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Half Year Economic and Fiscal Update 2013

Economic Risks

Risks to the forecasts are relatively balanced

As in the BudgetUpdate, risks around the main forecasts are fairly evenly balanced, with upside risks to the domestic outlook having increased relative to recent Economic and Fiscal Updates, while risks associated with a negative global shock remain.

There are a large number of ways in which events could turn out different from forecast. The risks with potentially the largest impact on the New Zealand economy relate to the speed of the Canterbury rebuild and its interaction with the wider economy, the extent to which demand is boosted by population growth via higher net migration inflows and consumer behaviour. Global economic developments, including shocks as the world economy undergoes an extended period of transition, could lead to more rapid adjustments for the prices of some of our main commodity exports and therefore affect the path of the terms of trade.

All of these factors are likely to have a significant role in influencing the size and dynamics of the current economic cycle. Other key judgements made in the forecasts include the level and flow-through of the exchange rate, the current amount of spare capacity in the economy and monetary policy developments.

The earthquake rebuild remains a significant area of uncertainty...

There is considerable uncertainty associated with the timing and magnitude of the Canterbury earthquake rebuild. Key determinants of the speed of the rebuild include insurance settlements and the capacity and capability of the construction sector. If the rebuild were to progress more slowly than expected, residential and non-residential construction and employment could all be weaker than in the main forecast. The overall size of the rebuild will also be influenced by the extent to which private firms ultimately decide to reinvest insurance proceeds within the Canterbury region.

Another risk to the forecasts is how much the Canterbury rebuild crowds out activity in other parts of the economy. Even with inward migration and the importation of capital goods, New Zealand has limited construction capacity and consequently it is likely that some rebuild activity will crowd out other activity elsewhere. Implicitly this means that activity outside Canterbury at the peak of the building cycle is likely to be a lower share of GDP relative to previous construction upturns. If the pace and level of the Canterbury rebuild is more sluggish, there will be less displacement of activity in the rest of the country and less competition for construction resources, resulting in less upward pressure on prices. does the strength of the current net migration cycle...

Despite large upward revisions to the net migration assumption since the Budget Update, there is the possibility that weaker activity in Australia and other developed economies sees even stronger net inflows into New Zealand. The impact on the economy will be influenced by the skills of migrants and the areas where they settle (or remain in the case of New Zealanders who choose not to leave for abroad). For example, appropriately skilled migrant inflows into Canterbury could mitigate some of the risks related to the Canterbury rebuild, albeit adding to accommodation pressures in the near term. However, a large proportion of the population gains from higher net migration will likely place additional pressure on the housing market in other parts of the country, such as Auckland, contributing to stronger domestic demand, which then flows through to the wider economy through multiplier effects.

…while households could be less cautious, resulting in greater cyclical volatility

If households exercise less spending restraint than is anticipated in the main forecasts, consumption may rise faster than disposable income, with the shortfall being funded by rising debt, resulting in a negative saving rate over the forecast period. While this would be positive for GDP growth in the near term, owing to a boost to private consumption, it may require a sharper adjustment in the medium term as households become more indebted and need to repair their balance sheets. Elevated debt levels also expose household balance sheets to sharp corrections in house prices.

The Alternative Scenarios section explores the risk of a more protracted and larger net migration cycle and more willingness on the part of households to spend, all resulting in a more cyclical pick-up across the economy.

Global downside risks persist…

Global risks continue in the background and remain skewed to the downside as major advanced economies continue to undergo significant adjustments to reduce government debt, and in addition the effects of monetary easing and its subsequent withdrawal remain uncertain. Some emerging Asian economies, which are significant for New Zealand's trading partner growth, could also experience weaker growth once global monetary stimulus is withdrawn, particularly in the US.

...with elevated debt levels requiring ongoing adjustment

European countries remain highly indebted, but the probability that the crisis will worsen significantly has subsided over the past year owing to actions taken by the European Central Bank and some pick-up in euro area growth. Nevertheless, there remains considerable ongoing risk of further flare-ups, which would further dampen growth in the region and trigger financial market turmoil if an event was significant enough. Peripheral countries in the euro area continue to struggle with austerity measures which, compounded by poor competitiveness, create the potential for political instability.

The US must also undergo significant adjustment to reduce high government debt. Following on from events in October when the debt ceiling was raised temporarily to prevent a default on interest payments for US Treasury debt, there is a risk that brinkmanship continues to create heightened uncertainty concerning a permanent increase in the debt ceiling. This could lead to significant volatility in global financial markets which rely heavily on US Treasury bills and bonds as collateral.

More sustained growth and therefore reduced need for monetary stimulus...

