Half Year Economic and Fiscal Update 2015

Statement of Responsibility#

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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 Update incorporates the fiscal and economic implications both of government decisions and other circumstances as at 27 November 2015 that were communicated to me by the Minister of Finance in accordance with the requirements of the Public Finance Act 1989 and of other economic and fiscal information available to the Treasury as at 27 November 2015. This Update does not incorporate any decisions, circumstances or statements that the Minister of Finance has determined, in accordance with section 26V of the Public Finance Act 1989, should not be incorporated in this Update.

Gabriel Makhlouf
Secretary to the Treasury

8 December 2015

To enable the Treasury to prepare this Economic and Fiscal Update I have ensured the Secretary to the Treasury has been advised, in accordance with the requirements of the Public Finance Act 1989, of all government decisions and other circumstances as at 27 November 2015 of which I was aware and that had material economic or fiscal implications.

I accept responsibility for the integrity of the disclosures contained in the Update and responsibility for the consistency and completeness of the Update information with the requirements of Part 2 (Fiscal responsibility) of the Public Finance Act 1989.

Hon Bill English
Minister of Finance

8 December 2015

Executive Summary#

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Overview#

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• New Zealand's economic growth slowed in the first half of 2015 relative to the Budget Update, reflecting weaker international economic conditions, falls in dairy prices and a softening of domestic demand. The forecasts in this Half Year Update show relatively muted growth persisting and the unemployment rate rising until early 2016. However, the economy is expected to recover over the medium term.

• Following growth of 3.2% over the year to March 2015, annual average growth in real gross domestic product (GDP) is forecast to slow to 2.1% in the year to March 2016 owing to weak global and domestic demand and lower terms of trade. Stimulatory monetary conditions and a recovery in the terms of trade are expected to see annual average growth increase to 3.6% in March 2018 before moderating to 2.2% in March 2020. Relative to the Budget Update, real growth forecasts are weaker in the near term but stronger in the medium term (Figure 1). Nominal GDP (which incorporates price changes as well as output growth) is forecast to continue growing slowly over the next year and, despite a strong recovery in later years, does not return to the forecast levels in the Budget Update.

Figure 1 - Real GDP growth

Source: Statistics New Zealand, the Treasury

• The operating balance before gains and losses (OBEGAL) returned to surplus in the 2014/15 fiscal year. The current year's results to 31 October continue to be above the forecast in the Budget Update. Looking ahead, the fiscal position is expected to be broadly balanced in 2015/16 and 2016/17, followed by rising surpluses over the remaining forecast horizon. This fiscal outlook is slightly weaker than in the Budget Update primarily as a result of lower tax revenues, which reflect the weaker economic outlook. The Government's fiscal stance is expected to be expansionary in 2015/16 before turning slightly contractionary over the remainder of the forecast horizon.
• Significant judgements influencing the economic forecasts and, in turn, fiscal forecasts relate to trading partner growth, the future paths of dairy and oil prices, the impact of El Niño, the extent and duration of the current migration boom, and the amount of spare capacity in the economy and its relationship with Consumers Price Index (CPI) inflation.

Economic Outlook#

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• Global economic growth is expected to recover gradually in 2016, following a downturn in 2015, as policies support demand and recoveries become entrenched. However, the outlook for New Zealand's trading partner growth is weaker throughout the forecast horizon compared with the Budget Update. At present, risks to the global economy are skewed to the downside, particularly in relation to the risk of a sharp slowing of growth in China and its impact on other economies, and the risk of the impact of monetary policy tightening in the US on emerging market economies.
• The weaker global growth outlook is expected to keep New Zealand's key commodity export prices low in the near term. Dairy export prices are expected to recover from the first quarter of 2016, though more gradually than assumed in the Budget Update. Oil prices are forecast to recover steadily, as expected in the Budget Update, although from lower levels. As a result, the terms of trade are forecast to show a subdued recovery from mid-2016 relative to the Budget Update forecasts.
• Net migration inflows reached a record high of 62,500 over the year to October 2015. Annual net inflows are now expected to remain strong through to the March 2016 quarter before returning to the long-run average of 12,000 in the year ended March 2018.
• Domestic demand growth is expected to remain weak until the middle of 2016. Forecasts show private consumption growth (on an annual average basis) slowing until the middle of 2016, partly reflecting the drop in farm incomes and a weakening of the exchange rate. Strong El Niño conditions are also expected to contribute to lower agricultural production in early 2016. Residential investment growth is assumed to slow with reduced impetus from the Canterbury rebuild. However, growth in the near term is expected to be supported by housing market activity in Auckland and surrounding regions, and strong growth in travel services exports.
• Demand growth picks up after mid-2016 as exports respond to the recovery in the terms of trade and a weaker exchange rate, and as the agricultural sector recovers from El Niño. Monetary policy settings are expected to stimulate the domestic economy in the near term. The unemployment rate is forecast to increase from 6.0% in September 2015 to 6.5% in March 2016 before declining to reach 4.5% by September 2019.

• Annual consumer price inflation is forecast to remain below 1.0% until the end of 2015 before rising to 1.9% in mid-2016 and remaining around 2% thereafter. Tradables inflation is expected to pick up sharply from early 2016 as the low New Zealand dollar flows through into higher prices, while non-tradables inflation rises from September 2017 as spare capacity in the economy reduces. Overall inflation forecasts are similar to the Budget Update forecasts as higher tradables inflation offsets lower non-tradables inflation in the near term (Figure 2).

Figure 2 - CPI inflation

Source: Statistics New Zealand, the Treasury

• Monetary conditions are assumed to become more accommodative as the policy interest rate is reduced further[1] and as the exchange rate continues to depreciate in 2016 as monetary policy tightens in the US. Short-term interest rates are forecast to increase gradually from early 2017 as inflation returns to 2%. The exchange rate is also expected to increase from around the same time with the increase in interest rates and improvement in the terms of trade.
• Although real GDP growth turned out to be lower than expected, annual average nominal GDP growth of 2.8% in the year to June 2015 was higher than forecast in the Budget Update. Annual average nominal GDP growth is forecast to slow to 1.8% in the year to June 2016 and recover thereafter to average 4.3% over the five years to June 2020. Compared with the Budget Update, nominal GDP growth is weaker in 2016 and 2017 owing to the income and price effects associated with a weaker terms of trade and lower real GDP growth, but is stronger in the subsequent forecast years.Nominal GDP is forecast to be a cumulative $17 billion lower compared with the Budget Update over five years to June 2019.

Fiscal Outlook#

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• Core Crown tax revenue is forecast to increase gradually as a share of GDP from 27.9% in the 2015/16 fiscal year to 28.4% in 2019/20. Actual tax revenue for 2014/15 was higher than forecast in the Budget Update partly owing to higher nominal GDP. However, tax revenue forecasts over the next four years are lower than in the Budget Update reflecting lower forecasts for nominal GDP growth and interest rates.

• Core Crown expenses are expected to increase from $72.4 billion in 2014/15 to $86.2 billion in 2019/20 reflecting increases in social assistance spending, operating allowances and finance costs. Social assistance spending is expected to be slightly higher than previously forecast for 2016/17 and 2017/18 owing to a softer labour market outlook. Forecasts of future operating allowances are unchanged at $1.0 billion for Budget 2016, $2.5 billion for Budget 2017 and $1.5 billion for Budget 2018, while $1.5 billion is allocated for Budget 2019. As a share of GDP, core Crown expenses are forecast to reduce gradually from 30.6% of GDP in 2015/16 to 29.1% in 2019/20 (Figure 3).

Figure 3 - Core Crown revenue and expenses

Source:  The Treasury

• Following a surplus of $0.4 billion in 2014/15, OBEGAL is forecast to show a deficit of $0.4 billion in 2015/16. Surpluses are expected to return thereafter and rise throughout the remaining forecast period (Figure 4). The changes to OBEGAL forecasts compared with the Budget Update are almost entirely owing to lower tax revenues. The cyclically adjusted balance, which adjusts OBEGAL for the cyclical position of the economy, is expected to remain in surplus throughout the forecast horizon.

Figure 4 - OBEGAL, core Crown residual cash and net core Crown debt

Source:  The Treasury

• The Government is forecast to generate operating cash flows from core Crown operations of $14.3 billion over the five years to June 2020, which are not sufficient to cover the net capital spending forecast of $24.7 billion. However, core Crown residual cash is forecast to return to surplus in the 2018/19 fiscal year as forecast in the Budget Update. Net capital spending is expected to be $0.7 billion more than previously forecast over the four years to June 2019, largely because of an increase in the Budget 2016 capital allowance of $1.0 billion. Capital allowances of $0.9 billion are forecast in Budget 2017 before growing at a rate of 2.0% per year for subsequent budgets.
• Net core Crown debt is expected to peak at 27.7% of GDP in 2016/17, before gradually declining to stand at 24.0% of GDP by 2019/20 (Table 1). Forecast net debt is higher than in the Budget Update across the forecast horizon.
• Net worth attributable to the Crown is expected to increase over the forecast period, reaching $107.2 billion by the year ending June 2020, which is similar to the level before the global financial crisis. The rate of increase is expected to be muted over the next two years before rising thereafter in line with increases in forecast operating surpluses.
• Forecasts show the Crown's total assets increasing by $35.3 billion and liabilities increasing by $14.3 billion over the five years ending June 2020. The largest increase occurs in social assets (including schools, hospitals and other properties, and student loans) followed by financial assets and commercial assets. The increase in liabilities is driven by borrowings to fund cash shortfalls, and the increase in commercial liabilities.

Risk and Scenarios#

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• The central forecast discussed above involves several key judgements on the risks and uncertainties facing the New Zealand economy. The Risks and Scenarios chapter presents two alternative scenarios to show how the economy might evolve if some of these judgements are altered (Figure 5).

Figure 5 - OBEGAL scenarios

Source:  The Treasury

• In Scenario One, three key judgements are changed relative to the central forecast - productivity growth is softer, demand is less responsive to monetary policy and the historical relationship between inflation and spare capacity takes longer to re-assert itself. This leads nominal GDP to be a cumulative $26 billion lower than the central forecast. The fiscal position shows larger operating deficits owing to lower nominal GDP impacting tax revenues, and the net core Crown debt to GDP ratio is higher throughout the forecast period compared with the central forecast.
• Scenario Two assumes that global dairy prices recover faster, international demand is more sensitive to the low New Zealand dollar and there are an additional 11,000 net migrants over the next year. This leads to an earlier recovery in the terms of trade, and stronger growth in services exports, private consumption and investment. Inflation is also slightly higher and interest rates rise three quarters earlier. Nominal GDP is higher than in the central forecast by a cumulative $15 billion. Overall, higher nominal GDP and interest rates lead to increased tax revenues, and an OBEGAL surplus in 2015/16 and higher surpluses thereafter relative to the central forecast.

Notes:

1. Real production GDP, annual average percentage change.
2. Percent of labour force, March quarter, seasonally adjusted.
3. CPI, annual percentage change, March quarter.
4. Annual balances as % of GDP.
5. Total Crown operating balance before gains and losses (OBEGAL).
6. Net core Crown debt excluding the New Zealand Superannuation Fund (NZS Fund) and advances.

Sources: Statistics New Zealand, the Treasury

Finalisation Dates for the Update#

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Economic data - 20 November[2]

Economic forecasts - 20 November

Tax revenue forecasts - 24 November

Fiscal forecasts - 27 November

Specific fiscal risks - 27 November

Text finalised - 10 December

Economic Outlook#

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Overview#

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• Economic growth slowed in the first half of 2015 and was lower than anticipated in the Budget Update. Economic growth is expected to remain muted in the near term in response to weak global and domestic demand and lower terms of trade. El Niño weather conditions, coupled with existing price signals, are likely to depress agricultural production and exports in early 2016. The degree of spare capacity in the economy is expected to increase further as growth slows, resulting in higher unemployment and lower non-tradables inflationary pressures. Real GDP growth is forecast to ease to 2.1% in the year to March 2016.
• Growth is expected to pick up in the second half of 2016 and remain above trend for most of the latter part of the forecast. Exports are expected to recover in response to the recovery in the terms of trade, the weaker dollar and as the agricultural sector recovers from El Niño, with further support from strong travel service exports. Stimulatory monetary policy conditions are expected to support domestic consumption and investment. Increases in the Government's operating and capital allowances increase public consumption and non-market investment respectively. Unemployment falls as spare capacity in the economy declines.
• Nominal GDP growth is expected to slow in the near term in response to slower real GDP growth and the lower terms of trade. Strong nominal GDP growth in later years, as real GDP growth picks up and the terms of trade increase, does not return nominal GDP to previously forecast levels. For the fiscal years 2014/15 to 2018/19, nominal GDP is forecast to be a cumulative $17 billion lower compared to the Budget Update.
• Key factors influencing the economic outlook include judgements around trading partner growth, the future path of commodity prices, the impact of El Niño, the extent and duration of the current migration cycle and the relationship between inflation and spare capacity. The risks to these judgements are discussed further in the Risks and Scenarios chapter.

