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Half Year Economic and Fiscal Update 2012

Downside Scenario

Global growth is weaker than expected over the forecast horizon…

While there are a large number of global downside risks, we have developed a downside scenario based on the International Monetary Fund's (IMF) lower global potential growth scenario from its October World Economic Outlook. This entails potential growth being approximately 0.5% per year lower than the IMF's central forecasts for advanced nations and 1% lower for Asian countries, with actual growth rates even lower as countries must make further fiscal cuts and trade is lower. Applied to New Zealand's top 16 trading partners, trading partner output is about 4% lower by 2017 compared to the IMF's central forecasts. Figure 3.1 illustrates the effect on New Zealand's trading partner growth rates.

We also assume for this scenario that New Zealand's potential growth rate is lower than in the main forecasts. While the Treasury has already lowered its potential output assumption for New Zealand in its main forecasts (see the ‘GDP Growth in the Half Year Update' box in the Economic Outlook chapter), we assume that New Zealand's potential output is even weaker than we anticipate, in part owing to the weaker world growth. In addition, we assume that the cyclical weakness evident in the September quarter in the New Zealand economy continues into the December quarter and beyond.

Slower-than-expected world growth and less liquidity in the world would mean Australian and New Zealand banks face a higher premium on their international wholesale borrowing. While part of these increased funding costs may be absorbed in falling bank margins and partly offset by a reduction in the policy rate, the remainder would be passed on to household and business borrowers. This scenario assumes that households and businesses are charged around an additional 40 basis point premium on their borrowing compared to the main forecasts.

...with lower terms of trade and reduced incomes...

Weaker-than-assumed global activity flows through to New Zealand in the form of lower prices for key commodity exports, particularly dairy, meat and forestry products. The good news for New Zealand is that the country is still exposed to the relatively faster growing parts of the global economy, such as emerging Asia and Australia, although they too experience lower growth. This means that New Zealand's terms of trade and demand for exports would not fall by as much as might otherwise be expected.

Figure 3.1 - Trading partner growth
Figure 3.1 - Trading partner growth.
Sources:  IMF, the Treasury
Figure 3.2 - Merchandise terms of trade (SNA)
Figure 3.2 - Merchandise terms of trade (SNA).
Sources:  Statistics New Zealand, the Treasury

In this scenario, the merchandise terms of trade fall further, and do not rebound as sharply as in the main forecast (Figure 3.2), reflecting the lower international demand for commodities and other exports. The terms of trade are still expected to rise over the forecast period, in part reflecting increasing demand for dairy products in Asia as incomes continue to grow. The lower terms of trade result in a more rapid deterioration in the current account balance, with the deficit increasing to 5.6% of GDP in the March 2014 year compared to 4.6% in the main forecasts. However, the gap between the main economic forecasts and scenario closes by the March 2017 year, with the current account deficit only 0.2% points wider at 6.7% in the downside scenario, in part owing to a slightly lower exchange rate.

The lower terms of trade lead to lower incomes, resulting in a more subdued outlook for household spending. The increased cyclical weakness in the near term results in a higher unemployment rate than in the main forecast, dampening pressures on wage growth, further lowering incomes. Despite a cut in the OCR, retail rates remain similar to the main scenario until 2016 and 2017, owing to the higher overseas funding costs. Private consumption growth averages 1.3% per year over the five years to March 2017, compared to 2.1% in the main forecasts. Lower demand and profits reduce business investment, although not to the same extent as consumption. This is in part owing to the Canterbury rebuild, which will help to drive strong growth in business investment.

All in all, the lower world growth, lower New Zealand potential output and increased near-term cyclical weakness result in real GDP growth averaging only 2.0% per year in the five years to March 2017 in comparison to 2.5% in the main forecasts. Of importance to tax revenues, the level of nominal GDP is about $26 billion lower in total over the period to June 2017.

…leading to lower tax revenue while raising operating deficits and net debt

Core Crown revenue is a cumulative $7.9 billion lower in the downside scenario by June 2017. The weaker domestic economy reduces source deductions and corporate tax by about $3 billion and $2 billion respectively, compared to the main forecasts, while other persons tax falls by $0.4 billion. Also, lower private consumption and residential investment lead to $1.4 billion lower GST revenue, compared to the main forecasts, while resident withholding tax is only slightly lower as interest rates are similar.

Figure 3.3 - Operating balance (before gains and losses)
Figure 3.3 - Operating balance (before gains and losses).
Source: The Treasury

Core Crown expenses (excluding financing costs) are $0.6 billion higher, as the weaker labour market flows through to increased Unemployment Benefit recipient numbers. In addition, finance costs are higher, owing to higher government borrowing.

In this scenario, the operating balance (before gains and losses) does not move into surplus within the forecast period and, consequently, net core Crown debt as a proportion of GDP is still rising at the end of the forecast period (June 2017), reaching 33.9% at that time.

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