Risks and Scenarios
The forecasts presented in the Economic and Fiscal Outlook chapters were produced in some of the most volatile economic and market conditions since the height of the Global Financial Crisis. The Chicago Board Options Exchange Volatility Index - a measure of volatility in the S&P500 index and generally considered to be a proxy for international financial market conditions – rose significantly during the September 2011 quarter and remains elevated.
- Figure 3.1 - Chicago Board Options Exchange Volatility Index (VIX)
- Source: Chicago Board Options Exchange (A higher number means more market volatility is expected over the next 30-day period.)
Against this backdrop, the first part of this chapter outlines key risks to the economic outlook, before presenting a plausible downside alternative scenario for the New Zealand economy. It then focuses on the established channels between the risks facing the real economy and the Crown’s fiscal position.
Global outlook is highly uncertain ...
Internationally, the biggest uncertainty is over how fast, or even if, policymakers and governments can stabilise financial markets. Our main forecasts assume that the global economy “manages through” in the near term, based on a reasonably orderly resolution of the ongoing sovereign debt problems in the euro area combined with the adoption of additional fiscal stimulus measures in the United States. However, the risks to this view are skewed to the downside. A failure on the part of governments to contain the crisis in the euro area could, in particular, cause a severe disruption to global funding markets.
In contrast to late 2008, there is limited room for policymakers in developed economies to cut official interest rates if such a situation were to occur again. Furthermore, differences of opinion over appropriate policy responses have come to the fore, particularly over fiscal settings in the United States. With private deleveraging set to continue in much of the world, we expect a prolonged period of sub-potential growth in the global economy.
... posing risks to New Zealand's economy
The risks to New Zealand from the global economy are threefold. If international activity turns out to be weaker than we have built into our main forecasts, this would reduce demand for our exports. Given the need for sizeable medium-term fiscal consolidation in much of the developed world - not least the United States - there is a great deal of uncertainty over the pace of global growth ahead. And while Asian economies appear to be relatively better placed, policymakers there - particularly in China - face their own challenges from persistently strong inflation and high-valued housing markets.
Our main forecasts assume that the terms of trade decline modestly in the near term but remain high relative to historical standards over the five-year forecast period. Should the terms of trade, in contrast, fall much further and reach their 30-year average, a sharp drop in incomes for agricultural producers would flow through into weaker domestic demand, less income for investment and debt repayment, and a significantly wider current account deficit. Lower commodity prices could also impact on New Zealand goods and services providers that export to Australia, which would also experience a cut in its national income from international commodity sales.
On the financial side, a drop in confidence and pick-up in global risk-aversion would be expected to reduce the availability, and raise the cost, of credit for New Zealand. In light of the recent downgrades to New Zealand's sovereign credit rating by international ratings agencies Fitch and Standard & Poor's, there is a risk that markets would demand a higher risk premium for New Zealand's debt in the future. That said, there is room for the Reserve Bank to provide liquidity as needed, and, if the outlook for inflation permits, to facilitate easier monetary conditions to help domestic borrowers adjust.
The economy faces existing challenges as well ...
The domestic economy faces other risks as well. Private consumption growth is expected to be held back by weak house price growth and households' aggregate desire to reduce their debt-to-income ratios to more comfortable levels. Given the wider potential for much tighter conditions in global funding markets, the risk is 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 the rebalancing that the economy needs in the long run, such a scenario would involve weaker domestic activity in the near term. At present, the risk of a large-scale increase in borrowing by households, reflecting an increased willingness by banks to lend, seems small. However, if this were to occur, it would drive a stronger economy in the near term, but would not prevent the inevitable household rebalancing further out.
... including ongoing uncertainty over the timing of the Canterbury rebuild ...
As outlined earlier this year, the timing and extent of the Canterbury earthquake rebuild is difficult to forecast. If significant extra seismic activity causes further damage, the risk that the cost of rebuilding exceeds the current $20 billion estimate factored into our main forecasts would clearly rise, as would the risk that the rebuild would be slower and overall economic activity lower in the short term. Conversely, if seismic activity and insurance-related issues that are currently delaying the process were to be rectified sooner than assumed, the rebuild could gather pace more quickly. Accordingly, residential and non-residential construction, imported goods 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 upward pressure, as well as prices for some goods - particularly housing goods and services. On top of this, a more rapid rebuild could boost wider confidence in the economy, providing a lift to consumer spending and business investment.
... and 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 and remain a residual risk. Equally, weather-driven supply shocks in New Zealand's competitor countries also pose risks to the price of New Zealand's exports. There are other inherent risks from a range of environmental events as well, including the potential for biosecurity issues to hit the agricultural sector and the impact of one-off events such as the recent Rena shipping incident in the Bay of Plenty.
There are upside risks, but these are small at present
The discussion up to now has centred on the negative risks facing the economy, but there are also some positive risks - albeit small at present. Possible factors this time around include the terms of trade holding up higher than forecast and/or a quicker and more decisive resolution to the problems in the euro area (as opposed to the “manage through” assumed in the main forecasts). In addition, a weaker exchange rate profile than we forecast would be expected to provide a competitive boost to New Zealand-based exporters.