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Budget 2006 Home Page Half Year Economic & Fiscal Update 2006

Economic Risks

There is uncertainty around the exact manner and timing of an unwinding of imbalances currently present in the economy

A period of strong economic growth in recent years has seen the emergence of macroeconomic imbalances – a rise in inflation pressures and a large current account deficit. Strong domestic demand growth has contributed to high levels of import demand, while exporters have struggled owing to the exchange rate remaining at a high level. This has led to an increase in the current account deficit to 9.7% of GDP.

Figure 3.2 – CPI inflation
Figure 3.2 - CPI inflation.
Source: The Treasury

The central forecast track sees these imbalances unwind in a fairly orderly and timely manner, helped by a sustained period of below average growth and a reorientation of the drivers of growth. However, there is a risk that imbalances may persist for longer. This is particularly so if domestic demand was to exhibit stronger growth than is incorporated in the central forecast. Higher domestic demand, particularly if concentrated in areas such as construction, may intensify capacity constraints and lead to further inflationary pressure. In addition, higher demand is likely to be partly met from imports and hence limit the magnitude of any reduction in the current account deficit.

The behaviour of households is a key factor influencing domestic demand. Implicit in the central forecast is the judgement that the continued accumulation of debt by households will act as a constraint on future private consumption growth. The ratio of debt to household income is at a record high level and, despite a forecast slowing in consumption growth, this ratio is expected to continue to increase over the forecast period. A key uncertainty in the economic outlook is around households’ willingness to continue to expand debt further and the impact of higher debt servicing costs. Should the debt constraint not impinge as strongly on the spending decisions of households then there is the potential for upside risk to household spending on consumption items and residential investment. Alternatively, a more substantial attempt by households at debt consolidation would pose downside risk. A scenario in which higher domestic demand contributes to more intense inflationary pressures, as consumers continue to be willing to accumulate debt at a rate faster than incorporated in the central track, is examined later in this chapter.

Exchange rate developments are important but notoriously difficult to predict

The expected depreciation of the exchange rate in the central forecast track is predicted to play an important role in the reorientation of the economy’s growth profile by reducing demand for imported goods and services while assisting the competitiveness of our exports. There is a risk that the recent strength in the exchange rate may persist for longer than is incorporated in the central track. A higher exchange rate would act to constrain export growth while making imports relatively cheaper. The net effect would be that the current account deficit could remain more persistent over the shorter term. Such a situation could arise if inflationary pressures were to remain elevated for some time with these pressures being regarded as sufficient to require tighter monetary policy, either through an increase in interest rates or for rates to remain at existing levels for longer. Under such circumstances, if financial market participants continued to focus on relative yield and providing that investor sentiment around the prospects for the New Zealand economy was not unduly dented, then the exchange rate may display a higher profile relative to the central forecast.

Figure 3.3 – Current account
Figure 3.3 - Current account.
Source: The Treasury

Countries running sustained high current account deficits are exposed to the risk of a sharp change in investor sentiment. Such an event, often called a “sudden stop”, could lead to an abrupt current account adjustment as access to offshore capital is reduced and the costs associated with obtaining such capital incorporate a much higher risk premium. Household consumption and residential investment behaviour would be particularly affected given their reliance on debt to finance much of the recent growth in such expenditure.

Research presented at the Macroeconomic Policy Forum in June concluded that the probability of New Zealand facing an abrupt current account reversal of 3% of GDP has increased to around 20%, while the probability of a larger 5% abrupt reversal has increased with the rising current account deficit to around 5%.5 Such results were considered by the author as suggesting that current external balances should not be a cause for great concern. The Government’s strong fiscal position has been considered an important offsetting factor in maintaining the country’s current credit rating. Combined with a strong banking system and a floating exchange rate, this means that concerns around the current account need to be kept in perspective.

While we regard the probability of a “sudden stop” scenario occurring as being low, a second scenario examines the impact of a reduction in demand for New Zealand dollar assets leading to a more rapid exchange rate depreciation and increased uncertainty for New Zealand households.

Productivity developments are an important driver of growth

An unobserved but important consideration in any set of economic forecasts is the rate of potential growth possible in an economy. Potential growth refers to the underlying growth potential of an economy, with growth at such levels consistent with keeping inflationary pressures and capacity issues in check. An important component determining an economy’s potential growth rate is productivity growth. Implicit in the central forecast’s return to higher levels of growth is an improvement in the recent weak levels of aggregate labour productivity growth. In the absence of such an improvement, growth may fall short of the central forecast. Alternatively, if potential growth has lifted then a recovery to higher levels of growth may be possible while at the same time keeping inflationary pressures in check.

The rate of population growth is another factor influencing both an economy’s rate of potential growth as well as consumption and housing demand. Net migration flows have an important influence on New Zealand’s population growth. Net migration flows are assumed to add around 14,000 people to New Zealand’s population during the year to March 2007, with the contribution expected to decline to around 10,000 a year by the end of the forecast period. However, migration flows are volatile and a significant positive deviation from this assumption would pose upside risk to economic growth. Conversely, if an increase in departures from New Zealand was to significantly lower the contribution of net migration to population growth, then domestic demand and economic growth would likely be lower than incorporated in the central forecast track.

A different response by firms to an expected period of weak growth would pose risks for the employment and investment outlook

With near-term growth expected to be relatively modest, the reactions of firms to falling profits in an environment where costs, including labour, continue to increase will be important. There are some indications that recent tight labour market conditions may have resulted in firms deciding to hoard labour in anticipation of better economic conditions in the future. However, the extent that firms continue to hoard labour is uncertain, with a greater degree of labour shedding certainly possible. This would contribute to increasing unemployment and have negative consequences for household incomes and spending behaviour. Recent improvements in business confidence suggest that the risks around firm behaviour are not all negative. Improved business sentiment poses the risk that firms may continue to keep employment at recent high levels. Improved confidence may also provide upside risk to investment spending.

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