3.2 Economic modelling
Changes in modelling assumptions can be used to illustrate the potential impact of unprecedented events. The two stylised events, used to examine these changes, are a 7.8 earthquake (roughly 11 times larger than the September 2010 Canterbury quake) and a rapid process of domestic deleveraging. Each event would affect the Crown's fiscal position in a different way depending on its source, scope, and how the government responds. An earthquake shows how the fiscal position could respond to a large, but discrete, spike in recovery-related spending. Conversely, a process of deleveraging illustrates the destabilising effect of a growth shock with a more persistent effect. These shocks are illustrative, and are only two of the many potential shocks the Crown faces. A summary of some other major shocks is included in Table 1.
| Examples of major shocks | Example | Impact on the economy | Persistence | Expected incidence | NZ specific, regional or global? |
|---|---|---|---|---|---|
| Pandemics and health emergencies | SARS, Swine Flu |
|
Usually short lived | Very rare | Usually Global |
| Natural disasters | An earthquake, volcanic eruption, large scale droughts, etc. |
|
Short to medium-term impact; but may have permanent effects | Very rare for large shocks to occur | NZ specific |
| Agricultural disease | A foot and mouth outbreak |
|
Short-term impact, but may have permanent effects | Rare | Largely NZ specific |
| Economic rebalancing | International credit crisis, domestic housing market crash etc. |
|
Medium-term impact | Rare | NZ specific, regional or global |
| Large negative terms of trade shock | A decline in demand/price perhaps associated with one of the above scenarios |
|
Short-term impact | Fairly regular | Regional |
The impact of changes in GDP, employment, and government spending associated with each shock were modelled using the Treasury's Fiscal Strategy Model (FSM). The FSM models how changes in financial flows (spending and tax) impact on key stock measures such as debt, net worth, or net debt. The FSM is not an economic model, which means the full interaction between economic variables and fiscal changes is not captured. Despite this, rudimentary analysis can be undertaken. The exact impact is highly uncertain. Thus, for these scenarios, the size of the changes has been based on previous modelling or the experience of other OECD countries. In each case, changes were made relative to the forecast financial numbers included in the 2010 Half Year Economic and Fiscal Update (HYEFU). Any scenario-specific changes to the standard assumptions published in the 2010 HYEFU documents are discussed in the relevant sections of this document.
Each of the scenarios modelled in this paper involve a significant increase in government debt. At elevated levels, government debt can impact on interest rates and economic growth. To recognise this impact, the FSM model has been adapted to include a feedback (refer Figure 2) between the stock of government debt and the five-year government bond rate[4]. Bond rates are assumed to increase by five basis points[5] for each percentage point increase in government debt (Baldacci & Kumar, 2010)[6].
- Figure 2: The fiscal strategy model with interest rate feedback
- Source: The Treasury
While higher government debt might also slow growth (Pattillo et al., 2002, Reinhart & Rogoff, 2010), the impact of debt on growth has not been explicitly incorporated in our model. Higher interest rates create uncertainty that can impact on both capital accumulation and productivity growth. The IMF estimate that growth declines by 0.11% at debt levels beyond 30% of GDP (Kumar and Woo, 2010b). This rises to -0.16% at debt levels greater than 60% of GDP, and again to -0.19% once government debt rises above 90% of GDP. However, the exogenous growth figures used in this paper, are sourced from actual case studies that already implicitly include these detrimental growth effects. If included, the IMF's growth estimates would only change the estimated debt levels under each scenario by between one to two percentage points.
Comprehensive balance sheet analysis utilises a wide range of metrics and measures. This study, which focuses on liquidity risk, uses gross debt as an internationally recognised measure of rollover or liquidity risk (IMF, 2010). Some broader measures, such as net debt (the current focus of fiscal strategy), provide a better measure of solvency over time. However, gross debt, as a relatively simple measure, enjoys a more standardised definition that facilitates inter-country comparisons (see Box 1).
Box 1: Measures of financial strength
The balance sheet in accounting terms is a measure of financial strength at a point in time. Depending on the question you are interested in asking, there are different ways to measure or analyse the balance sheet.
| Measure | Definition | Best measures | Comparability between countries | Stability of estimates |
|---|---|---|---|---|
| Comprehensive net worth (CNW) | Measures whether the net present value of future receipts exceeds the net present value of future expenditures. | Solvency over time | Poor - no country reports this measure | Poor - difficult to estimate and subject to change depending on choice of discount rate |
| Accounting net worth (ANW) | The net worth figure reported in the Crown financial statements based on generally accepted accounting practice. | Solvency at a point in time | Poor - few countries publish a balance sheet | Low - subject to valuation changes |
| Net Debt | Net debt is gross debt minus core Crown financial assets (excluding advances and the NZSF which are held for policy purposes). | A measure of the assets and liabilities that the Crown could use as a buffer in crisis | Low - the definition of net debt varies between countries | Good - some financial assets may vary in value |
| Gross debt | Gross debt includes all debt issued by the sovereign (core Crown). | Liquidity risk on the liability side of the balance sheet | High - countries have different reporting entities, although the definition is fairly standard | High - the face value of debt is fixed in nominal terms |
| Measure | Definition | Best measures | Comparability between countries | Stability of estimates |
|---|---|---|---|---|
| Operating Balance | The residual of revenues less expenses plus surpluses from Crown entities. | The operating deficit or surplus | High - the operating balance has an accepted definition | High |
| Structural balance | The operating balance less revenues or expenses that fluctuate over the economic cycle. | The proportion of the deficit that will not recover with growth | Low - separating structural and cyclical revenues is difficult | Low - estimates of cyclical revenues may be revised |
| Primary balance | The operating balance less net interest costs. | The proportion of the deficit needed to be cut to stabilise debt | High - Interest costs are easily identifiable | High |
Notes
- [4]A link between the operating allowance and interest rates is also possible, but, theoretically, the magnitude of the impacts should be similar.
- [5]A basis point is 1/100th of 1%.
- [6]In a crisis, the central bank may lower interest rates to stimulate growth, while government bond rates rise to attract lenders.
