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Pre-election Economic and Fiscal Update 2017

Key Risks to the Economic and Fiscal Outlook

A range of risks to global economic, financial and political stability exist that could have a significant impact on the New Zealand economy should they materialise. In China, high levels of debt present a risk to growth. There is considerable uncertainty regarding the extent and timing of fiscal stimulus in the US. In Europe and Japan, the ability to achieve sustainably higher growth rates remains unclear. The UK’s exit negotiations with the European Union will remain a key source of uncertainty and a risk to growth for some time. Other global risks include heightened geopolitical tensions and ongoing political debate about the merits of trade liberalisation. While international risks are skewed towards weaker growth outcomes than incorporated in the main forecasts, upside risks to New Zealand’s terms of trade remain. For example, despite slowing aggregate GDP growth in China, demand for consumption goods could be stronger than assumed, leading to higher export prices. Lower oil production costs could support lower import prices.

In addition to the above, there are a number of key risks to the domestic economy. Households could be more sensitive to tighter financial conditions than assumed, particularly given record-high debt levels relative to incomes. There are risks to the main forecast assumptions around the impact of net migration inflows and how migration flows may evolve in the future. Capacity constraints in the construction sector may prove more binding than assumed, while estimates of economy-wide capacity pressures are uncertain.

High debt levels in China are a risk to trading partner growth…

Growth in China has been supported by significant policy stimulus, strong credit growth and rapidly rising debt. This has been particularly apparent in the housing market, where residential investment has accelerated strongly. As authorities turn their attention towards tightening financial market regulations to reduce debt risks, the impact on the real economy could be stronger than expected. A sharper-than-anticipated slowdown in growth could negatively impact commodity prices, trade and capital flows, which could slow growth in China's trading partners, including New Zealand and other key trading partners in the Asia-Pacific region.

…along with uncertainty around fiscal settings in the US

In the US, challenges in reaching political agreement have increased uncertainty around the extent and timing of future fiscal stimulus. While the main forecasts continue to reflect expectations of an easing in fiscal policy settings over the next two years, it is possible that stimulus is more modest and less stimulatory for growth than assumed. That said, the size and impact could also be larger than incorporated into the main forecasts. Meanwhile, the US labour market has continued to strengthen and monetary policy is expected to tighten further. Higher-than-expected US interest rates present a risk to governments and businesses holding US dollar debt, particularly in China and other emerging market economies.

Exporters face uncertainty around the terms of trade…

As a commodity exporter, New Zealand's terms of trade are exposed to a raft of risks. Changes to regulatory settings in key overseas markets can have significant impacts on global supply and the price of goods New Zealand produces and exports. On the other hand, a stronger international outlook would likely increase demand for exports resulting in a higher terms of trade. The impact of increased global competition owing to shale oil production could be greater than assumed, supporting lower import prices and a higher terms of trade, particularly over the medium term.

The terms of trade have been trending upwards since the early 2000s. Until 2013, this was driven mostly by rising export prices. However, more recently falling import prices have driven the increase. For New Zealand's terms of trade to continue rising, global demand for exports would need to outpace global supply or the inverse would need to occur on the imports side. Developments in China have been a key determinant of the terms of trade in recent years. Chinese urbanisation and ongoing transition towards consumption-led growth has supported demand for New Zealand's exports, while China's ability to produce manufactured products cheaply and at scale has kept import prices low. Stronger demand from Chinese consumers and/or tighter supply restrictions in China on the goods New Zealand produces, including from environmental policies, presents an upside risk to New Zealand's export prices.

…and the future of global trade policy

Political debate about the merits of trade liberalisation has intensified in recent years. A shift in trade policy towards protectionism, particularly in the US, is a key risk to the outlook for global trade volumes and global GDP. In addition, uncertainty surrounding the future of trade has the potential to negatively impact investment and productivity growth.

Developments in the Australian economy could affect net inward migration

In Australia, low interest rates are supporting the transition of growth towards non-mining sectors. They are also encouraging household borrowing and contributing to rising house prices. Household debt relative to incomes has reached record highs, making households more vulnerable to rising interest rates. In the housing market, investment in medium-to-high density housing has increased rapidly, raising the risk that the market is oversupplied, which could lead to a slowdown in construction, a fall in house prices, slower growth and higher unemployment. Conditions in the Australian labour market are a major determinant of the strength and direction of trans-Tasman migration flows. To the extent that the labour market in Australia is weaker than expected, net trans-Tasman flows are likely to continue to support higher net migration inflows than assumed in the main forecast.

Overall, net migration inflows may prove to be higher than assumed in the main forecast if the relative attractiveness of living, working and studying in New Zealand is stronger than expected. However, stronger growth internationally or shifts in domestic factors may lead to lower migration and softer GDP growth. There are also risks around the assumed impacts of migration on the economy, particularly the degree to which the current net migration cycle contributes to demand for consumption, housing and non-residential investment, including public infrastructure, as well as supply though the labour market.

High household debt relative to incomes could lead to softer domestic demand

Low interest rates and strong demand for housing have contributed to rising house prices and record-high household debt relative to incomes. In recent months, tighter lending standards and increased mortgage interest rates have caused credit growth to slow. Availability of credit is a key determinant of consumption and investment growth. Further increases in lending standards, or a decrease in the availability of credit, could slow economic growth by imposing tougher constraints on housing activity, which could spill over to the wider economy. In this environment, house price growth, and therefore household wealth, could be weaker as fewer households will be in a position to bid up prices. This could also contribute to slower growth.

An unexpected rise in interest rates or softer income growth may also prompt households to reduce their exposure to future interest rate rises by prioritising debt repayment over consumption, leading to softer growth. Renewed concerns around global financial market stability or a faster pace of monetary policy normalisation in the US are possible examples where unexpectedly higher offshore funding costs could drive interest rates higher. That said, there is headroom for domestic monetary policy settings to provide an offset.

There are also risks around assumptions of potential output and capacity constraints. The following box discusses these in further detail.

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