Half Year Economic and Fiscal Update 2005

Statement of Responsibility

On the basis of the economic and fiscal information available to it, the Treasury has used its best professional judgement in supplying the Minister of Finance with this Economic and Fiscal Update. The Half Year Update incorporates the fiscal and economic implications both of Government decisions and circumstances as at 7 December 2005 that were communicated to me, and of other economic and fiscal information available to the Treasury in accordance with the provisions of the Public Finance Act 1989.

John Whitehead

Secretary to The Treasury

9 December 2005

This Update has been prepared in accordance with the Public Finance Act 1989. I accept overall responsibility for the integrity of the disclosures contained in this Update, and the consistency and completeness of the Update information in accordance with the requirements of the Public Finance Act 1989.

To enable the Treasury to prepare this Update, I have ensured that the Secretary to the Treasury has been advised of all Government decisions and other circumstances as at 7 December 2005 of which I was aware and that had material economic or fiscal implications.

Hon Dr Michael Cullen

Minister of Finance

9 December 2005

1 Economic and Tax Outlook

Summary

• The Half Year Update economic forecasts show a more cyclical path for the economy than the Budget and Pre-election Updates with higher growth in the near term but a deeper slowdown in the 2007 and 2008 March years.
• Real GDP growth of 2.9% is forecast in the year to March 2006. The economy is then forecast to record two years of sub-trend economic growth, with growth slowing to 1.7% in March 2007, before recovering to 2.5% in March 2008, compared with 2.6% and 3.5% respectively in the Pre-election Update. This forecast would represent the weakest two consecutive years of growth since 1998 and 1999 following the Asian Crisis and drought.
• Growth is forecast to rebound to 3.8% in 2009 and back to trend growth of around 3% in 2010. Trend growth prospects remain the same as in the Pre-election Update. The forecasts reflect the interaction of differing cyclical factors influencing the domestic and external sectors of the economy.
• Across the forecast period we see labour productivity making a bigger contribution to growth than has been the case in recent years. This reflects in part changing relative prices between capital and labour, with higher real wages on average over the forecast period expected to see a period of capital deepening. Business investment has increased sharply in recent years.

Figure 1.1 – Real GDP

Sources: Statistics New Zealand, The Treasury

• While aggregate real GDP growth in the year to June 2005 has slowed broadly in line with previous forecasts, the composition of GDP growth has been different. Domestic demand growth has not slowed as much as expected, while export growth has been weaker.
• A consequence of this growth performance has been that the imbalances and pressures in the economy that were noted in the Pre-election Update have intensified, highlighted by rising inflation, an expansion of the current account deficit and over valuation of house prices.
• A number of the factors forecast to lead to slower growth have been in place for some time, including lower levels of net migration, a high exchange rate, interest rate increases. We have also seen weak agricultural production. To date, these effects have been offset by continued strong household income and house price growth and high world prices for key exports, which have all contributed to an on-going willingness of households to take on more debt.
• A slowing in domestic demand through weaker consumption and residential and business investment, together with falls in house prices largely due to higher effective interest rates and the flow-on from lower net migration, is a key contributor to a period of weak GDP growth. The forecast slowing in domestic demand growth is more abrupt than in the Pre-election Update.
• Export growth is forecast to be constrained by a muted recovery in agricultural production and by the effect of the high level of the exchange rate on some other components of exports. The outlook for exports is substantially weaker than in the Pre-election Update. Export growth recovers in the March 2008 and 2009 years on the back of an assumed exchange rate depreciation.
• These developments are forecast to see the current imbalances unwind in a gradual manner.
• While more positive scenarios are possible, our view is that the current mix of global and domestic growth drivers and imbalances carry with them increased risk of a more abrupt adjustment in the economy. Some of these risks are explored in the Risks and Scenarios chapter.
• Tax revenue growth falls to 3.2% and 2.8% in the 2007 and 2008 June years, from the double digit growth rates in the last couple of years. The period of weak GDP growth contributes to a fall in profits in 2007. This is associated with slowing growth in corporate tax revenue, and some increase in tax loss utilisation.
• In the Central Forecast the response of businesses to weak growth in profits is muted due to strong corporate balance sheets. This is a key judgment underpinning the forecasts. The response of households to these developments is another key judgement underlying the Central Forecast. If there is a bigger response to high interest rates, or if firms shed labour, with a consequent effect on income, then the slowing in private consumption and residential investment would be greater than forecast in the Central Forecast.

Table 1.1 Economic Forecasts

Assumptions Underlying the Central Forecast

Global economic outlook: global economic growth, inflation and interest rates are assumed to conform to those presented in the October Consensus Forecasts and Asia and Pacific Consensus Forecasts. Economic growth for New Zealand’s 14 largest trading partners is forecast to be 3.2% in 2005 and 3.2% in 2006. There are some risks around the global outlook, including how high oil prices affect growth and inflation.

Climatic conditions are assumed to return to normal in the 2006/07 growing season. The 2005/06 season has been affected by a wetter than usual beginning to spring in the North Island and drier than usual conditions in the South Island. The North Island also began to become dry late in spring.

Oil prices temporarily moved above US$70/barrel in September due to a combination of strong demand and disruptions to supply and refining capacity around the Gulf of Mexico during Hurricanes Katrina and Rita. Since that time prices have declined, and are forecast to hold at around US$59 throughout the 2006 calendar year, then gradually decline to US$54 at the end of the forecast period. The outlook is based on futures prices at the time the forecasts were finalised.

Figure 1.2 – TWI

Source: RBNZ

Net migration inflows have declined from a peak of over 40,000 in the middle of 2003. Net inflows are assumed to be 7,000 in the year to March 2006, then hold steady at 10,000 people a year for the rest of the forecast period.

The TWI measure of the exchange rate is assumed to decline to around 68 early in 2006, 61 by the beginning of 2007 and then decline gradually to 58.5 by the end of the forecast period.

Recent Economic Developments

The rate of economic growth has moderated …

Economic growth has slowed from over 4% through much of 2004 to 3.1% in the year ended 30 June 2005. The final two quarters of 2004 and the first half of 2005 have seen three quarters of below trend growth rates, with growth of 1.1% in the June quarter breaking the pattern of below trend out-turns. The June quarter result was stronger than the 0.7% expansion in activity forecast in the Pre-election Update.

… following a period of strong growth.

A variety of factors have contributed to a period of strong growth from 2000 to 2005:

• The Overseas Trade Index measure of the terms of trade increased 9.7% from the beginning of 2003 to June 2005, through a period of accelerating world prices for New Zealand’s exports and declines in some categories of import prices, particularly plant and machinery imports. This has boosted incomes in the economy and reduced the cost of some investment projects.
• Net migration inflows, which peaked at just over 40,000 in 2003, lifted domestic demand and labour supply.
• A period of relatively low interest rates, compared with New Zealand’s historical experience.
• Strong employment and wage growth and a low unemployment rate.
• Rising household wealth due to house price increases.

On the supply side, labour utilisation growth has been strong in the 12 months to June 2005 while labour productivity growth has been subdued.

Much of the growth in GDP has come from increases in labour utilisation, with increases in working age population, labour force participation, average hours worked and a decline in the rate of unemployment. The contribution to GDP growth from growth in labour productivity in the year to June 2005 has been weak.

Sources of growth have deviated from forecast.

Headline GDP growth has been broadly consistent with the forecasts in the Budget Update and the Pre-election Update, slowing at a similar speed to forecast. The composition of GDP growth has however been quite different from forecast. Domestic demand growth has exceeded expectations, leading to strong growth in imports, while export growth has been weaker than expected. Imbalances and pressures have built up in the economy due to a sustained period of above trend growth and interest rates and the exchange rate have increased. A consequence of the recent growth performance is that the pressures have intensified, highlighted by rising inflation, an expansion of the current account deficit and a rise in household debt.

Figure 1.3 – Contributions to real GDP growth, first half of 2005 annualised

Source: Statistics New Zealand, The Treasury

Figure 1.4 – Growth in export volumes

Source: Statistics New Zealand

Recent growth has been constrained by a weak export sector …

Weak growth in export volumes has been one of the contributors to the slowing in GDP growth. Export volumes grew only 0.5% in the year to June 2005, compared with 4.4% in the previous June year. Agricultural exports were particularly weak, in large part due to a poor season of dairy production. Both dairy and meat export volumes recorded declines. A rising exchange rate dampened NZD prices, discouraging forestry export volumes, while the growth of manufactured exports has slowed in the face of a higher exchange rate. The effect of the exchange rate can also be seen in services exports where volumes increased less than 1% in the year to June, as it became more expensive for visitors to come to New Zealand.

… however, a strong labour market and buoyant housing market have helped sustain solid growth in domestic demand …

House prices measured in Quotable Value NZ data have increased 43.7% since the beginning of 2003, including solid rises during 2005, lifting household wealth, contrary to our expectations of an easing in price increases over the course of 2005. Meanwhile, growth in employment, which has seen the unemployment rate fall to 3.4% in September, has boosted incomes. These wealth and income effects have seen a sustained period of growth in private consumption and residential investment, despite some recent slowing in the growth of the latter, and have been coupled with a steady rise in household debt levels. Business investment has also increased as firms have sought to expand productive capacity during a period of strong demand and difficulty finding workers. Growth in real public consumption has also contributed to the strength in domestic demand, growing 5.2% in the year to June 2005. Non-market investment, largely through construction activity in a variety of infrastructure projects, has further contributed to domestic demand.

… leading to strong growth in import volumes.

Import volumes have been growing at double digit rates since the beginning of 2004 in response to strong domestic demand, a lack of spare capacity in New Zealand and the high level of the exchange rate. Growth has been broad-based with high capital imports on the back of growth in business investment and solid growth in imports of consumption goods.

In production terms the service sectors have provided the strongest growth

Over the year to June the service sectors have accounted for almost all of the growth in GDP, with the largest contributions coming from finance and business services, wholesale and retail trade and transport and communication, all reflecting strong domestic activity. The primary sector has made little contribution to growth, while the goods producing industries, with the exception of the construction sector, have subtracted from growth. Weak manufacturing performance, perhaps reflecting the effect of the high level of the exchange rate on exporters, has been one of the key reasons for the sluggish performance of the goods producing industries. These trends have been mirrored in the labour market, where most of the largest increases in employment between September 2004 and 2005 have come in the services sectors and in the construction industries. The levels of employment in the primary sector and manufacturing have both fallen.

Figure 1.5 – Contributions to production GDP growth

Source: Statistics New Zealand

There are growing signs of imbalances in the economy.

Growth in imports and weak exports have seen the deficit in the merchandise goods balance in the current account reach high levels, despite increases in the terms of trade. The strength in the domestic economy has translated into solid business performance and high profits, which have boosted corporate tax revenue but also expanded the deficit on investment income in the current account. All of these factors have seen the current account deficit reach 8% of nominal GDP in June 2005.

Increasing pressure on available resources, as suggested by high capacity utilisation and rising pricing pressures, with inflation increasing over 3%, together with the expansion in the current account deficit, suggest increasing imbalances and pressures in the New Zealand economy as was noted in the Pre-election Update. There has been little alleviation in these imbalances since the publication of the Pre-election Update, and if anything they have intensified.

Tax revenue has been marginally higher than forecast in the Pre-election Update.

Since the Pre-election Update forecasts were finalised, tax revenue has evolved broadly in line with forecast. However, some higher revenue flows than forecast are becoming evident in source deductions, fuelled by a strong labour market, and interest withholding tax, where we have previously underestimated the effect of relatively high domestic interest rates on the deposit base.

Although it is now starting to show signs of slowing, tax revenue is still growing at just under 10% per annum.

Imbalances in the Economy

Divergent growth in the economy

As discussed in the main body of this chapter, recent economic growth has featured a divergence in growth in different sectors of the economy. In expenditure GDP terms this has been highlighted by strong growth in elements of domestic demand, including household spending, market and non-market investment and public consumption, all lifting growth in Gross National Expenditure. Strong domestic demand has drawn in imports, while export growth has been weak, due to a combination of a high exchange rate and poor agricultural conditions. In production GDP terms the divergence is highlighted by the differing fortunes of the services sectors versus the rest of the economy. Almost all of the GDP growth in the last 12 months has come from the service sectors.

On-going strength in domestic demand, at above trend rates of growth, has gradually increased the pressure on available resources. This has shown up in a high level of capacity utilisation and firms facing difficulty finding skilled labour. In turn this has lifted pricing intentions as firms face rising costs, all of which has ultimately fed into rising inflation in the non-tradable sector.

Expanding household debt

Domestic demand has been partially funded by increases in income. It has also been funded from increased borrowing. Household debt has expanded sharply in the last few years, increasing to 158% of disposable income, compared with 136% in 2003.

Much of the expansion in debt has been more than matched by increasing house prices, such that household net wealth has increased. We do not believe that further gains in house prices can be sustained beyond the next couple of quarters. Vacancy rates have increased above historical levels and rental returns have not matched increases in prices, with many rental owners budgeting on future capital gains. We do not expect this to continue; indeed, prices are likely to decline a little as they move back in line with fundamental determinants, such as the growth of the population and income growth. This may leave some people, who have increased debt in the expectation of future capital gains, exposed to substantial debt servicing costs.

Widening Current Account Deficit

The current account deficit has expanded to 8% of nominal GDP. The current account can be analysed as the flow of goods, services and income, and the main body of this chapter touches on the influences of imports and exports on the current account. It can also be analysed as the difference between national saving and investment. From a saving and investment perspective, the increase in the current account deficit over the past few years has been due to a combination of a slightly lower national saving rate and increased investment in the economy. As a country, New Zealand has spent more than it has earned.

Figure 1.6 – Nominal investment as a proportion of GDP

Source: Statistics New Zealand

The government has been increasing its saving, which has been more than sufficient to meet its investment requirements. The expansion in the current account deficit has been due to the decisions and behaviour of people in the private sector. Growth in consumption has exceeded growth in income. On the investment side, the accompanying graph shows the pattern of nominal residential and other investment as a proportion of GDP, and suggests that much of the saving-investment shortfall has been due to growth in residential investment. With national saving not sufficient to cover New Zealand’s investment, the savings of foreigners have been required to finance the shortfall, raising net liabilities in the International Investment Position (IIP), which adds up all of New Zealand’s foreign assets and liabilities, to over 80% of GDP and lifting household debt.

We do not believe that such a current account deficit can be sustained indefinitely. It would imply an ongoing increase in the net liability position, with consequent increases in servicing costs that have to be met by New Zealanders. As an example, even in the current account outlook in the Central Forecast there needs to be a sizable capital inflow, which would be likely to increase the IIP position to 90-100% of GDP. Valuation changes mean that it is difficult to be precise about where the IIP will end up but this highlights that if there is no closing in the deficit then it is likely to expand even further. Such a level of the IIP would be difficult to maintain as it would be associated with an increasing share of national income devoted to servicing international liabilities. New Zealand has not been able to sustain prolonged deficits in the order of 8-9% in the past.

