1 Introduction
New Zealand has proven relatively resilient through the recent financial crisis. However, New Zealand, like any country, should, over a reasonable timeframe, expect to face a range of one-off economic shocks. Many shocks are short lived but may exert a significant fiscal cost. Examples could include unusually large swings in the terms of trade or risks associated with our relatively volatile natural environment. Other risks may have a more prolonged effect, which can lead to large changes in the fiscal position. For this reason, governments are equally concerned about economic imbalances or any factor that may unexpectedly alter the sustainability of policy over time.
Treasury has completed a number of studies looking at risk management and the Crown balance sheet. Bradbury, Brumby, and Skilling (1999) propose an analytic framework for sovereign risk based on measures of comprehensive net worth. Comprehensive net worth is a forward-looking measure that takes into account the present value of future tax and spending. Huther (1998), Fabling (2001), and Irwin and Parkyn (2009) use a mean-variance approach to estimate the volatility of the Crown's comprehensive balance sheet. Davis (2002) looked at uncertainty in the Crown's long-term fiscal projections. Work was also done by Grimes (2001) on the Crown's financial objectives and the issue of centralised versus decentralised financial management.
This paper explores the use of severe scenario analysis - sometimes referred to as stress testing - to supplement previous work on Crown risk. Scenario analysis can be used as a guide for contingency planning. While a crisis event would impact on a large share of the population, the focus of this paper is on how the fiscal position could evolve in such an event. Specifically, this analysis compares the potential size of fiscal adjustment to historical precedent to determine a subjective measure of liquidity risk. A liquidity crisis occurs when the government can no longer source enough cash at a reasonable cost to cover the cost of its current commitments.
The rest of this paper is divided into four main sections covering: Crown risk management; methodology; scenarios; and future work. Two main scenarios are modelled using HYEFU data from December 2010: an earthquake; and a process of economic rebalancing. The analysis in this paper was initiated before the September 2010 earthquake and, as such, the shocks in this paper are purely hypothetical. The focus of this paper is on how idiosyncratic shocks can be modelled, so no attempt has been made to incorporate any specific lessons from events in Canterbury.
