6 Scenarios

The Treasury's central expectation for the economy is set out in the economic and fiscal outlook section of the Budget Economic and Fiscal Update 2011. It is consistent with a view of continuing economic resilience, with incomes rising and some improvement in balance sheets.

The five-year forecasts show that economic activity is expected to steadily pick up from its current subdued levels following the earthquakes. Economic growth is expected to rise to around 4% in the March 2013 year before falling back closer to 3% in subsequent years. This economic pickup is expected to reflect earthquake-related investment, together with higher tradable activity and the current buoyancy in commodity prices expected to continue. Private consumption growth is expected to become a more important growth driver later in the forecast period, as household saving falls back towards historic norms. Underpinning private consumption growth, house prices are expected to start increasing by around 2% to 3% per annum from 2013 following a period of virtually no change. This compares to nearly 15% on average during the housing boom prior to the GFC.

Higher investment driven by the reconstruction of Christchurch will see a return to larger current account deficits of around 6% over the medium term. However, this is considerably less than before the GFC (around 8% of GDP). This is because there is an improvement in national savings. This is driven by higher household saving rates compared with prior to the GFC because of their current balance sheet concerns (albeit a diminishing driver over the forecast period), and higher government savings as the fiscal balance continues to improve. An expected fall in the exchange rate will also benefit tradables in the latter half of the forecast period. Higher expected current account deficits will see the net international investment position slowly tracking back towards its level prior to the GFC (Figure 5).

However, less benign paths for the economy are possible if “nothing” is done to reduce the threats to the economy. The following scenarios set out in more detail more extreme versions of the crisis risk identified in Section 4.2 from high debt imbalances. It is important to note that these are illustrative scenarios, rather than forecasts, and they should not be interpreted as describing the normal upside and downside risks that reflect variance around the central economic outlook.

It is difficult to predict or second-guess exactly how a financial crisis could unfold because of New Zealand's unique institutions and circumstances. While, in the first instance, a sovereign-debt crisis is unlikely in New Zealand, financial crisis could take the form of a domestic banking financial crisis. This could happen, if for example, a widespread bad property debt problem were to develop to the point that threatened banking solvency. Alternatively, it could take the form of a “sudden stop” in offshore capital inflows, if global capital markets were to seize up again, or if foreign investors were to reconsider New Zealand as an investment destination.[32] Or it could be some combination of a “sudden stop” and a banking crisis.

6.1 Banking crisis

The majority of bank lending in New Zealand is based more against an assessment of future income, and so ability to service debt, rather than the value of collateral. This reflects that mortgage lending to households and farms in New Zealand is generally recourse to a mortgagor's total assets and future income. It means banks' greatest risk exposure is to sharp economic contractions rather than falls in the value of property that can cause wide spread negative equity. A sharp economic contraction would cause widespread unemployment, reduced incomes, or increased debt-servicing costs, which in turn would cause nationwide financial stresses leading to defaults.

However, lending mainly against income instead of asset values does not mean the solvency of New Zealand's banking system is immune to declines in the property market, especially given the relationship between the property market and economic activity. A combination of liquidity and solvency problems in the property market caused by some shock can compound one another with aggravating economic consequences.[33] For example, forced property sales can lead to lower asset prices, setting off further solvency concerns, and so even tighter lending and economic conditions, reducing liquidity even more, which compounds soft prices (i.e. a downwards self-reinforcing spiral). This type of phenomena is often described as a “Minsky moment” after the economist who analysed asset and credit market cycles (Whalen, 2008).

Given New Zealand's currently high property prices relative to trend, a fall in prices below some notion of “fair valuation” would necessarily involve a very significant fall in price. This would have large associated economic-activity consequences, and would likely cause extreme banking stresses that required remedial actions by shareholders to the further detriment of the wider economy.[34] If bank losses were large enough and widespread, it could pose a significant risk to the whole banking sector. This could feed back again into lending behaviour, confidence, and so the macro economy, as well as the fiscal position. This has been the case in Ireland, where house prices have fallen by around 40%, and in the United States, which has seen house prices fall by around 30%.

In Ireland, the combination of the housing and banking crisis has resulted in its GDP falling by around 14.5%. This has recently led to international financial assistance being required to help the Irish government manage the economic and financial consequences. Unlike Ireland, which has a large banking sector relative to the size of its domestic economy, the smaller size of New Zealand's banking sector means a widespread systemic banking crisis is likely to be more manageable within New Zealand's financial resources.