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Budget 2005 Home Page Half-Year Economic & Fiscal Update 2005

Recent Economic Developments

The rate of economic growth has moderated …

Economic growth has slowed from over 4% through much of 2004 to 3.1% in the year ended 30 June 2005. The final two quarters of 2004 and the first half of 2005 have seen three quarters of below trend growth rates, with growth of 1.1% in the June quarter breaking the pattern of below trend out-turns. The June quarter result was stronger than the 0.7% expansion in activity forecast in the Pre-election Update.

… following a period of strong growth.

A variety of factors have contributed to a period of strong growth from 2000 to 2005:

  • The Overseas Trade Index measure of the terms of trade increased 9.7% from the beginning of 2003 to June 2005, through a period of accelerating world prices for New Zealand’s exports and declines in some categories of import prices, particularly plant and machinery imports. This has boosted incomes in the economy and reduced the cost of some investment projects.
  • Net migration inflows, which peaked at just over 40,000 in 2003, lifted domestic demand and labour supply.
  • A period of relatively low interest rates, compared with New Zealand’s historical experience.
  • Strong employment and wage growth and a low unemployment rate.
  • Rising household wealth due to house price increases.

On the supply side, labour utilisation growth has been strong in the 12 months to June 2005 while labour productivity growth has been subdued.

Much of the growth in GDP has come from increases in labour utilisation, with increases in working age population, labour force participation, average hours worked and a decline in the rate of unemployment. The contribution to GDP growth from growth in labour productivity in the year to June 2005 has been weak.

Sources of growth have deviated from forecast.

Headline GDP growth has been broadly consistent with the forecasts in the Budget Update and the Pre-election Update, slowing at a similar speed to forecast. The composition of GDP growth has however been quite different from forecast. Domestic demand growth has exceeded expectations, leading to strong growth in imports, while export growth has been weaker than expected. Imbalances and pressures have built up in the economy due to a sustained period of above trend growth and interest rates and the exchange rate have increased. A consequence of the recent growth performance is that the pressures have intensified, highlighted by rising inflation, an expansion of the current account deficit and a rise in household debt.

Figure 1.3 – Contributions to real GDP growth, first half of 2005 annualised
Figure 1.3 - Contributions to real GDP growth, first half of 2005 annualised.
Source: Statistics New Zealand, The Treasury

Figure 1.4 – Growth in export volumes

Figure 1.4 - Growth in export volumes.
Source: Statistics New Zealand

Recent growth has been constrained by a weak export sector …

Weak growth in export volumes has been one of the contributors to the slowing in GDP growth. Export volumes grew only 0.5% in the year to June 2005, compared with 4.4% in the previous June year. Agricultural exports were particularly weak, in large part due to a poor season of dairy production. Both dairy and meat export volumes recorded declines. A rising exchange rate dampened NZD prices, discouraging forestry export volumes, while the growth of manufactured exports has slowed in the face of a higher exchange rate. The effect of the exchange rate can also be seen in services exports where volumes increased less than 1% in the year to June, as it became more expensive for visitors to come to New Zealand.

… however, a strong labour market and buoyant housing market have helped sustain solid growth in domestic demand …

House prices measured in Quotable Value NZ data have increased 43.7% since the beginning of 2003, including solid rises during 2005, lifting household wealth, contrary to our expectations of an easing in price increases over the course of 2005. Meanwhile, growth in employment, which has seen the unemployment rate fall to 3.4% in September, has boosted incomes. These wealth and income effects have seen a sustained period of growth in private consumption and residential investment, despite some recent slowing in the growth of the latter, and have been coupled with a steady rise in household debt levels. Business investment has also increased as firms have sought to expand productive capacity during a period of strong demand and difficulty finding workers. Growth in real public consumption has also contributed to the strength in domestic demand, growing 5.2% in the year to June 2005. Non-market investment, largely through construction activity in a variety of infrastructure projects, has further contributed to domestic demand.

… leading to strong growth in import volumes.

Import volumes have been growing at double digit rates since the beginning of 2004 in response to strong domestic demand, a lack of spare capacity in New Zealand and the high level of the exchange rate. Growth has been broad-based with high capital imports on the back of growth in business investment and solid growth in imports of consumption goods.


In production terms the service sectors have provided the strongest growth

Over the year to June the service sectors have accounted for almost all of the growth in GDP, with the largest contributions coming from finance and business services, wholesale and retail trade and transport and communication, all reflecting strong domestic activity. The primary sector has made little contribution to growth, while the goods producing industries, with the exception of the construction sector, have subtracted from growth. Weak manufacturing performance, perhaps reflecting the effect of the high level of the exchange rate on exporters, has been one of the key reasons for the sluggish performance of the goods producing industries. These trends have been mirrored in the labour market, where most of the largest increases in employment between September 2004 and 2005 have come in the services sectors and in the construction industries. The levels of employment in the primary sector and manufacturing have both fallen.

Figure 1.5 – Contributions to production GDP growth
Source: Statistics New Zealand

There are growing signs of imbalances in the economy.

Growth in imports and weak exports have seen the deficit in the merchandise goods balance in the current account reach high levels, despite increases in the terms of trade. The strength in the domestic economy has translated into solid business performance and high profits, which have boosted corporate tax revenue but also expanded the deficit on investment income in the current account. All of these factors have seen the current account deficit reach 8% of nominal GDP in June 2005.

