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Half Year Economic and Fiscal Update 2010

Risks and scenarios

There are always uncertainties and risks associated with forecasts. These can be sourced from both the international economy and domestic developments.

Global developments present both upside and downside risks…

Although most economies are now growing again after the GFC, there is considerable uncertainty about the pace and durability of the recovery in many developed economies.

One source of downside risk relates to sovereign and banking system funding problems in some European economies and associated risks of contagion. An intensification and broadening of these problems to other countries would likely have significant negative impacts on activity levels, official interest rates and capital flows, particularly in Europe, with spill-overs to the rest of the world.

Another uncertainty relates to the response of the private sector to the ending of fiscal stimulus and in some economies the switch to fiscal consolidation. Consolidation will act to dampen domestic demand in the shorter term. As a result, the pace of growth will depend on the degree of offset coming from any crowding-in of private sector investment or higher net exports.

Other risks include the pace of recovery in the US, where there is continuing weakness in the labour and housing markets, and the extent of global imbalances which could lead to an increase in trade and capital barriers. These would impair world growth and, depending on the nature of the barriers, could adversely affect New Zealand export volumes.

Risks in China and emerging Asia are tilted to higher growth as these economies continue their economic development. Although China is currently taking steps to constrain credit growth, with some consequent short-term risks to growth, ongoing infrastructure investment and the scope for private spending to expand could see higher average growth over the next five years and further boost demand for minerals and soft commodities. It is also possible that the US and European economies could grow more quickly than expected if the current headwinds to growth dissipate faster than currently expected.

Economic strength in developing countries has helped support global commodity prices and boosted New Zealand's terms of trade, which are expected to remain elevated over the next five years. Past experience, however, indicates that negative shocks to commodity prices cannot be ruled out. Disappointing growth from emerging markets would be one factor that could result in lower demand and commodity prices than in the main forecasts.

...while the impact of atypical events and the behaviour of households present domestic risks

In the domestic economy, there is uncertainty about the degree to which rebuilding from the Canterbury earthquake will boost growth, and over what period. Since the forecasts were finalised, there have been a number of adverse developments. These are the discovery of a kiwifruit disease, the disaster at Pike River coal mine and the dry conditions developing in parts of the country as a result of the La Niña weather pattern. Risks of this kind will always exist in an economy with a large natural resource base, with drought effects having potentially significant adverse impacts on output and exports. Record temperatures during November mean that the risk that drought conditions will adversely impact on economic activity is particularly high.

New Zealand households have taken initial moves towards strengthening their financial position and are much more cautious about taking on debt, but it is not clear how sustained their restraint will be. Greater restraint will lead to lower growth in the short term, but possibly more sustainable growth in the long term; less restraint would bring higher growth in the near term, but risk a sharper deleveraging and rebalancing later. Developments in the housing market will influence household behaviour, with any additional housing market weakness likely to dampen household spending levels.

Two scenarios have been developed from these risks to illustrate the uncertainty associated with the current economic outlook. The scenarios are constructed by applying relevant shocks and alternative judgements to the New Zealand Treasury Model (NZTM). They should be treated as providing a high-level representation of how the economy could differ from the main forecasts. The focus is on key economic variables, rather than the larger suite produced as part of the main forecasts.

As a result, significantly different outcomes are possible

While the main forecast represents our view of the most likely path the economy will take, the scenarios illustrate that a large range of different outcomes is possible. The upside scenario assumes a stronger outlook for China and emerging Asia flows through to the economy in the form of higher prices for commodity exports. The downside scenario represents a more severe event with larger economic and fiscal implications, but with a lower probability. In this scenario, global growth falters and New Zealand's terms of trade are adversely affected. The scenarios are extended into the projection period in the same way as the main forecasts were in the preceding section, illustrating the considerable range in fiscal outcomes that could occur.

Table 1.10 - Summary of key economic variables for main forecasts and scenarios
(Annual average % change,
Year ended 31 March)
Real GDP (production measure)            
Main forecast -0.4 2.2 3.4 2.9 2.7 2.7
Upside scenario   2.2 3.9 3.1 2.9 2.8
Downside scenario   1.3 1.2 3.9 3.0 2.3
Merchandise terms of trade1            
Main forecast -6.3 7.0 -2.7 1.8 1.9 1.3
Upside scenario   7.9 1.6 2.5 1.8 1.2
Downside scenario   6.9 -7.3 -1.0 0.3 -0.4
Unemployment rate2            
Main forecast 6.0 6.1 5.2 4.9 4.6 4.5
Upside scenario   6.1 5.0 4.7 4.5 4.4
Downside scenario   6.5 6.2 5.8 5.6 5.5
Nominal GDP ($billion)            
Main forecast   187   199 211 222   234   245
Upside scenario     200   215   227   239   251
Downside scenario     197   201   213   223   231


1 SNA basis

2 March quarter, annual % change, seasonally adjusted

Upside scenario

Stronger demand for commodities lifts the terms of trade above the main track…

Figure 1.17 - SNA merchandise terms of trade
Figure 1.17 - SNA merchandise terms of trade.
Sources:  Statistics New Zealand, the Treasury

New Zealand is a key supplier of soft commodities to the global economy, particularly dairy products and meat. Limited global resources and long lags in production mean that changing demand manifests itself in price swings in the short term, having a significant impact on the terms of trade and the overall economy.

The main forecasts assume that the terms of trade ease off in the short run but remain elevated over the medium term. In the upside scenario, it is assumed that stronger demand from key trading partners (particularly China and Australia) results in higher commodity prices and a continuation of the upward trend seen in the terms of trade over the past decade (Figure 1.17).

…and benefits flow through the rest of the economy

A higher terms of trade places upward pressure on the exchange rate, which, coupled with stronger earnings, leads to increased domestic demand. Private consumption growth averages 3.1%, compared with 2.4% in the main forecasts, and residential investment also lifts, driving GST revenue higher. In line with recent trends, some of the income surprise is saved, lifting the household saving rate above that in the main forecasts over the medium term. Stronger export values relative to imports drive a lower overall profile for the current account deficit.

Figure 1.18 - Annual nominal GDP
Figure 1.18 - Annual nominal GDP.
Sources:  Statistics New Zealand, the Treasury

More robust demand creates some inflation pressure, but higher potential output owing to stronger investment, combined with a more elevated exchange rate, means the overall impact on consumer prices is relatively small, allowing official interest rates to remain broadly similar to those expected in the main forecasts.

…driving higher tax revenues and a more positive fiscal position

The stronger economic outlook in this scenario lifts nominal GDP $4.2 billion (2%) higher in the March 2012 year and a cumulative $23 billion higher than the main forecasts over the 2011 to 2015 June years. Such a scenario would boost demand for labour and wages, flowing through to higher PAYE tax revenue which, together with higher corporate tax and GST, results in overall tax revenue being a cumulative $6.6 billion higher than in the main forecasts.

Figure 1.19 - Total Crown operating balance (before gains and losses)
Figure 1.19 - Total Crown operating balance (before gains and losses).
Source:  The Treasury

With expenses broadly similar to the main forecasts, higher tax revenues mean the overall fiscal outlook is stronger than envisaged in the main forecasts. The operating balance (before gains and losses) breaks even in the June 2014 year, one year earlier than in the main projections. Net debt is projected to fall below 20% of nominal GDP in the June 2020 year, two years earlier than in the main projections.

Core Crown operating surpluses (before gains and losses) are projected to be of sufficient size to trigger the resumption of contributions to the NZSF by the June 2018 year - one year earlier than in the main projections.

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