Imbalances forecast to unwind

While the imbalances are expected to remain in the short-term, they are eventually forecast to unwind due to an easing in domestic demand through private consumption, residential investment and business investment and an easing in house prices. The reaction of households to interest rate increases is a key component of this unwinding of imbalances. The fall in residential investment is particularly important. The judgement underlying the forecasts is that housing market activity has gone beyond what can be explained by fundamental drivers of activity. Certainly, household incomes have been rising and job security is strong. However, slower population growth would normally be expected to put some downward pressure on prices. In addition higher house prices for rental properties have not been justified by higher rents; weekly rents have risen barely faster than consumer price inflation, and far more slowly than house prices.

It is possible that there will be a more abrupt adjustment in the household sector, if for example foreign investors react to the high current account deficit, triggering a sharp fall in the exchange rate, or if households feel the effects of higher interest rates more severely and curtail spending more sharply.

Economic Outlook

Growth is expected to slow over 2006 …

In the short-term some further momentum in domestic demand is expected. Solid GDP growth of 0.8% and 0.7% a quarter is forecast for the last two quarters of 2005. Growth of 2.9% is forecast in the year to March 2006. Below trend quarterly growth rates are forecast for 2006 through a combination of weak export growth and a slowing in domestic demand, as higher interest rates and an end to wealth gains from housing see a period of household consolidation.

… and the economy is forecast to record two years of sub-trend growth in March 2007 and 2008 …

During 2006 the combination of subdued export volumes and slowing domestic demand sees GDP growth slow to 1.7% in the year ended March 2007 and 2.5% in March 2008, compared with 2.6% and 3.5% respectively in the Pre-election Update. Growth is forecast to recover further to 3.8% in 2009 and to trend rates of growth of around 3% at the end of the forecast period. This outlook sees two years of sub-trend economic growth in 2007 and 2008 and would represent the weakest two consecutive years of growth since 1998 and 1999 following the Asian Crisis and drought.

Figure 1.7 – Real GDP

Sources: Statistics New Zealand, The Treasury

The outlook for growth is more cyclical than in recent forecasts. Part of the reason for this is the forecast adjustment in domestic demand. Some of the recent growth has been driven by household borrowing and growth is forecast to slow as past interest rate increases begin to affect behaviour. In a cyclical sense this is compounded by the outlook for exports, where volume growth is forecast to be limited due to a forecast weak recovery in dairy exports and the effect of the exchange rate on some other categories of exports. The combination of these domestic and external influences is forecast to lead to a bigger and more prolonged slowing in growth than forecast in recent Updates. The view of trend growth underlying these cyclical patterns is unchanged from the Pre-election Update.

… contributing to a slowing in tax revenue growth.

Tax revenue growth is forecast to decline. Weaker domestic demand growth leads to slower growth in GST and a decline in profits sees a slowing in company tax growth. There are risks around the tax forecasts. If economic growth does not slow to the extent forecast in the Central Forecast then tax revenue is likely to be stronger; likewise, higher inflation would see more tax revenue. Should household spending or the labour market slow more quickly, or further, than forecast, this would be associated with a period of weaker tax revenue. The risks and scenarios chapter considers the fiscal implications of two scenarios where judgements around the economy evolve differently from forecast in the Central Forecast.

Some key drivers of activity have turned down in recent times, while others are forecast to turn down over the next 12 months.

The prices of many of New Zealand’s commodity exports have begun to ease from previous highs. This is forecast to feed into a decline in the terms of trade during the early stages of the forecast period. Net migration inflows have eased over the past two years, interest rates have increased and the exchange rate remains at a high level. All of these factors are forecast to contribute to a further slowing in the rate of growth in GDP. To date these factors have largely been offset by a strong labour market and wealth gains from house price increases.

Figure 1.8 – SNA terms of trade

Sources: Statistics New Zealand, The Treasury

The effect of interest rate increases on households is a key judgement underlying the forecasts …

In the short-term, recent labour income growth and house price increases are forecast to continue to provide momentum to private consumption growth. We expect that house prices will have recorded further increases over the second half of 2005, and have forecast some declines during 2006 as recent interest rate increases begin to slow activity. Strength in the housing market, together with solid labour income growth, sees quarterly GDP growth of 0.8% in September and 0.7% in December. Annual private consumption growth is forecast to be 4.4% in the March 2006 year, before declining to 1.8% in 2007 and 1.0% in 2008.

… as it leads to a slowing in private consumption growth, falls in residential investment and house prices.

A number of the factors that have supported growth in recent times have already reversed or are forecast to do so. The factors contributing to the slowing of consumption growth include:

• The lagged effect of past interest rate rises on the effective mortgage rate faced by households.

Figure 1.9 – Private consumption and residential investment

Sources: Statistics New Zealand, The Treasury

• Higher oil and petrol prices which reduce the effective disposable incomes of households.
• Lower additions to the population from net migration.
• A slowing in house price growth and hence a reduction in wealth effects.
• A slowing labour market including slowing employment growth, slower labour income growth and rising unemployment.

While interest rate increases appear to have had little effect on household spending over the last 12 months, over the forecast period growth is forecast to slow due to the lagged effect of past rate increases. Many households have been insulated from interest rate increases by fixed rate mortgages. As these roll over, borrowers will experience increases in the effective interest rates that they face, raising debt servicing costs. Households are forecast to react to this by reducing growth in private consumption and residential investment spending. Despite this slowing, debt servicing remains at a high level and the financial position of households is an important risk to the Central Forecast. The risks and scenarios chapter includes a scenario where households make a larger adjustment to spending. A larger correction in household spending would be likely to be associated with a larger slowdown in economic growth.

The slowdown in real consumption spending also sees nominal consumption growth slow, contributing to an easing in the growth of GST tax revenue. Higher interest rates than forecast in the Pre‑election Update are forecast to boost Resident Withholding Tax (RWT) over the forecast period. Higher rates have already begun to have an effect with recent RWT revenue exceeding forecasts as attractive interest rates have lifted the deposit base.

Figure 1.10 – Household debt servicing as a percentage of disposable income

Sources: Statistics New Zealand, The Treasury

Residential investment growth has already started to ease and this is forecast to continue with some of the fundamental drivers of activity, including the size of the population and interest rates increases, leading to declines in new building work. The box “Imbalances in the economy” discussed the increase in housing vacancy rates. With these already sitting at high levels, further expansion in investment in new dwellings is unlikely.

Some domestic demand growth is expected to be maintained by growth in real public consumption, which is forecast to growth at annual rates of around 6% until March 2007.

Household Spending and Interest Rates

Since the beginning of 2004 the Reserve Bank has increased the OCR by 225 basis points, from 5% to 7.25%. During the same period floating mortgage rates have increased from around 7% to just over 9%, implying an increase of around 30% in the interest bill for a fixed level of borrowing. Yet to date interest rate increases appear to have had only a very limited effect on private consumption growth.

Figure 1.11 – Interest rates

Source: RBNZ

Part of the reason for continued strength in household spending is related to the strong labour market, which has provided additional jobs as well as strong wage growth. Low unemployment by historical standards is also likely to have buoyed consumers’ confidence about job security and their ability to service increased debt levels in the future.

An additional factor has been the ability of mortgage borrowers to dilute the effect of higher short term interest rates by opting for relatively attractive fixed term rates. This opportunity has been available to borrowers due to a combination of low international and New Zealand bond yields, as well as active competition in the home-loan market towards the end of 2004 as banks actively competed to gain market share. As borrowers have opted to allocate a greater proportion of their mortgage debt to fixed rate loans, the percentage of mortgage debt on floating rates has fallen from around 34% at the beginning of 2004 to just over 20% in October 2005. Over the same period the percentage of mortgage debt with interest rates having an existing fixed rate period of up to 2 years has increased from 50% to 65%.

Figure 1.12 – Mortgage allocation

Source: RBNZ

A consequence of the move to allocating a greater proportion of mortgage debt to fixed term rates has been that the effective (or weighted average) mortgage rate faced by households has not increased as rapidly as movements in the OCR. Between the beginning of 2004 and October 2005, the effective mortgage rate increased from approximately 6.9% to 7.6%, an increase of only 70 basis points compared to the 200 basis point increase in the OCR over the same period.

Over recent months fixed mortgage interest rates have increased. Over the next year or so a number of mortgage borrowers are going to have their home loans (or some part of them) come up for renewal. For a large proportion of these borrowers the lowest available rates available at the time will represent an increase relative to their current fixed rates. As a consequence the effective mortgage rate faced by borrowers is going to increase further, even in the absence of further increases in the OCR. The weighted average interest rate on mortgages due for renewal in less than a year was 7.3% in October 2005, with these loans representing just under a third of all mortgages by value. With one to two year fixed rate loans generally in the 8.2% to 8.5% range at the time of writing, borrowers will be facing higher debt servicing costs over the coming year.

Household debt levels have shown rapid increases over the past couple of years with mortgage debt estimated at $113 billion at June 2005, an increase of nearly $30 billion since June 2003. High debt levels coupled with rising effective mortgage rates will increase the debt servicing costs faced by households and contribute to a slowing in private consumption growth over the next couple of years. Debt servicing costs as a percentage of disposable income (prior to the deduction of interest expenses) are forecast to increase to 11.3% in the year to March 2007, up from 8.4% in 2004.

The extent to which households respond to increasing debt levels is an important judgement in the forecast. As the effect of higher debt servicing begins to impinge on household budgets there is a risk of a bigger slowdown if households become more uncomfortable about their debt levels. This may be particularly so if firms begin to shed some labour and the unemployment rate rises, making households feel more insecure or if a larger negative wealth effect eventuates from a slowdown in house prices.

Slower GDP growth cuts profits and businesses react by reducing investment and slowing their demand for extra labour …

Business investment growth is forecast to slow. Profit growth has been strong in recent years with steady growth in the operating surplus component of nominal GDP. The rate of growth is forecast to slow in 2006 and operating surplus is forecast to fall in 2007. Firms are forecast to respond by cutting back on some investment projects and reducing their demand for new workers.

… while lower profits lead to slower growth in company tax

Weaker profits are forecast to be associated with two years of weak corporate taxes. Corporate tax is forecast to grow 0.7% in 2007, before falling in 2008 as an increase in tax loss utilisation, following above average loss accumulation through 2007, slows revenue growth. As the loss effects dissipate, corporate tax growth recovers to an average of 8.5% over 2009 and 2010.

Figure 1.13 – Corporate taxes and operating surplus

Sources: Statistics New Zealand, The Treasury

“Other persons” tax forecasts are substantially lower than in the Pre-election Update. As with corporate profits, the entrepreneurial income forecast now includes a noticeable business cycle, prompting more of a cycle in the other persons tax forecast. Although entrepreneurial income forecasts are used as the primary driver of other persons tax forecasts, the historical link between the two is tenuous. There are many other factors that affect this tax type, for example personal investment returns, taxpayer choice of business structure. Some of these other factors may be contributing to the generally downward trend in this tax type over the last two years. However, even with a prominent business cycle present in the forecasts, we expect growth in this tax type to average around 3.5% over the next five years.

Labour productivity growth is forecast to lift

Labour productivity growth made little contribution to GDP growth in 2005 and is forecast to make little contribution in 2006. In large part this reflects the strong cyclical performance of the labour market, which has seen employment increase strongly and unemployment rates fall. Labour productivity made larger contributions to growth during the early stages of the upswing in activity. Over the forecast period the contributions to growth from labour productivity increase, averaging 1.4% across the forecast period as a whole, exceeding the average of 1.1% between 1993 and 2005.

Figure 1.14 – Labour productivity

Sources: Statistics New Zealand, The Treasury

The recent increase in employment and fall in unemployment is likely to have attracted an increasing number of inexperienced and lower skilled people into the workforce. As these people become more experienced, labour productivity is forecast to increase. The expansion in the capital stock, through strong investment, that has occurred since 2003 should also contribute to increases in productivity. In addition, despite the period of cyclical declines in investment as profits fall, the underlying trend in investment growth is strong. Coupled with weak employment growth this is forecast to see increases in the capital-to-labour ratio, which is another factor forecast to lead to higher labour productivity.

Sources: Statistics New Zealand, The Treasury

In the short-term the labour market may continue to be stronger than forecast …

The unemployment rate has steadily declined since 1999 to 3.4% in September 2005. Employment growth is forecast to slow as the economy slows and the unemployment rate gradually increases to 4.5%. The slowing in employment growth is forecast to begin from December 2005. In the Pre-election Update, employment growth was forecast to slow in the September quarter; however, the labour market has continued to perform more strongly than forecast. With current momentum in domestic activity it is possible that employment growth will continue to exceed the forecasts. Wage growth has picked up over the last 12 months, matching our Pre-election Update forecasts, reflecting reported difficulties firms are having finding staff. Annual wage growth is forecast to remain above 4% through 2006, helping to underpin income growth. There is a risk that wage growth may continue to rise in the medium term.

… falling employment growth would add to downside risks further out in the forecast period

The reaction of firms to a period of weak profit growth is an important judgement underpinning the forecasts. During the period of weak profits described above, with the operating surplus component of nominal GDP forecast to fall in 2007, it is possible that employment growth will slow further or that firms will seek to cut employment in an attempt to maintain profit levels. The key judgement in the forecasts is that firms will make only small changes to their investment and employment plans.

Apart from periodic changes in tax rates and thresholds, for example in the 1997 and 1999 June years, source deductions tax revenue tends to track Compensation of Employees (COE), a measure of total labour income, fairly closely. We are already seeing source deductions growth in the 2006 June year in excess of that forecast in the Pre-election Update and have therefore increased the current-year source deductions forecast by nearly $200 million, slightly more than the upward revision to COE would suggest. This represents a 1% change in the forecast of this $20 billion tax type. Overall, the growth profile of source deductions revenue tracks COE fairly closely and the upward revisions to the out-years are largely due to the level increase in the current year.

Figure 1.15 – Source deductions tax revenue

Sources: Statistics New Zealand, The Treasury

Weaker domestic demand sees import growth slow

The rate of growth in import volumes is forecast to slow sharply as household spending slows. As well as the direct impact of easing private consumption growth, the sharp slowing in residential investment is also forecast to add to slower consumption growth, with fewer durable goods needed to fit out new houses. The assumed depreciation of the exchange rate makes overseas travel more expensive, which is forecast to contribute to falls in services imports over much of 2007 and 2008. With business investment forecast to fall, imports of plant and machinery also decline. Altogether, import volume growth is forecast to decline to 0.7% and 0.6% in the 2007 and 2008 March years respectively. The closure of a major tobacco processing plant, scheduled for mid-2006, is likely to have a small, upward effect on imports and results in a switch of about $700 million per year from tobacco excise to customs duty.

