand, the large inflow of students to date may suggest structurally higher permanent migration gains should more of those students remain in New Zealand.

...and the impact of net migration on housing and consumption

Housing demand is expected to be supported by high net migration and low mortgage rates in the year ahead. However, there is a risk housing demand and house price growth are stronger than in the main forecast, particularly given the risks around higher migration inflows. Faster nationwide house price growth than in the main forecast would boost household wealth and consumer confidence, possibly leading to higher consumption. Likewise, stronger housing demand could lead to stronger-than-expected residential investment growth. On the supply side, faster release of land for residential building in Auckland would lead to stronger housing construction than forecast. In addition, if the mobility of construction workers between Canterbury and other regions is greater than assumed, industry capacity pressures would be reduced and construction costs would be lower, supporting residential investment.

While faster house price growth presents a positive risk for economic activity, a sharp fall in Auckland house prices from an elevated level presents a downside risk to household wealth and therefore consumption, although this is unlikely without a major external trigger given the presence of strong economic fundamentals supporting demand. In addition, potentially higher household debt relative to disposable income presents a risk to financial stability as households will be more vulnerable to interest rate increases.


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