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Pre-election Economic and Fiscal Update 2017

Scenario One - Higher Terms of Trade and Inflation

This scenario illustrates the impact of a higher terms of trade and stronger inflation on the economic and fiscal outlook. Export prices are assumed to rise slightly above the main forecast in 2017 and remain higher throughout the forecast period. Higher export prices are achieved through stronger demand for New Zealand's goods exports, particularly stronger demand in China for dairy, meat and forestry products. As a result, the terms of trade are around 7% above the main forecast by June 2021 (Figure 3.4).

Figure 3.4 - Higher goods terms of trade (SNA)
Figure 3.4 - Higher goods terms of trade (SNA).
Sources: Statistics New Zealand, the Treasury

The impact on domestic demand from the higher terms of trade is positive. Sustained higher exporter earnings support investment and consumption demand, which contributes to stronger employment growth and a lower unemployment rate. Wages increase at a faster pace than in the main forecast and real GDP per capita is higher.

The higher terms of trade also contributes to a stronger New Zealand dollar, which redistributes some of the higher export earnings to non-exporting households. However, exporters who do not benefit from a higher world price for their goods will have profits eroded by the stronger dollar.

While the stronger dollar has a dampening effect on tradables inflation, this scenario also assumes tighter capacity constraints and stronger non-tradables inflationary pressures than in the main forecast. As a result, the rate of CPI inflation is higher from the onset. The boost to domestic demand from higher export earnings also causes capacity constraints to bind sooner than assumed in the main forecast. In response to the stronger inflation outlook, the Reserve Bank lifts the Official Cash Rate earlier (Figure 3.5).

Figure 3.5 - Higher inflation and interest rates
Figure 3.5 - Higher inflation and interest rates.
Sources: Statistics New Zealand, Reserve Bank, the Treasury

Overall, higher export prices, stronger inflation and faster real GDP growth increase nominal GDP by a cumulative $22 billion over the forecast period to June 2021. This additional income generates $6.6 billion extra core Crown tax revenue than in the main forecast (Figure 3.7), with source deductions and GST $1.5 billion and $1.2 billion higher respectively.

In this scenario we assume that the Government's operating and capital allowances are unchanged from those in the main forecast (see Chapter 2 for details). Under these assumptions, OBEGAL surpluses are larger in each year, reaching $8.9 billion (2.7% of GDP) in 2021. This is $2.5 billion above that in the main forecast. The Government's debt position also improves, with the level of net core Crown debt $6.9 billion lower by June 2021 (Table 3.1).

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