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Budget 2006 Home Page Half Year Economic & Fiscal Update 2006

Economic Scenarios

Lower demand for New Zealand dollar assets

The second scenario illustrates a situation in which there is less demand for New Zealand dollar assets. This results in the exchange rate depreciating more rapidly than in the central forecast and also causes uncertainty for households that become less comfortable with accumulating debt.

Table 3.3 – Lower demand for New Zealand dollar assets
(Annual average % change, 2006 2007 2008 2009 2010 2011
year ending 31 March) Actual Forecast Forecast Forecast Forecast Forecast
Private consumption 4.5 1.6 0.3 -0.3 2.6 2.4
Residential investment -4.7 -5.5 -9.3 -1.1 15.0 5.3
Market investment 6.7 -6.2 -5.8 1.5 12.3 7.0
Gross national expenditure 4.5 -0.5 -0.4 0.9 4.9 3.7
Exports of goods and services -0.1 3.6 1.4 4.7 5.4 3.7
Imports of goods and services 5.0 -2.6 -2.4 -1.1 7.8 6.4
GDP (production measure) 2.2 1.8 1.3 3.1 4.3 2.9
Employment growth 2.6 1.7 -0.3 0.1 1.5 1.9
Unemployment rate1 3.9 4.0 5.2 5.3 4.7 4.5
90-day bank bill rate2 7.6 7.6 7.2 4.7 5.5 5.5
TWI2 68.3 63.0 53.0 55.6 57.4 57.1
CPI3 3.3 2.8 2.8 0.8 1.0 1.7
Current account balance (% GDP) -9.6 -9.3 -9.6 -4.0 -3.5 -4.9

Nominal GDP

(expenditure measure)

4.7 3.3 2.5 5.6 5.7 4.5

Sources: Statistics New Zealand, Reserve Bank of New Zealand, The Treasury

1 Percentage of labour force, March quarter, seasonally adjusted.

2 Average for March quarter.

3 Annual percentage change, March quarter.

Under this scenario, lower demand for New Zealand dollar assets contributes to the Trade Weighted Index (TWI) falling to 53.0 by the March quarter of 2008, nearly 12% lower than the central forecast. Higher import prices due to the lower exchange rate contribute to inflationary pressures which see 90-day bank bill rates 120 basis points higher than the central forecast in the March quarter of 2008.

Faced with higher interest rates and an environment of financial market uncertainty, households limit their spending growth and pull back from making big housing investment decisions. This sees private consumption growth around 1.4% lower than the central forecast in both the 2008 and 2009 March years. This results in private consumption increasing 0.3% in the March 2008 year followed by a 0.3% contraction in 2009. Residential investment growth is significantly slower than the central track with residential investment contracting 9.3% in the March 2008 year and 1.1% in the March 2009 year, meaning that residential investment has fallen in four consecutive years.

With less demand for their products in the domestic market and higher imported investment good prices, firms are also more reluctant to invest. This results in market investment growth being 4.6% lower than the central forecast in the March 2008 year and 2.9% lower in 2009. Firms also cut back on employment growth which contributes to the unemployment rate increasing to 5.3% by March 2009.

Higher import prices coupled with weak domestic demand growth contribute to a fall in import volumes which decline 2.4% in the 2008 March year and 1.1% in 2009. The lower exchange rate also flows through to the competitiveness of our exports. Export volumes display a lagged response to the lower exchange rate with relatively strong growth of 4.7% in the March 2009 year followed by 5.4% growth in the March 2010 year.

Figure 3.5 – TWI exchange rate
Source: The Treasury

With domestic demand contracting in the March 2008 year and real GDP growth 1% lower than the central track, inflationary pressures are quickly brought under control, with CPI inflation falling below the central forecast in the final three forecast years. To stimulate the economy, monetary policy is able to loosen considerably with 90-day rates falling below 5% by March 2009. This stimulates a recovery in consumption growth in the March 2010 year as well as a recovery in both residential and market investment.

Renewed confidence in the domestic economy and a much diminished current account deficit, following weak import volumes over the 2008 and 2009 March years and improved export volumes and export receipts on the back of the lower exchange rate, promote a renewed focus on New Zealand by international investors. By March 2010 current account adjustment has been substantial with the current account deficit diminishing to less than 4% of GDP. With renewed demand for the New Zealand dollar from foreign investors, the exchange rate appreciates to around 57 on the TWI during 2010 and 2011.