Notes:

1. Forecasts finalised 20 November 2015.
2. Contribution to GDP growth.
3. Estimated as the percentage difference between actual real GDP and potential real GDP.
4. Percent of the labour force, March quarter, seasonally adjusted.
5. Percent of the working-age population, March quarter, seasonally adjusted.
6. Quarterly Employment Survey, average ordinary-time hourly earnings, annual percentage change.
7. Annual percentage change.
8. System of National Accounts (SNA) and merchandise basis, annual average percentage change.
9. Quotable Value New Zealand (QVNZ) House Price Index, annual percentage change.
10. Treasury estimate for 2015.
11. Average for the March quarter.

Longer time series for these variables are provided on page 144.

Sources: Statistics New Zealand, Reserve Bank of New Zealand, CoreLogic, the Treasury

Key economic forecast judgements and assumptions

Key judgements for this update

• Trading partner growth is assumed to increase in 2016 and 2017 as slower growth in China is offset by stronger growth in Australia, the US and most other trading partners.
• El Niño is assumed to have a small negative impact on the economy in 2016. See the box on page 20 for further details.
• Dairy prices are expected to recover at a modest rate, returning towards the long-term levels forecast by the OECD-FAO of US$3,500/mt towards the end of 2017.
• West Texas Intermediate (WTI) oil prices are assumed to rise from US$46 per barrel in the September 2015 quarter to US$69 in the March 2020 quarter.
• Net permanent and long-term migration inflows are assumed to rise from 62,500 in the year ended October 2015 to a peak of 62,700 in the year ended December 2015 and to return to the long-run assumption of 12,000 per year in the year ended March 2018.
• Growth in potential output is assumed to increase from 2.5% in the year ended June 2015 to a peak of 2.6% in the year ended June 2017 and to ease to 2.4% by the end of the forecast period. Economy-wide labour productivity growth is estimated to average 1.2% per year between the years ending March 2016 and March 2020.
• The historical relationship between spare capacity (the output gap) and non-tradables inflation is assumed to hold. The output gap is estimated to be around -0.8% of GDP currently and to become increasingly negative over the next year or so, contributing to lower inflation. The output gap is expected to turn positive towards the end of 2017.
• Ninety-day interest rates are assumed to rise to the neutral rate of 4.5% by the June 2020 quarter.

Other forecast assumptions

• Average paid hours worked per week per person are estimated to decline from around 32.9 in the year to June 2015 to around 32.4 by the end of the forecast period.
• Labour force participation averages 68.7% across the forecast period.
• The non-accelerating inflation rate of unemployment (NAIRU) is estimated to be around 4.5% by the end of the forecast period.
• Investment associated with the rebuild following the Canterbury earthquakes is assumed to be around $40 billion in 2011 prices (rounded to the nearest $5 billion), spread across residential property ($16 billion), commercial and other property ($10 billion) and infrastructure and social assets ($11 billion).

Policy impacts

• The tobacco excise tax increase in the March quarter 2016 adds 0.2 percentage points to annual consumer price inflation.
• The reduction in Accident Compensation Corporation (ACC) vehicle levies in September 2016 quarter is estimated to reduce consumer price inflation by 0.2 points.

Recent Developments and Near-term Outlook#

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Economic growth has slowed...

The pace of economic expansion slowed during the first half of 2015 owing to weaker international and domestic demand and falling dairy prices. This led to more spare capacity in the economy, reflected in low non-tradables inflation and higher unemployment. Weaker demand is expected to lead to slower annual growth over the remainder of 2015 and into 2016. Real production GDP growth is expected to slow from 3.2%in the year to March 2015 to 2.1% in the year to March 2016 (Figure 1.1). Although real GDP growth was lower than forecast in the Budget Update in the year to June 2015, nominal GDP growth was higher. As a result, nominal GDP was $0.8 billion higher than forecast, contributing to higher tax revenues in the 2015 fiscal year.

Figure 1.1 - Real GDP growth

Source: Statistics New Zealand, the Treasury

…with several developments impacting the economy and its outlook

A number of key developments since the Budget Update have influenced the revisions to the near-term growth outlook. These include a more subdued and uncertain global outlook, falling commodity prices (dairy in particular) contributing to a lower terms of trade, an earlier than expected peak in the Canterbury residential rebuild and the onset of El Niño. These are partially offset by a number of positive developments, including stronger net migration and tourist arrivals, higher housing market turnover and more stimulatory monetary conditions.

Judgements around trading partner growth, the future path of commodity prices, the impact of El Niño, the extent and duration of the current migration cycle and the relationship between inflation and spare capacity are key factors influencing the economic outlook. These judgements and the risks around them are discussed further in the Risks and Scenarios chapter and in the migration and El Niño boxes on pages 15 and 20.

Global economic growth has slowed…

Global economic growth has slowed over 2015 as demand weakened in China, impacting on other developing economies and slowing the recovery in many developed economies. The exception to these developments is the continuing recovery in the US economy.

Slower global growth is chiefly a result of the weaker economic outlook for emerging economies. Growth has slowed in China as the economy transitions from the investment-led model of recent years to greater dependence on consumption as a driver of growth, and as authorities balance structural reform and short-term stimulus of the economy. Sharp declines in the share market and adjustments to the exchange rate mechanism caused additional concerns about future growth mid-year. Slower growth in China has had flow-on effects to other economies in Asia, many of which are key trading partners for New Zealand, as well as commodity exporters such as Canada, Brazil and Russia.

The slowdown in China has also affected the Australian economy through a further fall in its terms of trade. However, with lower interest rates and a lower value of the Australian dollar, the Australian economy is shifting from mining investment towards other areas of investment (including housing), private consumption and export volume growth (both goods and services) as the main drivers of demand.

Economic indicators in both the US and UK have remained largely upbeat throughout 2015, although there has been some loss of momentum recently in the UK. Growth has been more subdued in Japan and the euro zone, with both economies easing monetary policy further through quantitative easing. Concerns over Greece's sovereign debt have decreased since mid-year.

Slower global growth has been reflected in weak commodity prices. Oil prices have remained low throughout the year, having fallen by 50% in the latter part of 2014. Since July, WTI oil prices have remained below US$50/barrel. The Commodity Research Bureau Futures Index has fallen 45% from a year ago and is just above a 14-year low.

…as has domestic demand

Domestic demand was weak through the first half of 2015. Real GDP (production measure) rose 0.2% and 0.4% in the March and June quarters respectively. Household consumption growth was particularly soft, largely owing to weak services consumption growth. In addition to low consumption growth, there was reduced impetus from the Canterbury rebuild and lower mining-related investment (in response to lower oil prices).

There are some positive factors underpinning growth despite recent weakness. Although there has been slower growth in the Canterbury residential rebuild, construction activity has remained solid. Services industries have also continued to grow at a steady rate, supported in part by a 25.6% increase in travel services export values in the year to June 2015 (mostly tourism- and education-related). Activity in the housing market has increased, driven by a higher number of sales in Auckland and, more recently, surrounding regions.

Aggregate demand has been supported by high levels of net inward migration, which reached a record 62,500 in the year to October 2015. The drivers of migration and the impacts on the economy are discussed in more detail in the box on page 15.

Dairy prices remain at low levels...

Dairy prices rallied briefly at the start of 2015 on concerns that drought might curb New Zealand milk production. However, once it became apparent that drought had not significantly reduced New Zealand production and that global demand remained relatively subdued, dairy prices fell sharply on the GlobalDairyTrade (GDT) auction platform. Between March and August prices fell by 50%, with key product whole milk powder selling for as low as US$1,600/mt in August.

Prices have recovered somewhat since then, albeit from a very low base, and by mid-November the GDT average price was around US$2,500/mt (Figure 1.2). This has led to a significant drop in dairy farmgate prices and incomes across both the 2014/15 and 2015/16 seasons, with many farmers projected to have negative cash flows in the latter season. The large drop in dairy farm incomes has spill-over effects to the wider economy as well.

Figure 1.2 - Dairy prices

Source:  GlobalDairyTrade, Statistics New Zealand, the Treasury

...but have been partly offset by strength in other export prices and lower import prices

While dairy export prices have fallen sharply, New Zealand's other exports such as meat, horticultural and seafood products, and manufactured goods have held up better and have benefited from depreciation of the New Zealand dollar (discussed further below). At the same time, world prices for New Zealand's imports have also remained relatively low. In part this reflects low global inflation. New Zealand has also benefited from low oil prices. Taken together, these factors saw New Zealand's terms of trade rise over the first half of 2015 despite the weakness in dairy prices, which will be reflected in the terms of trade in the second half of the year.

Slower economic growth has led to lower inflationary pressures and higher unemployment...

Inflation has remained low, at 0.4% in the year to September 2015 (Figure 1.3). Non-tradables inflation eased to 1.5%, reflecting a greater degree of spare capacity in the economy as well as policy changes (chiefly the ACC vehicle levy reduction). Subdued non-tradables inflation has been offset by slightly higher tradables inflation in recent quarters, resulting from a weaker New Zealand dollar. That said, annual tradables inflation remains negative at -1.2%, indicative of weak global inflationary pressures as well as the lagged impact of the previously high dollar.

Figure 1.3 - Consumer price inflation

Source: Statistics New Zealand

Labour market movements also reflect the greater degree of spare capacity in the economy. Employment growth has eased, resulting in unemployment rising from 5.8% in March 2015 to 6.0% in September 2015. Nominal wage growth remains subdued but is well above the rate of inflation, indicating that growth in real wages has been positive.

...and loosening of monetary policy

In response to the weakening activity and inflation outlook, the Reserve Bank reduced the Official Cash Rate (OCR) by 75 basis points between June and September, to 2.75%, and retained an easing bias in October. Easier monetary conditions together with the decline in export prices have been associated with a depreciation of the New Zealand dollar. The trade-weighted exchange rate has fallen by about 10% since April.

Migration - causes and effects

The current net migration inflow to New Zealand is the largest on record, reaching 62,500 in the year to October 2015 (Figure 1.4), with key drivers being the Australian unemployment rate, relative growth between New Zealand and other countries, and New Zealand policy changes.

Figure 1.4 - Migration flows

Source:  Statistics New Zealand

Australia is the main destination for New Zealand citizen departures, but the outflow generally eases in response to higher Australian unemployment. With the Australian unemployment rate rising from just over 5.0% in 2012 to 6.4% in January 2015, annual departures to Australia fell from 54,000 in December 2012 to 25,000 in October 2015.

Stronger GDP growth in New Zealand relative to source countries and policy changes (increased work rights for students from the start of 2014) are the key drivers of increased arrivals this cycle, with work and student visa arrivals reaching record highs in the October 2015 year. Working holiday visas have accounted for 60% of the growth in work visas approved since June 2012, with over half of this inflow coming from France and the UK, with which New Zealand has uncapped working visa scheme agreements.

Net migration can impact both demand and supply in the economy. Domestic demand is impacted by the higher level of private consumption and by increased demand for housing, which drives up existing house prices and increases household wealth. There are also second-round effects, with households able to draw on their increased housing equity and spend more on goods and services or reinvest in housing. The demand for housing and the impact on house prices seems to be strongest for arrivals[3] and those in older age groups,[4] who are typically wealthier. More net migrants of working age also increase the size of the labour force and therefore the capacity of the economy, which allows it to produce more with less price pressure than otherwise. The composition of net migration this cycle was initially dominated by fewer departures, but increasingly by returning New Zealanders, migrant workers and students (chiefly aged 20 to 34). The composition compared to previous cycles has meant a lesser impact on demand, while the increase in labour supply has been greater.