Figure 1.16 – Inflation

Sources: Statistics New Zealand, The Treasury

Inflation pressures are forecast to moderate as domestic demand cools

The short-term momentum in domestic demand ensures that inflationary pressures remain in the economy, with annual CPI inflation remaining above 3% until March 2007. A quarterly CPI increase of around 0.8% is forecast in December 2005 and a 0.6% increase in March 2006, with transportation, reflecting higher oil prices, and housing likely to make the largest contributions to inflation.

Inflationary pressures in the non-tradable sector are forecast to diminish as growth slows. This reflects an easing in the labour market and a slowing in domestic components of growth. The fall in the New Zealand Dollar contributes to higher tradable inflation over 2006.

If growth does not slow as quickly as forecast then pricing pressure in the non-tradable sector is likely to be maintained for longer. It is also possible that inflation will turn out to be more persistent than forecast, even if GDP growth develops as expected.

Figure 1.17 – Nominal GDP

Sources: Statistics New Zealand, The Treasury

An easing in inflation pressures and the forecast slowing in real GDP growth see nominal GDP growth fall to 2.9% in the year to March 2007 and 3.7% in 2008. This is a substantial slowing from growth of over 7% in the March 2005 year.

In the export sector the performance of the agricultural sector is an important judgement

The recovery in dairy production is likely to be later than previously forecast. Agricultural production was weak in the 2004/05 production season, resulting in falls in both meat and dairy exports in the year to June 2005. Weak dairy production was the result of a cold spring in 2004. In previous poor seasons that have been caused by climatic conditions, production has quickly recovered once conditions returned to normal. At the time of the Pre-election Update we expected production to return to normal in the 2005/06 season, leading to a sizable lift in export volumes.

Figure 1.18 – Export growth

Sources: Statistics New Zealand, The Treasury

Discussions with the Ministry of Agriculture and Forestry suggest that the 2005/06 season is also likely to be affected by slightly adverse climatic conditions, further delaying the expected recovery in export volumes. The Central Forecast is underpinned by this outlook over the current season. We expect to see a small recovery in dairy production, leading to a small increase in exports over the course of the 2006, but the recovery is smaller than forecast in the Pre-election Update. The forecasts include some volatility, with merchandise trade data pointing to a sharp fall in dairy exports in the September 2005 quarter, some of which we believe reflects a degree of stock-building, which will boost exports in December.The forecasts assume growing conditions return to normal in the 2006/07 production season, with a subsequent strong lift in dairy exports.

The exchange rate appreciation of the last couple of years is forecast to constrain some other categories of exports

The exchange rate is another important determinant of export volumes, particularly for services exports. Visitor arrivals have been relatively flat in recent times, albeit with some volatility associated with the Lions rugby team tour of New Zealand. This flat period of visitor growth has fed into services export volumes. New Zealand has been a more expensive destination for overseas visitors, reducing the growth in visitor arrivals and limiting the average expenditure of visitors. Growth in services exports is forecast to be muted over the course of 2006 in response to the previously high level of the exchange rate.

Manufactured export volumes have also been weak over the last 6 to12 months. The transmission mechanism from the exchange rate is a little different from services exports. From our business talks we know that many manufacturing exporters try to maintain volumes even in the face of rises in the exchange rate, in order to maintain market share. However, volumes have fallen recently and are forecast to remain weak in the short term, with quarterly growth rates of around 1%, due to the impact of the exchange rate.

The outlook for the exchange rate poses some risks

The Central Forecast assumes that the exchange rate depreciates over 2006 and 2007 back towards its long-run average value. This appreciation is assumed to begin in the first quarter of 2006. Since the forecasts were finalised on November 18 the exchange rate has continued to appreciate. If the exchange rate appreciates further, or stays at a high level over 2006, this will pose some risks to the forecasts. Export volume growth is likely to be weaker than forecast while imports will be cheaper, and more attractive, increasing the likelihood of stronger import volume growth than forecast. Both of these factors would weaken real GDP growth and potentially see the current account deficit expand further. Inflationary pressures would be likely to be smaller.

The current account deficit narrows during 2007

The current account deficit is forecast to widen to around 9% of nominal GDP by March 2006. This reflects a combination of a forecast decline in the terms of trade, a weak outlook for export volumes and an on-going deficit on investment income due to strong domestic economic activity and solid profit growth of foreign owned firms. Over the rest of 2006 the deficit is forecast to narrow. Import volume growth eases with the slowing in domestic demand growth and export volumes lift, in part due to the depreciation of the exchange rate. Declining business profitability sees the investment income deficit narrow as the profits of foreign-owned firms decline.

Growth rebounds to 3% or above in March 2009 and 2010 years

Depreciation in the exchange rate and a return to normal agricultural growing conditions are forecast to contribute to a lift in export growth in the 2008 and 2009 March years. Manufactured exports and services exports are both forecast to pick up as the exchange rate depreciates, albeit with some lag.

This, together with some recovery in both residential and business investment, underpins a cyclical lift in GDP growth to 3.8% in 2009, before returning to close to 3% in 2010.

Business investment rises

With the outlook for growth and profits improving, firms lift their planned new investment. Employment growth also rises. However, there is a period of capital deepening where the capital-to-labour ratio increases as firms seek productivity gains from their existing workforce, with wage growth remaining solid, making capital more attractive. As a result, the supply-side contributions to growth change, with smaller contributions to growth from increasing labour and greater contributions from increasing labour productivity.

Effect of Tax Policy Changes on Tax Forecasts

The implementation of the alignment of provisional tax dates with GST due dates and GST-based provisional tax calculation for small businesses has been delayed by one year.

2 Fiscal Outlook

Fiscal Forecasts – Finalisation Dates and Key Assumptions

Key assumptions

The fiscal forecasts have been prepared in accordance with the Public Finance Act 1989. They are based on the Crown’s accounting policies and assumptions (refer page 90 of the GAAP tables). As with all assumptions, there is a degree of uncertainty surrounding them. This uncertainty increases as the forecast horizon extends. A summary of the key economic assumptions that are particularly relevant to the fiscal forecasts is provided below (on a June-year-end basis to align with the Crown’s balance date of 30 June):

Source: The Treasury

New Zealand Superannuation (NZS) Fund

The contribution to the NZS Fund for the year ending 30 June 2007 is $2.351 billion. The contribution to the NZS Fund is calculated over a 40-year rolling horizon to ensure that superannuation entitlements over the next 40 years can be met if the contribution rate were to be held constant at that level. The Government is making the required minimum annual contribution for 2005/06 as calculated by the formula set out in the NZS Act.

Source: The Treasury

The underlying assumptions in calculating the contributions for 2007 are the nominal GDP series to 2047, the NZS expense series to 2047 and the expected long-term, net after-tax annual return of the NZS Fund (6.1%) (6.1% Pre-election Update). The forecast rate of return is based on the Treasury’s assumptions for the rate of return on financial portfolios of Crown financial institutions. The Treasury website contains further information on the NZS Fund, as well as a copy of the NZS Fund model.

Summary

The forecast fiscal outlook for the Half Year Update reflects:

• the OBERAC as a percentage of GDP declining from 5.9% in 2004/05 to 3.7% in the current year. It drops to a low of 1.9% in 2008/09 before rebounding to 2.7% in 2009/10
• net worth increasing by around $24 billion over the forecast period, largely resulting from the accumulation of financial assets (primarily the NZS Fund)
• the cash equivalent of the OBERAC is not sufficient to fund all of the Government’s investing activity over the forecast period, leaving an expected cash shortfall to be met by reducing financial assets and additional borrowing
• gross sovereign-issued debt as a percentage of GDP slowly reducing over the forecast period, while in nominal terms gross debt rises near the end of the forecast period.

Compared to the Pre-election Update the OBERAC is lower due to:

• tax revenue being slightly higher in the early forecast years
• the increase in the operating allowance for Budget 2006 for the extension to the Working for Families package announced on 18 August which reduces the OBERAC by around $2.2 billion over the forecast period
• the impact of the fair value changes due to the interest free student loan policy reducing the OBERAC by around $1 billion in the current year (refer page 39)
• the economic assumptions used in compiling the fiscal forecasts is the Central Forecast outlined in the Economic and Tax Outlook chapter.

Fiscal Indicators

There are a number of indicators that are important in understanding the state of the Government’s fiscal position. No single indicator provides an all-purpose measure of the financial performance of the Crown and its impact on the economy. For example:

• the total Crown operating balance reflects the difference between current revenues (tax revenue, investment income etc) and current expenses (salaries, benefit payments etc). The operating balance shows whether the Government has generated enough revenue to cover expenses
• the total Crown OBERAC reflects the difference between current revenues and current expenses adjusted for valuation movements and accounting policy changes. The OBERAC provides a measure of the Government’s underlying stewardship
• the total Crown net worth reflects the difference between total assets and total liabilities. The change in net worth in any given forecast year is primarily driven by the operating balance
• the cash available/(shortfall to be funded) reflects the net effect of the Government’s core Crown operating (cash equivalent of the OBERAC) and investing activities (such as contributions to the NZS Fund and purchases of physical assets). It shows whether the cash generated is sufficient to meet all government spending (both operating and investing)
• gross sovereign-issued debt reflects the debt burden of the core Crown (excluding the activity of the NZS Fund and GSF). The movement over the forecast period is primarily driven by the cash available/(shortfall to be funded)
• net core Crown debt reflects borrowings (financial liabilities) less cash and bank balances, marketable securities and deposits, and advances (financial assets). Net debt excludes the financial assets of the NZS Fund and GSF as these assets are restricted in nature.

Source: The Treasury

Key Trends

The OBERAC is expected to drop before rebounding towards the end of the forecast horizon…

The OBERAC is forecast to fall from $5.9 billion (3.7% of GDP) in the current year to $3.4 billion (1.9% of GDP) by 2008/09, before rising to $5.1 billion (2.7% of GDP) by 2009/10. However, this is still sufficient to meet the requirements for contributions to the NZS Fund and progress towards the debt objective of 20% of GDP by 2015.

Revenues are forecast to exceed operating expenses…

Over the forecast horizon revenue is expected to be more than sufficient to meet operating expenses (salaries, benefit payments, depreciation costs, etc).

Figure 2.1 – Total Crown revenue, expenses and operating balance

Source: The Treasury

In recent years core Crown revenue growth has exceeded expense growth, largely consistent with strong economic growth. This trend is expected to reverse over the initial stage of the forecast period. This reflects:

• the fair value measurement of student loans in 2005/06 and an extension to the Working for Families package from 2006/07
• the impact of the forecast economic cycle on tax revenue. Tax revenue growth decreases due to an expected slowdown in economic growth in the early part of the forecasts, before rebounding by 2009/10.

Figure 2.2 – Core Crown revenue and expense growth (excluding GSF valuation)

Source: The Treasury

… but not by enough to finance all investments …

In line with the Government’s fiscal objectives the OBERAC has been applied to fund the Government’s investments. The existing fiscal strategy is to strengthen public finances to prepare for future fiscal costs associated with an ageing population. Over the forecast period total assets are expected to increase by around $29.4 billion.

Figure 2.3 – Core Crown investments on a year-by- year basis

Source: The Treasury

The OBERAC is not fully available to finance the capital programme. This is because some components of the OBERAC are non-cash (ie, depreciation) or retained by entities within the Crown (ie, SOE/Crown entity surpluses and NZS Fund returns) for the purpose of achieving their long-term objectives. Adjusting for these items gives the core Crown operating cash flows. Figure 2.3 shows how these cash flows are applied across the forecast years.

As outlined in Table 2.2 below, the cumulative operating balances are expected to be in surplus by a total of $24 billion over the years from 2005/06 to 2009/10. Adjusting for returns retained by entities within the Crown ($13.4 billion) and non-cash items ($9.9 billion) gives a cash flow from operations which generates around $20.5 billion over the forecast horizon.

Table 2.2 – Impact of Crown operating surpluses on the balance sheet from 2005/06 to 2009/10 inclusive

Source: The Treasury

This will be invested primarily in NZS Fund contributions of $12.6 billion, purchases of physical assets of $8.7 billion (for example, schools and defence equipment), advances of $4.8 billion (mainly student loans and refinancing existing private sector debt of the health and housing sectors), injections into Crown entities for hospitals and housing of $1.3 billion and the purchase of foreign exchange reserves of $1.2 billion.

There is a residual financing requirement of around $8.1 billion, which will be partially met by reducing the holdings of marketable securities and deposits which have accumulated from 2003/04 and 2004/05, and by raising some debt.

… while gross debt as a percentage of GDP slowly reduces over the forecast period

As a percentage of GDP, gross debt is expected to fall from 23.2% in 2004/05 to 19.3% by 2009/10. In nominal terms, gross debt is forecast to fall to $33 billion by 2006/07 and then rise to $36.2 billion by the end of the forecast horizon.

Figure 2.4 – Gross sovereign-issued debt (% of GDP and $ million)

Source: The Treasury

The initial decrease in debt in nominal terms reflects residual cash from the strong results in 2003/04 and 2004/05. Gross debt is then expected to slowly rise, reflecting the fact that capital spending will be greater than the funding available due to the OBERAC.

The Government’s 2005/06 bond programme has been increased to $2.7 billion, compared with $2.2 billion at the Pre-election Update. There have also been increases to the 2006/07, 2007/08 and 2008/09 domestic bond programmes of around $1 billion in each of those years. The changes are attributable to the lower OBERAC’s outlined earlier flowing through to higher financing requirements over the forecast horizon, which with this Update now includes 2009/10. The Government’s approach is to smooth the size of the bond programme from year to year to provide a steady supply of new bonds to the market, with any over-funding in a year being used to pre-fund part of future years’ borrowing requirements.

Net core Crown debt is expected to rise over the forecast horizon

Net core Crown debt[3] in both nominal terms and as a percentage of GDP is forecast to increase due to the financing requirement outlined above.

Figure 2.5 – Net core Crown debt (% of GDP and $ million) and % of GDP including assets of NZS Fund

Source: The Treasury

Net core Crown debt with the financial assets of the NZS Fund is forecast to be below zero by 2006/07.

Revenue and Expenses

Source: The Treasury

Over the forecast period, total revenue to GDP is expected to increase initially before dropping in 2008/09 due to a tax policy decision resulting in a change to provisional tax dates (aligning the payment dates for provisional tax and GST will result in payment deferral. For some taxpayers, the deferral pushes a provisional tax payment out of 2008/09 and into the following fiscal year) before returning to previous levels by 2009/10. Total expenses to GDP are also forecast to rise initially before flattening by 2008/09.

