Economic Risks (continued)

Meanwhile, domestic challenges still lie ahead...

There are risks to our forecasts arising from domestic sources as well. However, unlike the global risks, domestically-sourced risks are more balanced. In our main forecasts, the Treasury expects private consumption growth to remain modest over the five-year forecast horizon, as households reduce their debt-to-income ratios to more comfortable levels. The risks to this outlook are to both the upside and downside. Given the greater potential for tighter conditions in global funding markets, there is a risk that the degree of household consolidation could be more intense than expected, with households seeking to move to an even lower level of debt than we have forecast. While this might bring forward some rebalancing in the economy from later years, such a scenario would involve weaker domestic activity in the near term. On the other hand, households may return to higher rates of consumption growth as confidence improves and house prices rise. If this were to occur, it would drive a stronger economy in the near term and defer household rebalancing until later years.

...including the exchange rate...

Another notable risk to the outlook is the exchange rate. The Treasury's main forecast expects the NZD to remain around current levels (on the trade-weighted index) until 2014 before depreciating thereafter. The exchange rate can be volatile, thus there are risks to either side of the main forecast. The NZD could potentially move higher than we have assumed, or hold up for longer. This could come about for a number of reasons, including New Zealand remaining a relatively attractive place to invest compared to other countries, the terms of trade rebounding higher than expected or a faster-than-expected domestic recovery leading to higher domestic interest rates. The result would be lower export incomes, flowing through to lower consumption. The current account deficit would also widen.

On the other hand, if, as a number of measures suggest, the NZD is overvalued at current levels, it could depreciate sooner and faster than the Treasury anticipates. A larger-than-expected decline in the terms of trade or an improvement in global growth leading to a closing of interest rate differentials are both possible reasons for a depreciating currency, but would have different implications for the New Zealand economy. Higher global growth (and thus demand) at the same time as a depreciating currency would boost exporter incomes. However, New Zealanders' purchasing power on a global comparison would be lower, as imports become more expensive. Inflationary pressures would also be higher, which may result in higher interest rates, dampening the benefits from a lower exchange rate. If falling terms of trade were the reason for the depreciating exchange rate, the lower NZD may partly offset lower prices on exported goods, cushioning the economy to some degree.

...and the Canterbury rebuild...

The timing and extent of the Canterbury earthquake rebuild is difficult to forecast. If large aftershocks cause further damage, the current $25 billion damage estimate factored into our main forecasts could rise, as would the risk that the rebuild could be slower and overall economic activity lower in the short term. Conversely, the rebuild could gather pace more quickly. Accordingly, residential and non-residential construction, imported goods volumes and employment would all be stronger than in the main forecasts. As a result, we would expect wages in and around the rebuild area to come under greater upward pressure, as well as prices for some goods - particularly housing construction-related goods and services.

On the other hand, higher worker migration into Canterbury, as well as increased productivity in the construction sector owing to the localised nature of the rebuild, may help to relieve pressure on prices in the construction sector. On top of this, a more rapid rebuild could boost wider confidence in the economy, providing a lift to consumer spending and business investment.

...as well as risks from non-economic events

There are also non-economic risks that may impact on the economy, particularly climatic conditions here and abroad. Poor weather and droughts have adversely affected domestic agricultural production in the past; equally, climatic conditions can lift production as we have seen in New Zealand over the past season. Any impact on agricultural incomes from production may be offset by prices moving in the opposite direction, although this will depend on many factors, particularly production abroad. Other risks may impact on the economy, including the potential for biosecurity issues to affect the agricultural sector.

Note:

1. March quarter, seasonally adjusted

Sources: Statistics New Zealand, the Treasury