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3 Risks and Scenarios (continued)

Economic Risks

Risks to the global outlook remain skewed to downside

Most of the downside risks to the global economy identified in the Budget Update which have started to materialise, are still compelling in this Update. As mentioned above, the turmoil in international financial markets has worsened significantly since the Budget Update, with increased risk aversion and investor uncertainty in financial markets.

The key downside risks concerning the global growth outlook are:

  • The credit crisis that originated in the US in 2007 could be deeper and longer than incorporated in the main forecast. The International Monetary Fund (IMF) projected that losses on mortgages and mortgage-related securities could amount to US$500 billion and total credit-losses could potentially cost up to US$1 trillion if loans and securities related to commercial real estate, consumer credit and corporations are included. The uncertainty about the losses depends on how deep and protracted the US housing recession will be and how far house prices will decline. Furthermore, the turmoil could be more prolonged owing to the uncertainty created by lack of transparency of securitised products and derivatives.
  • A further tightening of lending conditions and reduced credit availability is likely to raise the prospect of a self-reinforcing process of debt reduction. As it becomes harder to raise capital, firms and households in the US and other developed countries with large current account deficits are being forced to reduce debt and save aggressively, which in turn leads to an economic slowdown. An economic slowdown will exacerbate this process as borrowers with unsustainable amounts of debt will fail.
  • A significant slowing in growth in developing economies. So far, China and emerging markets have escaped the credit crisis relatively unscathed. With exports accounting for half of China's GDP and most of these directed to Europe and North America, there is greater uncertainty about the extent of the impact of negative financial shocks in the US and Europe on the Chinese economy. A severe US recession could cause China's growth to decline to 8% or below.

As the credit crisis has become more severe and persistent, the global growth outlook may prove weaker than anticipated in the main forecast. A worse-than-foreseen slowdown in world growth could affect the New Zealand economy further through lower export prices, higher costs of funding and, possibly more importantly, increased risk aversion and investor uncertainty. This would also provide downside risks to the rebound in export growth built into the main forecast even if the exchange rate was lower than the main forecast. A lower exchange rate could arise from rising global risk aversion which could cause large exits in carry trade positions.

Households have finally entered a period of consolidation

In the past eight years, New Zealand has experienced a dramatic fall in its household savings rate: the household savings rate has declined from 0% to -14% of household disposable income over the period from 2000 to 2008 and the ratio of household debt to annual disposable income increased from 112% to 196% over the corresponding period (Figure 3.1). The increasing trend of dis-saving is not unique to New Zealand. Many developed economies such as the US and Australia have experienced a similar phenomenon. To some extent, the fall in the saving rate over this period is partly owing to a long period of stability with interest rates falling to low levels. This may have led households into thinking that they were permanently operating in a low-cost and low-risk environment. As a result, households were encouraged to take on more debt and invest in housing which in turn caused house prices to rise. Higher house prices encouraged households to invest more in housing and increased house prices further, creating a positive feedback loop.

Figure 3.1 - Household savings and debt as % of disposable income
Figure 3.1 - Household savings and debt as % of disposable income.
Source:  Statistics New Zealand, RBNZ and The Treasury

The decline in households' saving contributed directly to rising current account imbalances: the current account balance has deteriorated from a deficit of 6.4% of GDP in 2000 to a deficit of 7.8% of GDP in 2008 with the current account deficit peaking at 9.2% in the March quarter of 2006. Such a high level of external indebtedness makes New Zealand dependent on overseas investors' willingness to lend at affordable rates. It appears that the current financial turmoil has triggered the long-awaited adjustment of external imbalances and households have finally begun to consolidate their balance sheets since the beginning of this year by cutting spending.

In the main forecast, consumption and residential investment growth forecasts are much weaker relative to the Budget Update, reflecting the judgement that households decide to lower their debt-to-income ratio relative to the Budget Update. However, the pace and depth of consolidation will depend on what happens to house prices, credit availability, the level of net migration and the employment outlook.

Figure 3.2 - House prices
Figure 3.2 - House prices .
Source:  QVNZ,  S&P/Case Shiller and Halifax

In particular, there is considerable uncertainty about the extent of the house price fall in the forecast. In the main forecast, we assume an 11% fall in nominal house prices from their peak. Some developed countries which started their housing cycles earlier than New Zealand have seen their house prices fall sharply. In the US, average house prices nationwide rose by 90% between 2000 and 2006 and have since fallen by 20%. Although there are differences in housing market conditions between the US and New Zealand, a larger decline in New Zealand house prices is possible (Figure 3.2).

A further point we can touch on here concerns the link between changes in house prices and consumption. There is greater uncertainty on the extent of the impact of wealth on consumption. Therefore, if households attempt to consolidate their balance sheets more aggressively and the estimated wealth effect is larger than assumed, we could see private consumption growth weaker than forecast.

The economy could be stronger in the near term

On the upside, while the international growth outlook has deteriorated, the domestic economy may be showing signs of having turned the corner: the business outlook improved according to the National Bank Business Outlook and the Westpac McDermott Miller measure of consumer confidence rebounded strongly to 104.8 for the September quarter from the 18-year low recorded in the June quarter. The renewed optimism is mainly attributed to falling petrol prices and expected further interest rate cuts. During the time of writing, WTI oil prices fell below $US100 per barrel at one stage from their recent peak of US$146 per barrel. Historically, the New Zealand economy, especially consumer spending, was very sensitive to changes in petrol prices. If petrol prices are lower than forecast, this will result in an upside risk to the consumption growth forecast in the near term.

In addition, higher consumer sentiment, lower petrol prices and expected further interest rate cuts together could spur households to spend more of their tax cut than is the case in the main forecast. As a result, this could see GDP growth slightly stronger in the near term than forecast.

From a medium-term perspective, the economy may be more resilient to weather the global economic storms now than in the late 1990s because of a stronger fiscal starting position and a better monetary framework. The main forecast incorporates a weak response of export services to the falling exchange rate to reflect a more protracted recovery in the world economy. It is possible that demand for our goods and services from Asia could be stronger if the Asian economies undergo only a mild slowdown and the exchange rate depreciates more sharply than incorporated in these forecasts. Finally, the fall in residential investment may not be quite as large as predicted in the main forecast because we do not have a large inventory of unsold houses as in the US.

Risks for inflation remain tilted to the upside

The balance of risks for inflation continues to be tilted to the upside even with a weaker GDP growth outlook and the recent drop in oil prices. Annual inflation is now expected to peak at around 5% in the September 2008 quarter. The Consumer Price Index (CPI) spike, driven by petrol and food price increases, could cause households and firms to revise up their inflation expectations in the medium term which in turn could lead to more sustained inflationary pressures. With implementation of the ETS, there are risks that the emissions price is higher than assumed in the forecast and the second round effects of the ETS could be greater than incorporated in the forecast. In addition, the ETS could have a larger effect on business investment than assumed in the forecast.

Besides inflation, the key drivers of the nominal economy are world export and import prices. In view of the weaker global growth outlook, the balance of risks to international prices for export and import goods is somewhat to the downside in the medium term, with the impact on the terms of trade dependent on whether it is export or import prices that are most affected.

Last, but not least, any extreme weather patterns such as drought and flooding could have a profound but temporary impact on the New Zealand economy.

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