There appears to have been a smaller impact on house prices than in previous cycles, which is likely a result of fewer departures initially dominating and net inflows strongly concentrated in those aged 20 to 34. The lower concentration of wealthier age groups and more students may reduce the ‘spend per migrant'. This, along with a reduced impact on house price growth, may dampen the impact on private consumption and residential investment growth compared to previous cycles.

The current composition of net migration is also likely providing a greater contribution to the labour force than in previous cycles, with net migration accounting for 68% of the increase in the working-age population over the September 2015 year (compared to 48% at the peak of the previous boom in the June 2003 year).

Net migration can turn quickly as the drivers of the underlying flows reverse. The weaker outlook for the New Zealand economy, combined with somewhat lower unemployment in Australia, is expected to reduce the attractiveness of New Zealand as a destination and may encourage an increase in departures to Australia in the forecast period.

Global economic growth is expected to remain subdued in the near term...

Global economic growth is expected to recover in the near term from its downturn in 2015 as policies support demand and recoveries become more entrenched. Despite the pick-up, global growth is likely to remain relatively subdued. Economic activity in China is expected to be supported by reductions in interest rates and bank reserve requirement ratios, but the trend in growth will remain down as a result of structural factors, including a rebalancing towards consumption-led growth. The pace of economic activity in Australia is expected to quicken as the economy rebalances and responds to easier monetary conditions and resource exports increase as projects are commissioned.

The stabilisation of growth in China is expected to have a positive impact on the Asian economies closely linked to it, and Japan and the euro area are expected to respond to current monetary stimulus. The recovery in the US economy is forecast to strengthen as growth becomes more self-sustaining and employment and earnings increase further. As a result, global economic growth is expected to pick up in 2016 from its dip in 2015, but at a slower pace than previously forecast. New Zealand's trading partners' growth has been revised down from 3.8% to 3.5% for 2015 and from 3.9% to 3.6% in 2016 (Table 1.2).

* South Korea, Taiwan, Hong Kong, Singapore, Malaysia, Indonesia, Thailand, Philippines, India

Sources: International Monetary Fund (IMF), Consensus Forecasts, the Treasury

Despite the pick-up, trading partner growth will remain relatively low, resulting in weak inflationary pressures. As a result, monetary policy conditions across most regions are expected to remain stimulatory. The main exception to this trend towards easing monetary conditions in the near term is the US. As domestic economic conditions continue to improve there, the Federal Reserve is expected to begin raising interest rates in mid-December or in early 2016 from current historic lows. The normalisation of monetary policy in the US could have adverse effects on emerging economies around the world. This risk and others associated with the global economy are discussed further in the Risks and Scenarios chapter.

...contributing to lower terms of trade...

The slower pace of global economic growth compared to the Budget Update is expected to reduce demand and therefore international prices for some of New Zealand's key commodity exports, including meat and forestry products. Together with the falls in dairy prices that are still flowing through to exports, this is expected to reduce New Zealand's terms of trade in coming quarters (Figure 1.5). Lower international import prices, reflecting low global inflationary pressures and demand, provide a partial offset. Dairy prices are expected to remain around their current levels of US$2,500/mt into early 2016 before picking up gradually from the March quarter onwards as the global dairy market becomes more balanced between supply and demand. The terms of trade are expected to begin improving from the middle of 2016, reflecting the recovery in dairy and other export prices as global demand picks up.

Figure 1.5 - Goods terms of trade (SNA)

Source: Statistics New Zealand, the Treasury

...and slower domestic growth as consumers and businesses respond to lower incomes

Recent domestic economic indicators are consistent with stronger economic growth in the second half of 2015 than in the first half, resulting in annual average growth of about 2.2%. Both consumer and business confidence have rebounded from their August lows and business outlook and trading activity measures have improved. Meanwhile, retail trade and electronic cards transaction data suggest private consumption growth will rebound from the low rates seen in late 2014 and early 2015. Annual net inward migration is assumed to peak at 62,700 in the December 2015 quarter, adding further support to consumption. Building consents point to a continuation of solid construction activity.

However, strong El Niño conditions are expected to persist through the 2015/16 summer and into autumn. El Niño frequently leads to drought in parts of New Zealand. Together with the price signals already being made to farmers, dry conditions are expected to lead to lower agricultural production in the first half of 2016 and a 3.1% decline in goods exports in the year to September 2016. El Niño is also likely to reduce hydroelectric production. While these effects contribute to annual average GDP growth slowing to around 2.1% in early 2016, they reverse in subsequent quarters as climate conditions return to normal and growth is expected to recover. There is considerable uncertainty about this judgement given uncertainty over the impact of El Niño and the degree of resilience in the economy. The box on page 20 discusses the potential impacts of El Niño in more detail.

Demand growth is expected to remain modest through 2016 as consumers and businesses adjust to lower farm incomes and the weaker New Zealand dollar. For consumers, much of this adjustment occurs through lower consumption expenditure, with annual average private consumption expected to slow to 2.4% in 2016 (Figure 1.6). The household saving rate is also assumed to decline in 2016 as households adjust to lower incomes.[5] Public consumption growth remains at a relatively high level in the near term. See the Fiscal impulse box on page 40 for further details.

Figure 1.6 - Private consumption

Source: Statistics New Zealand, the Treasury

Market investment growth is forecast to ease as the lower terms of trade put downward pressure on business profitability and as the price of investment goods increases with the lower exchange rate. Slower domestic demand growth will reduce capacity pressures, leading to lower demand for investment by businesses.

Residential investment growth is also assumed to slow as the growth impetus from the Canterbury residential rebuild eases. However, growth rates are expected to remain high compared to the previous decade as the market responds to strong demand for houses in Auckland and surrounding regions.

House price growth is expected to ease in the near term but remain at relatively high levels over 2016. Recent indicators suggest that the pace of activity has slowed slightly, partly in response to new lending and tax measures. Nonetheless, the fundamental drivers of high population growth and relatively constrained housing supply remain in place. Strong demand in Auckland and, to a lesser extent, surrounding regions, is assumed to be the main driver behind house price growth remaining at high levels. House price growth is expected to remain fairly muted in some other parts of the country, including Christchurch.

The degree of spare capacity in the economy is expected to increase...

In the short term, weak demand increases the degree of spare capacity in the economy.[6] The unemployment rate is forecast to rise to 6.5% in early 2016, largely as a result of slower employment growth, while the labour force continues to expand rapidly with high net migration inflows (Figure 1.7). Annual average weekly earnings growth falls below 2.0% as demand pressure in the labour market eases.

Figure 1.7 - Unemployment

Source: Statistics New Zealand, the Treasury

With weaker inflationary pressures, non-tradables inflation is expected to be lower than forecast in the Budget Update, although an offset from higher tradables inflation (as a result of the lower exchange rate) means the overall inflation path is broadly similar. Headline annual inflation is expected to rise to around 2.0% by the end of 2016. This assumes that the historical relationship between inflation, the output gap (spare capacity) and monetary policy reasserts itself. The uncertainty around this judgement is examined further in Scenario One of the Risks and Scenarios chapter.

...and monetary policy is expected to remain accommodative

Monetary conditions are assumed to become more accommodative over the period ahead as the policy interest rate is reduced further and the exchange rate continues to depreciate. One further 25 basis points reduction of the OCR is assumed to occur by March 2016, in line with market expectations.[7] Short-term interest rates are expected to remain low throughout 2016 before beginning to move higher in early 2017 (Figure 1.8). The exchange rate is assumed to fall slightly over 2016, as monetary policy tightens in the US (reducing the relative attractiveness of New Zealand's interest rates).

Figure 1.8 - 90-day interest rates

Source: Statistics New Zealand, the Treasury

Nominal GDP growth is expected to slow...

Figure 1.9 - Nominal GDP growth

Source: Statistics New Zealand, the Treasury

Annual average growth in nominal GDP is forecast to ease below 2% in the middle of 2016 before picking up again (Figure 1.9). The slowdown in nominal growth reflects slower real GDP growth as well as reduced inflationary pressures and the lower incomes associated with the fall in the terms of trade. As a result, nominal GDP is expected to be $5.0 billion lower than in the Budget Update for the year to June 2016.

...while the current account deficit widens further

The decline in the goods terms of trade and lower agricultural export volumes (owing in part to El Niño) are the main drivers behind the widening of the annual current account deficit to 6.0% of GDP in 2016 (Figure 1.10). A large services surplus, as a result of high travel services exports, provides a partial offset to the deterioration in the goods balance, while the income deficit is expected to remain stable.

Figure 1.10 - Current account components

Source: Statistics New Zealand, the Treasury

El Niño

El Niño is one phase of a global climatic cycle known as the El Niño-Southern Oscillation. El Niño events typically result in above average rainfall in south eastern South America, eastern equatorial Africa and the southern US, and below average rainfall in parts of Australia and India. For New Zealand, El Niño typically leads to wetter conditions in the west of the country and drier than normal, frequently drought conditions in the east.[8] The current El Niño event could be as severe as the 1997/98 event, the strongest since 1950 (Figure 1.11).

Figure 1.11 - Southern Oscillation Index

Source:  NIWA

El Niño's impact on the economy is primarily via the agricultural sector and related primary manufacturing, and hydroelectric production. For agriculture, drier conditions in the east of the country reduce pasture quality and quantity. Milk production typically falls as a result, although this can be mitigated somewhat by providing supplementary feed and use of irrigation. Given the current low farmgate milk price, dairy farmers are less likely to buy supplementary feed than otherwise. Milk production typically rebounds in the following season (assuming a return to “normal” conditions), unless there has been a reduction in the size of the dairy herd.  El Niño impacts on meat production by reducing the rate at which livestock gain weight, resulting in lower carcass weights. If pasture conditions are particularly poor, some breeding stock may also be sent to slaughter, temporarily boosting production but reducing livestock numbers. The effects can persist for more than one season given the time to rebuild herds and flocks.

The impact on prices and therefore farm revenues is more uncertain. If there is sufficient price reaction (as a result of reduced overall supply) to offset declines in milk and meat production, the overall impact on farm revenues may be partially offset or even neutral.  In the Treasury's judgement, prices are unlikely to fully offset production declines given current global supply and demand dynamics for both dairy and meat.

Hydroelectric production also tends to fall during El Niño events. Hydroelectric generation has a higher value-add than thermal and gas electricity generation owing to its low-cost inputs; switching the electricity generation mix towards thermal sources consequently reduces GDP.

The impact from an El Niño varies considerably from event to event, given both the large variation in the strength of El Niño events and the severity of their impact on New Zealand weather conditions. The degree of resilience in the economy and agricultural sector in particular also influences the impact. Furthermore, El Niño affects regions differently, so there is scope for greater production in wetter western regions to offset drier eastern regions.

IMF research estimates that a ‘standard' El Niño shock reduces New Zealand's annual real GDP growth by 0.4 percentage points, with most of the impact in the first quarter following the shock.[9] The IMF's methodology suggests the current, relatively strong El Niño will reduce GDP growth by 0.6 percentage points. The Treasury estimated that the 2013 drought reduced annual real GDP growth by 0.7 percentage points.[10] Although the 2013 drought was not caused by El Niño, it nonetheless provides an indication of the potential size of a drought impact.

The IMF estimates an overall positive impact on world real commodity prices from an El Niño. This reflects overall reduced agricultural production pushing up non-fuel commodity prices, as well as higher oil prices owing to increased demand for electricity from non-hydro sources. Higher commodity prices are likely to flow through to higher inflation in some regions, notably Asia, which may reduce household purchasing power and therefore demand. For dairy products, the price signals are less clear-cut. Although milk production is likely to fall in New Zealand and Australia as a result of El Niño, it may rise in the US (particularly if the four-year drought in California is broken) while the EU is largely unaffected by El Niño.  The global supply and demand imbalance may not be materially altered as a result.

