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Budget 2007 Home Page Half Year Economic & Fiscal Update 2007

Economic Scenarios

The following scenarios show how the growth path of the economy might evolve if some of the key judgements in the main forecast are altered (Table 3.1). The scenarios are two of a large number of possible examples, and do not represent upper or lower bounds for the main forecast, with more extreme paths possible. They represent what we assess to be the key risks to the Half Year Update forecast and illustrate the impact of relatively small changes in the assumptions on key variables, especially the fiscal aggregates. Although not the most likely outcome, we consider that there is a realistic prospect that these scenarios could occur.

Figure 3.4 - Real GDP
Figure 3.4 – Real GDP   Sources:  Statistics New Zealand, The Treasury.
Sources: Statistics New Zealand, The Treasury

The first scenario is entitled “Lower terms of trade and weaker residential investment”. In this scenario, there is a larger fall in the terms of trade and weaker domestic demand led by residential investment. This scenario leads to lower real GDP growth initially (Figure 3.4). Non-tradables inflation also falls, but total inflation is higher as a lower exchange rate drives up the price of imports and thus tradables inflation in the short term. Compared to the main forecast, interest rates are not cut as early because of high inflation and the current account deficit does not narrow as much because of the lower terms of trade.

The second scenario, entitled “Higher terms of trade and stronger domestic demand”, incorporates stronger terms of trade owing to higher export prices throughout the forecast period. In this scenario, there is stronger growth in consumption and market investment relative to the main forecast, which raises real growth in GDP in the near term, but also increases inflationary pressures.

Table 3.1 – Alternative scenarios: summary
  2007
Actual
2008
Estimate
2009
Forecast
2010
Forecast
2011
Forecast
2012
Forecast
Real production GDP (annual average % change, year ending 31 March)            
Half Year Update forecast 1.7 3.0 2.1 2.8 2.7 2.9
Lower terms of trade and weaker residential investment 1.7 3.0 1.1 3.3 3.3 2.9
Higher terms of trade and stronger domestic demand 1.7 3.0 2.8 2.5 2.1 3.0
Nominal expenditure GDP (annual average % change, year ending 31 March)            
Half Year Update forecast 4.7 7.3 5.4 4.1 4.2 4.6
Lower terms of trade and weaker residential investment 4.7 7.3 3.9 3.9 3.8 4.2
Higher terms of trade and stronger domestic demand 4.7 7.4 6.7 4.4 3.8 4.5
OBEGAL ($billion, year ending 30 June)1            
Half Year Update forecast 5.3 6.6 4.3 4.1 4.0 3.9
Lower terms of trade and weaker residential investment 5.3 6.4 3.1 3.0 2.3 2.0
Higher terms of trade and stronger domestic demand 5.3 6.6 5.2 5.0 4.6 4.6

Note: 1 Operating balance before gains and losses.

Sources: Statistics New Zealand, The Treasury

Lower terms of trade and weaker residential investment

The first scenario illustrates a situation in which the terms of trade fall sooner and by more than assumed in the main forecast and – in conjunction with an assumption of a greater impact on housing from recent increases in interest rates – there is weaker residential investment (Table 3.2).

Table 3.2 – Lower terms of trade and weaker residential investment
Annual average % change, year ending 31 March 2007
Actual
2008
Estimate
2009
Forecast
2010
Forecast
2011
Forecast
2012
Forecast
Private consumption 2.4 3.8 1.1 1.6 1.8 1.3
Residential investment -2.1 5.7 -13.5 -7.3 4.4 5.6
Market investment -3.3 5.6 4.5 -0.6 3.5 3.7
Gross national expenditure 0.7 4.7 1.4 1.7 2.6 2.2
Exports of goods and services 3.0 1.6 2.6 3.6 3.7 4.1
Imports of goods and services -1.4 6.1 3.1 -1.0 1.8 2.3
Real GDP (production measure) 1.7 3.0 1.1 3.3 3.3 2.9
Real GDP per capita 0.5 2.0 0.2 2.3 2.3 1.9
Employment growth 1.9 1.9 0.6 0.9 1.0 0.3
Unemployment rate1 3.7 3.8 4.1 4.0 4.3 4.6
90-day bank bill rate2 7.8 8.5 8.5 8.3 8.2 7.5
TWI2 68.8 70.0 61.3 56.1 55.1 54.2
CPI3 2.5 3.1 3.0 3.1 2.6 2.6
Current account balance (% GDP) -8.3 -7.3 -7.0 -8.0 -8.4 -8.6
Nominal GDP (expenditure measure) 4.7 7.3 3.9 3.9 3.8 4.2

