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Budget 2017 Home Page Budget Economic and Fiscal Update 2017

Key Risks to the Economic and Fiscal Outlook

There is a range of risks to global economic, financial and political stability that may have material impacts on the New Zealand economy should they materialise. In the US, the extent and timing of fiscal stimulus is unclear while political challenges in progressing policy initiatives more broadly are also contributing to uncertainty. In China, the recent policy-driven pickup in growth is adding to already high levels of debt, which present a risk to growth. In Europe, the ability of many economies to achieve sustainably higher rates of growth remains unclear. The impacts of slower growth in the UK, the potential negative impacts of ongoing political debate about the future of the European Union and rising geopolitical tensions in some regions are further sources of uncertainty. Overall, the balance of international risks is skewed towards weaker outcomes, particularly over the medium term, than are incorporated into the main forecasts.

Disruption to global trade

Recent political developments in the US and parts of Europe highlight a weakening in the base of public support for continued trade liberalisation. Political debate on protectionist policy actions has intensified. A rise in trade protection poses the risk of a significant slowdown in global trade volumes and in global GDP. These effects could be compounded by the negative effects of increased uncertainty on investment and productivity growth.

Fiscal policy in the US

In the US, the economic outlook has been buoyed by the prospect of stimulatory fiscal policy. However, the details remain unclear and the process of reaching political agreement on the policy changes is at an early stage. At the same time, spare capacity in the labour market is limited, raising the risk of higher inflation. Nonetheless, as noted earlier, our forecasts for US growth and inflation incorporate an easing in fiscal policy over the next two years that lifts growth by around 0.5% points. It is possible that fiscal policy stimulus is larger than has been incorporated into forecasts, which could lead to higher US growth that spills over to higher global growth. On the other hand, the size and composition of fiscal policy easing may be more modest and less stimulatory for growth than assumed. There is also uncertainty surrounding US trade and immigration policy and the reaction of authorities in other countries to any policy changes.

Financial stability in China

Growth in China has been supported by significant policy stimulus in recent quarters. The impact of this support is particularly apparent in the housing market, where residential investment has accelerated, supporting demand for steel and other inputs. In the short term, the Government may continue to provide more support than expected in the main forecast. However, the recent stimulus has added to already high levels of debt that, combined with significant excess capacity in some sectors, increases the potential for a sharp slowing. The negative impacts on commodity prices, trade and capital flows would lead to slower growth in China’s main trading partners, including Australia and elsewhere in the Asia-Pacific region.

New Zealand's terms of trade  

New Zealand's terms of trade rose strongly in the final quarter of 2016, underpinned by higher international dairy prices. Some of the recent rise in dairy prices appears to reflect the negative effects of temporary weather-related factors on domestic output and lower prices are anticipated in coming quarters. Nonetheless, in the main forecasts the terms of trade remain at an historically high level. However, the terms of trade would likely weaken if the international outlook deteriorated.

Recent terms of trade scenarios

The terms of trade, which comprises the ratio of export prices to import prices, are one of the major economic channels linking New Zealand to the rest of the world. Typically, trading partner growth and the terms of trade move in the same direction, reflecting the impact of changes in external demand on export prices. Over the past few years, the risks to trading partner growth, and hence the terms of trade, have been skewed to weaker growth. Reflecting this skew, a number of recent scenarios in the Treasury's Economic and Fiscal Updates have incorporated a weaker terms of trade than in the main forecasts.

Figure 3.3 overlays past scenarios of lower terms of trade onto the current terms of trade projection. The fan chart, which is based on past forecast errors, shows the scenarios have encompassed much of the range of terms of trade movements experienced over the past 16 years. The most extreme terms of trade scenario is on the boundary of the 80th and 90th percentile fans, which means we would expect that in only 5 to 10 out of 100 occasions the actual outcomes will be below the scenario. In the most extreme scenario, the reduction in nominal GDP over the  forecast  period is around $40 billion and tax revenue is proportionately lower. Falls in the terms of trade also affect fiscal expenditures, chiefly owing to higher welfare expenses associated with a rise in the unemployment rate as domestic demand growth slows and employment growth weakens. The combined impact of lower revenues and higher expenses weakens the operating balance and increases the net debt-to-GDP ratio. In the most extreme scenario modelled by the Treasury, the ratio of net debt-to-GDP is around 7 percentage points ($23 billion) higher than in the main forecasts.

Figure 3.3 - Recent terms of trade scenarios
Figure 3.3 - Recent terms of trade scenarios.
Sources: Statistics New Zealand, the Treasury

Although the terms of trade are close to their recent 40-year high, they remain susceptible to unexpected weakness, which has broader implications for the economic outlook. The terms of trade scenarios modelled by the Treasury help to illustrate the important role of building fiscal buffers to help manage such events.

The Australian economy and developments in the labour market

Growth in Australia continues to transition towards non-mining sectors, supported by substantial monetary policy accommodation. Low interest rates have enabled households to borrow more and contributed to increases in house prices. Meanwhile, household income growth has been moderate, reflecting low wage growth and modest increases in employment. Reflecting these developments, household debt-to-income ratios have risen to historically high levels, making households vulnerable to increases in interest rates or to decreases in expectations of future income.

In the housing market, investment in medium-to-high density housing has increased rapidly, raising the risk of a sharper than expected decline in housing market activity. This could prompt a slowdown in consumption and a correction in house prices that generates a period of slower growth and higher unemployment. Conditions in the Australian labour market are a major determinant of the strength and direction of trans-Tasman migration flows. To the extent that the labour market in Australia is weaker than expected in the main forecasts, net trans-Tasman flows are likely to continue to support higher net migration inflows than expected.

Net migration

Net migration cycles are frequent and difficult to predict. Gross inflows and outflows often change at the same time, and may be driven by political and economic developments both domestically and internationally.

The current net migration upswing is significantly larger than usual, which is adding to uncertainty around the economic outlook (Figure 3.4). Migration inflows are supporting consumption and housing demand and adding to the risk of increased non-residential construction activity and public infrastructure investment, including on education and transport networks.

Figure 3.4 - Net migration 1952-2016
Figure 3.4 - Net migration 1952-2016.
Source: Statistics New Zealand

Net migration inflows may prove to be higher than assumed in the main forecast if the relative attractiveness of living and working in other locations, particularly Australia, is weaker than expected. However, stronger growth internationally, or shifts in domestic factors, may lead to sharply lower migration and slower GDP growth than projected in the main forecast.

Household consumption, saving and the housing market

Households' views about the outlook for their own income and wealth are important determinants of the consumption growth forecast, as are households' expectations around future interest payments and the availability of credit. New Zealand house prices have risen strongly in recent years and household balance sheets are characterised by high levels of debt relative to income. An unexpected rise in interest rates may lead some households to conclude that they have borrowed too much. To reduce their debt and their exposure to further interest rate increases, these households may reduce their consumption, perhaps quite sharply. Potential sources of unexpectedly higher interest rates include higher offshore funding costs for banks from a faster pace of monetary policy normalisation in the US, or renewed concerns around financial stability in Europe.

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