Medium-term Outlook#

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Growth increases in the medium term…

Economic growth is expected to pick up in the second half of 2016. Annual average growth is expected to lift to 2.4% in the year to March 2017, peak at 3.6% in the year to March 2018 and then ease over the remainder of the forecast period. Exports are expected to increase in response to the lift in the terms of trade and weaker dollar, and as the agricultural sector recovers from El Niño. Monetary policy settings stimulate the domestic economy. The shortfall in the supply of housing together with low interest rates and high population growth underpin residential investment growth. Market investment also picks up in response to the increasing terms of trade and low interest rates. Increase in the Government's operating and capital allowances increases public consumption and non-market investment respectively. Unemployment falls as spare capacity in the economy declines.

The economy's potential growth rate has been revised downwards compared to the Budget Update, largely owing to slower growth in investment.[11] Higher population growth, owing to higher net migration, provides a partial offset to lower investment. The annual average potential growth rate is estimated to increase from around 2.5% currently to 2.6% in 2017 as productivity growth rises from low levels (Figure 1.12). Potential growth averages around 2.5% over the forecast period as a whole. The implications of lower productivity growth than assumed are discussed further in Scenario One in the Risks and Scenarios chapter. The contribution of productivity to growth is explored further in the Composition of growth box on page 25.

Figure 1.12 - Actual and potential GDP

Source: Statistics New Zealand, the Treasury

…as the terms of trade recover…

The terms of trade begin to recover from the middle of 2016, largely as a result of increasing export prices. Dairy prices are expected to pick up from around this time as surplus Chinese inventories clear and as global milk production growth slows sufficiently to rebalance supply and demand in the market. Dairy prices steadily increase towards their assumed long-run level of around US$3,500 by the end of 2017. Prices for New Zealand's other key commodity exports are also expected to pick up from the middle of 2016 in response to strengthening global demand. The implications of a faster recovery in export prices than assumed are explored in Scenario Two of the Risks and Scenarios chapter.

Slowly rising import prices, in line with low global inflationary pressures, provide a modest drag to the terms of trade. Oil prices are assumed to trend slowly but steadily higher, to reach around US$70/barrel by the end of the forecast period.

These assumptions on balance result in lower terms of trade than in the Budget Update. At the end of the forecast period that difference narrows to around 1.5%. The lower end-point reflects the view that lower production costs and structural changes in the dairy market outweigh the effects of lower prices for oil (and other commodities) on the terms of trade. The Structural fiscal balance indicators box on page 39 estimates the fiscal position adjusted for the terms of trade.

…and accommodative monetary policy stimulates domestic activity

After remaining at low levels in 2016 and into early 2017, short-term interest rates are assumed to rise gradually to the long-run assumption of 4.5%, keeping inflation near 2%. The long-run interest rate assumption has been lowered by 0.25 basis points compared to the Budget Update, with recent research by the Reserve Bank[12] and the Treasury pointing to a lower neutral interest rate than previously estimated. The trade-weighted exchange rate index appreciates from early 2017 onwards in line with the gradual rise in interest rates and improvement in the terms of trade (Figure 1.13).

Figure 1.13 - Trade-weighted exchange rate

Source: Statistics New Zealand, the Treasury

Exports are expected to grow strongly from 2017 (Figure 1.14). Agricultural output is expected to begin recovering in the 2016/17 season, assuming a return to normal climatic conditions and no lasting impact from El Niño, leading to strong growth in agricultural exports in the year to March 2018. The recovery in the terms of trade as well as depreciation of the New Zealand dollar contributes to sustained growth in these exports over the medium term. The depreciation of the dollar is also expected to boost the competitiveness of non-commodity and services exports, leading to strong volume growth in these areas. Growth in services export volumes is expected to be further supported by continued growth in travel services exports (chiefly tourism-related). Taken together, these factors see exports making a substantial contribution to real GDP growth in the latter years of the forecast.

Figure 1.14 - Total exports

Source: Statistics New Zealand, the Treasury

The shortfall in the supply of housing, together with low interest rates and relatively high population growth, underpins residential investment growth throughout the forecast. Although construction activity associated with the Canterbury residential rebuild is thought to have peaked, it is expected to remain at a relatively high level through the forecast period.[13] Construction resources will progressively move from Canterbury to other regions, notably Auckland, in order to reduce the existing shortfall of housing.

Growth in market investment picks up from 2017 in response to low interest rates, strengthening trading partner growth and the resultant recovery in the terms of trade. Non-market investment is increased by a one-off $1.0 billion increase in the Government's capital allowance. The majority of this increase is assumed to occur in the year to June 2017. However, approximately half of the total increase in the capital allowance is expected to be used for imported capital goods, which has an offsetting effect on GDP. See the Fiscal Outlook chapter for further details on the change in the capital allowance. The commercial and the social and infrastructure elements of the Canterbury rebuild will also support market and non-market investment respectively.

Private consumption growth eases to around 2.3% in early 2017 and then remains stable around this level for the remainder of the forecast. This reflects lower labour and farm incomes and the relatively higher price of consumption owing to the lower exchange rate. Low interest rates provide a partial offset to these factors by reducing household debt servicing costs. Households are assumed to lower their saving rates somewhat to buffer reduced incomes and smooth their consumption. If households are more sensitive to slower income growth then private consumption growth could be slower.

Public consumption growth lifts in 2018 as a result of the increase in the government operating allowance from $1.0 billion to $2.5 billion in fiscal year 2018 (Figure 1.15). Growth eases thereafter. For the purpose of the economic forecast, the increase in the operating allowance is assumed to increase expenditure. See the Fiscal impulse box on page 40 for further details on how discretionary changes in the fiscal position impact on the economy.

Figure 1.15 - Public consumption

Source: Statistics New Zealand, the Treasury

Unemployment declines as spare capacity is reduced...

As economic growth picks up in 2017, the degree of spare capacity in the economy declines. The output gap, a measure of this spare capacity, closes rapidly through 2017 before turning positive. This is reflected in the steady decline in the unemployment rate from 6.5% in 2016 to 4.5% in 2020. The main driver of the fall in unemployment is the increase in employment growth, with the participation rate assumed to remain at relatively high levels. Slower working-age population growth, as net migration returns to its long-run average of 12,000 per year, will also contribute to a lower unemployment rate.

...while inflation remains stable

The shift in the output gap from negative to positive is also reflected in non-tradables inflation, which steadily picks up from below 2.0% at the end of 2016 to 3.4% by the end of the forecast. The increase assumes that the historical relationship between the output gap and non-tradables inflation reasserts itself. In contrast, tradables inflation falls steadily from 2.4% at the end of 2016 to below 1.0% from 2018 onwards, in line with the gradual appreciation of the exchange rate. Taken together, increasing non-tradables inflation and decreasing tradables inflation are broadly offsetting, leaving headline CPI inflation relatively stable at around 2.0% across most of the forecast.

However, strong nominal GDP growth in later years does not return nominal GDP to previously forecast levels

Nominal GDP growth is forecast to pick up strongly, with annual average growth accelerating from 1.8% in the middle of 2016 to 6.4% in 2018. Growth then eases to 4.0% by the end of the forecast. High nominal GDP growth in 2018 and 2019 reflects high real GDP growth, the recovery in the terms of trade and the increase in inflation. The contribution from the terms of trade is evident in the annual current account deficit, which narrows from 6.0% of GDP in 2016 to 4.0 - 4.5% in later years.

However, the strong growth in nominal GDP is from a lower base in the year to June 2016 than in the Budget Update. As a result, nominal GDP is cumulatively lower by around $17 billion over the five fiscal years to 2018/19 (Figure 1.16). The downward revision to nominal GDP reduces forecast tax revenue from the Budget Update. In addition, lower short-term interest rates contribute to a fall in tax revenue from Resident Withholding Tax (RWT). The Fiscal Outlook chapter discusses changes in tax revenues in more detail.

Figure 1.16 - Nominal GDP

Source: Statistics New Zealand, the Treasury

Composition of growth

In 2008 the New Zealand economy experienced a pronounced contraction in economic activity. Subsequently, growth in real GDP has been subdued relative to its long-run trend. To better understand the nature of New Zealand's recent growth performance, and the drivers of growth over the forecast period, this box uses a simple growth accounting framework.

This framework decomposes GDP growth into ‘supply side' components:  population growth, labour utilisation (total hours worked), capital deepening (investment in capital) and multi-factor productivity (MFP or technical change, essentially anything that increases output for given inputs including more efficient processes, better management, new technology etc). 

Labour utilisation is further decomposed into average hours per worker, the employment rate and growth in the working-age population to population ratio.  This framework may miss important interactions between the inputs to GDP; nevertheless, it may help to identify the nature of changes in the economy and the risks to our forecasts.

*Note totals may not add, due to rounding 

Sources: Statistics New Zealand, the Treasury

Table 1.3 compares pre- and post-recession GDP growth with the long-term average and with growth over the forecast period.[14] In the years leading up to the 2008 recession, labour productivity (output per hour worked) was the dominant driver of per capita GDP growth, led by MFP growth. Increased labour utilisation was also a significant contributor, mostly owing to increased employment.  The ratio of the working-age population to the total population also increased over this period, while average hours per employee declined.     

In the post-recession period, growth in labour productivity has been more moderate, primarily reflecting slower MFP.  On the other hand, the amount of capital used by each worker has grown more quickly than in the past.  Labour utilisation fell markedly in the 2008/09 recession and, while it has been increasing since 2011, labour utilisation remains below its pre-recession level. The factors behind the slower rate of labour productivity growth are not well understood.  Suggested causes include rapid growth in export commodity prices and sectoral shifts in output, and the impact of the 2008 recession.  However, the evidence supporting each of these suggested causes is not compelling.

New Zealand is not alone in experiencing slower productivity growth over recent years; similar phenomena are evident in a number of advanced economies.[15]  Equally, evidence on the causes of the slowdown remains elusive.  To some extent the widespread nature of the slowdown may reflect a common cause; for example, relatively weak aggregate demand may be impairing supply-side performance.

Uncertainty around the causes of slower growth flows through to uncertainty around the outlook for productivity growth.  These forecasts assume that labour productivity returns to its long-run average rate, consistent with a view that slower productivity growth has partly been a cyclical development.  MFP is the main driver of the rise in labour productivity growth, although capital deepening is expected to remain relatively strong as growth in the capital stock outstrips labour supply growth, which expands at a modest pace.  In light of the uncertainty surrounding the outlook for productivity growth, the implicationsof slower productivity growth are explored further in the Risks and Scenarios chapter.

Fiscal Outlook#

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Overview#

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• The Crown's fiscal position has improved over the past few years with an OBEGAL surplus being recorded in the 2014/15 fiscal year for the first time since 2007/08 (up from a deficit of $18.4 billion in 2010/11) and compared to a forecast deficit at the Budget Update.
• The current year's results to 31 October continue to be ahead of previous forecast levels. However, we are expecting some of the recent economic events to result in a slowdown in revenue growth in the second half of the fiscal year.
• OBEGAL is now expected to be broadly in balance over the next few years with a small deficit forecast for 2015/16 and modest surpluses from 2016/17. OBEGAL then begins to significantly improve, growing to reach $4.9 billion over the forecast horizon.
• The steadily improving fiscal outlook reflects a growing nominal economy which is forecast to drive growth in tax revenue at a rate higher than the expected growth in expenses.
• Core Crown expenditure as a percentage of GDP is expected to be 30.6% in 2015/16, falling across the forecast period to be 29.1% in 2019/20.
• Future operating allowances remain at $1.0 billion for Budget 2016, $2.5 billion in Budget 2017 and $1.5 billion in Budgets 2018 and 2019.
• Capital spending by the core Crown is estimated to be $24.7 billion over the forecast period. Capital allowances for new initiatives in Budget 2016 have been increased by $1.0 billion (supplementing the Future Investment Fund allocation of $0.7 billion) before falling to $0.9 billion in Budget 2017 and then growing at a rate of 2.0% per year for subsequent budgets.
• Net core Crown debt is expected to peak at 27.7% of GDP in 2016/17, before dropping to 24.0% of GDP by 2019/20 reflecting increasing cash flows.
• Net worth attributable to the Crown is expected to increase over the forecast period, reaching $107.2 billion by 2019/20 similar to the level before the global financial crisis. This growth is the result of forecast surpluses from 2016/17 onwards as growth in assets exceeds liability growth.
• Within the balance sheet, total assets are forecast to grow by $35.3 billion to stand at $314.0 billion by 2019/20. Of this, social assets have the largest growth increasing $16.7 billion to stand at $155.9 billion by 2019/20. Liabilities fall in nominal terms initially as earthquake obligations are settled and then increase again slightly as borrowings are increased. Total liabilities are expected to stand at $200.7 billion at the end of 2019/20, with borrowings making up $125.6 billion of that balance.
• Overall tax revenue forecasts have been revised down since the Budget Update primarily owing to the weaker nominal GDP outlook and lower interest rates. However, improved ACC forecasts (lower insurance expenses, coupled with higher levy revenue from 2017/18) offset the lower revenue somewhat. Core Crown expenses remain relatively close to the previous forecasts. As a result, OBEGAL is expected to be lower across the forecast horizon. The revised tax forecasts also impact on residual cash with higher cash deficits leading to net core Crown debt being higher than previously expected. Refer to page 50 for more detailed discussion on the comparison to the Budget Update.
• These forecasts are sensitive to a number of assumptions and should be read in conjunction with the Risks and Scenarios and Specific Fiscal Risks chapters.