Notes:

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

2 Average for March quarter.

3 Annual percentage change, March quarter.

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

In this scenario, the terms of trade fall more sharply as export prices reverse much of their recent rise. This scenario envisages a sharp fall in world dairy prices to levels prevailing in 2005/06, prior to the current boom. Such a fall would likely involve some slowing of world growth, particularly in the United States, and a larger negative reaction to the recent increase in dairy prices, especially for products that are relatively price elastic (eg, yoghurt and ice-cream). A faster rise in dairy production, in response to previous increases in dairy prices, would likely be another important contributor to a fall in world dairy prices.

The exchange rate falls more quickly in this scenario because of lower prices for New Zealand exports. Over the first two years of the forecast period, the TWI is approximately 10% lower than in the main forecast at 61.3 in the March 2009 quarter and 56.1 a year later. The exchange rate then levels off but it is still slightly below the Half Year Update track towards the end of the forecast period because of the lower terms of trade.

Residential investment is much lower initially in this scenario, falling by 13.5% in the March 2009 year and 7.3% the next year. Although this is a large fall, it would not be unusual relative to previous downturns (eg, 2000/01) and the recent experience of the United States. The larger fall in residential investment in this scenario is caused by a greater reaction to recent increases in interest rates than is incorporated in the main forecast. Furthermore, interest rates are high for longer in this scenario because of the inflation pressure that results from a faster fall in the exchange rate. Relative to the main forecast, market investment is also lower as a result of the weakening in domestic demand, a lower New Zealand dollar raising the cost of imported capital, and higher interest rates.

Private consumption growth is around one percentage point lower than in the main forecast in the years to March 2009 and 2010 as a housing market downturn reduces perceptions of household wealth and reduces the ability of households to borrow against their home. Higher costs of imported consumption goods, owing to the weaker dollar, also act to weaken private consumption growth.

Weaker domestic demand results in slower growth in imports over the years to March 2009 and 2010, including a fall in import volumes over the March 2010 year. In the final two years of the forecasts, import growth is higher than in the main forecast as domestic demand strengthens again. Export volumes, particularly export services, grow by more in this scenario than in the Half Year Update forecast because of the lower exchange rate.

Growth in real GDP of 1.1% over the year to March 2009 is much lower than in the main forecast, but stronger export growth relative to import growth leads to higher growth in real GDP of 3.3% in each of the following two years.

Employment growth is lower through much of the forecast period as firms utilise a lower level of labour input in response to weaker demand. The unemployment rate is higher as a result, rising to 4.6% by March 2012. Wage growth is weaker throughout the period, compounding the weaker private consumption and residential investment growth.

Figure 3.5 - CPI inflation
Figure 3.5 – CPI inflation   Sources:  Statistics New Zealand, The Treasury.
Sources: Statistics New Zealand, The Treasury

Consumer price inflation is higher than the Half Year Update forecast because of the pass-through from the sharp fall in the exchange rate. Annual inflation rises to 3.1% at March 2008, as in the main forecast, but remains at or above 3% in the following two years (Figure 3.5). Monetary policy is loosened later than in the Half Year Update forecast, with 90-day rates staying above 8% until the final year of the forecasts.

The current account deficit narrows initially as growth in imports slows in response to weaker domestic demand. However, the current account deficit is larger throughout the period compared to the main forecast because of lower export prices.

Despite high consumer price inflation, the initial lower rate of growth in real GDP means the level of nominal GDP is lower throughout the forecast period by a cumulative total of approximately $15 billion. This brings a reduction in tax revenues, as discussed in the Fiscal Scenarios section.

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