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Budget 2007 Home Page Half Year Economic & Fiscal Update 2007

Weaker world growth, but higher terms of trade

Slowdown in the United States led to a reappraisal of the near-term outlook

The prospect of slower economic growth in the United States, largely as a result of heightened concerns about the fallout from the financial turmoil arising from the sub-prime mortgage market and the deepening downturn in the housing market, has led to a reappraisal of the prospects for United States and world growth since the Budget Update. Our forecasts of the international economy are based on the October 2007 Consensus Forecasts, a monthly survey of more than 240 forecasters worldwide. Compared with those underlying the Budget Update, they contain downward revisions for the United States, Japan and the euro area in the near term, partly offset by upward revisions for Australia and non-Japan Asia. Economic growth for our top 20 trading partners is now expected to decline from an estimated 4.0% in 2007 to 3.5% in 2011, compared with stable growth of 3.6% throughout the period in the Budget Update.

The latest views of major international forecasting agencies are consistent with the downward revision of the outlook for the world economy. In October the International Monetary Fund revised down its forecasts for global growth in 2008 from 5.2% to 4.8%, with lower growth expected in the United States and in most other economies. Since our forecasts were finalised, the OECD has commented that “more recent economic news points towards a more protracted adjustment” in the United States and the world economy.[1] In its December 2007 Economic Outlook, the OECD commented that the probability distribution around its baseline scenario (which incorporated downward revisions to growth from their mid-year Outlook) is skewed to the downside, with the main negative risks being greater cooling in housing markets, additional turbulence in financial markets and further upward pressure on commodity prices.

Risks to the outlook for the world economy

Our forecast for the world economy is based on the most common view which is that a recession is unlikely. However, the risks of such an event have increased since we finalised the forecast.

We have taken the outlook for our main trading partners from the October Consensus Forecasts, the latest available when we finalised the forecast and in line with our standard practice. Since that survey of other forecasters was released in mid-October, the outlook for the world economy has changed as fresh concerns have emerged regarding the effects of the financial turmoil and the United States housing market has weakened further.

Interest rate spreads between commercial and government securities in the United States and elsewhere have increased again close to their levels in August when the financial turmoil first developed. This is occurring as more losses by commercial banks and finance companies become apparent and the full implications of the sub-prime mortgage crisis unfold. The need to consolidate balance sheets prior to the end of the financial year may also be bringing some of these problems to light.

Although official forecasters are not picking a major downturn in the United States or world economy at present, the risks of such an event have increased recently. The most common view is still that the United States will not experience a recession, although most commentators consider that growth will be lower than previously forecast. The fresh concerns about the extent of the financial turmoil mean that the risks of a major downturn in the United States are greater than previously thought and these concerns have increased since we finalised our forecasts. This situation is developing rapidly and presents a major risk to the outlook presented in this forecast.

If there is a major downturn in the United States economy and it spreads to other parts of the world, there would be reduced demand for New Zealand exports. This would manifest itself primarily through lower terms of trade and lower real income. The Risks and Scenarios chapter explores the impact that lower terms of trade would have on key economic and fiscal aggregates.

Higher prices in world dairy markets …

Figure 1.7 – World dairy prices
Figure 1.7 – World dairy prices.
Source:  ANZ National Bank

An important development for the New Zealand economy since the Budget Update is the continued increase in world dairy prices. In the six months from September 2006 to March 2007, spot prices for dairy products in international markets increased 45%; in the six months since then they increased by a further 49% as a result of a combination of supply and demand factors (Figure 1.7).

Changes to the Common Agricultural Policy (CAP) have brought lower subsidies for European farmers and less incentive for increased production. In addition, the virtual elimination of butter stocks in Europe has removed downward pressure on prices, and milk production quotas and reduced export subsidies effectively place a ceiling on European Union dairy exports. In Australia, the effects of the drought have lingered and delayed recovery in dairy production. Persistent drought has cut the availability of irrigation water, reduced pasture growth and driven fodder costs higher. In the United States, the expansion of ethanol production has limited the supply of feed corn and driven up its price, pushing up dairy prices at the same time.

Income growth in developing countries, along with changing consumer preferences towards more Western-style foods, has increased the demand for dairy products. High oil prices have also led to increased demand from oil-exporting nations as incomes have increased.

… will flow through to New Zealand exporters and the terms of trade

Figure 1.8 – Goods terms of trade (SNA basis)
Figure 1.8 – Goods terms of trade (SNA basis).
Sources:  Statistics New Zealand, The Treasury

The increase in spot prices for dairy products in world markets in the past year has so far had little impact on dairy export prices, but we expect the majority of the increase to appear between the third quarter of 2007 and the first quarter of 2008. The full extent of the increase in spot prices will not be transmitted to local prices because the use of supply contracts by exporters smoothes the peaks and delays the flow-through. We have assumed that annual growth in the world dairy prices received by New Zealand producers peaks at 64% in the March quarter 2008 and that they will level off in mid-2008, before declining gradually from the December quarter of 2008. By that time we expect increased production from other exporters (such as South America and the United States) as well as increased domestic production in China, and that higher prices for consumer products will have started to reduce demand. Higher dairy prices will lead to significantly higher terms of trade than previously forecast (Figure 1.8).

We expect dairy prices to remain above their pre-boom level at the end of the forecast period, reflecting higher costs of production (as a result of the factors outlined above) and increased global demand. However, further price declines are likely beyond the forecast period as world supply expands further. There is considerable uncertainty related to these projections for dairy prices and alternative scenarios are presented in the Risks and Scenarios chapter, including their implications for the economy and fiscal indicators.


  • [1]Financial Market Trends No. 93, OECD 2007.
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