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Half Year Economic and Fiscal Update 2012

Economic Risks

Global risks skewed to the downside... 

The global economy still faces several significant challenges. The euro area economy remains weak, as the sovereign debt crisis affects market confidence, impacting on business and household decisions alike. The US does not escape unscathed, with policy uncertainty around the “fiscal cliff” contributing to subdued business investment. While Asian growth has started to stabilise in the final quarter of 2012, significant weak patches remain. Risks to the Treasury's main forecasts have become slightly more balanced since Budget 2012, but remain skewed to the downside.

...with the euro area sovereign debt crisis yet to be resolved...

The euro area economy remains weak, having re-entered a technical recession in the September 2012 quarter. The weakness has mostly been caused by the sovereign debt crisis, which has negatively affected the region since late 2009. So far, policy makers have been able to “manage through” the crisis, with the area remaining intact. The Treasury's main forecasts assume that policy makers will continue to “manage through” the crisis, but with euro area output recovering only slowly. The likelihood of large-impact, low-probability events, such as a full or partial breakup of the euro area, has been reduced substantially during 2012, primarily owing to the Outright Monetary Transactions (OMT) programme announced by the European Central Bank (ECB) in August 2012. Nevertheless, risks remain to the outlook. The main one now is that the euro area crisis will remain unresolved, causing ongoing uncertainty. This would mean growth rates would remain lower for much longer than we expect, further impacting on global growth.

...and US and Asia still of some concern...

Another significant risk to the global economy is the so-called “fiscal cliff” in the US. This refers to a number of automatic tax increases and spending cuts (amounting to over 4% of GDP) due to take place in the first quarter of 2013 unless an agreement can be reached on alternative settings for tax rates and government spending to stabilise future government debt at an appropriate level. If legislators cannot reach agreement, the US economy is expected to re-enter recession. Most commentators expect this will be avoided, given the stakes, with only part of the fiscal tightening expected to occur. Nevertheless, it is possible that the issue is not addressed in time, negatively affecting world growth.

After a soft patch through the middle of 2012, growth in the Asian region has begun to stabilise. Nevertheless, significant risks remain in the second and third largest economies in the world: China and Japan. China faces downside risks from over-inflated house prices and debt-burdened local governments. However, risks are not all to the downside, with a faster-than-expected pickup in activity possible over 2013 if policy makers successfully navigate through the challenges ahead and implement additional reforms. Japan's situation is becoming more serious; public debt (although mostly held by domestic citizens) is at a record high and continues to grow, while an ageing population adds to the challenges. The Treasury expects only modest growth going forward (excluding the tsunami rebuild), with risks to the downside if these challenges are not met. As New Zealand's largest trading partner, the prospects for the Australian economy are important for New Zealand. The main risk for Australia is that a larger-than-expected fall in commodity prices leads to a further scaling back in mining investment and broader demand. This would lower growth in the mining and mining-related industries in Australia, reducing demand for manufactured goods exports from New Zealand.

A further downside risk, which is explored in more detail in the downside scenario, is that the recovery in global growth is slower than expected owing to weaker-than-expected global potential growth. Advanced nations' debt sustainability would become more of an issue, likely leading to further fiscal consolidation, adding to the slowing in growth. The effect on New Zealand would primarily be in the form of lower demand for exports, but also possibly through a higher cost of capital in the event that such developments see significant increases in global risk premiums and given central banks have little room to ease policy rates.

Global risks are not all to the downside, as hinted at above with China, but overall upside risks are smaller in magnitude than the downside risks. The OECD notes that possible upside risks include a comprehensive resolution of the euro crisis, a medium-term fiscal framework for the US and the benefits of structural reform being undertaken in Europe flowing through faster than currently anticipated. These would all drive higher global growth, and flow through to greater demand for New Zealand exports.

Other notable international risks include the ongoing conflict in the Middle East, which has the potential to push up oil prices and disrupt trade. Weather events, such as tropical cyclones, could also impact on growth rates.

...potentially impacting on New Zealand's economy through lower export demand...

If international activity turns out to be weaker than we have built into our main forecasts, demand for New Zealand's exports would fall. Reduced demand would lead to lower volumes of manufactured goods exports and lower tourist arrivals and spending. For commodity exports, production tends to respond less than non-commodity exports to reduced demand; instead, the reduced demand is reflected in falling prices of commodity exports. Lower export prices would result in lower terms of trade.

...lower terms of trade...

Our main forecasts assume that the terms of trade decline modestly in the near term, but remain high relative to historical standards over the five-year forecast period. Should the terms of trade, in contrast, fall much further and reach their 30-year average, a sharp drop in incomes for agricultural producers would flow through into weaker domestic demand, less income for investment and debt repayment and a significantly wider current account deficit. This would negatively impact on nominal GDP, leading to lower tax revenues for the Government. Lower prices for commodities such as iron ore, minerals and coal could also affect New Zealand indirectly through Australia. Australia would experience a fall in its national income from international commodity sales, lowering demand for New Zealand's goods and services, although a depreciation in the NZD may provide an offset.

...and lower availability of credit and confidence

On the financial side, a drop in confidence and pick-up in global risk-aversion would be expected to reduce the availability, and raise the cost, of credit for New Zealand. With a high current account deficit, there is a risk that markets would demand a higher risk premium for New Zealand's debt in the future. That said, there is room for the Reserve Bank to provide liquidity as needed and, if the outlook for inflation permits, to facilitate easier monetary conditions to help domestic borrowers adjust.

Finally, if any of the downside risks identified above were to materialise, this would lead to falls in consumer and business confidence. With lower confidence, households would lower their spending and increase their saving by more than assumed in the main forecasts. Similarly, businesses would invest less and hire fewer workers than assumed in the main forecasts.

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