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Budget 2007 Home Page Half Year Economic & Fiscal Update 2007

3 Risks and Scenarios

Introduction

The forecasts presented in the Economic and Tax Outlook chapter incorporate a number of judgements about how various forces affecting the economy will evolve. These judgements reflect the balancing of a number of positive and negative risks facing the economy to arrive at our best assessment of how it is likely to develop. Some of these judgements are related to the cyclical drivers of activity and some are related to the structural characteristics of the economy. The path taken by the economy will deviate from the Half Year Update forecast if events turn out differently from our assessment.

The first part of this chapter, Economic Risks, outlines the main risks to the economic outlook. Although we believe the forecast presented in the Economic and Tax Outlook chapter is the most likely outcome, two scenarios that illustrate different paths for the economy are presented in the second part of this chapter, Economic Scenarios. These two scenarios focus on different paths for the terms of trade, which are a key area of uncertainty. However, these scenarios are only two of a number of possible outcomes so do not show the full range of possibilities and should not be considered as upper or lower bounds.

The third part of this chapter, Fiscal Scenarios, considers the implications of the economic scenarios for the fiscal position, while the fourth part, Fiscal Sensitivities, examines how sensitive the fiscal position is to changes in specific variables.

Economic Risks

The chief uncertainty in these forecasts is the terms of trade …

The terms of trade, the ratio of export prices to import prices, are at their highest level in over 30 years and are expected to increase further in coming quarters before easing back. However, there are key risks to the terms of trade on both the upside and downside. The terms of trade could stay elevated for longer than expected or could decline more sharply than expected, largely depending on commodity prices, particularly for dairy products.

Changes in international commodity markets can have a large impact on the New Zealand economy. A range of demand and supply factors have caused world spot prices for dairy products to more than double since mid-2006, and the resulting higher export receipts will boost domestic incomes, especially in the agricultural sector. However, predicting prices for dairy products involves uncertainties with regard to both world demand and supply.

Demand for dairy products has been driven higher by rising incomes in developing nations (eg, China) coinciding with shifting preferences towards high-protein foods. However, there is uncertainty as to the extent demand will respond to the rise in prices, with less reaction likely for staples such as milk compared to other products such as cheese, yoghurt and ice-cream. Prices for dairy products, and for other commodities, would also be negatively affected in the event of a marked slowing of world growth.

A range of factors has limited the supply of dairy products (eg, in Australia, Europe and the United States). How these factors evolve are key judgements, as is the ability of other parts of the world to raise production, including South America for exports and China for their own domestic consumption.

Figure 3.1 - Total terms of trade index

Figure 3.1 – Total terms of trade index   Sources:  Statistics New Zealand, The Treasury.
Sources: Statistics New Zealand, The Treasury

An additional uncertainty is that, while information is available on world spot dairy prices, much of New Zealand’s dairy exports are pre-sold at agreed contract prices. As a result, judgements have to be made as to how a given change in spot dairy prices impacts on the price received by New Zealand exporters. It is also possible that New Zealand’s other commodities could enjoy larger price rises in response to the factors lifting dairy prices.

Given risks associated with the terms of trade on the upside and downside, two scenarios are developed below that focus on these risks (Figure 3.1). Alternative scenarios involving differences in the terms of trade show the consequences for the economy and implications for tax revenue and other fiscal indicators.

… and there are risks around the strength of domestic demand in the near term

Figure 3.2 - Real residential investment

Figure 3.2 – Real residential investment   Sources:  Statistics New Zealand, The Treasury.

Sources: Statistics New Zealand, The Treasury

Domestic demand experienced an upturn in late 2006 and early 2007, but a number of factors that contributed to this strength have turned: house price growth has slowed, fuel prices have risen and net migration has declined. In addition, 2007 has seen further increases in interest rates, including for mortgages, and finance company collapses. As a result of these factors, growth in domestic demand appears to have eased in the second half of 2007, but there is much uncertainty about the extent of this apparent easing and how long it will endure.

Residential investment is forecast to weaken and house price growth is expected to slow further from late 2007 (Figure 3.2). Based on leading indicators (eg, house sales), there is a risk of a sharper fall in residential investment and house price growth in the coming year, as has happened in the United States in the past year. Such a housing downturn has the potential to have a large impact on the labour market given the high employment growth in construction and property services since 2002.

Not all risks to domestic demand are on the downside. Although retail trade data point to a slowing in consumer spending since high growth in early 2007, data such as electronic card transactions and consumer confidence suggest there is still momentum left. Higher domestic demand could occur if more of the income boost expected from the higher terms of trade is spent, or if higher wage growth results from the tight labour market.

Consumers Price Index (CPI) inflation is forecast to rise to 3.1% in the year to March 2008 and stay near the top of the Reserve Bank target band (1% to 3% per annum) for much of the forecast period. Additional domestic demand strength would put further upward pressure on non-tradables inflation. Rising food and oil prices are other upside risks to inflation.

Risks to the global economy have heightened over the course of this year …

The world economy has experienced a strong expansion during the past three years, with real Gross Domestic Product (GDP) growth among our trading partners averaging around 3.6% per annum. Trading partner growth is forecast to continue at a broadly similar rate, but risks to this outlook are concentrated on the downside.

Global financial markets have experienced a high degree of volatility in recent months. A downturn in the United States housing market led to concerns about sub-prime mortgages (riskier loans made to those with poor credit histories) and uncertainty among investors as to where associated losses would be felt. These events triggered financial market turmoil in August 2007 and a generalised rise in risk aversion. The situation stabilised in September and October, but there has been renewed uncertainty since the forecast was finalised.

The Half Year Update forecast reflects a view that recent developments in global financial markets and the United States housing market will not cause a marked slowing of growth in the world economy. There is a risk that further fallout in the housing market weakens growth in the United States and slows world growth, which would make conditions more difficult for firms and households in New Zealand, particularly if it reduced the availability of credit.

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