The trend in total revenue and expenses over the forecast horizon will largely be driven by activity in the core Crown segment of reported government activity.

The following section discusses revenue and expenses of the Crown by segment of reported government activity (ie, core Crown, SOEs and Crown entities).

Core Crown – Revenue

Tax revenue is the major source of Core Crown revenue.

Source:The Treasury

Ignoring such things as cyclical effects and tax policy changes, tax revenue should grow slightly faster than nominal GDP. This is because the influence of fiscal drag, caused by the progressive nature of the personal tax system, outweighs the influence of some of the tax types for which growth is not necessarily linked to any component of GDP, e.g. excise taxes.

Figure 2.6 – Tax revenue forecasts

Source: The Treasury

The small rise in tax revenue to GDP in 2006/07 comes mainly through source deductions. Source deductions is closely linked to the economic aggregate of Compensation of Employees (COE). As COE accounts for an ever-increasing portion of GDP through the forecast period, so too does source deductions, most noticeably in 2006/07. Source deductions growth is more muted later in the forecast period as the threshold adjustments announced as part of Budget 2005 start to take effect from 2007/08.

There is a pronounced business cycle present in the economic forecasts. This will necessarily be reflected in the business-related tax types of corporate tax and other persons tax. In addition, through the trough of the business cycle, we are likely to see above-average tax loss accumulation. The subsequent utilisation of these losses will suppress tax growth in 2007/08 and 2008/09. This is the major cause of the drop in tax relative to GDP in 2007/08. The further drop in 2008/09 can be ascribed to changes in the provisional tax system that will push a major revenue recognition point across the fiscal year boundary into 2009/10. Note that this occurs a year later than in the Budget Update and the Pre-election Update as the implementation of this change has been delayed for one year.

Inland Revenue’s tax forecasts

In line with established practice, the Inland Revenue Department has prepared an independent set of tax forecasts, based in the short term on more detailed analysis of taxpayer information, and in the longer term on the same broad macroeconomic trends that underpin Treasury’s tax forecasts.

Inland Revenue’s total tax forecasts are higher than Treasury’s in all years. The differences in 2006/07 and 2009/10 are small, given the size of total tax revenue. The difference in 2005/06 is a bit larger and is evident mainly in the individuals and resident withholding tax types.

The differences in 2007/08 and 2008/09, at just over $1 billion, are much larger than in the other years and also much larger than the differences seen in previous forecast Updates. In individuals’ taxes, the differences arise mainly in source deductions as a result of the different methods used by the respective forecasting teams to model the effect of fiscal drag. The differences in corporate taxes result from differing views around how company income tax will be affected by the business cycle with the Treasury forecast incorporating a build-up of tax losses over the next few years. In RWT on interest, the two forecasting teams have different views about the effect of interest rates on the size of the deposit base, with Treasury forecasting that the recent rate of growth in deposits will not be sustained over the full forecast period. The Treasury and Inland Revenue use different methods for forecasting GST, with Treasury putting more weight on residential investment than does Inland Revenue. With residential investment forecast to decline in each of the next two March years, Treasury’s GST forecasts are somewhat lower than Inland Revenue’s.

Detailed comparisons of Treasury and Inland Revenue tax forecasts can be found at www.treasury.govt.nz/forecasts/hyefu/2005/.

Core Crown – Expenses

Source:The Treasury

Core Crown operating expenses (excluding valuation items) are expected to rise by around 0.7% of GDP from 31.7% in 2005/06 to 32.4% of GDP by 2009/10. This represents the continuing impact of the 2004 Budget (which has an impact on expenses going forward, reflecting the implementation phase of the Working for Families initiative), the 2005 Budget and spending allocated for future Budgets.

Figure 2.7 – Core expenses excluding valuations ($ and % of GDP)

Source: The Treasury

As indicated in the 2005 FSR,the core Crown spending areas of health and education were allocated a significant portion of the 2005 Budget, with Health already allocated $489 million from Budget 2006. In part this reflects the current spending pressures within these sectors.

Health expenses as a percentage of GDP are forecast to increase from 5.6% to 6.2% between 2000/01 and 2005/06, while education expenses as a percentage of GDP are forecast to increase from 5.2% to 6.3% over the same period (mainly due to the move to the fair value measurement of student loans in the current year).

Figure 2.8 – Core Crown functional expenses as a percentage of GDP (excluding valuations)

Source: The Treasury

Health spending as a proportion of core Crown expenses is forecast to increase from 18.2% in 2000/01 to 19.5% by 2005/06. Education spending as a proportion of core Crown spending is also expected to increase from 16.8% in 2000/01 to 19.9% by 2005/06.

Figure 2.9 – Core Crown functional expenses as a percentage of total expenses (excluding valuations)

Source: The Treasury

In nominal terms, core Crown expenses are expected to increase by around $10.1 billion between 2005/06 and 2009/10. Removing the GSF liability movements, expenses are forecast to increase by $10.4 billion over the same period. The major drivers of these expense increases are indexation of benefits, the 2005 Budget package and forecast new spending for future Budgets.

Forecast new spending

The 2005 Budget Update allowed for $1.9 billion in new initiatives (including revenue initiatives) for Budget 2006. The 2006 BPS has signalled an increase in the allowance for new initiatives in Budget 2006 to $2.4 billion per annum from 2006/07. This is to allow for the extension of the Working for Families package. Since the Pre-election Update, the Government has agreed $100 million per annum of policy to be met from the in between Budget spending amount.

Figure 2.10 – Net Allowance for new operating initiatives (GST exclusive)

Source: The Treasury

Allowances for the 2007 and 2008 Budgets remain around $1.9 billion as indicated in the 2005 FSR.

Post Budget Decisions

Operating

The 2006 Budget has incorporated new operating spending of between $2.4 billion and $2.5 billion. The table below provides a summary of the policies already agreed as part of Budget 2006.

Table 2.7 – Budget 2006 Operating decisions

Source: The Treasury

Capital

The Pre-election Update incorporated new forecast capital spending of $2.3 billion. The table below provides a summary of subsequent decisions against these allowances.

Source: The Treasury

Student Loan Policy

In November the Government agreed that interest will not be charged on student loans where certain criteria, largely related to being domiciled in New Zealand, are met. To better reflect the value of student loans under this no-interest policy, the accounting policy for reporting loans has also been updated. The accounting policy is to initially recognise student loans at their fair value and to subsequently report them at amortised cost. This accounting policy is to apply from 2005/06 and is consistent with the ‘loans and receivables’ designation under International Accounting Standard 39 (IAS 39) for financial instruments. The Crown will be adopting the New Zealand equivalent to IAS 39 for all financial instruments from 1 July 2007.

The key changes resulting from the no-interest student loan policy and adopting a new accounting policy are:

• There is a one-off write-down in 2005/06 of the existing stock of loans to fair value(approximately $1.5 billion)
• The difference between the fair value of new loans and the amount lent is recognised as an expense in the year the loan is provided
• The initial fair value write-down will be unwound (i.e. recognised as income) over the maturity of the loans. The value will be adjusted for any impairment (e.g. non repayments caused, for example by death or bankruptcy of the borrowers).

The methodology and data for measuring the unwind of the fair value write-down and impairment under the new accounting policy is being developed. For this Economic and Fiscal Update student loans are presented at their forecast fair value with changes in fair value flowing through the statement of financial performance. These forecast changes in fair value may differ to those actually reported under IAS 39 using the amortised cost approach. Fair values have been calculated using a model constructed for the Ministry of Education. This model applies a number of assumptions on future income levels, repayment behaviour in addition to economic assumptions (the discount rate, inflation and so on). As such, the estimated fair value of existing and new loans at initial recognition is sensitive to changes in these assumptions.

The difference between net interest accrued (interest less provision for write off) under the previous policy and net interest accrued under the new policy has been included as a Budget 2006 policy decision. These amounts are outlined with all the decisions taken since the Pre-election Update on page 38.

Actual results for 2005 and forecasts for the Pre-election Update were compiled under the previous accounting policy, which was to value the loans at the amounts expected to be ultimately collected in cash.

State-Owned Enterprises (SOEs) – Revenue and Expenses

SOE revenue and expenses to GDP follow a similar trend over the forecast horizon.

The initial increase in both revenue and expenses is largely driven by the electricity sector, reflecting forecasts based on the initial use of short-term assumptions around electricity spot prices, before moving to medium-term assumptions beyond the current year.

Figure 2.11 – SOE revenue and expenses to GDP

Source: The Treasury

Over the rest of the forecast period, both revenue and expenses are expected to remain relatively flat, reflecting the fact that growth in SOEs is consistent with overall growth in the economy.

SOEs are forecast to run total operating surpluses of $4.7 billion over the forecast period. Around $2.1 billion of the operating surpluses will be returned as dividends. The remainder of the operating surpluses will be retained by individual entities for investment according to individual asset strategies.

Crown Entities – Revenue and Expenses

Both revenue and expenses to GDP are expected to remain flat initially, before decreasing from 2008/09.

The primary source of revenue for Crown entities is funding from core Crown departments. Since spending for future Budgets has yet to be allocated and therefore passed on to delivery agents (such as district health boards and schools) this leads to revenue and expenses to GDP falling near the end of the forecast period. Future allocations to delivery agents would lead to revenue and expenses rising back to similar levels.

Figure 2.12 – Crown entities’ revenue and expenses to GDP

Source: The Treasury

Crown entities are also forecast to generate operating surpluses over the forecast period, which total around $6.5 billion. There are only a few Crown entities expected to generate significant operating surpluses. These entities will retain their surpluses for long-term purposes. For example, the Accident Compensation Corporation (ACC) will retain its surplus in order to build up its asset portfolio to help meet its outstanding claims liability, while the Earthquake Commission (EQC) will use its operating surplus to build up assets to cover claims in the event of any future natural disasters.

Net Worth

Source:The Treasury

The change since the Pre-election Update reflects revaluations of property, plant and equipment at June 2005 partially offset by lower operating balances over the forecast period. Net worth is forecast to increase from $50 billion in 2004/05 to $74 billion by 2009/10. The growth in net worth reflects the Government’s strategy to run operating surpluses to strengthen its fiscal position. This strategy is evident across the whole of the Crown. The following section discusses the net worth of the Crown by segments of reported government activity.

Core Crown

Source:The Treasury

Over the forecast horizon, core Crown assets are expected to increase from $87.5 billion to $103 billion, largely reflecting the application of the OBERAC and additional borrowing to build-up assets. As Figure 2.13 illustrates, the majority of growth occurs within financial assets, which increase by around $12.8 billion, while investments in Crown entities (primarily to fund hospitals and housing capital projects) and physical assets also increase slightly.

Figure 2.13 – Core Crown asset growth

Source: The Treasury

Within the financial asset portfolio of the core Crown:

• the NZS Fund is expected to increase by around $15.6 billion over the forecast period. These funds are being set aside to assist in meeting pressures on future NZS payments associated with an ageing population
• advances are forecast to increase by around $2.6 billion, primarily due to student loans which are provided to help students to access tertiary education, offset by the move to the fair value measurement of those loans
• the Reserve Bank’s and New Zealand Debt Management Office’s (NZDMO’s) financial asset portfolio is expected to decrease over time largely due to the unwinding of the past build-up of financial assets to assist in funding some of the Government’s operating and investment programme partially offset by foreign reserves build-up
• GSF holdings are forecast to remain relatively flat at around $3.4 billion over the forecast period. The assets held by the GSF have been built up from employee contributions over time and are used to partially offset the GSF unfunded liability, which is forecast to be $15 billion by 2009/10.

By 2009/10 the make-up of the financial asset portfolio is expected to have changed significantly, primarily driven by the increase in the holdings of the NZS Fund.

Figure 2.14 – Core Crown financial assets by portfolio

Source: The Treasury

Investments in Crown entities are forecast to increase by around $1.2 billion to allow for maintenance and improvement to the asset base, especially within the health and housing sectors.

Physical assets are expected to increase slightly over the forecast horizon, illustrating the maintenance and expansion of the core Crown’s physical asset base. Figure 2.15 provides a breakdown of the physical assets held by the core Crown, by major asset classes.

Figure 2.15 – Core Crown physical assets by asset class (including capital provisions)

Source: The Treasury

The level of liabilities is expected to remain relatively stable over the forecast period at just under $60 billion. The major component of core Crown liabilities is gross debt, which as previously mentioned is forecast to decrease as a percentage of GDP over the forecast period.

SOEs

Source: The Treasury

SOE assets are forecast to increase by around $8.3 billion by 2009/10.

Similar to the core Crown, the expansion in assets will be driven by the use of retained surpluses. In addition, a portion of this growth has been funded by raising debt (which is net worth neutral). The majority of the growth will come from:

• physical assets, which are forecast to increase by around $5.6 billion, reflecting the expansion of assets in line with individual entities’ asset strategies. Figure 2.17 provides a breakdown of assets by the major asset classes held by SOEs
• financial assets are forecast to increase by $2.4 billion, showing the expected growth in Kiwibank deposits. This growth is net worth neutral, as borrowings also increase by a similar level.

Figure 2.16 – SOE asset growth

Source: The Treasury

Figure 2.17 – State-owned enterprises’ physical assets

Source: The Treasury

Crown Entities

Table 2.12 –Components of Crown entities’ net worth

Source:The Treasury

Crown entities’ assets are forecast to increase by around $10.2 billion by the end of the forecast horizon. The growth in assets is largely driven by physical assets and financial assets.

Figure 2.18 – Crown entity asset growth

Source: The Treasury

Physical assets are forecast to increase by around $4 billion. This growth is largely in the health, housing and transport sectors. These sectors make up the majority of the physical assets held by Crown entities. The primary source of funding for the asset expansion in these sectors will be injections from the core Crown.

Figure 2.19 – Crown entities’ physical assets broken down by major sectors

Source: The Treasury

Financial assets are forecast to increase by around $5.6 billion due to growth in the ACC and EQC investment portfolios, resulting from the investment of these entities’ expected retained surpluses. These portfolios are expected to grow over time, reflecting the fact that:

• ACC is building an asset portfolio to match the outstanding claims liability associated with past claims. The portfolio is expected to be $8.5 billion in the current year, rising to around $11.5 billion by 2009/10. ACC’s aim is to have the residual claims fully funded by 2014.
• EQC is New Zealand’s primary provider of seismic disaster insurance to residential property. To help meet future claims in case of a natural disaster, EQC is building up its financial asset portfolio.

