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

Economic Outlook

… falling employment growth would add to downside risks further out in the forecast period

The reaction of firms to a period of weak profit growth is an important judgement underpinning the forecasts. During the period of weak profits described above, with the operating surplus component of nominal GDP forecast to fall in 2007, it is possible that employment growth will slow further or that firms will seek to cut employment in an attempt to maintain profit levels. The key judgement in the forecasts is that firms will make only small changes to their investment and employment plans.

Apart from periodic changes in tax rates and thresholds, for example in the 1997 and 1999 June years, source deductions tax revenue tends to track Compensation of Employees (COE), a measure of total labour income, fairly closely. We are already seeing source deductions growth in the 2006 June year in excess of that forecast in the Pre-election Update and have therefore increased the current-year source deductions forecast by nearly $200 million, slightly more than the upward revision to COE would suggest. This represents a 1% change in the forecast of this $20 billion tax type. Overall, the growth profile of source deductions revenue tracks COE fairly closely and the upward revisions to the out-years are largely due to the level increase in the current year.

Figure 1.15 – Source deductions tax revenue
Figure 1.15 - Source deductions tax revenue.
Sources: Statistics New Zealand, The Treasury

Weaker domestic demand sees import growth slow

The rate of growth in import volumes is forecast to slow sharply as household spending slows. As well as the direct impact of easing private consumption growth, the sharp slowing in residential investment is also forecast to add to slower consumption growth, with fewer durable goods needed to fit out new houses. The assumed depreciation of the exchange rate makes overseas travel more expensive, which is forecast to contribute to falls in services imports over much of 2007 and 2008. With business investment forecast to fall, imports of plant and machinery also decline. Altogether, import volume growth is forecast to decline to 0.7% and 0.6% in the 2007 and 2008 March years respectively. The closure of a major tobacco processing plant, scheduled for mid-2006, is likely to have a small, upward effect on imports and results in a switch of about $700 million per year from tobacco excise to customs duty.

Figure 1.16 – Inflation
Figure 1.16 - Inflation.
Sources: Statistics New Zealand, The Treasury

Inflation pressures are forecast to moderate as domestic demand cools

The short-term momentum in domestic demand ensures that inflationary pressures remain in the economy, with annual CPI inflation remaining above 3% until March 2007. A quarterly CPI increase of around 0.8% is forecast in December 2005 and a 0.6% increase in March 2006, with transportation, reflecting higher oil prices, and housing likely to make the largest contributions to inflation.

Inflationary pressures in the non-tradable sector are forecast to diminish as growth slows. This reflects an easing in the labour market and a slowing in domestic components of growth. The fall in the New Zealand Dollar contributes to higher tradable inflation over 2006.

If growth does not slow as quickly as forecast then pricing pressure in the non-tradable sector is likely to be maintained for longer. It is also possible that inflation will turn out to be more persistent than forecast, even if GDP growth develops as expected.

Figure 1.17 – Nominal GDP
Figure 1.17 - Nominal GDP.
Sources: Statistics New Zealand, The Treasury

An easing in inflation pressures and the forecast slowing in real GDP growth see nominal GDP growth fall to 2.9% in the year to March 2007 and 3.7% in 2008. This is a substantial slowing from growth of over 7% in the March 2005 year.

In the export sector the performance of the agricultural sector is an important judgement

The recovery in dairy production is likely to be later than previously forecast. Agricultural production was weak in the 2004/05 production season, resulting in falls in both meat and dairy exports in the year to June 2005. Weak dairy production was the result of a cold spring in 2004. In previous poor seasons that have been caused by climatic conditions, production has quickly recovered once conditions returned to normal. At the time of the Pre-election Update we expected production to return to normal in the 2005/06 season, leading to a sizable lift in export volumes.

