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Special Topic: Recent global economic developments

There is increasing evidence of a slowdown in the United States economy and lower growth in other major world economies. These developments may affect the New Zealand economy through financial and equity markets and through reduced demand for New Zealand export products.

The threats to the outlook are balanced by a number of ongoing positives for the New Zealand economy. However, the risks to the downside have increased since we released our Half-Year Update forecasts and we will continue to monitor developments closely.

Recent developments increase likelihood of recession in the United States

Most data for the United States released in January showed that the economy weakened in the final quarter of 2007. The unemployment rate increased from 4.7% in November to 5.0% in December, a 2-year high, and non-Government employment fell in December. The housing market showed continued weakness, with average prices down 10% annually on one measure. The advance release of GDP for the fourth quarter of 2007 showed that the economy grew at an annual rate of only 0.6%.

In response to these adverse developments, the Federal Reserve made an inter-meeting 75 basis point reduction in its funds rate on 22 January and a further 50 basis point reduction at its scheduled review on 30 January (US time). The US administration also announced a US$150 billion fiscal stimulus package.

Weak economic data were also released in other major economies, with business confidence falling in both Europe and the United Kingdom, retail sales generally showing signs of easing and consumer confidence low at the end of last year. In Europe, industrial production fell in November and financial analysts were their most pessimistic in 15 years in January.

Despite the signs of weaker economic growth, inflation in many economies remained high. Headline inflation in the US was 4.1% in 2007; in the EU, the harmonised inflation measure reached 3.1% for 2007 calendar year, confirming the European Central Bank’s inflation concerns. In the UK, retail price inflation was 4.0% in 2007 and inflation was also high in New Zealand and Australia at 3.2% and 3.0% respectively.

The financial market turmoil in the second half of 2007, combined with continuing weakness in the US housing market, led to further difficulties in the banking sector. The exposure of some financial institutions to losses from sub-prime mortgages was apparent with large write-downs at Citigroup and Merrill Lynch, and Countrywide (a mortgage lender) was taken over by Bank of America. Further risks exist with credit downgrades likely for “monoline” insurers (credit default insurers), increasing in turn the need for banks to hold higher amounts of capital. Further large losses were also announced by European and Japanese financial institutions.

Equity markets reacted nervously to economic and financial market developments. Stock markets fell sharply in the first week of January, but were buoyed by the monetary and fiscal policy moves in the US later in the month. The reversal of some rogue trader activity at Société Générale, a major French bank, mid-month may have contributed to renewed weakness in equity markets. At the end of the month, most major stock markets were well down on their end-2007 levels (Figure 6). Falls were not limited to the major economies, with falls in the Shanghai and Australasian markets pointing to risks of flow-on effects from the major developed economies to other parts of the world.

Figure 6 - Equity market prices
Figure 6 – Equity market prices.
Source: Datastream

Commodity markets also reacted to the latest developments. Oil prices receded from their early January peak of just above US$100/barrel, while gold prices rose above US$900/oz as risks of a recession increased. Soft commodity prices were generally stable, although US dairy prices eased slightly, but more on reports of increased US supply than any fall in demand. The Baltic Dry Index fell from its late 2007 peak, indicating reduced demand for bulk commodity shipping space, providing support for forestry returns.

IMF revised its forecasts down

These adverse developments in the leading world economies in January 2008 have increased fears that the US economy is about to enter recession or is already in recession and that the other key world economies will follow suit.

The International Monetary Fund revised their forecasts for world growth in 2008 down from 4.4% to 4.1%, a slowing from the 4.9% estimated for 2007. Forecasts for 2008 were revised down for all country groupings, including developing economies. They noted that the risks are still tilted to the downside, with the ongoing turmoil in financial markets a key concern.

Developments could affect the New Zealand economy directly ...

There are several channels through which a slowdown in the United States might affect the New Zealand economy. The most direct and immediate would be through financial markets as commercial interest rates increase as a result of the risks associated with the investments in sub-prime mortgages, resulting in a higher cost of credit globally.

To some extent this is already happening. Two-year fixed term home loans have already increased by 0.2 percentage points in New Zealand above 9½%, a 10-year high. Higher interest rates will lead to a slowing in household consumption and further cooling in the housing market. This effect would be offset to some extent by lower central bank interest rates, although spreads between commercial and policy rates have been high recently. Also, some longer-term fixed mortgage rates are easing as international institutions continue to borrow in New Zealand dollars, making more funds available.

Movements in share markets tend to be correlated across countries and the NZX50 has declined 9.2% since the end of 2007. Declines in wealth (either through local or overseas investments) are likely to make households more cautious about their spending decisions. A fall in company valuations would also make them more cautious about committing to investment expenditure.

... and indirectly

Other transmission channels are less direct and immediate and depend on other linkages. A recession in the US on its own may not be sufficient to cause a slowdown here, as New Zealand growth remained strong in 2002-03 following the bursting of the dotcom bubble. On the other hand, New Zealand experienced a downturn in 1997-98 when the United States did not (Figure 7).

Figure 7 - US and NZ GDP growth
Figure 7 – US and NZ GDP growth.
Source: Datastream, Statistics NZ

The extent of any flow-on from a recession in the US to New Zealand depends chiefly on the extent of “decoupling” in the world economy. Some commentators have claimed in recent years that much of the world economy has become “de-coupled” from the traditional engines of growth, such as the US and Europe, and that they are less important in sustaining world growth as other centres of growth, such as China, India, Brazil and Russia, have increasingly driven world growth.

It is not clear to what extent the rest of the world economy depends on the large developed economies for growth. China is less dependent on the US than previously and has developed more internal momentum and closer linkages with the rest of Asia than before. However, previous links most likely continue to have some strength.

The main way in which a slowing in world growth would affect the New Zealand economy would be through reduced demand for exports, in particular agricultural commodities (such as dairy and meat). Demand for these products would fall as income growth slowed in key markets and prices would fall, leading to lower returns to New Zealand producers. Lower prices would affect the terms of trade, but would likely be offset to some extent by a fall in the value of the New Zealand dollar and oil prices. However, there is no sign of any significant fall in demand at this stage.

There would be both a direct effect as demand from major markets impacted on returns and an indirect effect as the global slowdown affected other economies such as Australia (with less demand for mineral commodities), leading to lower demand for NZ products and services.

There are also some other factors affecting the outlook

Recent international economic developments are only one set of factors impacting on the New Zealand economy at present. There are other positive offsetting factors; for example, the terms of trade are likely to remain high even if dairy prices do fall somewhat. The economy has also proved resilient recently and monetary and fiscal policy settings have room to ease if necessary to offset a slowdown. Any such action would also have to take account of inflationary pressures.

Recent slowdowns in the New Zealand economy have generally been the result of a combination of factors rather than any single cause. The 1997-98 recession was a result of the combined effect of the Asian financial crisis, two successive droughts and excessive monetary tightening.

There are other risks to the outlook for the New Zealand economy, although they are not great at present. Dry conditions are currently developing in parts of the country, particularly the east coast of both islands and central South Island, and milk production is being affected in parts of the North Island. Slowing house price growth may affect consumer confidence and domestic demand adversely. Finance company collapses may also have the same effect, but to a lesser extent.

At present, most commentators are forecasting a slowdown in both the US and other developed economies, but few are predicting a high probability of a US recession. Since the Half Year Update, the profile of risks has shifted towards slower growth in the world economy (a risk which was highlighted in the Update). We will continue to report on developments, including the effect of any global slowdown on the New Zealand economy.

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