Figure 2.20 – Crown entities’ financial assets broken down by major portfolios

Source: The Treasury

Comparison with Pre-election Update

OBERAC and operating balance

Compared with the Pre-election Update the OBERAC is expected to be lower over the forecast period due to:

• the move to fair value measurement of student loans in 2005/06 (refer page 39)
• the working for families package extension from 2006/07
• reforecast transport spending including a change in mix between operating and capital spending
• higher net finance costs (finance costs less interest income) due to the increase in net core Crown debt
• other core Crown functional expenses higher including increases to family support debt provisioning and decisions made from the future new operating spending.

Figure 2.21 – OBERAC comparison

Source: The Treasury

This has been partially offset by higher forecast tax revenue in 2005/06, 2006/07 and 2007/08 reflecting increases in nominal GDP.

Source:The Treasury

Source:The Treasury

Cash available/(shortfall to be funded)

The amount required to be financed (cash shortfall) is around $2.5 billion higher across the forecast period than the Pre-election Update mainly due to a reduction in cashflow from operations.

Debt indicators

Compared to the Pre-election Update both gross sovereign-issued debt and net core Crown debt are forecast to be higher over the forecast period. Gross sovereign-issued debt is higher due to the borrowing requirement mentioned above. Net core Crown debt is expected to be higher due to the reduction in financial assets as a result of the move to fair value measurement of student loans and the increased borrowing requirement.

Figure 2.22 - Gross sovereign-issued debt comparison

Source: The Treasury

Source: The Treasury

Source: The Treasury

Why is there an operating surplus?

A surplus represents the difference between operating revenues (eg, taxes) and operating spending (eg benefit payments, health and education spending, etc.). It is a measure of the ongoing operations of a government.

A government also has a capital expenditure programme whereby it provides money for student loans, saves some money by making contributions to the New Zealand Superannuation Fund, invests in asset acquisitions (eg building more roads, prisons, new hospitals, schools and defence equipment) and other capital activity. None of this shows up as operating expenses as it is the purchase of an asset (with a useful life in excess of one year and will provide benefits through time rather than an operating expense such as a benefit payment). All of this type of activity is called investment expenditure.

The cash generated from the operating balance is not always sufficient to meet all investing decisions. There may still be a need to borrow in order to fund the shortfall between the forecast operating surplus and the capital programme (which is often larger than the surplus).

The following graph shows how the operating surplus (or OBERAC) is used in each year over the forecast horizon, and therefore why nominal debt can increase even when there is a “surplus”.

 

Source: The Treasury

The following table explains how the operating surplus/OBERAC is calculated for the 2005/06 and the 2006/07 financial years and then how it is applied. Any extra spending or reduced tax revenue would add to the bottom-line cash shortfall (and add to the need to borrow).

Risks to fiscal forecasts

The fiscal forecasts were finalised on 7 December 2005 in accordance with the forecast accounting policies. There are certain risks around the forecast results. To assist in evaluating such risks the following chapters should be read in conjunction with the fiscal forecasts:

• Risks and Scenarios (Chapter 3) – The fiscal forecasts are based on the economic forecasts presented in Chapter 1 and any variation from the economic forecast will affect the fiscal forecasts, in particular tax revenue and benefit expenses. The Risks and Scenarios chapter discusses the effect on the forecasts under different circumstances.
• Specific Fiscal Risks (Chapter 4) – The fiscal forecasts incorporate government decisions up to 7 December 2005. The Specific Fiscal Risks chapter covers specific policy decisions that are under active consideration by the Government at the time of the finalisation of the forecasts.

In addition to the specific fiscal risks and the link to the economic forecasts, there are a number of forecasting issues explained below that may arise in future.

Tax forecasting risks

The tax forecasts prepared for this Half Year Update are based on current tax policy and on the macroeconomic central forecast. Sensitivities of tax revenue to changes in economic conditions are presented in the Risks and Scenarios chapter on page 65.

SOEs and Crown entities’ forecasts

The forecasts for large SOEs and Crown entities were provided in October 2005 based on their best assessments at that time.

Revaluation of property, plant and equipment

Crown accounting policy is to revalue certain classes of property, plant and equipment on a regular basis. In certain circumstances the valuation will be affected by foreign exchange rates, so any appreciation in the New Zealand dollar (from 30 June 2005) will adversely affect the current physical asset values included in the fiscal forecasts.

Discount rates

The GSF and ACC liabilities included in these forecasts have been valued as at 31 October and 30 September respectively. The liabilities are to be next valued for the 2006 Budget Update. Any change in discount rates will affect the presented fiscal forecast. For example, if the discount rate rises, the value of the liabilities will decrease.

International financial reporting standards

The New Zealand Accounting Standards Review Board announced in December 2002 that International Financial Reporting Standards (IFRSs) will apply to financial reporting by both public and private sector entities from 1 January 2007, but with entities having the option to adopt from 1 January 2005.

The Crown plans to adopt the New Zealand IFRSs in the 2007 Budget.

Tertiary education institutes’ (TEIs’) accounting treatment

The forecast information presented in the 2005 Half Year Update combined TEIs on an equity accounting basis. As noted in previous publications the combination treatment of TEIs remains unresolved.

The combination method adopted in these forecasts is to equity account for the TEIs’ net surpluses and net investment (ie, TEI revenues, expenses, assets and liabilities are not included on a line-by-line basis). This is consistent with the treatment adopted in the 2005 Crown financial statements.

The key indicators are unchanged as a result of the combination approach for TEIs (refer page 60 of the 30 June 2005 Crown financial statements).

3 Risks and Scenarios

Summary

• The Half Year Update forecasts reflect a number of judgements about how the economy is likely to develop. If actual events evolve differently from these judgements, the economy could take an alternative path to that of our central forecast, with consequential impacts on the fiscal outlook.
• The central forecast presented in the Economic and Tax Outlook chapter shows an economy that is expected to continue slowing over the next two years before rebounding in the year to March 2008. Whether the economy develops as forecasts depends on how different factors evolve. This chapter explores what is likely to happen to economic and fiscal outcomes if some of the factors evolve differently.

Figure 3.1 - Real GDP

Source: The Treasury

• Although we place greatest weight on the economy evolving in a manner consistent with the central forecast presented in the Economic and Tax Outlook chapter, we present two scenarios in the second part of this chapter which illustrate alternative paths. These are just two of a number of possible outcomes and therefore do not fully illustrate the full range of possible outcomes.
• The first scenario shows the evolution of the economy in the event that there is a more rapid depreciation of the exchange rate. This scenario results in a period of higher economic growth than outlined in the central forecast and permanently raises nominal GDP, improving the fiscal position. The second scenario illustrates generalised weakness where households reduce spending relative to the central forecast and exports are also weaker. It shows a temporary reduction in real GDP but permanently lower nominal GDP, which results in a deterioration of the fiscal position.

Introduction

The central forecast, as set out in the Economic and Tax Outlook chapter, reflects the balancing of upside and downside risks facing the economy to arrive at our best assessment of the way the economy is likely to develop. This requires a number of key judgements about how the various forces affecting the economy will evolve. If actual events differ from these judgements, the economy may deviate from the central forecast. The first part of this chapter, Economic Risks, outlines some of the risks around the economic outlook. There are both upside and downside risks – some domestically and some internationally oriented.

The second part of this chapter, Economic Scenarios, presents in more detail two scenarios that could develop.

Economic Risks

Domestically oriented risks

Businesses have been facing inflationary pressures in the form of rising inputs and capital costs, as well as higher labour costs. This has been reflected in declining margins and weaker business confidence. Profits are expected to fall in 2007. One of the key judgements underpinning the central forecast is that the response to weak profits is relatively muted due to strong corporate balance sheets. There is a risk that if significant upward pressure on costs were to continue, the squeeze on business sector margins would be even greater. This would feed through into lower business sector investment and employment than outlined in the central forecasts.

In contrast to a business sector under pressure, household consumption has been strong. The Economic and Tax Outlook chapter highlighted that private consumption growth is expected to decline in line with a slowing labour market, higher effective mortgage rates, and a reduction in the positive wealth effects associated with slowing house price growth. There is a risk that the expected downward adjustment in house prices will be more abrupt than expected in the central forecast. It is also possible that the likely negative wealth effect associated with this adjustment will have a greater than expected impact on household expenditure. Both these potential outcomes could result in lower consumption growth. The longer households continue to spend more than they earn, the greater the likelihood of a more severe adjustment in the future.

If the economy does not slow as expected and domestic inflation is higher than currently forecast, interest rates may rise higher than expected. This would also be likely to impact negatively on household expenditure in the medium term. One of the scenarios in the following section of this chapter considers how the economy might evolve if the current strength in household expenditure were to dissipate faster and more deeply than expected in the central forecast.

The strong labour market, which has been a key feature of the recent economic expansion, is expected to soften over the course of the next two years. There is a risk to the central forecast that strong employment and wage growth continues for longer than expected. If employment growth were to continue - amplifying difficulties in finding labour - wage pressures may be stronger than expected. This would have flow-on impacts for household spending through higher incomes and increased confidence and potentially increased inflationary pressure, or alternatively it would provide more room for debt consolidation.

Net migration has had a significant impact on New Zealand population growth in recent years which has relevance for the size of the workforce as well as demand for goods and services. In the central forecast net migration inflows are assumed to be 7,000 in the year to March 2006, then hold steady at 10,000 people a year for the rest of the forecast period. There is a risk that as employment growth slows and the economy weakens, net migration will be lower than forecast or even turn negative. This would result in lower domestic demand than built into the central forecast. Alternatively an increase in net migration will provide a boost to economic demand.

Climatic conditions are an important influence on agricultural-related production in New Zealand. According to the National Institute of Water and Atmospheric Research (NIWA), over the next three months from November, rainfall is likely to be near normal in all regions, except in the east of the North Island where it may be below normal. A more severe outcome with drier conditions than predicted could have a detrimental impact on agricultural production and hydro electric generation.

A reasonably weak dairy season is built into the central forecast. If dairy production is higher than forecast this is likely to have a positive impact on exports as well as domestic consumption as rural incomes are given a boost.

Internationally oriented risks

Developments in the world economy are important drivers of economic activity in New Zealand through the impact on both the prices and volumes of exports and imports, and through interest rates and confidence. Over the next year, steady economic growth for New Zealand’s largest trading partners is expected. If world economic growth were to slow, New Zealand’s export volumes and prices could fall faster than forecast and economic growth would slow accordingly. China is expected to remain a significant driver of world economic growth over the forecast period and the New Zealand economy is exposed to a risk of a slowdown in demand from China.

The future path of the exchange rate and how it impacts on the future performance of the economy is a key judgement of the forecasts. The central forecast sees the New Zealand dollar depreciating over the forecast period from around 71 on the TWI to settle at 58.5. There is a lot of uncertainty around the timing and extent of the expected depreciation which will affect the economic outlook largely through the resultant growth in exports as well as the level of tradables inflation. The New Zealand dollar is susceptible to a variety of factors. For example if New Zealand’s large current account deficit causes overseas investors to lose confidence, it could fall further and faster than set out in the central scenario. Such a scenario is explored further later in the chapter.

Uncertainties around how the sizeable US current account and fiscal deficits may impact on global exchange rates are also a factor. If the US dollar were to weaken further in response to the twin deficits, the New Zealand dollar might appreciate with a subsequent impact on New Zealand’s economic outlook. In particular, there would be a greater negative impact on export volumes and on the receipts of exporters than built into the central forecast.

The high level of the terms of trade, largely driven by the record high commodity prices recently recorded for some agricultural commodities, has been one of the key contributors to growth over the past couple of years. The high prices have been due to strong world demand and some temporary supply issues including lower lamb production in the UK after the 2001 foot and mouth outbreak, the effect of the BSE scare on Canadian and US beef exports and the drought in Australia. Some of the agricultural commodity prices are forecast to fall over the forecast period as supply returns to normal and world growth weakens. If some of these tight supply conditions were to continue, world prices of these commodities may hold up for longer, resulting in higher than expected incomes for agricultural producers. On the other hand, if supply were to return to normal more quickly than expected, for example if US beef were accepted back into Asia earlier than expected, or if world growth were to slow faster than thought, it would pose some downside risk to the central forecast.

Another factor that poses risk to the global outlook and the terms of trade is the recent volatility in oil prices. Between January and September 2005 oil prices increased 67%. They have since fallen 15%. If prices were to reverse their recent fall and increase significantly, world growth would most likely be negatively affected. Conversely, if they were to fall faster than our forecast, New Zealand’s terms of trade would most likely stay higher than forecast.

The outcome of the current Doha Development Round of international trade negotiations is as yet unknown. Therefore its effects are not factored into this forecast. A successful round could raise the relative prices and volumes for some exports towards the end of the forecast period. A failure could lead to some turbulence in international trading arrangements. An intermediate outcome, with smaller price and volume effects, is also possible.

The World Health Organisation (WHO) and other health authorities have warned of the risk of an influenza pandemic with the emergence and spread of a highly pathogenic strain of avian influenza, H5N1. The continued spread of avian influenza (as an animal disease, rather than human disease) may itself pose some risks to our forecasts through its impact on trading partners and possible risks to the poultry industry in New Zealand. Moreover, the risk of a pandemic may itself have some impact on international travel, tourism, and trade in services. Finally, while the likelihood of a pandemic, and its severity should it occur, is unknown, it is clear that a serious pandemic would have major human, social and economic costs.

Economic Scenarios

The following scenarios present two possible growth paths for the economy when some of the key judgements underlying the central forecast are altered.

1. Generalised weakness - a harder landing scenario - This scenario involves households reducing their spending relative to the central forecast and exports also being weaker.
2. More rapid exchange rate led adjustment - This scenario illustrates the implications for the economy if the exchange rate depreciates more rapidly than in the central scenario.

The scenarios are two of a large number of possible outcomes, and do not represent upper or lower bounds for the central forecast, with more extreme paths being possible.

Sources: Statistics New Zealand, The Treasury

Generalised weakness – a harder landing scenario

The generalised weakness scenario illustrates an alternative path for the economy in the event that households reduce spending relative to the central forecast and exports are also weaker. Lower household spending on both consumption items and housing could occur due to households displaying a greater responsiveness to interest rates and debt levels than is incorporated in the central forecast. Weaker export growth could stem from the recent high level of the exchange rate having a larger negative impact on export volumes than is incorporated in the central forecast or could reflect weaker agricultural production or weaker trading partner growth.

Figure 3.2 – Total exports

Source: The Treasury

In the central forecast, real GDP growth is expected to slow over the course of 2006 to 1.7% in the year to March 2007 and 2.5% in the year to March 2008. In this scenario, growth is slightly lower in the 2006 March year as household concern about debt levels and the associated servicing costs sees them begin to reduce their rate of expenditure growth. The trough in real GDP growth in the year to March 2007 is deeper with growth slowing to 0.7% prior to stronger growth in the year to March 2009 of 4.4% as households and businesses respond to lower interest rates.