Notes:

1. Operating balance before gains and losses.
2. Net core Crown debt excluding the NZS Fund and advances.

Source: The Treasury

Source: The Treasury

Key judgements and assumptions

The fiscal forecasts are based on assumptions and judgements developed from the best information available at the time they were prepared. Actual events are likely to differ from these assumptions and judgements. Uncertainty around the forecast assumptions and judgements increases over the forecast period.

In addition to the key assumptions underpinning the economic forecasts (refer page 54), the following key judgements and assumptions supporting the fiscal forecasts were made:

• Tax policy changes enacted and announced by the Government will take place as planned and will affect tax revenue and receipts.
• Any future new spending or revenue reductions will be limited to the operating and capital allowances set by the Government.
• ACC levies will be implemented in line with ACC’s funding policy and consultation papers.
• Departments will continue to spend less than the upper limits of approved spending (referred to as appropriations).
• The form and timing of any significant divestment of social housing assets remains uncertain and therefore not included in the forecasts, with the exception of the transfer of housing stock from Housing New Zealand Corporation (HNZC) to Tāmaki Redevelopment Company, which is included.
• Forecast returns of the large investment portfolios managed by ACC and the NZS Fund are based on their expectations of long-term benchmark rates of return for their respective portfolios.
• The valuations of the student loan portfolio, ACC claims liability and the Government Superannuation Fund (GSF) retirement liability are based on their underlying assumptions (eg, discount rates, salary increases and inflation) made at the time the valuations were prepared.

Further information on the fiscal forecast assumptions can be found on pages 54 to 56.

Core Crown Tax Revenue#

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Tax revenue grows over the forecast period...

Core Crown tax revenue (Figure 2.1) is forecast to rise in each year of the forecast period. By 2019/20, core Crown tax revenue is expected to reach $84.0 billion, $17.4 billion higher than in 2014/15. Forecast core Crown tax revenue increases as a percentage of nominal GDP, from 27.7% in 2014/15 to 28.4% at the end of the forecast period (Figure 2.1).

Figure 2.1 - Core Crown tax revenue

Source:  The Treasury

The main driver for the increase in tax revenue is forecast growth in nominal GDP (Figure 2.2). This graph also illustrates the timing lag between GDP growth and its impact on revenue.

Figure 2.2 - Core Crown tax revenue and nominal GDP growth

Source:  The Treasury

In addition, other factors such as the composition of GDP growth, fiscal drag (being the additional personal income tax generated as an individual's average tax rate increases as their income increases), movements in interest rates and the interest-bearing deposit base and CPI indexation of excise rates also influence tax revenue.

...with this year's tax outturns currently ahead of expectations...

Core Crown tax revenue for the four months to 31 October shows some tax types above the Budget Update forecast levels. However, some negative forecast variances have begun to appear: lower-than-forecast RWT indicates that reductions in interest rates are starting to impact on tax revenue and lower-than-forecast GST indicating weakness in nominal domestic consumption. The lower interest rates and weaker domestic demand contribute to the overall slower growth rate for 2015/16.

...growth in 2015/16 is expected to slow...

Nominal GDP growth is expected to slow to 1.8% in 2015/16 from 2.8% in the 2014/15 (Figure 2.2) fiscal year. This has affected the growth forecasts of all tax types to varying degrees with growth in every tax type forecast to be lower in 2015/16 than it was in 2014/15 and with some tax types expected to contract. Total growth in core Crown tax revenue for 2015/16 is forecast to be 2.7% compared to the actual growth of 8.4% in 2014/15.

In addition, timing of income tax plays a large part in the growth rates. In 2014/15, a surge in terminal tax and strong growth in provisional tax resulted in positive growth in both individuals' and corporate income tax, contributing to the above-forecast tax revenue results in that year. Although this strength has continued into the first part of 2015/16, income tax timing effects are forecast to be negative for growth in 2015/16 as the positive spill-over into 2014/15 is not expected to repeat in the current year.

...and nominal GDP growth picks up in later years driving tax revenue growth

Nominal GDP and its components are the principal drivers of tax revenue growth through the forecast period, as shown in Table 2.3. The other factors contributing the most to the forecast growth in tax revenue are:

• fiscal drag (ie, the effect of higher marginal tax rates applying to higher incomes), adding approximately $1.3 billion to PAYE and the growth of source deductions across the forecast period
• CPI indexation of excise rates adds $0.6 billion to customs and excise duties by 2019/20
• growth in the interest-bearing deposit base (ie, the sum of cash-like investments on which interest is earned that, in turn, is subject to RWT) is forecast to add $0.6 billion to RWT by 2019/20
• although they have a negative effect on tax growth in the early part of the forecast period, interest rates are forecast to rise from 2017 onwards, overall increasing the interest RWT forecast by $0.5 billion, and
• various policy initiatives are expected to add to tax revenue towards the end of the forecast period. See Additional Information on the Treasury website at www.treasury.govt.nz/budget/forecasts/hyefu2015 for details of these policy initiatives.

Inland Revenue has also prepared a set of tax forecasts which, like the Treasury's tax forecasts, were based on the Treasury's macroeconomic forecasts. The two sets of forecasts differ from each other because of the different modelling approaches and assumptions and judgements made by the two agencies. This comparison is included in the Additional Information on the Treasury website.

Source: The Treasury

Tax Expenditure Statement

The Treasury prepares a Tax Expenditure Statement annually in conjunction with the Budget Update. The purpose of this statement is to provide additional transparency around policy-motivated ‘expenditures' made through the tax system. Tax expenditures impact on the Crown's operating balance by either reducing tax revenue (eg, through an exemption or a preferential tax rate) or by increasing expenditure (eg, Working for Families tax credits). Refer to the Treasury website for a copy of the 2015 Tax Expenditure Statement.

http://www.treasury.govt.nz/budget/2015/taxexpenditure

Core Crown Expenses#

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Nominal core Crown expenditure increases...

Core Crown expenses are expected to grow $13.8 billion over the forecast period from $72.4 billion in 2014/15 to $86.2 billion in 2019/20 (refer Figures 2.3 and 2.4). This nominal growth is largely attributable to $6.5 billion of operating allowances set aside for future Budgets in addition to the $1.4 billion[16] allocated at Budget 2015. In addition, social assistance spending is forecast to increase by $4.6 billion, an annual increase of $1.0 billion on average per year. Finance costs are forecast to rise by $0.7 billion over the next five years owing to increased borrowing requirements (refer discussion on gross debt on page 42).

Figure 2.3 - Core Crown expenses

Source:  The Treasury

Figure 2.4 - Increase in core Crown expenses relative to 2014/15 actuals

Source:  The Treasury

...reflecting new budget spending...

Future operating allowances are currently set at $1.0 billion for Budget 2016, rising to $2.5 billion in Budget 2017 before reducing to $1.5 billion in Budget 2018 and Budget 2019 (Figure 2.5). These forecasts are based on the current allowance assumptions noted above. Some re-phasing of these allowances between Budgets is possible, however, to meet particular spending priorities.

Figure 2.5 - Budget 2016 and future Budget allowances

Source:  The Treasury

For forecasting purposes, the allowances are assumed to be all expenditure. However, these allowances can be used for a combination of revenue and expense initiatives when allocated.

New operating spending will be allocated to department baselines when budget decisions are made. As a result, the different functional expense areas, with the exception of social security and welfare and finance costs, remain flat across the forecast period (refer page 131). Therefore comparisons across the forecast period will not necessarily reflect the expected spend at a functional level.

...and increasing social assistance...

Apart from new budget spending, social assistance spending is expected toincrease by $4.6 billion across the forecast period. New Zealand superannuation (NZS) payments account for $3.5 billion of this increase. NZS recipient numbers are forecast to increase from 665,000 in 2014/15 to 797,000 by the end of the forecast horizon. This increase in recipient numbers accounts for just over 60% of the increase in NZS costs, with the remaining increase largely owing to indexation of entitlements to wage growth (Figure 2.6). By the end of the forecast period New Zealand superannuation is around 53% of the total social assistance spending.

Figure 2.6 - Social assistance spending

Source:  The Treasury

Apart from superannuation, other welfare expenditure grows by $1.1 billion over the five-year forecast period, including income-related rents subsidy ($0.3 billion), family tax credits ($0.2 billion) and sole parent support ($0.1 billion).

The expected weakening in the economic outlook and labour market is expected to flow through to higher numbers receiving the Jobseeker Support component of the Jobseeker Support and Emergency Benefit, with expenditure peaking in 2016/17. Jobseeker Support recipient numbers, which generally lag economic and labour market movements by several months, are expected to increase from around 118,000 in June 2015 to 121,000 in June 2017. They are then forecast to decline to around 106,000 by June 2020.

...although as a percentage of nominal GDP core Crown expenses reduce

Growth in core Crown expenses is forecast to be at a slower rate than growth in the nominal economy, falling from 30.1% of GDP in 2014/15 to stand at 29.1% of GDP at the end of the forecast period (Figure 2.3).

Cost to the Crown of the Canterbury rebuild

Table 2.4 outlines the latest estimates of the net impact on the Crown of the earthquakes included in these forecasts. These estimates reflect the known costs under current policy settings. They do not include future decisions the Government may take regarding the rebuild.

The forecasts assume that any additional costs to the Crown will be met within budget allowances.

The total cost to the Crown is currently estimated to be $17.0 billion, $0.5 billion higher than the Budget Update. Operating expenses have reduced by $92 million while capital costs are $606 million higher than the Budget Update. The lower operating costs are largely owing to updated valuations of the Earthquake Commission's (EQC's) insurance claim costs as at 30 June 2015. Additional capital costs relate to the Christchurch central city rebuild projects as well as the inclusion of the total estimated capital spending on schools in the Canterbury region. This programme is currently expected to extend out to 2023, three years beyond the forecast period, and involves the repair and rebuild of around 115 schools.

Notes:

1. Crown assets includes capital expenditure on Canterbury hospitals, schools, Tertiary Education Institutions (TEIs), housing and the Justice and Emergency Services Precinct.
2. Central city rebuild costs include land acquisition and are net of expected recoveries and contributions from third parties.
3. Some expenses are non-cash (eg, asset write-offs and impairments) and therefore do not have a cash element to them.

Source: The Treasury

Key risks in relation to the Canterbury rebuild are set out in the Specific Fiscal Risks chapter.

Operating Balance#

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Operating performance of the Crown strengthens…

OBEGAL is expected to be broadly balanced over the next few years. OBEGAL reached a surplus of $0.4 billion in 2014/15, however a small deficit of $0.4 billion is expected in the current year. This deficit is then forecast to return to a surplus in 2016/17 rising to $4.9 billion by 2019/20.

The forecast deterioration in OBEGAL in the current year is largely owing to the growth in core Crown expenses outpacing growth in core Crown revenue. As mentioned earlier in this chapter, forecast growth in tax revenue is considerably lower than actual growth in 2014/15, while core Crown expenses are expected to increase in the current year compared to last year.