The overall impact of the recovery is that real GDP growth exceeds 4% in 2010 before returning to more trend levels in 2011. However, the initial weakness upfront in this scenario results in the level of nominal GDP being around $3 billion per annum lower than the central forecast in the majority of the forecast years, or an aggregate impact over the four March years to 2011 of $11 billion.

Fiscal Scenarios

The fiscal position is strongly influenced by the economy. The major economic determinants, and how they impact on the fiscal position, are listed below. While each effect is expressed in terms of an increase in the determinant, the opposite impact applies for a decrease.

  • Nominal GDP – higher GDP levels are reflected in higher tax revenue, which increases the operating balance and lowers the Government’s net debt.
  • Interest rates – higher interest rates lead to increased debt financing costs. While interest-based revenue also increases, the negative effect of higher finance costs on the operating balance dominates, meaning net debt increases.
  • The level of unemployment – higher levels of unemployment translate to an increase in spending, because the number of unemployment beneficiaries rises. This decreases the operating balance and raises net debt levels.
  • CPI inflation – as most benefits are indexed to CPI movements, higher inflation results in increased benefit costs. This reduces the operating balance and increases net debt.
Table 3.4 – Alternative scenarios: impact on OBERAC and debt
Year ending 30 June 2006 2007 2008 2009 2010 2011
  Actual Forecast Forecast Forecast Forecast Forecast
OBERAC ($ billion)            
Central forecast 8.6 6.7 6.1 5.2 5.8 6.0
Stronger domestic demand 8.6 7.0 7.2 6.4 6.9 6.9
Lower demand for NZ dollar assets 8.6 6.7 4.9 4.5 5.5 5.5
Gross sovereign-issued debt
($ billion)1
Central forecast 35.5 37.9 40.2 39.2 38.6 41.1
Stronger domestic demand 35.5 37.5 38.7 36.5 34.9 36.4
Lower demand for NZ dollar assets 35.5 37.9 41.4 41.1 40.8 43.7
OBERAC (% GDP)            
Central forecast 5.5 4.1 3.6 2.9 3.1 3.0
Stronger domestic demand 5.5 4.3 4.1 3.5 3.6 3.4
Lower demand for NZ dollar assets 5.5 4.1 2.9 2.5 3.0 2.8
Gross sovereign-issued debt
(% GDP)1
Central forecast 22.5 23.3 23.5 21.8 20.5 20.7
Stronger domestic demand 22.5 22.9 22.2 19.8 18.0 18.0
Lower demand for NZ dollar assets 22.5 23.3 24.7 23.2 21.9 22.5
Net debt (% GDP)            
Central forecast 4.9 3.9 3.5 4.0 4.1 3.8
Stronger domestic demand 4.9 3.7 2.6 2.4 2.0 1.4
Lower demand for NZ dollar assets 4.9 3.9 4.3 5.1 5.3 5.2

Sources: Statistics New Zealand, The Treasury

NOTE: 1 This chapter assumes that changes in the operating balance translate into changes in gross sovereign-issued debt.

The stronger domestic demand scenario is characterised by higher nominal GDP, higher interest rates and inflation and lower unemployment relative to the central forecast.

Figure 3.6 – OBERAC
Source: The Treasury

Higher nominal GDP and lower unemployment result in an increase in tax revenue and a decrease in benefit payments. Higher inflation results in an increase in indexed benefit payments and higher interest rates result in an increase in interest expenses net of interest income. The overall impact of this scenario is an increase in the operating balance over the forecast period.

By the end of the forecast period the OBERAC is around 0.4% of GDP higher than in the central forecast and gross sovereign-issued debt (GSID) is 2.7 percentage points of GDP lower than the central forecast.

Figure 3.7 – Gross sovereign-issued debt
Source: The Treasury

The lower demand for New Zealand dollar assets scenario is characterised by a lower exchange rate out until 2009. Compared to the central forecast, nominal GDP is lower, unemployment is higher and interest rates and inflation are lower.

Lower nominal GDP leads to lower tax revenue and higher unemployment leads to higher expenses. However, lower interest rates and inflation result in lower expenses compared to the central forecast. The overall impact is a lower operating balance from 2007/08. The OBERAC as a percentage of GDP is 0.2% lower than the central forecast at the end of the forecast period. The cumulative impact of the lower operating balance results in GSID being 1.8 percentage points of GDP higher than the base case by the end of the forecast period.

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