Under this scenario, private consumption growth is particularly weak in the year to March 2007 with growth of only 0.5%. In addition residential investment is a little weaker than the central forecast, contracting 11.3% in the 2007 March year. The impact of the recent high level of the exchange rate has a longer-lasting impact on export volumes making the recovery in export volumes in the March 2007 year weaker than in the central forecast.

With slower domestic demand and falling demand for New Zealand exports, businesses cut back on employment plans and annual average employment growth falls to 0.1% in each of the 2007 and 2008 March years, pushing the unemployment rate to 4.8% by the end of the forecast period. With weaker demand pressures and a less-tight labour market, both general price and wage inflation are lower than in the central forecast.

Figure 3.3 – Private consumption

Source: The Treasury

With less inflationary pressure, an easing in monetary policy is possible with 90-day bill rates lower from the end of 2006. Lower interest rates eventually encourage households to increase their spending growth and also contribute to stronger residential and business investment growth in the March 2009 year relative to the central forecast.

Under the generalised weakness scenario, the negative impact of lower exports on the current account more than offsets the lower demand for imports stemming from weaker domestic demand, resulting in a slight widening of the current account deficit relative to the central forecast.

Sources: Statistics New Zealand, Reserve Bank of New Zealand, The Treasury

By the end of the forecast period real economic activity is around $450 million lower than the central forecast. The effect of the lower price inflation accumulates so that by the end of the forecast period, nominal GDP is approximately $4.6 billion lower than in the central forecast. This has a negative impact on the size of the OBERAC.

More rapid exchange rate led adjustment

This scenario illustrates a possible path for the economy if the exchange rate were to depreciate more rapidly and reach a lower trough than is incorporated in the central forecast. Such a scenario would have implications for the manner in which imbalances in the economy unwind.

Sources: Statistics New Zealand, Reserve Bank of New Zealand, The Treasury

NOTES:

• Percentage of labour force, March quarter, seasonally adjusted.
• Average for March quarter.
• Annual percentage change, March quarter.

The Economic and Tax Outlook chapter highlighted that recent economic developments have led to the build up of imbalances in the economy. This has been due to a relatively unbalanced growth profile in which the strength in domestic demand has dominated overall growth. Exchange rate developments are likely to play an important role in the manner in which these imbalances are unwound and a more balanced growth profile achieved. Under the central forecast the New Zealand dollar is expected to fall over the forecast period. It is currently at a historically high level and imbalances in the economy, such as the present size of the current account deficit, pose a risk that the exchange rate could fall more quickly than assumed. When sentiment related to a currency turns negative, previous experience suggests that depreciation can be rapid.

In this scenario the exchange rate falls more rapidly in the first half of calendar 2006 and remains lower than the central track until the beginning of the 2009 calendar year.

Figure 3.4 Trade weighted index

Source: The Treasury

The high exchange rate has contributed to increased demand for imported goods and services by both consumers and businesses. The lower exchange rate under this scenario makes such imports more expensive, contributing to lower consumption and investment growth relative to the central forecast until the final year of the forecast when the exchange rate returns to the central forecast level.

Tradable inflation rises rapidly as import prices increase. Monetary policy reacts to dampen the higher inflation and the associated interest rate increases also contribute to slower growth in consumption as well as slower residential and business investment than was set out in the central scenario. Despite tighter monetary policy, higher inflation relative to the central forecast persists over the 2008 and 2009 March years.

Under this scenario the depreciation is more rapid than in the central forecast with the TWI falling 26% between March 2006 and March 2007. The exchange rate depreciation increases the competitiveness of our exporters with export growth stronger than the central forecast. In this scenario it is assumed that export growth exhibits quite a rapid response to the large depreciation in the exchange rate. This is likely to be the case in sectors such as tourism and potentially forestry, however the response of some types of manufacturing may not be as rapid due to the relocation of some production lines offshore. This poses a risk that export growth may be more muted than is incorporated into this scenario. Under this scenario export growth is modestly stronger in the 2007 March year prior to being 3% higher than the central forecast in the 2008 March year with export volume growth of 8.4%.

The combination of stronger export growth and lower import demand results in a reduction in the current account deficit relative to the central forecast with the deficit falling below 8% of nominal GDP in the March 2007 year and below 4% in the following two years. The current account deficit ends the forecast period a little over 4% in 2010.

The aggregate impact of the shock on real GDP growth is relatively small with March year growth not varying from the central forecast by much more than ½% over the forecast period. However, the composition of growth is quite different. Real GDP growth is stronger in the March 2007 and 2008 years as a combination of higher exports and lower imports growth more than offset lower domestic demand growth. Domestic demand growth is particularly weak in 2008 with consumption growth just over 2% lower than the central forecast and residential and business investment lower by around 5% and 3% respectively. Real GDP growth is lower relative to the central forecast in the March 2009 and 2010 years as the stimulus to export growth from the lower exchange rate diminishes and import demand increases.

In this scenario, the level of real GDP at the end of the forecast period is around $500 million lower than the central forecast. However, the price-level shock is permanent, so nominal GDP is about $2.5 billion higher at the end of the forecast period. Higher nominal GDP will flow through to a higher nominal tax take. However, with higher inflation, it is likely that the Government would require higher nominal expenditure in order to maintain real service provision at a similar level to the central forecast.

Fiscal Scenarios

The fiscal position is strongly influenced by the economy. The major economic determinants, and how they impact on the fiscal position, are listed below. While each effect is expressed in terms of an increase in the determinant, the opposite impact applies for a decrease.

• Nominal GDP – higher GDP levels are reflected in a higher tax take, which increases the operating balance and lowers the Government’s debt.
• Interest rates – higher interest rates lead to increased debt financing costs. While interest-based revenue also increases, the negative effect of higher finance costs on the operating balance dominates, meaning debt increases.
• The level of unemployment – higher levels of unemployment translate to an increase in spending, because the number of unemployment beneficiaries rises. This decreases the operating balance and raises debt levels.
• CPI inflation – as most benefits are indexed to CPI movements, higher inflation results in increased benefit costs. This reduces the operating balance and increases debt.

Sources: Statistics New Zealand, The Treasury

The generalised weakness scenario is characterised by lower nominal GDP, lower interest rates, a higher unemployment rate and lower inflation in comparison to the central forecast.

Lower nominal GDP and higher unemployment result in a decrease in taxes collected and an increase in benefit payments. Lower inflation results in a partial reduction in benefit payments and lower interest rates result in a reduction in debt servicing costs, but the overall impact of this scenario is a lower OBERAC and higher debt.

Figure 3.5 – OBERAC

Source: The Treasury

By 2007/08 the OBERAC is around half a percentage point of GDP lower than the central forecast and by the end of the period gross sovereign-issued debt (GSID) is around 3.5 percentage points of GDP higher than the central forecast.

The more rapid exchange rate led adjustment scenario is characterised by a more cyclical profile for unemployment and interest rates. Inflation is higher throughout the forecast period in comparison to the central forecast. Nominal GDP is higher than the central forecast for most of the forecast period.

Higher nominal GDP leads to higher tax revenue in the more rapid exchange rate led adjustment scenario, but higher interest rates and unemployment in the early part of the forecast also result in higher expenses. The overall impact of higher taxes and expenses is a small increase in the OBERAC by around 0.1 percentage points of GDP throughout most of the forecast period. The cumulative impact of having a higher OBERAC is a reduction in GSID by less than a percentage point of GDP by the end of the period compared to the central forecast.

Figure 3.6 – Gross sovereign-issued debt

Source: The Treasury

The net impact of generalised weakness scenario is much larger than the net impact of the more rapid exchange rate led adjustment scenario.

Fiscal Sensitivities

The scenarios above indicate the sensitivity of fiscal aggregates to changes in economic conditions. Table 3.5 provides some “rules of thumb” on the sensitivities of the fiscal position to changes in specific variables.

The forecasts of capital contributions to the New Zealand Superannuation (NZS) Fund are sensitive to the expected net after-tax annual return on the NZS Fund, which in turn depends on the expected gross rate of return assumed on the Fund’s assets:

A +1% change in the gross rate of return would have symmetrical negative effect on the required capital contribution track across these years.

4 Specific Fiscal Risks

Introduction

This chapter describes the specific fiscal risks to the Crown, including contingent liabilities. The Public Finance Act 1989 (PFA) requires disclosure of all government decisions and other circumstances that may have a material effect on the fiscal and economic outlook.

Criteria for Disclosure of Specific Fiscal Risks

To ensure a practicable and consistent disclosure approach, fiscal risks are disclosed based on the following criteria, consistent with the principles of the PFA:

• Reasonable certainty criterion – risks have not been included in the fiscal forecasts because they reflect Government decisions or legislative commitments with uncertain fiscal consequences or timing.
• Materiality criterion – risks have an impact on the fiscal forecasts (operating balance, net worth or gross debt) of $10 million or more in any one forecast year.
• Active consideration criterion – risks are being actively considered by the Minister of Finance and responsible Ministers (e.g. are the subject of written reports) or are decisions that have been deferred until a later date.

Exclusions from Disclosure

The PFA requires that all specific fiscal risks be disclosed, except where it is determined by the Minister of Finance that disclosing a risk is likely to:

• prejudice the substantial economic interests of New Zealand, or
• prejudice the security or defence of New Zealand or international relations of the Government, or
• compromise the Crown in a material way in negotiation, litigation or commercial activity, or
• result in a material loss of value to the Crown.

Specific fiscal risks do not include:

• normal forecasting risks, such as uncertainty around welfare benefits, SOE/Crown entity surpluses, the impact of regular revaluations of physical assets, finance costs, or fluctuations in external markets
• possible changes to the interpretation of accounting policies, such as the changes to revenue recognition rules and recognition of liabilities, or
• discussion documents containing proposals that the Minister of Finance and responsible Ministers will not actively consider until the consultation process has been completed.

In addition, the Minister of Finance has to determine that there is no reasonable or prudent way the Government can avoid this prejudice, compromise or material loss by making a decision on the fiscal risk before the finalisation of the forecasts, or by disclosing the fiscal risk without reference to its fiscal implications.

Contingent liabilities are also included according to materiality. Contingent liabilities below $10 million are included in the “other quantifiable contingent liabilities” total. Comparatives have been adjusted where appropriate to align with the disclosure of new “material” contingent liabilities. The total amount of contingent liabilities remains unchanged.

Information Relating to All Disclosed Risks

• The risks disclosed may not eventuate into Government policy and the final cost or saving may differ from the amount disclosed if the policy is developed.
• All risks, should they eventuate, would impact on the Government’s forecast operating and/or capital spending amounts. These are forecast spending amounts already incorporated into the forecasts to accommodate policy initiatives on which decisions have yet to be made. Most risks outlined in this chapter, if they eventuate, would be covered by these amounts and therefore have no impact on the forecasts. The risks have been disclosed to indicate the pressure the risks place upon the forecast spending amounts.
• If the total of all risks considered exceeds the forecast new operating spending amounts in the forecasts, this would impact on the operating balance.
• There are a number of other pressures on the fiscal position that have not been included as risks. These pressures comprise proposals largely generated within individual departments and not yet considered by the Minister of Finance and responsible Ministers. Such items are expected to be managed within forecast spending amounts noted above.

Charges against Future Budgets

As part of its Budget strategy, the Government has put in place some longer-term funding paths for particular sectors. This aids long-term planning and demonstrates the Government’s commitment to specific policies.

Charges against future Budgets do not meet the definition of a “risk” under the PFA, as these items are incorporated in the fiscal forecasts. This section is provided to increase transparency about the provisions for future Budgets.

Defence Funding Package

The Defence Funding Package (DFP) is designed to provide the New Zealand Defence Force (NZDF) with the funding required to address issues identified by the Defence Capability and Resourcing Review, including capability, and maintaining equipment and reserves. Budget 2005 included $60 million per annum as the first tranche of the 10-year plan. The following table shows the additional tranches as charged against future Budgets.

Health Funding Package

In Budget 2005, the health sector received $475 million per annum as the third tranche of the Health Funding Package (HFP). A fourth tranche of $489 million per annum is charged against Budget 2006.

Official Development Assistance

The Government has committed to an Official Development Assistance to Gross National Income ratio (ODA:GNI ratio) of 0.27% for the fiscal years 2005/06 and 2006/07 and increasing this to 0.28% in 2007/08. Budget 2005 included funding for 2005/06 levels only. The 0.27% in 2006/07 is expected to cost an additional $19 million per annum to be charged against Budget 2006, and the 0.28% in 2007/08 is expected to cost $38 million to be charged against Budget 2007.

Tertiary Student Component Funding Rate Changes (The rolling funding triennium and fee and course cost maxima)

The Government has a policy of increasing Student Component funding rates for tertiary education by the rate of forecast CPI inflation on a rolling triennium. Funding is appropriated for future years at the rate of the CPI forecast plus 1%, and in the Budget preceding the relevant academic year funding rates are confirmed using a more up-to-date CPI forecast. The differential between the CPI increase and the appropriation is retained within the Vote for application elsewhere in the Student Component.

Transport Capital Decisions

The Government has made several long term capital commitments relating to Transport. This table notes the implications for the capital allowances beyond the forecast period.

Time-Limited Funding

Time-limited funding does not meet the definition of a “risk” under the PFA, but is further information that is prepared to increase transparency about initiatives with funding profiles that cease or decrease during the forecast period.

The following table outlines those areas where initiatives have time-limited funding that decreases or ceases at some point and may potentially be extended, using a $5 million materiality threshold. They are often related to pilot programmes.

The following table shows the impact on the operating balance if funding were to be appropriated to maintain funding levels for these initiatives (i.e. extend the initiatives beyond their current scheduled completion dates). These amounts would need to be managed within the forecast operating spending.

Quantified Risks

The risks outlined in these tables would, if they eventuated, impact on the Government’s forecast new operating and/or capital spending amounts.

The Minister of Finance has yet to fully consider the quantum of these risks.

Unquantified Risks

The risks outlined in these tables would, if they eventuated, impact on the Government’s forecast new operating and/or capital spending amounts.

Risks removed since the Pre-election Update

The following risks have been removed since the Pre-election Update.

Statement of Fiscal Risks

Child, Youth and Family Services – Collective Employment Contract Negotiations (unchanged, unquantified risk)

The Department of Child, Youth and Family Services has two collective employment agreements that expired on 30 June 2005. The Government is currently in negotiation with the Public Service Association and the National Union of Public Employees to settle new collective employment agreements. Some funding has already been agreed, but any additional funding that may be sought would reduce the operating balance.