As OBEGAL is the residual of a large revenue and expense base small variations to forecast can therefore have a significant impact on OBEGAL. The higher-than-forecast result in the 2014/15 year and the decrease in the current year's OBEGAL forecast reflects the level of uncertainty around these forecasts. Refer to the Risks and Scenarios chapter for further discussion of some of the risks that could impact on the 2015/16 outturn.

Figure 2.7 shows the composition of OBEGAL from the different segments of the Government. The core Crown segment is forecast to have an OBEGAL deficit of $0.6 billion in 2015/16, before returning to a surplus of $0.2 billion in 2016/17, with OBEGAL surpluses continuing to rise over the remainder of the forecast period, largely reflecting growth in tax revenue outpacing growth in nominal spending.

Figure 2.7 - Components of OBEGAL by segment

Source:  The Treasury

State-owned Enterprises (SOEs) contribution to OBEGAL is fairly stable with operating surpluses forecast throughout the forecast period.

Contrasting this Crown entities' (CEs') contribution to OBEGAL reduces across the forecast period from $0.7 billion in 2014/15 to a break-even position from 2017/18 onwards and is spread across a number of entities, with ACC's results generally having the largest impact. For example, changes to ACC levies result in ACC's contribution to the OBEGAL reducing.

...with investment returns contributing to the operating balance

The total Crown operating balance, inclusive of gains and losses, is forecast to be in surplus across all years of the forecast period with a surplus in 2015/16 of $0.3 billion growing to $7.8 billion in 2019/20 Figure 2.8 shows the continuing growth in the operating balance and its components.

Figure 2.8 - Components of operating balance

Source:  The Treasury

ACC and NZS Fund hold the largest investment portfolios and market movements in these portfolios can have a significant impact on the operating balance.

In 2015/16 gains on investments are forecast to be substantially lower than in previous years, primarily owing to NZS Fund recording net losses on their investments in the first four months of the current financial year. The forecasts assume investment income returns to a long-term rate of return, resulting in continued growth going forward. The level of investment gains plays a significant part in increasing the Government's financial assets and contributing to growth in the Crown's net worth (discussed on page 45).

In addition to gains on investments, gains and losses on long-term liability valuations for ACC and GSF may also impact on the Crown's operating balance. However, in the 2015/16 year they contribute only a small amount with $0.1 billion of actuarial losses.

Gains and losses are sensitive to balance sheet movements. Refer to the total Crown balance sheet section later in this chapter for further discussion of these sensitivities.

Structural fiscal balance indicators

The Treasury calculates a range of fiscal indicators to help assess the relationship between fiscal policy and the economy. These indicators include measures of the structural budget balance and a fiscal impulse indicator. Further detail on both these indicators can be found in the Additional Information section of the Half Year Update, which is available on the Treasury website (www.treasury.govt.nz/budget/forecasts/hyefu2015).

Source: The Treasury

Cyclically-adjusted balance

Indicators of the structural fiscal balance help to inform assessments of the sustainability of fiscal settings and identify shifts in discretionary fiscal policy. The Treasury's headline structural fiscal balance indicator, the cyclically-adjusted balance (CAB), is an estimate of the OBEGAL adjusted for fluctuations of actual GDP around potential GDP. When the economy is operating above its potential level, automatic stabilisers raise the budget balance; that is, tax receipts are higher, and unemployment expenses are lower, than they otherwise would be. When the economy is operating below its potential level, the opposite is true.

CAB provides an estimate of what the budget balance would be without the effect of these automatic stabilisers. CAB is subject to uncertainty because it uses estimated variables and is sensitive to new information, particularly regarding the output gap. The economy is forecast to be operating below its potential level until 2017/18, so CAB is estimated to be higher than OBEGAL until then. The difference between forecast and potential GDP is largest in the 2015/16 fiscal year, leading to a surplus in CAB while OBEGAL is in deficit. This suggests that the OBEGAL deficit forecast for 2015/16 is not a structural deficit.

Looking across the whole forecast period, OBEGAL increases by nearly 2% of GDP between 2015/16 and 2019/20. However, owing to a rising output gap, CAB only increases by about 1% of GDP over the same period; therefore, approximately half of the increase in the forecast OBEGAL is indicative of structural improvement in the fiscal position. This structural improvement largely reflects reductions in the level of government expenses as a percentage of GDP over time.

There is a range of other structural fiscal balance indicators that can be calculated to adjust for other factors such as the effects of asset or commodity prices on the fiscal position. Because of the importance of New Zealand's terms of trade in influencing the economic cycle, a terms of trade adjusted measure is of particular relevance to New Zealand. This measure estimates what OBEGAL would be if the terms of trade returned to its long-run average and the economy was operating at its potential level.

Although the terms of trade has recently fallen from a 40-year high, it remains above its long-term historical averages, and is forecast to remain so. The terms of trade for the June 2015 quarter is approximately 22% higher than the 30-year average and it remains 19% higher at the end of the forecast period. CAB with a terms of trade adjustment, using the 30-year average, shows structural deficits persisting across the forecast horizon.

Fiscal impulse

The fiscal impulse is an estimate of discretionary changes in the fiscal position that have an impact on aggregate demand in the economy. The year-to-year change in the structural budget balance is a rough indicator of the fiscal impulse. The fiscal impulse indicator calculated by the Treasury takes the change in a cash measure of the cyclically-adjusted fiscal balance and makes a number of adjustments. These include:

• incorporating capital spending that contributes to aggregate demand (eg, purchases of physical assets), and
• excluding some items that do not directly affect aggregate demand, such as KiwiSaver subsidies, net interest payments and goods with high import content (eg, defence equipment).

The fiscal impulse indicator shows that discretionary fiscal policy is expected to have a contractionary impact on demand in all but the first year of the forecast horizon and to be broadly neutral on average. The positive fiscal impulse in 2015/16 is caused by:

• an increase in operating expenses (as a share of GDP) partly owing to some payments from 2014/15 shifting into the 2015/16 fiscal year, and
• an increase in capital spending relative to 2014/15, partly reflecting some re-phasing of expenditure originally planned for previous years.

The negative fiscal impulse from 2016/17 to 2019/20 reflects ongoing reductions in operating spending (relative to GDP), and from 2017/18, a decline in capital spending. The most contractionary impulse across the forecast period occurs in 2018/19, reflecting accelerating revenue growth along with operating and capital expenditure falling as a percentage of GDP.

Figure 2.9 - Operating balance indicators

Source:  The Treasury

Residual Cash and Net Core Crown Debt#

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Operating cash flows steadily improve...

Net operating cash flows are forecast to be in surplus across the forecast period with a small surplus in the 2015/16 year increasing to an operating cash surpluses of $6.2 billion by 2019/20. Over the forecast period, the Government is expected to generate cash flows from core Crown operations of $14.3 billion.

The growth in operating cashflows largely mirrors the trend shown in OBEGAL and strengthens each year of the forecast period. The strength in operating cashflows largely represents growth in tax receipts exceeding growth in operating payments.

...outpacing capital spending near the end of the forecast period

Net capital spending is forecast to exceed operating cash flows until 2018/19, when core Crown residual cash[18] returns to surplus (Figure 2.10). The increase between 2014/15 actual net capital spending and 2015/16 forecast is partly owing to 2014/15 including $0.6 billion of proceeds from the Government Share Offer programme (2014/15 being the last year to include proceeds). In addition, expenditure previously expected to be spent in 2014/15 has been delayed until 2015/16 (eg, Canterbury Earthquake Recovery Authority's (CERA's) rebuild projects, defence and schools capital expenditure). These two factors result in an increased residual cash deficit in 2015/16 when compared to 2014/15.

Figure 2.10 - Core Crown residual cash

Source:  The Treasury

Over the entire forecast period a cash shortfall of $10.4 billion is expected. This cash shortfall is funded largely through additional bond issuances (Table 2.6).

Net core Crown debt peaks as a share of GDP in 2016/17...

Net core Crown debt as a share of nominal GDP is forecast to peak at 27.7% in 2016/17 (Figure 2.11) before reducing to 24.0% by 2019/20 and continuing to decline thereafter.

Figure 2.11 - Net core Crown debt

Source:  The Treasury

Net core Crown debt on a nominal basis increases for the first three years as a result of cashflows from operating activities not being sufficient to meet capital spending (as discussed above) before starting to decline once residual cash returns to surplus in 2018/19, to stand at $71.1 billion at the end of the forecast period.

...and gross debt begins to decline after 2016/17

Gross debt is expected to peak at $95.7 billion in 2016/17. Forecast maturities are then expected to exceed new debt being issued, and gross debt begins to decline. Gross debt is forecast to be $91.3 billion in 2019/20 which is equivalent to 30.8% of nominal GDP (Figure 2.12).

Figure 2.12 - Gross debt

Source:  The Treasury

The bond programme is expected to raise funds of $43.6 billion over the forecast period, while $33.0 billion of existing debt will be repaid, providing net cash proceeds of $10.6 billion (Table 2.6). Any excess cash proceeds raised from the bond programme are expected to be invested in financial assets and used to meet future debt maturities.

The issuance profile is relatively flat in order to reduce year-to-year volatility of bond programmes and ensure consistency of supply over this time.

Source: The Treasury

Capital Expenditure#

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The Government is forecast to spend a net total of $24.7 billion on capital items over the forecast period, which includes purchasing physical assets (eg, school buildings), advances (eg, student loans), providing capital to Crown entities (eg, New Zealand Transport Agency (NZTA)) and future new capital spending (Table 2.7). Figure 2.13 includes a breakdown of the most significant forecast capital expenditure.

Source: The Treasury

Figure 2.13 - Forecast capital activity for 2015/16 to 2019/20 by significant spending

Source:  The Treasury

Net purchases of physical assets represents forecast spending by core Crown agencies to maintain their existing asset base and includes spending on defence equipment and school property and also includes capital spending related to the Canterbury earthquakes (refer to the box on Canterbury earthquake costs on page 36).

Net investments largely represent capital injections to Crown entities, to expand their asset base, and are estimated to be between $1.5 billion and $2.0 billion a year. The largest capital injections across the forecast period are to NZTA for state highways (between $1.1 and $1.3 billion each year of the forecast).

Net advances largely relate to the issuance and repayment of student loans. Student loan issuances peak at $1.8 billion in 2020 with repayments of $1.6 billion forecast in the same year.

The capital allowance for Budget 2016 has been set at $1.7 billion which includes the $700 million previously set aside in the Future Investment Fund. Around $1.0 billion of the Budget 2016 allowance has already been allocated with $0.7 billion remaining to be allocated. Capital allowances of $0.9 billion are forecast in Budget 2017 before growing at a rate of 2.0% per year for subsequent budgets.

New capital spending is expected to be allocated in future Budgets. The new capital spending for each Budget is spread over four fiscal years reflecting the assumed profile of future spending. This profile is illustrated in Figure 2.14.

Figure 2.14 - New capital spending (capital allowances)

Source:  The Treasury

Figure 2.15 sets out a history of capital expenditure over the past 10 years and includes the forecast capital activity to 2019/20. The graph excludes contributions to the NZS Fund (2006-2010 years) and also excludes proceeds from the Government Share Offer programme in 2012-2014 (a total of $4.7 billion) which were used to fund capital expenditure.

Figure 2.15 - Net capital spending history

Source:  The Treasury

Capital spending is expected to increase in 2016 (largely owing to delayed expenditure from 2014/15) and increase again in 2017 largely owing to a significant portion of the Budget 2016 spending expected to occur in that year (discussed above).

Total Crown Balance Sheet#

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Increasing operating balance surpluses result in a stronger balance sheet...

Net worth attributable to the Crown is forecast to grow in nominal terms across the forecast period largely owing to forecast operating balance surpluses. Beyond 2016, net worth attributable to the Crown is expected to grow by $20.7 billion to stand at $107.2 billion by 2019/20, increasing as a share of nominal GDP to reach 36.2% by 2019/20 (Figure 2.16).

Figure 2.16 - Net worth attributable to the Crown

Source:  The Treasury

...with assets increasing by $35.3 billion over the forecast period...

Total assets are forecast to grow by $35.3 billion over the forecast period to $314.0 billion in 2019/20, made up of additional investments in assets (both physical and financial) of $70.1 billion, partially offset by reductions (largely depreciation) of $34.8 billion.

