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Pre-election Economic & Fiscal Update 2011

Economic Outlook

Introduction

This Pre-election Update, like its 2008 predecessor, has been prepared during a period of heightened uncertainty in the world economy. The repercussions of the financial crisis that erupted in 2008 are a key source of today's uncertainty. In many countries debt levels remain high and economic growth is weak. Many governments face unprecedented challenges in seeking to reverse fiscal deficits, and to stabilise, and eventually reduce, their debt levels. The global process of debt reduction has a long way to run and concerns about the sustainability of government debt, the strength of banking systems and economic growth are likely to continue to create periodic bouts of turbulence in financial markets for some time to come.

In contrast to the weak and fragile recovery in the major developed economies, growth in China and east Asia has been solid. Income growth in the region has led to its increased importance as an export destination and has helped lift New Zealand’s terms of trade to their highest level in 37 years. Despite an easing in the short term, the terms of trade are expected to remain elevated over the forecast period, providing a significant boost to nominal GDP. But history shows that commodity prices are volatile and, particularly in the current environment, the risks of a more significant fall than forecast here are substantial.

In New Zealand, as elsewhere, fiscal support for the economy will be withdrawn and a return to surplus is expected in the year ending June 2015. Monetary conditions are also expected to tighten as output expands and spare capacity is used up. However, the speed of the tightening process is conditional on the strength of world economic growth - slower world growth could delay the start of the tightening cycle.

For households in New Zealand, the rise in unemployment, combined with falls in asset prices and losses in wealth, has contributed to a change in saving behaviour: household saving is positive for the first time in more than a decade and the household debt-to-income ratio is declining. The change in behaviour is expected to be enduring and to result in lower consumption growth relative to that experienced over the past decade.

The rebuild following the Canterbury earthquakes provides an internal driver of growth that offsets the negative impact coming from abroad. Much of the rebuild cost is met from insurance claims, which means that progress is largely independent of the state of the world economy. Recent information has led us to revise our estimates of the damage to $20 billion from our initial estimate of $15 billion. As a consequence the rebuild will be larger and take longer than assumed in the Budget Update.

The Treasury's view of the most likely path for the economy over the forecast horizon is based on judgements around the impact of each of these forces and their interaction. However, in the current environment of heighted uncertainty, the range of plausible outcomes is wide. The Risks and Scenarioschapterpresents a view based on a weaker outlook for the world economy.

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