This risk is unquantified as disclosure may compromise the Crown in negotiations.

Child, Youth and Family Services – Residential Services Strategy 2003 (unchanged, quantified risk)

The Government is implementing the 2003 Residential Services Strategy for youth justice, which builds on the considerable investment made in facilities when implementing the 1996 Residential Services Strategy.

The Government has agreed in principle to fund the 2003 Strategy subject to fully developed and costed proposals. Some initiatives have already been agreed, and the remaining operating cost risk is $8.4 million in 2006/07 rising to $16.1 million in 2009/10 and outyears, which would decrease the operating balance. The remaining capital risk is $29.5 million, which would increase gross debt. The current proposed phasing of this is $4.4 million in 2006/07, $7.4 million in 2007/08 and $17.7 million in 2008/09.

The Minister of Finance has yet to fully consider the quantum of this risk.

Source: Department of Child, Youth and Family Services

Child, Youth and Family Services – Reviewing Levels of Funding and Service Delivery (changed, unquantified risk)

The Government is reviewing the Department of Child, Youth and Family Services’ funding requirements in order to identify options for sustainable levels of funding and service delivery in the medium term. In addition, there are ongoing demand pressures for which additional funding is sought. Options may be submitted for consideration in Budget 2006. The risk is unquantified as it is unclear what change in departmental funding is required. Any change in funding to reflect a new baseline and/or meet necessary capital injections would impact on the operating balance and/or debt.

Conservation – Foreshore and Seabed Compensation (new, unquantified risk)

Section 25 of the Foreshore and Seabed Act 2004 directs the Minister of Conservation to provide compensation to local authorities that lost their title to any area of foreshore and seabed through the operation of section 13 of the Foreshore and Seabed Act. Councils were to apply for redress by 25 November 2005.

As work is still underway on assessing the quantum of these claims, total potential compensation is not yet known.

Conservation – Lease of Taupo Property Rights from Tuwharetoa (new, unquantified risk)

On 18 May 2005, The Government agreed to enter into negotiations with Tuwharetoa Māori Trust Board following legal clarification of property rights relating to Lake Taupo. The Crown is considering leasing certain property rights from the Tuwharetoa Māori Trust Board in order to resolve current disputes. Negotiations are ongoing and the outcome is not yet known.

This risk is unquantified as disclosure could compromise the Crown in negotiations.

Corrections – Capital Projects (changed, quantified risk)

In Budget 2005, $206 million capital and $220 million operating was approved for Corrections capital projects. The Department of Corrections has estimated that a further total of $180 million capital and $236 million operating funding may be required over the forecast period. The actual amounts depend on the specification and timing of the individual projects and the contracted prices. These estimates include consideration of funding for the Otago Region Corrections Facility and Mt Eden Prison and have increased since the Pre-election Update to reflect revised inmate forecasts and construction costs.

Capital injections would increase gross debt while operating funding would decrease the operating balance.

The Minister of Finance has yet to fully consider the quantum of these risks.

Source: Department of Corrections

Culture and Heritage – Public Broadcasting Programme of Action (unchanged, quantified risk)

On 3 February 2005, the Government released a Public Broadcasting Programme of Action. The Programme contains a set of priorities to guide public broadcasting policy over the next six years, and a series of proposals to give effect to these priorities. The Programme as a whole (if fully implemented) would have total ongoing operating costs rising to around $44 million in 2009/10. Broadcasting initiatives of $10.5 million per annum were included in Budget 2005, leaving a remainder of around $33.5 million. Other individual elements of the Programme of Action may be considered in future Budgets over the next six years. These would decrease the operating balance.

The Minister of Finance has yet to fully consider the quantum of this risk.

Source: Ministry for Culture and Heritage

Economic Development – Large Budget Screen Production Fund (unchanged, quantified risk)

The Large Budget Screen Production Fund was increased by $12 million in July to cover payments up to September 2005. In addition, the Film Commission is aware of a number of other possible applications being made later in 2005/06 that, if approved, would require up to a further $17 million. This would decrease the operating balance.

The Minister of Finance has yet to fully consider the quantum of this risk.

Source: Ministry of Economic Development

Education – Early Childhood Education (new, quantified risk)

As part of the ten-year Strategic Plan for Early Childhood Education, the Government provided funding in Budget 2004 to introduce 20 hours free early childhood education for all three and four year olds who attend community-based teacher-led ECE services from July 2007.

The Government is now considering expanding the type of providers eligible to offer the 20 hours free ECE policy to include any licensed, teacher-led services. Policy development is still underway but this initiative would decrease the operating balance by up to $54 million per annum from 2007/08.

The Minister of Finance has yet to fully consider the quantum of this risk.

Source: Ministry of Education

Education – School Property (changed, quantified risk)

The Government has provided capital of $77.5 million in 2005/06 for school accommodation. Additional capital injections for school accommodation are likely to be required in future years to meet roll growth. Additional capital injections could be up to $125 million in each of the next four years with a corresponding increase in debt.

In addition to capital injections, consequential operating costs of $7 million in 2007/08, $12 million in 2008/09 and $18 million per annum thereafter are likely to be incurred, which would decrease the operating balance.

The Minister of Finance has yet to fully consider the quantum of this risk.

Source: Ministry of Education

Education – Schools ICT Network Infrastructure Upgrade (unchanged, unquantified risk)

The Government is considering the roll-out of the Schools ICT Network Infrastructure Upgrade. This would assist schools to meet the costs of upgrading their computer networks to meet the new IT infrastructure standards.

The Government will consider rolling out phase 2 as part of Budget 2006. This would decrease the operating balance and increase debt.

This risk is unquantified as disclosure could compromise the Crown in negotiations.

Education – Tertiary Student Support Changes (new, unquantified risk)

The Government is considering increasing eligibility for student allowances and expanding scholarships over the parliamentary term. The impact on the operating balance and debt of these changes is unclear as it would depend upon the options chosen.

Education – Tertiary Education Expenditure Review (changed, quantified risk)

The Government has initiated a review on the quality, relevance, sustainability and predictability of tertiary education spending. A number of decisions relating to certificate and diploma tertiary education provision were taken in July 2005. The ongoing capital impacts of these and other decisions on Tertiary Education Institutions are as yet unclear but could increase debt by up to $250 million.

Further policy development is underway and decisions are expected late in 2005 with a particular focus on policy and funding mechanisms that support the long term sustainability of tertiary education and research that is high quality, relevant and value for money. At this stage the impact on the operating balance is unclear as decisions have yet to be taken.

The Minister of Finance has yet to fully consider the quantum of this risk.

Source: Ministry of Education

Education – Vocational Training (new, quantified risk)

The Government is considering a number of policies regarding the expansion of vocational training. These would include increasing the total number of Modern Apprentices to 14,000 by 2008 (up from the existing target of 11,000 funded places by 2007); having 250,000 people participating in industry training; and expanding the Gateway programme to all state secondary schools by 2007. These policies would decrease the operating balance by up to $7 million in 2006/07; $20 million in 2007/08; and $24 million per annum thereafter.

The Minister of Finance has yet to fully consider the quantum of this risk.

Source: Ministry of Education

Education – Wananga Capital Injection (unchanged, unquantified risk)

The Government is currently negotiating with one Wananga (Māori tertiary institution) over settlement of its Waitangi Tribunal claim. The Waitangi Tribunal has recommended that the Wananga be compensated for capital expenditure that has been incurred on facilities to date, be provided funding to bring their facilities up to a standard comparable with other tertiary institutions, and to meet additional capital requirements. A second Wananga claim, which has already been settled, may require a further capital injection should certain conditions be met.

Any capital injection would increase gross debt. This risk is unquantified as disclosure could compromise the Crown in negotiations with the Wananga.

Environment – Review of Climate Change Policies (new, unquantified risk)

A review of all climate change policies is currently underway. The impact on the operating balance is unclear, as it would depend on the outcome of the review.

Finance – Crown Overseas Properties (unchanged, unquantified risk)

The Government is considering options relating to the continued use of certain Crown overseas properties.

The risk is unquantified as disclosure could compromise any negotiations the Crown may enter, but any additional operating funding would decrease the operating balance, and any additional capital funding would increase debt.

Finance – National Rail Access Agreement (unchanged, unquantified risk)

The Government is considering options for amending the National Rail Access Agreement between Toll and Ontrack. Any impact on the operating balance or debt would depend on the option chosen.

This risk is unquantified as disclosure could compromise the Crown in negotiations.

Finance – National Rail Network Upgrade (unchanged, quantified risk)

The Government has committed $200 million between 2004/05 and 2007/08 to upgrade the national rail network. Further expenditure of between $200 million and $300 million is likely to be required over the forecast period, but the amount and timing will depend on policy decisions yet to be made.

Under the National Rail Access Agreement, additional funding of this nature would generally be recovered through track access fees. Any additional funding would increase debt.

The Minister of Finance has yet to fully consider the quantum of this risk.

Source: The Treasury

Finance – SOE long term hold reviews (unchanged, unquantified risk)

To implement its long-term hold ownership policy, the Government is conducting reviews of each SOE. These reviews are examining the strategic direction for each SOE and therefore the appropriate capital structure to support the individual SOE's strategy. One possible outcome of current reviews is that some capital could be returned to the Crown. This may be in the form of a special dividend, which would decrease gross debt.

Fisheries – Māori Interest in Marine Farming (unchanged, unquantified risk)

The Māori Commercial Aquaculture Claims Settlement Act 2004 addresses Māori claims in commercial marine farming space from 21 September 1992 to 31 December 2004 (pre-commencement space) by providing Iwi with 20% equivalent space. This obligation is to be met through three possible options: the provision of additional new space; or Crown purchase of existing farms from 2008; or provision of the financial equivalent of space from 2013.

Under the Act, any Māori claim relating to new aquaculture space after 31 December 2004 will be met by the provision of 20% of the new space.

To the extent that financial compensation or Crown purchase of existing farms is necessary to address Māori interests (as opposed to using new space), this would decrease the operating balance. The risk is unquantified as the amount or timing of any funding is unclear, and in addition, disclosure could compromise the Crown in negotiations with either commercial marine farm owners or Iwi.

Foreign Affairs and Trade – Official Development Assistance (unchanged, unquantified risk)

The Government is considering increasing the aid budget as and when resources allow, in line with United Nations commitments. The Government has committed to an ODA to GNI ratio of 0.27% for the fiscal years 2005/06 and 2006/07, increasing to 0.28% in 2007/08. From 2008/09, the Government will investigate a range of options for increasing and allocating any additional funding above 0.28% of GNI, which would decrease the operating balance.

Health – District Health Board Deficits (changed, unquantified risk)

Draft District Annual Plans from District Health Boards (DHBs) for 2005/06 and progress by DHBs against these indicate deficits in the order of $80 million in 2005/06 spread across Auckland, Waitemata, Tairawhiti and Whanganui. A similar level of deficits is forecast for 2006/07. The Government has not accepted the size of the forecast deficits and is actively discussing actions and cost-containment measures with these DHBs.

Any deficits in excess of the forecast amount would potentially decrease the operating balance and/or increase debt. Specific potential pressures for DHBs include wage bargaining, funding for health of older people services, and financing costs of capital projects.

This risk has changed since the 2005 Pre-election Update to take into account the new projections of DHB deficits.

Health – New Zealand’s Preparedness for a Possible Pandemic (new, unquantified risk)

The World Health Organisation and other international organisations are advising of the possibility of a new human influenza pandemic. The Government is currently developing a strategy aimed at improving New Zealand's response to a possible pandemic. The quantum of this risk will depend on the options chosen.

Housing – HNZC's Long-term Capital Requirements (unchanged, quantified risk)

The Government is currently considering Housing New Zealand Corporation’s (HNZC) long-term capital requirements in light of the demand for state housing and the need to reconfigure and modernise its housing stock. While some decisions were made in the 2005 Budget regarding the acquisition of new stock, the Government is likely to review acquisition targets and has still to consider options around modernisation programmes directed at existing stock.

The Government is further examining the range of options and associated costs, with initial estimates of up to $1.6 billion of capital costs over a 10 to 15 year horizon. Any new capital contributions would increase gross debt and would likely lead to an increase in the Income-Related Rent subsidy with a subsequent decrease in the operating balance.

The Minister of Finance has yet to fully consider the quantum of this risk.

Source: Department of Building and Housing

Housing – State Housing Project at Hobsonville (unchanged, unquantified risk)

In Budget 2005, HNZC has received funding of $54.3 million to acquire, under the Housing Act 1955, NZDF land at Hobsonville deemed surplus to defence requirements but suitable for state housing purposes. The Government is considering development options that may lead to the Crown giving additional capital to HNZC, which would increase gross debt.

Housing – Weathertight Homes (unchanged, unquantified risk)

The Government is considering measures to increase the rate at which non-weathertight homes in New Zealand are repaired. Options may include administrative or legislative changes to enhance the operation of the Weathertight Homes Resolution Service. The Government is also considering whether there is a need for targeted assistance for low income homeowners to undertake repairs. The fiscal impact, if any, depends on what measures and options are agreed, but any additional operating funding would decrease the operating balance.

Immigration – New Immigration Service Delivery Strategy (new, unquantified risk)

The Government is in the process of developing options for a new immigration service delivery strategy that would allow better management of the risk surrounding immigration decision-making. Options are likely to be considered in early 2006. As options are still being developed the impact of the operating balance is unclear.

Internal Affairs – 2004 and 2005 Storms Response and Infrastructure Costs (unchanged, quantified risk)

The lower North Island and the Bay of Plenty were hit by severe storms during 2004, and the Bay of Plenty again in May 2005. The Government reimburses some local authority costs under the National Civil Defence Plan. Several local authorities have made submissions for reimbursement, and further submissions are expected. The Government has already provided around $20 million as a contribution toward response and recovery costs. Remaining costs could be between $5 million and $20 million and would reduce the operating balance.

The Minister of Finance has yet to consider fully the quantum of this risk.

Source: Department of Internal Affairs

Justice – New Supreme Court – Cost Escalation (unchanged, quantified risk)

In order to meet revised functional requirements, the Government is considering altering the 2003 design for accommodating the new Supreme Court. This could increase construction costs. The original scheme was approved by Cabinet at a cost of $19 million; the additional capital cost could range from $15 million to $20 million, depending on the revised design option selected. This would increase gross debt.

The Minister of Finance has yet to fully consider the quantum of this risk.

Source: Ministry of Justice

Labour – Department of Labour Strategic Baseline Review (new, unquantified risk)

The Government is currently conducting a review of the Department of Labour. The review will consider the appropriate mix of delivery outputs to achieve desired labour market outcomes. The impact on the operating balance and/or gross debt is unclear.