The largest asset growth over the forecast period is in the social assets portfolio (eg, schools, hospitals and social housing) which is expected to increase by $16.7 billion to be $155.9 billion in 2019/20 (Figure 2.17) over the forecast period. This growth reflects increases in future new capital spending, property, plant and equipment and student loans.

Figure 2.17 - Total Crown assets

Source:  The Treasury

The financial asset portfolio is expected to increase by $10.8 billion to be $97.8 billion in 2019/20, reflecting investment growth in the large investment portfolios (NZS Fund and ACC), partly offset by a reduction in the Treasury’s New Zealand Debt Management Office (NZDMO) financial assets to help fund the expected cash shortfall.

The commercial asset portfolio is expected to increase by $7.8 billion over the forecast period to be $60.3 billion in 2019/20, with growth coming from SOEs' investment in physical assets and growth in Kiwibank mortgages.

What is net worth attributable to the Crown and why does it matter?

The Treasury calculates a range of fiscal indicators to help assess the relationship between fiscal policy and the economy. These include net debt and net worth measures. Historically, net debt has been used as the primary indicator of fiscal sustainability[19] as it is reasonably well understood, relatively stable (compared to other measures) and internationally comparable. However, as net debt excludes a range of Crown assets and liabilities it is a relatively narrow measure of fiscal sustainability. Net worth provides a much fuller picture about the fiscal sustainability of the Government.

Net worth measures the difference between the Crown's total assets and its liabilities. However, not all of this net worth is attributable to the Crown. Minority interest shareholdings in Government entities (eg, Air New Zealand, Mighty River, Meridian Energy and Genesis Energy) are entitled to part of the net worth of the companies they have invested in. The Crown owns the rest. Net worth attributable to the Crown is a measure of the Crown's share of the balance sheet.

A positive level of net worth indicates that the Crown broadly has sufficient assets to meet its liabilities. However, net worth is a measure at a point in time. It does not include an assessment of potential risks or future activities. Therefore it is most useful in conjunction with other information such as assessments of contingent liabilities and fiscal risks.

Prudent net worth should provide the Crown with a sufficient buffer, given the Crown's current fiscal position and expected future fiscal outcomes, such that fiscal sustainability is not jeopardised by fiscal shocks (such as natural disasters or significant deterioration in the global economy).

Figure 2.18 illustrates how net worth has changed over the past 20 years and how it is expected to change over the next five years. While net worth declined sharply between 2009 and 2011 reflecting the global financial crisis and Canterbury earthquakes, recovery has been underway since 2012, and further increases are forecast in nominal terms by the end of the forecast period (although it takes much longer as a percentage of nominal GDP).

Figure 2.18 - Net worth attributable to the Crown

Source:  The Treasury

Over time the change in net worth is largely attributable to two things:

• whether the Crown is making deficits or surpluses, and
• revaluations of long-term assets such as land and buildings (where the asset's current value is higher than its original cost).

Figure 2.19 shows how the composition of net worth has changed over time. Ten years ago net worth was fairly evenly split between cumulative operating surpluses and asset revaluations. However, since that time the Crown has reported operating deficits, decreasing net worth, while revaluations of the Crown's property, plant and equipment have increased net worth.

Figure 2.19 - Composition of net worth attributable to the Crown

Source:  The Treasury

The size of the balance sheet does not determine net worth. For example, borrowing to fund capital expenditure, while increasing the size of the balance sheet, does not impact net worth (assets and liabilities have increased by the same amount). Similarly, the composition of the balance sheet does not impact net worth (eg, selling property for cash does not change total assets). However, both the size and composition of the balance sheet can influence the risk profile of the Crown and therefore the ‘buffer' required against future events.

Figure 2.20 shows the correlation between the net worth and net debt fiscal indicators.

Figure 2.20 - Net worth attributable to the Crown and core Crown net debt

Source:  The Treasury

Net worth differs from core Crown net debt as net worth:

• is a total Crown measure (whereas net debt excludes SOEs, Crown entities and the NZS Fund), and
• includes all assets and liabilities (whereas net debt only includes liquid assets and borrowings).

Net worth should therefore be monitored in conjunction with net debt when assessing fiscal sustainability. Rising net worth means the Government is well placed to meet the costs that could be posed by a possible future shock.

...while liabilities are expected to remain fairly constant from 2016/17

The Crown's liabilities increase in 2016/17 and then begin to fall in 2017/18, before increasing again slightly to reach a peak of $200.7 billion in 2019/20 (Figure 2.21).

Figure 2.21 - Total Crown liabilities

Source: The Treasury

Of the $14.3 billion total increase, $6.1 billion is driven by the financial sector and is largely owing to borrowings which start to decline before increasing again slightly in the last year of the forecast.

Borrowings are mostly undertaken by NZDMO (which manages the Crown's bond programme), the Reserve Bank and Kiwibank, and are forecast to peak at $126.9 billion in 2016/17 before decreasing slightly to stand at $125.6 billion by 2019/20.

The commercial liability portfolio is expected to increase by $7.3 billion over the forecast period to stand at $39.4 billion in 2019/20, with growth coming mainly from Kiwibank (consistent with growth in their loan book).

Insurance liabilities are mostly held by ACC, EQC and Southern Response. Insurance liabilities are expected to decrease in the current year owing to further progress in settling EQC and Southern Response claims liabilities. Insurance liabilities then increase again in 2016/17 to reach $38.6 billion in 2019/20 primarily relating to the ACC claims liability.

Retirement plan liabilities, primarily GSF, are forecast to be $10.7 billion in 2015/16 falling to $8.7 billion by 2019/20.

The Crown's balance sheet remains sensitive to market movements...

Many of the assets and liabilities on the Crown's balance sheet are measured at ‘fair value' in order to disclose current estimates of what the Crown owns and owes. While the measurement at fair value is seen as the most appropriate value of these items, it can be volatile, resulting in fluctuations in the value of the assets and liabilities reflecting changes in the market and underlying assumptions.

Refer to the Risks and Scenarios chapter page 57 for more details.

...and judgements and estimates will also impact on the balance sheet...

Apart from market factors, valuations are subject to a number of judgements and estimates. In general, as time goes on, better information becomes available and initial estimates are updated to reflect current information. Some examples of this include: ACC rehabilitation costs; earthquake-related liabilities; and future wage growth of students, which directly impacts the value of the student loan book.

...while other risks remain

In addition to those items on the balance sheet there are a number of liabilities (and assets) that may arise in the future but are not yet included in our forecasts, either because they are contingent on an uncertain future event occurring (eg, outcome of litigation) or the liability cannot be measured reliably. If these liabilities crystallise, there will be associated costs with a negative impact (or positive in the case of contingent assets) on the operating balance or net debt. Refer to page 86 for a list of the contingent liabilities at 31 October 2015.

The Treasury prepares its forecast balance sheets in accordance with generally accepted accounting practice (GAAP). However, sometimes it can be useful to look at potential assets and liabilities that are excluded from the standard GAAP balance sheet. When these are measured and added to the standard GAAP balance sheet, these are referred to as the comprehensive balance sheet. The comprehensive balance sheet concept is discussed in further detail in the Treasury's Investment Statement published in 2014. Refer www.treasury.govt.nz/government/investmentstatements/2014/07.htm

Comparison to the Budget Update#

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The Budget Update was published on 21 May 2015. Since then, there have been a number of developments that have significantly impacted the fiscal outlook. Table 2.8 below summarises the changes in the key fiscal indicators since then.

Source: The Treasury

 A weaker economic outlook has adversely impacted the fiscal outlook...

Slowing economic growth since the Budget Update has adversely impacted the fiscal outlook, with tax revenue now expected to be lower in each year of the forecast period.

Core Crown tax revenue forecasts have been revised down by a combined $4.3 billion across the forecast period, mainly owing to the cumulative $17 billion reduction in the forecasts (from 2014/15 to 2018/19) for nominal GDP. Forecasts for most of the major tax types have been reduced with the exception of corporate tax which is higher than at the Budget Update (Figure 2.22). Table 2.9 below summarises the movements by tax type since the Budget Update.

Figure 2.22 - Movement in core Crown tax revenue since the Budget Update

Source:  The Treasury

Table 2.9 - Reconciliation of the change in core Crown tax revenue

Source: The Treasury

As a result of the weaker nominal GDP outlook and lower interest rate track, forecasts for most of the major tax types have been reduced:

• A lower forecast for compensation of employees (aggregate wages and salaries) has contributed to the source deductions forecasts being reduced by $1.5 billion across the forecast period.
• The forecasts for entrepreneurial income, mainly on the farming side, are lower than in the Budget Update which has caused a $0.8 billion reduction in the other persons' tax forecast.
• Interest rate forecasts are lower than in the Budget Update, which was the main contributor to the $1.4 billion reduction in interest RWT forecasts across the forecast period.
• The Goods and Services Tax (GST) forecast is $1.5 billion lower in total than in the Budget Update owing to weaker forecasts of nominal consumption.

In contrast to the above tax types, corporate tax forecasts are, in total, higher than in the Budget Update for a number of reasons:

• Portfolio Investment Entity (PIE) tax was around 25% higher than forecast in 2014/15 and this is expected to persist into the future, although there will continue to be considerable volatility around the trend in this tax.
• Although initially lower, the outlook for profits through the latter part of the forecast period is higher than in the Budget Update, providing a boost to corporate tax in 2018/19 and 2019/20.
• Based on the most recent published financial statements of companies operating in the financial sector, forecasts of income tax from that sector have been revised up.

...with the fiscal outlook now more subdued than previously forecast

Overall, OBEGAL is expected to be lower in each year of the forecast compared to the Budget Update (Table 2.10).

Table 2.10 - Changes in OBEGAL since the Budget Update

Source: The Treasury

An increase in expected social assistance spending in 2016/17 and 2017/18 is a result of a softer labour market outlook, causing an increase in recipient numbers compared to the Budget Update (particularly in Jobseeker Support and Sole Parent Support benefits). Jobseeker Support benefits increase by a total of around $430 million (6.9%) across the forecast period. Annual increases of between $61 million (3.8%) and $147 million (9.6%) compared to the Budget Update are expected with the largest increase in the 2017/18 year. However, this trend is expected to start unwinding by 2018/19 with the increase since the Budget Update forecast to be $77 million (5.1%).

The GSF liability has reduced since the Budget Update mainly owing to higher discount rates. The reduction in the liability results in lower forecast GSF pension expenses as the interest unwind is now less than previously expected.

Updated ACC forecasts have resulted in an increase in OBEGAL in each year of the forecast and are owing to a number of factors:

• Similar to the GSF liability, higher discount rates have resulted in a reduction in the ACC claims liability and lower insurance expenses across all years than previously forecast.
• In September, the Government made the decision to stop the residual levy from 1 April 2016. This decision had the effect of bringing forward costs from later forecast years into the 2014/15 year.
• From 2017/18, ACC levy revenue is expected to be higher than previously forecast owing to assumptions around levy rate reductions being based on ACC's agreed funding policy.

Net finance costs are affected by both favourable and unfavourable factors:

• Decreases in short-term interest rates have resulted in a reduction in interest income. However, the impact in 2015/16 is somewhat offset by the starting position at 2014/15 being stronger than expected.
• The lower residual cash forecast has led to an increase in the Government's borrowing requirements resulting in increased debt servicing costs.
• Lower medium-term interest rates have resulted in a reduction in finance costs and offset some of the unfavourable impacts mentioned above.

Other changes include re-phasing of operating expenses previously forecast to occur in 2014/15 but now expected to occur in 2015/16.

...leading to an increase in net core Crown debt by the end of the forecast period

Residual cash deficits increase by $8.1 billion across the forecast period compared to the Budget Update. The majority of the weaker cash position is a result of reduced tax receipts ($5.6 billion), higher benefit payments ($0.4 billion) and higher net finance costs ($0.8 billion) over the forecast horizon.

On the capital side, net spending is now expected to be $0.7 billion more than previously forecast largely owing to the increase in the Budget 2016 capital allowance of $1.0 billion and also transfers of unspent capital expenditure from the 2014/15 year.

