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Half Year Economic and Fiscal Update 2010

Fiscal Risks

The Government's fiscal strategy aims to return the budget to surplus, bring down debt to restore a buffer against unforeseen circumstances, and support growth in a way that minimises economic vulnerability. The ability of the Government to achieve this fiscal strategy depends on future government decisions and, to a significant extent, the level of risk inherent in the global and domestic economies. This chapter describes risks to the economic and fiscal outlook from the perspective of a taxpayer.

The Public Finance Act 1989 (PFA) requires that each Economic and Fiscal Update incorporate, to the extent that it is possible to do so, all future government decisions and other circumstances that may have a material effect on the economic and fiscal outlook. Providing this information serves two purposes. First, providing information on uncertainty ensures that any risks that are able to be identified are transparently disclosed. The only exceptions to this requirement are where disclosure might cause serious harm to New Zealand's security, economy or Government. The second purpose is to aid interpretation of the statements by providing a sense of the uncertainty surrounding the economic and fiscal outlook.

The HYEFU 2010 risk chapter has been expanded to cover how events in the wider economy can impact on the fiscal position. This expands the focus of the risk chapter beyond the traditional contingent risks and the policy under active consideration, which are now included in the second part of this chapter. In providing this information no attempt has been made to specify individual economic events. Instead the focus of the additional material is on the size of potential change (variance) relative to what is included in our forecasts. Specific economic risks, to the extent that they impact on the economic outlook and are able to be identified, are discussed in the Economic and Fiscal Update chapter.

Fiscal strategy must respond to changes in the economy

Fiscal strategy specifies the Government's future spending intentions given expectations about how much tax it is likely to collect. Changes in the economy affect the Government through changes in tax and, to a lesser extent, through changes in either spending or the value of assets and liabilities held on the balance sheet. Thus, the key risk to the Government's ability to deliver on its fiscal strategy is that the economy will not evolve in line with the Treasury's economic forecasts over an extended period.

Revenue uncertainty

Taxation revenue is the primary channel through which changes in the economy affect the Crown's fiscal position. For taxation revenue, it is uncertainty about the level of nominal GDP that is most important. Two uncertainties that could significantly alter our forecasts for taxation revenue include: a change in trend growth; or uncertainty about the permanence of declines in tax following a large shock. Significant changes in prices, most notably through the terms of trade, have been especially important in the New Zealand context.

Figure 2.1 - Revenue uncertainty (holding policy constant)[8]
Figure 2.1 - Revenue uncertainty (holding policy constant).
Source:  The Treasury

Note: The blue bands represent sequential deciles such that the difference between the 10th and 90th pecentiles represents an 80% confidence interval.

The experience of New Zealand over the past three decades provides three clear examples:

  • The 1997 Asian crisis: The shock was assumed to be more permanent than it was and, as a result, the economy recovered faster than forecast.
  • Growth through the 2000s: Forecasts persistently underestimated the strength and sustained persistence of above par economic growth mainly as a result of a terms of trade shock.
  • The global financial crisis: Tax revenue suffered a structural decline after forecasts overestimated trend growth in government revenues (refer Figure 2.1).

The Economic and Fiscal Update provides the Treasury's current view of how the economy is expected to evolve. The upside and downside scenarios (refer page 38) provide two possible alternative scenarios for how the economy could differ from our central forecasts, although more extreme outcomes are possible. Historic variance in taxation revenues for the next fiscal year (refer Figure 2.1), once the impacts of policy change are taken into account, would normally fall within a two standard deviation range of plus or minus $4.9 billion (8.8%) on the current revenue base of $56 billion. Outcomes beyond this range could be expected to occur one year out of every 20.

Historic estimates of uncertainty may understate the potential volatility of forecasts over the next five years. Global imbalances that have not unwound to any significant extent, a large negative net international investment position and high levels of domestic debt all create uncertainty. Structural changes in the economy that affect the rate at which revenue grows relative to spending would place pressure on the Government's fiscal strategy.

Expenditure uncertainty

Most unexpected costs are likely to be captured through reprioritisation or from within the $1.12 billion annual budget operating allowance. However, large unexpected events, such as the Canterbury earthquake (refer page 22), can still place significant pressure on the Government's other spending priorities. A summary of the risks that are able to be specifically identified at the time of writing have been included in the second part of this chapter.

On 22 November 2010 Standard and Poor's placed the New Zealand sovereign rating on a negative watch. The decision referenced declining fiscal flexibility as a result of government budget deficits and widening external imbalances with respect to growing private sector debt. A credit downgrade would likely increase the Government's expenses through rising debt servicing costs.

Valuation uncertainty

Valuations of the assets and liabilities held on the Government's balance sheet respond to changes in interest rates, exchange rates and market prices. Significant changes in the balance sheet could eventually flow through placing pressure on the Crown's fiscal position. Risks to the government balance sheet lie beyond the scope of this chapter. However, the Government's capital spending intentions and information on portfolio risk are laid out in the Budget Policy Statement, National Infrastructure Plan and Investment Statement.

Uncertainty about the buffer provided by net worth

Figure 2.2 - Variation in past forecasts for net worth
Figure 2.2 - Variation in past forecasts for net worth.
Source:  The Treasury

The impact of tax, spending and valuation changes all create significant uncertainty about the future level of the Government's net worth. Higher net worth, or lower net debt, provide the Government with the fiscal headroom to spend or avoid increasing taxes in a recession. In this way, balance sheet measures, or lower debt, can be viewed as rough indicators of the risk that policy may need to change in a future crisis or a recession.

The global financial crisis has highlighted that the value of net worth can change rapidly when the economy is hit by an unusually large shock. This chapter makes no assessment of risk to the New Zealand economy. However, the effect of the economy and the impact of unexpected events on uncertainty about the future value of net worth can be illustrated by plotting forecasts for net worth against actual outcomes (refer Figure 2.2). Net worth is forecast to decline from 50.2% of GDP in June 2010 to 33.6% of GDP by June 2015, before recovering thereafter. A summary of the assumptions and judgements underlying our expectations for net worth, net debt and the economy as a whole has been included on page 45.

Notes

  • [8]A full summary of the methodology and critical assumptions is included in Treasury Working Paper 10/08. Standard deviation assumptions used for 0-, 1-, 2- and 3-year ahead forecasts are 2.0%, 4.3%, 6.1% and 6.8% of the actual respectively. These are interpolations of the BEFU forecast estimates, adjusting for the timing of the HYEFU forecast.
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