New Zealand Defence Force – Defence – Capital Injections (unchanged, quantified risk)

Implementing the Government’s decisions on the future structure of the NZDF will involve a series of capital acquisitions across all three armed services and for HQNZDF to achieve the required capability upgrades. The Government has agreed to a capital injection of up to $1.244 billion over 2001/02 to 2010/11.

Of the Long-Term Development Plan funding, $690 million has been agreed, with the remainder likely to be required within the forecast period. The actual expenditure profile will depend on the specification and timing of the individual projects, the contracted prices, and the prevailing exchange rate at the time of purchase.

Any capital injections would increase gross debt.

The Minister of Finance has yet to fully consider the quantum of this risk.

Source: New Zealand Defence Force

New Zealand Defence Force – Environmental Clean-up of Devonport Seabed Contamination (unchanged, quantified risk)

The Government has identified historic contamination in the seabed adjacent to the Calliope Dock at the Devonport Naval Base. Investigatory work on the contamination is underway, and it is anticipated that better information will be available shortly to determine the scope of the issue. Costs are estimated to be $13 million over 2006/07 and 2007/08, which would decrease the operating balance.

The Minister of Finance has yet to fully consider the quantum of this risk.

Source: New Zealand Defence Force

New Zealand Defence Force – Sale of Skyhawks and Aermacchi Trainers (changed, quantified risk)

As a result of the Government’s decisions on the future structure of the NZDF, NZDF has signed an agreement with Tactical Air Services Inc for the sale of the Skyhawks and Aermacchi trainers for $US110 million. Proceeds from the sale would decrease debt and increase the operating balance.

The Minister of Finance has yet to fully consider the quantum of this risk.

Source: New Zealand Defence Force

Police – Increases to Police Staff (new, unquantified risk)

The Government is considering increasing police numbers by 1000 over the next three years. Costs would depend on the types of positions created and the flow on effects through the justice system. This would decrease the operating balance and increase debt.

Revenue – Extension of the Temporary Tax Exemption for New Migrants (new, quantified risk)

Potential changes to the temporary tax exemption for new migrants could increase the cost of that exemption by $10-13 million per annum. This additional amount would reduce the operating balance.

The Minister of Finance has yet to fully consider the quantum of this risk.

Source: Inland Revenue

Revenue – Family Assistance Indexation and Review of Rates (new, unquantified risk)

The Working for Families package included a commitment to index Family Assistance payment rates and abatement thresholds, once inflation beyond 1 April 2007 cumulatively exceeds 5%. Legislation also requires a review of the amounts of the In Work Payment and Parental Tax Credits to be undertaken no later than June 2008. This policy cannot be costed with sufficient accuracy until the reviews are completed. The indexation changes would reduce the operating balance.

Revenue – Fringe Benefit Tax Review (unchanged, quantified risk)

The Budget 2005 Business Package included changes to fringe benefit tax policies. The Government is considering further work on changes to the fringe benefit tax rules focusing on eliminating certain anomalies in relation to motor vehicles.

The reduction in the operating balance would depend on what proposals are finally approved and the details of the legislation. However, the estimated net fiscal cost is likely to be within the range of $24 million to $64 million per annum.

The Minister of Finance has yet to fully consider the quantum of this risk.

Source: Inland Revenue

Revenue – Rebuild of the Student Loan IT System (new, unquantified risk)

To facilitate the implementation of zero-interest on student loans, the Government is considering rebuilding the student loans IT system. The rebuild would allow zero-interest to be assessed, improve the integrity of the system, produce better information to inform policy decisions and allow flexibility for policy changes. Work is still underway on assessing the indicative costs, but any additional funding would reduce the operating balance and increase debt.

Revenue – Review of Superannuation Contribution Withholding Tax (unchanged, unquantified risk)

The Government is considering reforming the provisions relevant to superannuation contributions withholding tax with a view to simplifying the provisions and investigating possible equity issues arising from the current provisions. Any changes to the provisions are expected to come into effect in 2007. Whether the outcome of this review will have an impact on the operating balance is unclear and would depend on the proposals that are finally developed and approved.

Revenue – Subsidies for Payroll-Related Tax Compliance Costs (changed, quantified risk)

As part of the tax simplification programme the Government plans to implement a legislative framework to subsidise the use of payroll agents to meet small employers’ PAYE obligations. The structure and amount of the subsidy are contingent on successful negotiation with payroll agents and the reduction in the operating balance will depend on the final structure of the subsidy adopted. The estimated cost of the subsidy is between $7 million and $45 million per annum. This would decrease the operating balance. A target date has not yet been set for implementation.

The Minister of Finance has yet to fully consider the quantum of this risk.

Source: Inland Revenue

Revenue – Tax and Depreciation (unchanged, unquantified risk)

The Budget 2005 Business Package included changes to depreciation policies. The Government is considering further issues related to depreciation, including the treatment of long-lived assets and potential changes to the tax treatment of rental housing in particular. However, the impact on the operating balance remains unclear as it would depend on the options chosen.

Revenue – Taxation of Offshore Portfolio Investment and Intermediaries, Including Superannuation (unchanged, quantified risk)

The Budget 2005 Business Package included changes to the taxation of domestic intermediaries and further work is underway. This includes consideration of the taxation of both onshore and offshore investments in equity by New Zealand residents. A target date of April 2007 has been set for implementation of changes, some of which had been included in the Budget 2005 Business Package. Further proposals are being considered. Depending on the decisions made, there would be a reduction in the operating balance by an additional $80 million to $90 million or an increase in fiscal revenue by $50 million to $60 million. These changes would be on top of the previously announced expenditure on the taxation of investment income of $100 million. As a result, the total reduction in the operating balance for changes to investment income would range from a reduction of $40-50 million to a reduction of $180-190 million.

The Minister of Finance has yet to fully consider the quantum of this risk.

Source: Inland Revenue

Revenue – Taxation of Partnerships Review (unchanged, unquantified risk)

The Government is considering reform to the taxation of partnerships, including replacing the current ‘special partnerships’ tax rules with more modern and internationally comparable ‘limited partnerships’ tax rules. Any new rules are likely to take effect on 1 April 2007. The impact on the operating balance is unclear and would depend on the proposals that are finally developed and approved.

Revenue – Taxation of Racing Industry (new, unquantified risk)

A new taxation regime for the racing industry is under consideration. The impact on the operating balance is unclear as it would depend on the outcome of the review.

Social Development – Early Intervention (unchanged, unquantified risk)

Budget 2005 includes initial funding of $37.6 million over four years in early intervention services for children and families. Ministers are considering proposals for further development of the early intervention programme, including enhancements and expansion of the existing initiatives. New programmes may also be considered to respond better to the needs of children and their families. Further proposals are still being developed, with a report-back due in early 2006. Any additional funding would decrease the operating balance.

Social Development – Extending Opportunities to Work (unchanged, unquantified risk)

Following on from Working for Families, the Government is considering options for simplifying the benefit system and reforming labour market assistance and service delivery in order to better support beneficiaries’ entry to employment. Decisions are likely to be made as part of Budget 2006. The impact on the operating balance is unclear, as proposals are still being developed.

Social Development – New Zealand Superannuation – International Mobility Issues (new, unquantified risk)

Over the next 12 months, the Government will consider the results of a review of arrangements for the payment of New Zealand Superannuation to New Zealanders residing overseas; and the treatment of overseas pensions paid to recipients of New Zealand pensions and welfare benefits. The impact on the operating balance is unclear, as proposals are still being developed.

Social Development – New Zealand Superannuation – Rate Adjustment (new, unquantified risk)

The Government is considering increasing the net married couple rate of New Zealand Superannuation (NZS) to 66% of the net average ordinary time weekly wage on 1 April. The impact on the operating balance would be dependent on future CPI and wage statistics. This policy would decrease the operating balance.

State Services Commission – State Sector Retirement Savings Scheme (unchanged, unquantified risk)

The Government is considering options for extending the employer subsidy for members of the State Sector Retirement Savings Scheme beyond 3% (3% is the level of employer subsidy from 2005/06), and is also considering options for extending the scheme to the wider state sector. The decrease in the operating balance would vary depending on the options chosen.

Transport – Regional Transport Initiatives (changed, unquantified risk)

The Government is involved in regional transport initiatives working in conjunction with Local Government to make significant and timely improvements to regional land transport outcomes. This would decrease the operating balance and increase debt.

Youth Development – United Nations Convention on the Rights of the Child (unchanged, quantified risk)

If unconditionally adopted, the United Nations Convention on the Rights of the Child would require New Zealand to confer the rights of the Convention on all children. To date, New Zealand has reserved its right to distinguish between persons according to the nature of their authority to be in New Zealand. The Government established a review to consider whether this reservation can be removed. This could involve making changes to eligibility for some health, education and social services, which would decrease the operating balance by approximately $20 million per annum.

The Minister of Finance has yet to fully consider the quantum of this risk.

Source: The Treasury

Contingent Liabilities

Contingent liabilities are costs that the Crown will have to face if a particular event occurs. Typically, contingent liabilities consist of guarantees and indemnities, legal disputes and claims, and uncalled capital. The contingent liabilities facing the Crown are a mixture of operating and balance sheet risks, and they can vary greatly in magnitude and likelihood of realisation. In general, if a contingent liability were realised it would reduce the operating balance and net worth, and increase Crown debt. However, in the case of contingencies for uncalled capital, the negative impact would be restricted to Crown debt.

Where contingent liabilities have arisen as a consequence of legal action being taken against the Crown, the amount shown is the amount claimed and thus the maximum potential cost. It does not represent either an admission that the claim is valid or an estimation of the possible amount of any award against the Crown.

Only contingent liabilities involving amounts of over $10 million are separately disclosed. Contingent liabilities below $10 million are included in the “other quantifiable contingent liabilities” total. Comparatives have been adjusted where appropriate to align with the disclosure of new “material” contingent liabilities. The total amount of prior years’ contingent liabilities remains unchanged.

Contingent liabilities have been stated as at 31 October 2005, being the last set of published contingent liabilities.

Details of each of the following contingent liabilities can be accessed from the Treasury website at http://www.treasury.govt.nz/forecasts/hyefu/2005/.

Quantifiable Contingent Liabilities

Quantifiable Contingent Liabilities

Unquantifiable Contingent Liabilities

5 Generally Accepted Accounting Practice (GAAP) Series Tables

These forecasts have been prepared in accordance with the Public Finance Act 1989.

They are based on the accounting policies and assumptions that follow. As with all such assumptions, there is a degree of uncertainty surrounding them. This uncertainty increases as the forecast horizon extends.

The forecasts have been prepared in accordance with the Statement of Responsibility and reflect the judgements and information known at the time they were prepared. They reflect all Government decisions and circumstances communicated to 7 December 2005.

Finalisation dates and key assumptions that underpin the preparation of the GAAP tables are outlined at the start of the Fiscal Outlook chapter on page 27.

10 year trend information

Statement of Accounting Policies and Forecast Assumptions

General Accounting Policies and Forecast Assumptions

General accounting policies

Accounting policy

These Forecast Financial Statements comply with generally accepted accounting practice. The measurement base applied is historical cost adjusted for revaluations of property, plant and equipment (where appropriate), commercial forests and marketable securities & deposits and equity investments held for trading purposes.

Revaluations are made to reflect the forecast service potential or economic benefit obtained through control of the assets. The accrual basis of accounting has been used.

Forecast assumptions

For forecast purposes, no revaluations of property, plant and equipment are projected beyond the current year.

Specific Accounting Policies and Forecast Assumptions

Forecast periods

The reporting periods covered by these Forecast Financial Statements are the years ending 30 June 2006, 30 June 2007, 30 June 2008, 30 June 2009 and 30 June 2010.

Certain state-owned enterprises and Crown entities have different reporting periods from the Crown.

The forecasts for 30 June 2006 have generally been prepared using actual data to 30 September or 31 October 2005 (in some instances). Transactions for the remainder of the year are forecast in accordance with the Crown’s accounting policies and forecast assumptions.

Changes in accounting policies

There has been a change in the accounting policy for student loans to better reflect their value under the new no-interest policy. Further information on the nature of the change is disclosed in the Student Loan Policy box on page 39 and the impact of the change is reflected in Note 10 on page 113.

All other policies have been applied on a consistent basis during the forecast period.

Changes in forecast assumptions

Changes to the forecast assumptions used for the forecasts published in the 2005 Half Year Update are outlined on page 27.

Detailed accounting policies and forecast assumptions

The specific accounting and forecasting policies are reproduced in full on Treasury’s website at http://www.treasury.govt.nz/forecasts/hyefu/2005/.

Reporting Entity as at 7 December 2005

These Forecast Financial Statements are for the Crown reporting entity as specified in Part III of the Public Finance Act 1989. This comprises Ministers of the Crown and the following entities:

Organisations named or described in Schedule 4 to the Public Finance Act 1989

Forecast Statement of Financial Performance

The revenues and expenses are GST exclusive.

The accompanying Notes and Accounting policies are an integral part of these Statements.

Below is an analysis of total Crown expenses and core Crown expenses by functional classification. This information reconciles to segmental information within the Statement of Segments.

The accompanying Notes and Accounting policies are an integral part of these Statements.

Forecast Statement of Cash Flows

1 Net issues of Government stock include movements within government stock holdings of entities such as NZS Fund, GSF, ACC and EQC. The Bonds Reconciliation at the end of these forecasts outlines NZDMO issues of Government stock.

The accompanying Notes and Accounting policies are an integral part of these Statements.

The accompanying Notes and Accounting policies are an integral part of these Statements.

Forecast Statement of Movement in Equity

The accompanying Notes and Accounting policies are an integral part of these Statements.

Forecast Statement of Financial Position

The accompanying Notes and Accounting policies are an integral part of these Statements.

Below is an analysis of the NZS Fund and Gross and Net Debt information. The notes to the accounts provide breakdown of other key items.

The accompanying Notes and Accounting policies are an integral part of these Statements.

Forecast Statement of Borrowings

The accompanying Notes and Accounting policies are an integral part of these Statements.

Statement of Actual Commitments

The accompanying Notes and Accounting policies are an integral part of these Statements.

Statement of Actual Contingent Liabilities

The accompanying Notes and Accounting policies are an integral part of these Statements.

A detailed Statement of Contingent Liabilities and Assets (quantified and unquantified) is outlined on pages 86 to 88 of the Specific Fiscal Risk chapter.

The Statement of Specific Risks (quantified and unquantified) is outlined on pages 75 to 86 of the Specific Fiscal Risk chapter.

Forecast Statement of Segments

Notes to the Forecast Financial Statements