Figure 1.18 – Export growth
Figure 1.18 - Export growth.
Sources: Statistics New Zealand, The Treasury

Discussions with the Ministry of Agriculture and Forestry suggest that the 2005/06 season is also likely to be affected by slightly adverse climatic conditions, further delaying the expected recovery in export volumes. The Central Forecast is underpinned by this outlook over the current season. We expect to see a small recovery in dairy production, leading to a small increase in exports over the course of the 2006, but the recovery is smaller than forecast in the Pre-election Update. The forecasts include some volatility, with merchandise trade data pointing to a sharp fall in dairy exports in the September 2005 quarter, some of which we believe reflects a degree of stock-building, which will boost exports in December.The forecasts assume growing conditions return to normal in the 2006/07 production season, with a subsequent strong lift in dairy exports.

The exchange rate appreciation of the last couple of years is forecast to constrain some other categories of exports

The exchange rate is another important determinant of export volumes, particularly for services exports. Visitor arrivals have been relatively flat in recent times, albeit with some volatility associated with the Lions rugby team tour of New Zealand. This flat period of visitor growth has fed into services export volumes. New Zealand has been a more expensive destination for overseas visitors, reducing the growth in visitor arrivals and limiting the average expenditure of visitors. Growth in services exports is forecast to be muted over the course of 2006 in response to the previously high level of the exchange rate.

Manufactured export volumes have also been weak over the last 6 to12 months. The transmission mechanism from the exchange rate is a little different from services exports. From our business talks we know that many manufacturing exporters try to maintain volumes even in the face of rises in the exchange rate, in order to maintain market share. However, volumes have fallen recently and are forecast to remain weak in the short term, with quarterly growth rates of around 1%, due to the impact of the exchange rate.

The outlook for the exchange rate poses some risks

The Central Forecast assumes that the exchange rate depreciates over 2006 and 2007 back towards its long-run average value. This appreciation is assumed to begin in the first quarter of 2006. Since the forecasts were finalised on November 18 the exchange rate has continued to appreciate. If the exchange rate appreciates further, or stays at a high level over 2006, this will pose some risks to the forecasts. Export volume growth is likely to be weaker than forecast while imports will be cheaper, and more attractive, increasing the likelihood of stronger import volume growth than forecast. Both of these factors would weaken real GDP growth and potentially see the current account deficit expand further. Inflationary pressures would be likely to be smaller.

The current account deficit narrows during 2007

The current account deficit is forecast to widen to around 9% of nominal GDP by March 2006. This reflects a combination of a forecast decline in the terms of trade, a weak outlook for export volumes and an on-going deficit on investment income due to strong domestic economic activity and solid profit growth of foreign owned firms. Over the rest of 2006 the deficit is forecast to narrow. Import volume growth eases with the slowing in domestic demand growth and export volumes lift, in part due to the depreciation of the exchange rate. Declining business profitability sees the investment income deficit narrow as the profits of foreign-owned firms decline.

Growth rebounds to 3% or above in March 2009 and 2010 years

Depreciation in the exchange rate and a return to normal agricultural growing conditions are forecast to contribute to a lift in export growth in the 2008 and 2009 March years. Manufactured exports and services exports are both forecast to pick up as the exchange rate depreciates, albeit with some lag.

This, together with some recovery in both residential and business investment, underpins a cyclical lift in GDP growth to 3.8% in 2009, before returning to close to 3% in 2010.

Business investment rises

With the outlook for growth and profits improving, firms lift their planned new investment. Employment growth also rises. However, there is a period of capital deepening where the capital-to-labour ratio increases as firms seek productivity gains from their existing workforce, with wage growth remaining solid, making capital more attractive. As a result, the supply-side contributions to growth change, with smaller contributions to growth from increasing labour and greater contributions from increasing labour productivity.

Effect of Tax Policy Changes on Tax Forecasts

Table 1.3 – Material changes in tax revenue forecasts owing to changes in tax policy since Budget Update

($ million)
Material policy changes          
Provisional tax dates - - 600 (600) -
GST-based provisional tax - - 160 (160) -
Total - - 760 (760) -

The implementation of the alignment of provisional tax dates with GST due dates and GST-based provisional tax calculation for small businesses has been delayed by one year.

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