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Budget 2006 Home Page Half Year Economic & Fiscal Update 2006

Recent Economic Environment

… with net exports the key reason for the divergence from forecast

The easing in domestic demand described above has broadly matched the forecasts in the Budget Update. Private consumption declined 0.4% in the June quarter, with high petrol prices in the quarter acting to constrain spending.

Figure 1.4 – Annualised contributions to half
year growth
Figure 1.4 – Annualised contributions to half.
Source: Statistics New Zealand, The Treasury

Strength in net exports (exports minus imports) has been the source of the upside surprise to forecasts. The decline in the exchange rate early in 2006 appears to have boosted services exports. However, much of the upward surprise has come from dairy exports. The 2005/06 dairy production season started poorly owing to cold conditions in the spring of 2005. Favourable conditions at the end of the season boosted production, with Fonterra announcing a record production season. This helped boost dairy exports, together with what looks to have been a run-down of dairy stocks in the June quarter, with a 20.3% increase in dairy exports volumes in the June quarter greatly exceeding the lift in production.

Weaker domestic demand, together with the decline in the exchange rate making imports more expensive, saw import volumes fall in the March and June quarters after also falling in December 2005. This easing in imports was sharper than the gradual easing forecast in the Budget Update.

GDP is estimated to have increased 0.6% in the September quarter

After declining 0.4% in June, private consumption is estimated to have increased 0.7% in the September quarter. Residential investment is also expected to post a small gain in the September quarter after declining in June, with building consent data pointing to some rebound in activity in the second half of the year. In the external sector, export volumes are estimated to have recorded another rise in the quarter, albeit not as large as the 4.7% increase in June. However, as in the June quarter, some of the dairy exports look to have been met by running down inventories, which will detract from growth in the quarter. Import volumes are estimated to have been relatively flat in the quarter, recording only a small increase. These components are estimated to add-up to GDP growth of 0.6% in the quarter.

The labour market has remained stronger for longer than expected …

Employment growth in the first half of 2006 was stronger than forecast in the Budget Update, growing at or over 1% in each quarter and taking annual employment growth to 3.1% in June 2006. Employment growth has been substantially stronger than economic activity more generally. One result of this is that productivity growth, measured on a total economy basis, has been particularly weak, with little growth since the middle of 2004. The September quarter saw some signs of an easing in the labour market with employment falling 0.4%, suggesting that activity in the labour market is becoming closer to activity in the rest of the economy. The labour force participation rate fell from its record high of 68.7% to 68.3% and the unemployment rate rose to 3.8% from 3.6% in June. The central track incorporates some further easing in the labour market during 2007, with employment forecast to be flat.

… contributing to continued growth in tax revenue

Strong demand for labour boosted annual wage growth to close to 5% in September 2006, with firms continuing to report difficulty finding skilled staff. This growth in wages, together with the growth in employment, has led to growth in labour income of close to 8%, boosting source deductions tax revenue growth to just over 8%.

Figure 1.5 – Difference from forecast by tax
Figure 1.5 – Difference from forecast by tax.
Source: Inland Revenue Department, The Treasury

Total tax revenue is around $300 million ahead of forecast, after removing the effect of some one-off effects, with source deductions and corporate taxes contributing most of the increase.

Nominal GDP growth has slowed

Despite rising inflation, the recent decline in real GDP growth, as well as falls in the terms of trade, have seen nominal GDP growth drop from over 8% in 2004 to 4.2% in the year to June 2006, with annual growth estimated to have declined to 3.6% in the September quarter. The level of nominal GDP in the year to June 2006 was around $700 million higher than forecast in the Budget Update.

Assumptions Underlying the Central Forecast

Global economic activity – global economic growth, inflation and interest rate forecasts are taken from the October 2006 Consensus Forecasts and Asia Pacific Consensus Forecasts. The general global outlook is positive as growth becomes more broad-based. Growth in the United States is expected to continue to soften to 2.6% in 2007, before recovering to 3.1% to 3.2% for the rest of the forecast period. Australia is expected to see growth recover to 3.3% in 2007, up from 2.8% in 2006. Japan has emerged from recession but growth is forecast to be modest at around 2% per annum, with similar rates of growth forecast in European GDP. Economic growth for New Zealand’s top 14 trading partners is forecast at 3.5% to 3.6% across the forecast period.

Oil prices – prices for West Texas Intermediate (WTI) in the March and June quarters were higher than forecast in the Budget Update, but falls in September have taken prices back close to forecast. Futures pricing at the time these forecasts were finalised suggests that prices will increase to US$68/barrel in September 2007 before declining to around US$65/barrel by 2011. Prices at the end of the forecast period are projected to be almost identical to those forecast in the Budget Update.

Net migration – net migrant inflows appear to have troughed on an annual basis in October 2005 at 6,000 and have since recovered to around 13,000. Net migration is assumed to stay at current levels during 2007 before declining to around 10,000 per annum by 2009, and then remain at that level for the rest of the forecast period.

Monetary conditions – the New Zealand dollar exchange rate as measured by the TWI is assumed to decline from a December 2006 quarter average of 65.6 to 54.5 by the end of the forecast period. A neutral short-term interest rate of 5.8% is assumed.

Climate – agricultural growing conditions and the level of hydro electricity storage lakes are assumed to be normal over the forecast period.

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