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Modelling Shocks to New Zealand's Fiscal Position WP 11/02

4  Scenario 1: A one-off spending shock

The New Zealand economy faces a range of one-off risks that could lead to a spike in spending. These could include natural disasters, an outbreak of disease, or events brought about by political decisions. We model a size 7.8 Richter scale earthquake centred close to Wellington. A Wellington earthquake has been chosen as an example of a one-off shock because: its impact on growth is muted over a reasonable timeframe; its effects on spending are, for the most part, short-lived; and, in terms of magnitude, a large earthquake exceeds the cost of many other one-off shocks.

Box 2: Canterbury Earthquake

The Earthquake scenario was chosen prior to either Canterbury earthquake. As a result, no attempt has been made at this stage to update this modelling based on events in Canterbury.   The estimates sourced from Savage (1997) are based on a 7.8 Richter scale Wellington quake.  This amounts to a quake 11 times the size of the September 2010 Canterbury earthquake.  We have taken Savage's estimates of losses based on limited insurance cover to get a large downside scenario.  The presence of reinsurance, as shown by the Canterbury quake, would make the final cost of a quake even more manageable from a fiscal perspective. 

Actual damage is a factor of magnitude, depth, and distance from the epicentre.  Wellington's proximity to a large number of fault lines, steep hillsides, and limited access routes suggest a quake in Wellington could cause significant damage.   Savage expected that the quake damaged 80% of all commercial buildings, 15-20% of plant and equipment is destroyed, and up to 85% of private dwellings would have some damage.  Of these only 12% of houses would have extensive damage.

An earthquake would impact on government expenses through publicly provided EQC insurance for residential property, damaged infrastructure, and higher benefit payments. The estimated cost[8] to the government of $15 billion (Savage, 1997) is assumed to lift debt over the three years after the quake, although, costs after a large quake could show more persistence. The resulting investment boom (replacing damaged assets) offsets the loss of output through the Wellington region over the short term. Much of the earthquake repairs and investment frontload maintenance: thus regional GDP drops over the medium term as investment declines into a trough. Longer term, the net impact on growth, as measured by GDP[9] over the projection period, is largely negligible.

Table 4: GDP impacts of an earthquake scenario (nominal % deviation from forecast)
Year after quake Quake + 1 + 2 + 3 + 4 +5 + 6 + 7 + 8 + 9 + 10
GDP impact (% change) +5.9 +3.6 +2.6 0.0 -0.8 -1.5 -1.7 -1.3 -0.7 -.3 0.0

Source: Savage 1997

Note: +1 implies the deviation from forecast one year after the year in which the quake occurred.

In terms of the government accounts, the net impact on the balance sheet is a decline in net worth as debt increases by $15 billion (refer Figure 5). Beyond the immediate cost of the quake, spending is assumed to continue to grow at the same rate based on the operating and capital allowances outlined in the 2010 HYEFU. The increase in debt increases debt servicing costs by $1 billion per annum 0.4 % of GDP). This increase in debt servicing costs is not large enough to overcome the projected decline in debt as the economy recovers. Thus, the resulting debt track is largely a level shift upwards with a minimal change in the trajectory.

Figure 5: Gross debt following an earthquake in Wellington
Figure 5: Gross debt following an earthquake in Wellington.
Source: The Treasury, HYEFU 2010

These estimates of the costs of a Wellington earthquake are purposely severe and could vary significantly. While extreme, these estimates serve to illustrate that the liquidity risks around a one-off increase in debt are not particularly significant. $15 billion is a large number, but as a percentage of GDP the impact is less pronounced. Markets may be concerned about the increase in debt, but would likely be satisfied that the downward trend beyond 2013/14 signals that the fiscal position remains sustainable. A slight increase in bond rates is possible, especially if the credit rating suffered.

Table 5: Earthquake scenario summary statistics
Risk indicator Summary Liquidity Risk Adjustment cost
Stock of debt Debt peaks under 40% of GDP four years after the quake then declines thereafter. This peak is still below either Spain or Ireland in the OECD comparison chart (Figure 3). Liquidity risk is still elevated at 40% of GDP, but would depend on market conditions. Reducing debt from 40% of GDP would only require government to stick to $1.1 billion operating allowance.
Direction of the projected debt track Debt peaks in 2014/15 at 41% of GDP and declines towards the end of the projection period. The decline in debt towards the end of the projection period signals limited liquidity risk. N/A
Amount of consolidation to stabilise debt track over five years Unlikely to be required by markets, but the government may choose to try and reach its 20% net debt target by the end of the projection period. N/A N/A
Change in the structural balance A one-off spike in spending is not treated as structural.  N/A N/A
Change in the NIIP Growth in the NIIP slows as reinsurance claims lower the current account temporarily. A lower NIIP, all else equal suggests a moderation in liquidity risk. N/A
Conclusions Limited liquidity risk as although debt peaks at 40%, debt declines to a more prudent level by the end of the projection period.  Adjustment would still be desirable to bring debt down quicker and to lower the level at which debt peaks.

Based on this illustrative analysis we conclude that the growth in Crown net worth (lower debt) over the past couple of decades has put the government in a fairly healthy position with respect to most one-off shocks. The government may decide to rebuild its fiscal buffers faster, but it would have some flexibility about when this occurs. A combination or series of shocks would still signal concern, but, for the most part, a strong balance sheet provides the fiscal headroom necessary to be able to handle a fairly large natural disaster (or similar) with limited financial distress.

Notes

  • [8]Savage estimates that quake costs could range from $2.9 billion to $11.6 billion as a downside scenario we take his upper estimate and gross it up to cover inflation over recent years.
  • [9]Gross domestic product measures economic activity but largely ignores the fact that much of this activity will be focussed on replacing damaged material. Thus, the proposition that GDP, which affects government revenue, is largely unchanged should not be taken to imply that welfare is not reduced by a quake.
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