Well anchored inflation expectations and existing spare capacity mean Japan, the US and the UK are still undertaking significant quantitative easing programmes to stimulate their economies through the purchase of financial assets. However, the US economy has recently shown signs of more sustainable growth and markets are expecting a tapering of quantitative easing in early 2014, although the US remains vulnerable if the removal of stimulus proves to be premature. Japan has implemented additional fiscal stimulus and structural reforms to kick-start growth. However, whether this will translate into sustainable growth over the medium term remains uncertain, particularly following a prolonged period of economic malaise.

…could expose fragilities elsewhere...

A rise in global bond rates once the US tapers its quantitative easing programme could leave some emerging economies significantly exposed given their currently high levels of debt. This could be exacerbated by losses in the banking sector in those emerging economies if the rapid growth in credit in recent years was facilitated by easy lending standards. An increase in US bond rates, combined with a weaker economic outlook in emerging market economies, could also lead to an outflow of foreign capital, putting downward pressure on exchange rates and raising inflation.

Of New Zealand's emerging Asia trading partners, Indonesia and India are the most vulnerable, as neither is currently running a current account surplus. The risk of a severe event similar to the Asian financial crisis in 1997 appears less likely now given that most Asian economies have floating exchange rates, hold larger foreign exchange reserves and have less foreign currency-denominated external debt.

…while risks for New Zealand's key trading partners remain…

Of more significance to New Zealand are the risks to the growth outlook for China, which is our second largest trading partner after Australia. The property investment and construction boom in China following the global financial crisis led to a build-up of poor-quality debt, especially in the local government sector. The risk of a sharp correction in house prices remains, and could expose a high level of bad debts in the banking sector and may cause credit conditions to tighten even further.

China is aiming to rebalance its economy away from export- and investment-led growth towards consumption. Rebalancing could lead to lower growth in the short term, particularly if the transition is disorderly, while faster progress to this goal would benefit New Zealand as it is a major supplier of food products to Chinese households. Weaker growth in China would also negatively impact on activity in emerging Asia, particularly amongst commodity producers, given their reliance on Chinese demand and tightly-linked supply chains.

One of the main risks associated with New Zealand's largest trading partner, Australia, is the transition of growth from investment to domestic demand and exports. It will take some time for the exports associated with this investment to come online, requiring increased residential and non-mining business investment to replace high levels of mining investment and maintain Australia's recent strength in economic growth. Australia is also exposed to a slowdown in China and emerging market economies which would reduce the demand for hard commodities.

…which, if they eventuate, would adversely impact on the New Zealand economy

Weaker growth in our trading partners could result in weaker demand for New Zealand's exports and commodity prices may fall. This would affect domestic incomes, confidence and asset prices as households behave more cautiously owing to higher risk aversion. The result of these developments would be lower private consumption, while more caution on the part of firms would decrease business investment growth and new hiring. The higher level of uncertainty faced by financial market participants could flow through to reduced availability, and a higher cost, of credit for New Zealand. However, in contrast to other developed countries, there is still scope for the Reserve Bank to provide liquidity as needed and lower the base interest rate (or slow increases) to mitigate the impact of higher funding costs on the interest rates faced by households and businesses.

Other risks surround key judgements...

Economic relationships are complex and developments are subject to inherent uncertainty, particularly the evolution of the exchange rate. There is a risk that the exchange rate remains supported for longer owing to the stronger domestic outlook, prolonged monetary stimulus in advanced economies and ongoing gains in global commodity prices for key New Zealand exports. A higher exchange rate would decrease tradables inflation, as imported goods would become less expensive, and encourage consumption of imported products. On the other hand, exporters and import-competing businesses would become less competitive, hindering manufacturing and services exports and production of import substitutes for the domestic market.

Another area of uncertainty is the current amount of spare capacity in the economy (the output gap) and its relationship with inflation. If the output gap is currently more negative, because potential GDP is higher than we have assumed in the main forecast, then there is greater scope for an increase in real GDP with less domestically generated inflation. Alternatively, if the strength of inflationary pressures were to surprise, perhaps owing to a stronger spill-over of rebuild costs from Canterbury into the wider economy, the response of monetary policy may be greater than anticipated. While implemented for macro-prudential reasons, the effectiveness of the recent loan-to-value restrictions in moderating house price growth is another area of uncertainty.

…including the perennial risks associated with the weather

Pasture conditions have improved since last summer and the impact of the drought on real GDP was broadly in line with estimates outlined in the Budget Update. In the near term, the agricultural sector is expected to bounce back strongly from the drought, although this is dependent on the assumption that pasture conditions remain favourable in coming quarters. Feed prices and availability amongst New Zealand's international competitors will also influence global supply and have a strong bearing on commodity prices and therefore the path of New Zealand's merchandise terms of trade.

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