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Special Topic 2: The economic impacts of the drought

Most of the country has enjoyed the long, hot summer, but the dry conditions have taken an increasing toll on the agricultural sector. This Special Topic outlines the Treasury’s estimates of the impact of the drought on the economy, with regard to both the volume and value of output produced. Further analysis of the drought will be included in the forthcoming 2013 Budget Economic and Fiscal Update.

All eyes are on the skies...

In terms of soil moisture deficit, the 2012/13 season to date has been the driest in at least 40 years. The entire North Island has been designated a drought zone, along with parts of the South Island’s West Coast too (although the higher incidence of irrigation in the rest of the South Island has helped to reduce the impact there to date).

The outlook is still subject to much uncertainty and depends in large part on weather conditions in the coming months. Increasing parts of the country are starting to receive rain and are forecast to see more, but this is not expected to break the drought conditions at this stage (Figure 7). The analysis below assumes that the drought does not intensify further effects of the drought to date will continue to be felt for some time.

Figure 7 – Soil moisture anomaly (deviation from average 1981-2010, as at 9am on 3 April)

Figure 7 - Soil moisture anomaly (deviation from average 1981-2010, as at 9am on 3 April)
Source:  NIWA

...but the drought has already taken a toll

By assuming that the drought does not intensify from now on, the Treasury expects its economic impact to be largely contained to the 2013 calendar year. We estimate that the negative impact on real GDP growth this calendar year will be approximately 0.7% points from what it would have been otherwise.

The Treasury’s estimate takes into account the expected direct impacts of the drought on lower agricultural production, including reduced dairy and meat production and earlier than usual meat slaughter and processing, as well as indirect multiplier effects throughout the economy in line with previous studies.

The dairy industry made a strong start to the season, with cumulative milk production running around 5-7% ahead of the previous year into the new year. However, pasture conditions have deteriorated rapidly over the past two months or so, particularly in the North Island, and total milk production over the season as a whole is now likely to be around 1% down at best compared to last season. Meanwhile, faced with reduced feed supply, farmers in the most-affected areas have started to shift sheep and cattle to be finished in less-affected areas of the country, or sent stock for early slaughter. Meat slaughter is tracking well ahead on last year.

There remains considerable uncertainty as to when the impacts of the drought will be most visible in the quarterly GDP data. In its latest GDP release, Statistics New Zealand noted that the full impact of the drought on value-added output would not be clear until comprehensive annual data on intermediate consumption by the agricultural sector become available. Assessing the quarterly timing of the drought’s impact on the economy is additionally complicated by the fact that its effects on individual industry sectors will at least partially offset each other. In particular, this is likely to have been the case in the March 2013 quarter, in which the negative impact on quarterly real GDP growth from lower dairy production is expected to have been partially offset by front-loaded and earlier-than-usual meat slaughtering.

Overall, we expect the biggest negative impact of the drought on quarterly real GDP growth to show up in the June 2013 quarter. However, depending on the extent that farmers front-load slaughtering, the impact may be spread more evenly across the June and September quarters.

Impact on nominal GDP less clear-cut

It is difficult to assess with any certainty what the corresponding impact of the drought will be on nominal GDP. The direct impact of lower agricultural production may be offset to some extent by higher global prices (reflecting drought-induced supply fears) and also a potentially lower New Zealand dollar.

Somewhat fortuitously, the domestic drought has coincided with tighter global dairy supply conditions that have contributed to a sharp increase in global dairy prices in recent weeks. Prices at Fonterra’s Global Dairy Trade auction have surged by nearly 45% at the past three fortnightly auctions alone (Figure 8). Farmers in the least-afflicted areas – mainly in the central South Island – face clear price signals to maintain milk output levels, or even increase if possible, in the near term.

That said, the indirect impacts of the drought on the rest of the economy will be more akin to a negative demand shock in the economy, leading to more typical negative price impacts, including on wages and inflation. All else equal, the drought-induced increased supply/slaughter of meat will also put downward pressure on prices in the near term, but lead to reduced supply – and possibly higher prices – next season.

Figure 8 – Global Dairy Trade dairy prices

Figure 8 - Global Dairy Trade dairy prices
Source:  Global Dairy Trade, the Treasury

On balance, we assess the corresponding impact on nominal GDP for the 2013 calendar year relative to the HYEFU baseline to be broadly similar to the 0.7% real impact outlined above. However, we note that this estimate is more uncertain given the wide range of possible developments in agricultural prices and incomes.

Risks to the Treasury’s estimate

The Treasury’s estimate of the impact of the drought is subject to considerable uncertainty and ongoing risks. On the downside, the latest indications from the dairy industry suggest that the impact of the drought on milk production may be more negative than we have factored in to our central estimate outlined above.

Moreover, our estimate does not include any potential impact of the drought on lake storage levels and hydroelectric power generation. Reduced hydroelectric power generation would be negative for value-added GDP if producers switch to more costly thermal generation and pass these costs on to consumers and producers.

This effect would be likely to be reversed later, however, as hydroelectric generation is restored. Lake levels across the country as a whole are currently broadly in line with their corresponding levels last year. But while water inflows have picked up as rainfall in the lower South Island has increased over the past few weeks, overall inflows remain around 40% lower than their 80-year average for this time of the year.

There are also possible offsets associated with the drought, reflecting industries that may have been positively influenced by the dry weather conditions relative to our HYEFU forecasts. This includes parts of the horticulture industry including wine, the construction and forestry industries, and hospitality. However, on balance, the immediate risks to our drought impact estimate are for a larger negative impact on real GDP than outlined above, possibly up to 1% in the 2013 calendar year.

More generally, there may be longer-term effects from the drought than we have assumed, particularly into the 2014 calendar year if the drought persists longer than assumed in this analysis and a cold, dry winter weighs on ewe conception rates this autumn. An estimate of the size of this impact, however, would have to consider a wide range of possible offsets. These include any potential boost from a weaker exchange rate, different monetary policy settings than forecast, the possibility of higher average livestock weights next season because of lower stock numbers.

Monthly Economic Indicators is a regular report prepared by the Forecasting and Monitoring team of the Treasury

Disclaimer: The Treasury has made every effort to ensure that the information contained in this report is reliable, but makes no guarantee of its accuracy or completeness and does not accept any liability for any errors.  The information and opinions contained in this report are not intended to be used as a basis for commercial decisions and the Treasury accepts no liability for any decisions made in reliance on them.  The Treasury may change, add to, delete from, or otherwise amend the contents of this report at any time without notice.

Contact for enquiries:

The Treasury
PO Box 3724, Wellington
NEW ZEALAND
information@treasury.govt.nz
Tel: +64 4 472 2733
Fax: +64 4 473 0982
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