Increasing pressure on available resources, as suggested by high capacity utilisation and rising pricing pressures, with inflation increasing over 3%, together with the expansion in the current account deficit, suggest increasing imbalances and pressures in the New Zealand economy as was noted in the Pre-election Update. There has been little alleviation in these imbalances since the publication of the Pre-election Update, and if anything they have intensified.

Tax revenue has been marginally higher than forecast in the Pre-election Update.

Since the Pre-election Update forecasts were finalised, tax revenue has evolved broadly in line with forecast. However, some higher revenue flows than forecast are becoming evident in source deductions, fuelled by a strong labour market, and interest withholding tax, where we have previously underestimated the effect of relatively high domestic interest rates on the deposit base.

Although it is now starting to show signs of slowing, tax revenue is still growing at just under 10% per annum.

Imbalances in the Economy

Divergent growth in the economy

As discussed in the main body of this chapter, recent economic growth has featured a divergence in growth in different sectors of the economy. In expenditure GDP terms this has been highlighted by strong growth in elements of domestic demand, including household spending, market and non-market investment and public consumption, all lifting growth in Gross National Expenditure. Strong domestic demand has drawn in imports, while export growth has been weak, due to a combination of a high exchange rate and poor agricultural conditions. In production GDP terms the divergence is highlighted by the differing fortunes of the services sectors versus the rest of the economy. Almost all of the GDP growth in the last 12 months has come from the service sectors.

On-going strength in domestic demand, at above trend rates of growth, has gradually increased the pressure on available resources. This has shown up in a high level of capacity utilisation and firms facing difficulty finding skilled labour. In turn this has lifted pricing intentions as firms face rising costs, all of which has ultimately fed into rising inflation in the non-tradable sector.

Expanding household debt

Domestic demand has been partially funded by increases in income. It has also been funded from increased borrowing. Household debt has expanded sharply in the last few years, increasing to 158% of disposable income, compared with 136% in 2003.

Much of the expansion in debt has been more than matched by increasing house prices, such that household net wealth has increased. We do not believe that further gains in house prices can be sustained beyond the next couple of quarters. Vacancy rates have increased above historical levels and rental returns have not matched increases in prices, with many rental owners budgeting on future capital gains. We do not expect this to continue; indeed, prices are likely to decline a little as they move back in line with fundamental determinants, such as the growth of the population and income growth. This may leave some people, who have increased debt in the expectation of future capital gains, exposed to substantial debt servicing costs.

Widening Current Account Deficit

The current account deficit has expanded to 8% of nominal GDP. The current account can be analysed as the flow of goods, services and income, and the main body of this chapter touches on the influences of imports and exports on the current account. It can also be analysed as the difference between national saving and investment. From a saving and investment perspective, the increase in the current account deficit over the past few years has been due to a combination of a slightly lower national saving rate and increased investment in the economy. As a country, New Zealand has spent more than it has earned.

Figure 1.6 – Nominal investment as a proportion of GDP
Source: Statistics New Zealand

The government has been increasing its saving, which has been more than sufficient to meet its investment requirements. The expansion in the current account deficit has been due to the decisions and behaviour of people in the private sector. Growth in consumption has exceeded growth in income. On the investment side, the accompanying graph shows the pattern of nominal residential and other investment as a proportion of GDP, and suggests that much of the saving-investment shortfall has been due to growth in residential investment. With national saving not sufficient to cover New Zealand’s investment, the savings of foreigners have been required to finance the shortfall, raising net liabilities in the International Investment Position (IIP), which adds up all of New Zealand’s foreign assets and liabilities, to over 80% of GDP and lifting household debt.

We do not believe that such a current account deficit can be sustained indefinitely. It would imply an ongoing increase in the net liability position, with consequent increases in servicing costs that have to be met by New Zealanders. As an example, even in the current account outlook in the Central Forecast there needs to be a sizable capital inflow, which would be likely to increase the IIP position to 90-100% of GDP. Valuation changes mean that it is difficult to be precise about where the IIP will end up but this highlights that if there is no closing in the deficit then it is likely to expand even further. Such a level of the IIP would be difficult to maintain as it would be associated with an increasing share of national income devoted to servicing international liabilities. New Zealand has not been able to sustain prolonged deficits in the order of 8-9% in the past.

Imbalances forecast to unwind

While the imbalances are expected to remain in the short-term, they are eventually forecast to unwind due to an easing in domestic demand through private consumption, residential investment and business investment and an easing in house prices. The reaction of households to interest rate increases is a key component of this unwinding of imbalances. The fall in residential investment is particularly important. The judgement underlying the forecasts is that housing market activity has gone beyond what can be explained by fundamental drivers of activity. Certainly, household incomes have been rising and job security is strong. However, slower population growth would normally be expected to put some downward pressure on prices. In addition higher house prices for rental properties have not been justified by higher rents; weekly rents have risen barely faster than consumer price inflation, and far more slowly than house prices.

It is possible that there will be a more abrupt adjustment in the household sector, if for example foreign investors react to the high current account deficit, triggering a sharp fall in the exchange rate, or if households feel the effects of higher interest rates more severely and curtail spending more sharply.

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