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Pre-election Economic & Fiscal Update 2011

Downside Scenario

With the balance of probabilities around our main forecasts skewed heavily to the downside, this section presents a downside scenario based on the risks discussed earlier in this chapter. To be clear, the following is just one possible outturn based on a set of risks. It should be considered an illustrative outcome rather than a ‘worst case' scenario. The main drivers of this downside scenario are:

  • European leaders do not manage to contain the ongoing sovereign debt challenges in the euro area, leading to a significant spike in global risk-aversion and an associated increase in market funding costs.
  • With little scope for fiscal and monetary policy in the developed world to step in as it did in 2008, a protracted global recession ensues. The United States and euro area economies contract by 1.5% and 2.0% respectively in the 2012 calendar year, and stage relatively weak recoveries thereafter. Monetary policy around the globe stays supportive for longer.
  • An increase in funding costs triggers housing market corrections in a number of Asian economies, exacerbating their economic downturns. Annual Chinese GDP growth slows to 6% in 2012 (versus an average of over 10% per year in the past decade).

In this scenario, aggregate output in New Zealand's trading partners is approximately 3% lower than the main forecasts in the year ending March 2016. The cumulative loss of trading partner growth over five years is 13.5% of one year's annual GDP. In a deliberate effort to capture the downside risks to the global economy at present, this magnitude is around twice as severe as the IMF's downside scenario from its September 2011 World Economic Outlook.

Figure 3.2 - Trading partner growth
Figure 3.2 - Trading partner growth.
Source: The Treasury
Figure 3.3 - Merchandise terms of trade (SNA)
Figure 3.3 - Merchandise terms of trade (SNA).
Source: The Treasury
Figure 3.4 - Inflation
Figure 3.4 - Inflation.
Source: The Treasury
Figure 3.5 - Nominal GDP
Figure 3.5 - Nominal GDP.
Source: The Treasury

The impact on New Zealand of this downside scenario primarily comes through lower demand for our goods and services exports (including inbound tourism), and also lower prices for our key commodity exports - particularly dairy, meat and forestry products. The terms of trade fall sharply, down 7.0% in the year ending March 2013, largely reflecting lower prices for export commodities, and remain below levels incorporated into the main forecasts throughout the forecast period. That said, given their high starting point, the terms of trade remain around 9% higher than their long-run average during the five-year forecast period.

Lower export receipts flow through to a more rapid deterioration in the current account balance in this downside scenario. The current account deficit widens to 4.6% of GDP in the year ending March 2013 (compared with 3.6% in the main forecasts) and to 7.9% by the year ending March 2016 (compared with 6.9%). The exchange rate drops sharply and undershoots in the near term, although in a world of weak monetary settings it does not fall as far as in previous recessions. In this scenario, the trade-weighted exchange rate falls to 63.4 by the middle of the 2012 calendar year - more than 9% lower than in the main forecasts but still higher than the average since 2000 - before regaining some lost ground in 2013. In the near term at least, slower global growth outweighs any competitive boost from a weaker currency.

Lower terms of trade would also hit consumer and business confidence. The levels of both consumer spending and market investment remain below their main tracks throughout the forecast period. The latter is held back by a lack of availability, and the higher cost of credit, reflecting the disruption to global funding markets - another key headwind in this downside scenario.

As in the main forecasts, the Canterbury rebuild is a sizeable mitigating factor in this downside scenario. Residential investment is hit in the near term but recovers as reconstruction funded largely by insurance flows gathers pace over the coming years. While unemployment rises to 6.8% in the mid-2012 calendar year in the scenario - 1.2 percentage points higher than the main forecasts - rebuilding activity helps to bring the rate back down towards the end of the forecast period.

However, the overall impact of weaker economic activity in the short run results in the inflation rate being lower throughout the forecast period, coming in at 1.8% in the March 2013 and 2014 years. Accordingly, short-term interest rates are lower than in the main forecasts. The combination of weaker domestic demand and lower terms of trade means that nominal GDP is a cumulative $35 billion lower through to the year ending June 2016 in the downside scenario. A comparison of the downside scenario with the main forecasts for the key economic variables is given in Table 3.1.

Government's fiscal position deteriorates as a result

Tax revenue in this scenario is lower than in the main forecasts because of weaker growth in the economy. However, the relationship between the performance of the economy and tax revenue is very imprecise. In addition to the negative impact forecast by our model, we have lowered tax revenue by a further cumulative $4 billion over the forecast period in the downside scenario. This adjustment is intended to emphasise the downside risks facing the economy at present and the extra uncertainty that this means for tax revenues (note that GDP is lower in the scenario but so is the ratio of tax to GDP).

Overall, core Crown tax revenue in the scenario is a cumulative $14.5 billion lowerthrough to the year ending June 2016. In contrast to the main forecasts, the total Crown operating balance before gains and losses remains in deficit throughout the forecast period, registering a deficit of 0.5% of GDP in the year ending June 2016 compared with a 1.2% of GDP surplus in the main forecasts. Accordingly, core Crown net debt in the downside scenario rises to 35% of GDP in the year ending June 2016 (from 20% of GDP in 2011) – some 7% of GDP higher than in the main forecasts.

Other downside risks not captured in the scenario

As noted earlier, the downside scenario sets out one plausible scenario of a downside event and should be considered more of an illustrative outcome than a ‘worst case'. Overall, historic forecasting performance suggests that there is at least a one-in-five chance of an outcome worse than that captured in the downside scenario. Indeed, there are a number of risks for the economy over and above those captured in the scenario. Specifically, if a variety of factors conspired to result in the exchange rate not depreciating as we expect in the downside scenario, New Zealand would have less of a cushion from the weaker global economy. Meanwhile, to the extent that a stronger exchange rate leads to wider current account deficits than in the downside scenario, New Zealand's external liabilities and potential vulnerabilities would be still higher. Conversely, should the exchange rate depreciate more than we expect in the downside scenario, this would help to cushion the export sector further.

Table 3.1 - Summary of key economic variables for main forecasts and scenario
March years 2011

Real GDP (annual average % change)

Main forecast 1.6 2.3 3.4 3.3 2.9 2.4
Downside scenario 1.7 2.5 3.6 3.2 2.6

CPI inflation (annual % change)

Main forecast 4.5 2.8 2.2 2.4 2.5 2.7
Downside scenario 2.5 1.8 1.8 2.4 2.6

Unemployment rate1

Main forecast 6.5 5.8 5.2 4.9 4.7 4.7
Downside scenario 6.5 6.3 5.8 5.1 4.7

Nominal GDP (expenditure measure, $billion)

Main forecast 198 209 219 231 243 254
Downside scenario 207 212 223 235 246

Current Account Balance (% of GDP)

Main forecast -3.6 -2.4 -3.6 -5.4 -6.4 -6.9
Downside scenario -2.9 -4.6 -6.2 -7.4 -7.9
  1. March quarter, seasonally adjusted

Source: The Treasury

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