The increase in cash deficits was partially offset by a $1.1 billion lower actual net debt position in 2014/15 than previously forecast. As a result, net core Crown debt is forecast to be $7.3 billion higher by 2018/19 when compared to the Budget Update.

Fiscal Forecast Assumptions#

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The fiscal forecasts are prepared on the basis of underlying economic forecasts. Such forecasts are critical for determining revenue and expense estimates. For example:

• A nominal GDP forecast is needed in order to forecast tax revenue.
• A forecast of CPI inflation is needed because social assistance benefits are generally indexed to inflation.
• Forecasts of interest rates are needed to forecast finance costs, interest income and discount rates.

A summary of the key economic forecasts that are particularly relevant to the fiscal forecasts is provided in Table 2.11 below (on a June-year-end basis to align with the Government's balance date).

Notes:

1. Production measure.
2. Expenditure measure.

Source: The Treasury

In addition, a number of other key assumptions are critical in the preparation of the fiscal forecasts.

Government decisions

The forecasts incorporate government decisions and other circumstances known to the Government and advised to the Treasury up to 27 November 2015.

Tax revenue

Tax policy changes enacted and announced by the Government will take place as planned and will affect tax revenue and receipts.

Earthquake costs

Expenditure (accrual measure) is forecast based on estimates of when key decisions will be taken.  The timing of cash payments is based on estimates of when actual spending will take place.  Refer to page 36 for further discussion.

Operating allowance

Operating allowances are a net $1.0 billion for Budget 2016, increasing to $2.5 billion in Budget 2017 and reducing to $1.5 billion in Budget 2018.  For further details, see note 9 of the Forecast Financial Statements.

Provision for new capital spending

Capital allowances are $1.7 billion in Budget 2016 and $0.9 billion in Budget 2017 then growing at a rate of 2.0% per year for subsequent Budgets.  For further details, see note 9 of the Forecast Financial Statements.

Social housing

The Government has announced social housing reforms as a key priority for this term.  Cabinet has agreed the general direction of the Social Housing Reform programme.  This includes transferring HNZC stock to non-government providers to create a competitive market for social housing.  The level of uncertainty, particularly around the structure of the transactions, makes it difficult to quantify the fiscal impacts, and therefore they are not included in the forecasts, with the exception of funding to the Tāmaki Redevelopment Company (TDC) and the transfer of social housing assets from HNZC to TDC which is included in these forecasts.

Finance cost on new bond issuances

Based on the five-year rate from the main economic forecasts and adjusted for differing maturities.

Top-down adjustment

A top-down adjustment is made to compensate for departments that tend to forecast upper spending limits (appropriations) rather than best estimates.

Top-down adjustments to operating and capital expenses are as follows:

The adjustment will be higher at the front end of the forecast period as departments' appropriations (and therefore expenses) tend to be higher in these years, reflecting the flexibility departments have around transferring underspends to later years.

Property, plant and equipment

For the purposes of the Forecast Financial Statements, no revaluations of property, plant and equipment are projected beyond the current year.  Valuations as recorded for the 2015 annual financial statements and any additional valuations that have occurred up to 30 September 2015 are included in these forecasts. 

Student loans

The carrying value of student loans is based on a valuation model adapted to reflect current student loans policy.  As such, the carrying value over the forecast period is sensitive to changes in a number of underlying assumptions, including future income levels, repayment behaviour and macroeconomic factors such as inflation and discount rates used to determine the effective interest rate for new borrowers.  Any change in these assumptions would affect the present fiscal forecasts.

Investment rate of returns

The forecasts incorporate the actual results to 30 September 2015.  Beyond this time, gains on financial instruments are based on long-term benchmark rates of return for each portfolio.

GSF and ACC liabilities

The GSF and ACC liabilities included in these forecasts have been valued as at 30 September 2015 and 30 June 2015 respectively.  The ACC liability has also been adjusted for the 30 September 2015 discount rate.  Both liabilities are valued by projecting future cash payments, and discounting them to the present.  These valuations rely on historical data to predict future trends and use assumptions such as inflation and discount rates.  Any changes in actual payments or economic assumptions would affect the present fiscal forecast.  For example, if the discount rate decreases, the value of the liabilities would increase.

GSF's assets are offset against the gross liability and have been updated to reflect market values.  The value of assets over the forecast period reflects long-run rate of return assumptions appropriate to the forecast portfolio mix.

NZS Fund contributions

No contribution is assumed in the forecast period in line with the Government's stated intentions to commence contributions once net core Crown debt has fallen to 20.0% of GDP as set out in the Fiscal Strategy Report (FSR).

Note:  1  Calculations of annual contributions if they were to resume in 2015/16.

The underlying assumptions in calculating the required contribution in each year are the previous year's NZS Fund balance and projected series, over the ensuing 40 years of nominal GDP, net (after-tax) NZS expenses and the government five-year bond rate.  The latter is used in calculating the Fund's expected long-run after-tax annual return.  Over the forecast years, all Fund variables, apart from the capital contributions, are provided by the NZS Fund itself.

Refer to the Treasury's website for the NZS Fund model.

Risks and Scenarios#

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Overview#

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• This chapter outlines the main economic and fiscal risks associated with the central forecast. The first part of the chapter outlines the key risks to the economic outlook. The second part of the chapter presents two alternative scenarios for the economy, and the remainder focuses on general fiscal risks. At present, risks to the global economy are skewed to the downside, while domestic risks are more balanced.
• Internationally, the risks with potentially the largest impact on the New Zealand economy relate to the demand for commodities and global inflation. These include a sharp slowing of growth in China and its impact on other emerging market economies, the impact of the unwinding of easy US monetary policy on emerging economies and persistent weak inflation in many advanced economies. Recent volatility in dairy prices has increased the uncertainty about their future direction.
• Domestically, the risks with potentially the largest impact on the New Zealand economy relate to the impact on agriculture from El Niño, whether inflation dynamics have changed, the demand response to monetary policy, uncertainty around productivity growth, the length and peak of the current migration cycle and house price growth.
• Two scenarios are presented that show possible ways in which the New Zealand economy could deviate from the central forecast. Scenario One is based on slower potential growth, demand less responsive to monetary policy and a longer period before historical inflation relationships re-assert themselves. In this scenario, nominal GDP, tax revenue and OBEGAL would be lower. Scenario Two is based on higher dairy prices, increased tourism and a longer period of elevated net migration. This scenario lifts nominal GDP, tax revenue and OBEGAL over the forecast period.
• In addition to the risks associated with the economy, the Crown is also subject to expenditure and balance sheet risks. In particular, volatility in financial asset prices and interest rates can have a significant impact on the Crown's fiscal position.

Economic Risks#

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Key judgements in the forecasts (see Key economic forecast assumptions and judgements box in the Economic Outlook chapter) are among the main risks to the economic forecasts.

Risks to global growth continue to be skewed to the downside. The US recovery remains on track with tightening of US monetary policy expected to begin soon, which may lead to the unintended effect of destabilising emerging market economies. Growth in China continues to slow, with risks of a sharp slowdown, while growth in Australia may remain below trend for longer. The realisation of any of these downside risks to the world economy would weigh on growth in the New Zealand economy. Risks remain around demand and prices for New Zealand's key commodity exports, with El Niño possibly leading to reduced supply through drought. Geopolitical tensions in the Middle East and terrorist attacks in Europe pose a risk to financial market and economic stability.

The outlook for domestic demand is balanced. High net migration, increased visitor arrivals and house prices present upside risks, while uncertainty around the effectiveness of monetary policy, inflation dynamics and productivity growth present downside risks.

Normalisation of monetary policy is expected in the US...

The US Federal Reserve is expected to begin tightening monetary policy in late 2015 or early 2016 owing to continued improvement in the economy and the labour market. However, uncertainty regarding the timing of the first move and the speed of tightening may lead to further financial market volatility, reducing confidence and subsequently demand. Once tightening has started, higher interest rates in the US may increase the attractiveness of US assets and lead to a re-pricing of risk, following a period of low risk premiums with investors seeking high-yielding assets. Increased demand for US assets and re-pricing of risk may prompt large capital outflows from emerging market economies, as well as tighter credit conditions and weaker exchange rates. If this were to eventuate, growth in emerging market economies would likely be softer, leading to weaker demand (and prices) for New Zealand exports.

...while there are risks of a sharper slowdown in China

In contrast to the US economy, risks to the growth outlook for China remain skewed to the downside. Annual GDP growth was on the lower side of the Government's target (around 7%) in September 2015 (6.9%) and economists are expecting a downward revision for 2016. In addition, financial market developments in mid-2015 - falls in the Chinese stock market and the depreciation of the Renminbi after liberalisation - have increased concerns that the Chinese economy is weaker than headline GDP indicates. A slowdown in China may be exaggerated by authorities not acting to support activity in order to avoid creating further imbalances, especially if the key risks of high levels of local government debt and a further slowdown in the housing market increase.

The direct effect on New Zealand of a slowdown in China may be offset to some extent by China's structural rebalancing towards consumption from investment as the main driver of growth. A successful rebalancing into more consumption-based growth would be positive for New Zealand by increasing Chinese demand for our primary products. However, a sharp slowdown in China’s growth would weaken demand for Australia and other trading partners in Asia, in turn lowering their income and demand for their exports, directly affecting New Zealand. Other risks to the Australian economy centre on the more gradual-than-expected transition in the growth drivers from mining to non-mining sectors, resulting in a longer period of below-trend growth. There is also some uncertainty about Australia's trend growth rate with slower population and productivity growth, a need for debt consolidation and lower trading partner growth.

Effect of El Niño is uncertain...

The nature and severity of any drought impacts from El Niño on agricultural supply and prices are uncertain, along with the eventual impact on economic growth (see El Niño box in the Economic Outlook chapter). If the drought was severe, it could lead to a sharp drop in dairy production and, initially, a further pick-up in meat production as more livestock may be sent to slaughter. In turn, dairy prices would likely rise and meat prices would initially decline, while the overall impact on nominal growth would be uncertain. On the other hand, a mild El Niño impact could lead to no material change in production or prices for New Zealand.

There is similar uncertainty about the effect of El Niño on other countries, with negative effects of reduced production for commodity exporters, while any rise in prices is positive for commodity exporters and negative for commodity importers. If the price of staple foods were to increase as a result of El Niño, this would reduce real incomes in emerging market economies and demand for other products, weakening global demand further.

...as is the evolution of dairy exports

As well as the concern around El Niño, the evolution of supply of and demand for dairy exports continues to generate uncertainty. Concerns of a temporary reduction in domestic supply from drought may have held prices up, although prices remain at low levels and are expected to recover only gradually. Growth in international production may also ease in response to lower prices, although these effects seem to be limited at this stage with the removal of the EU quotas, and US subsidies and EU intervention prices distorting price signals. On the other hand, Chinese dairy demand may pick up faster than expected, leading to dairy prices recovering earlier than in the central forecast.

Similarly, prices for other key international commodities are expected to remain subdued for an extended period of time, although the effects of this are uncertain. On balance, low oil prices are expected to be beneficial for growth in our trading partners. However, this positive effect may, at least temporarily, be largely offset by weaker export commodity prices in those countries as a result of generally weaker global demand.

Inflation remains low in advanced economies...

Falls in oil and other commodity prices, as well as weaker economic growth, have kept inflation low in most economies. Core inflation (excluding food and energy; ie, direct commodity price effects) remains below target in the major advanced economies, including the US. As interest rates are close to the zero lower bound, in the event of further weakness in advanced economiesthere is limited scope for increased monetary stimulus to provide a boost to inflation. If ongoing weakness in global inflation continues, tradables inflation in New Zealand is likely to remain low, despite the lower New Zealand dollar.

...possibly compounded in New Zealand by a change in inflation dynamics

As well as the potential for weak tradables inflation, the persistent weakness in domestic inflation and lower inflation expectations are generating uncertainty around inflation dynamics (see Why has inflation been surprisingly low? box in the Budget Update 2015 Economic Outlook chapter). In recent times, non-tradables inflation has been weaker than the long-term relationship with the output gap would suggest, and there is a risk that the historical relationship remains weaker for longer or does not re-assert itself. Similarly, the degree and timing of pass-through from the lower New Zealand dollar to tradables inflation may be more subdued than expected, particularly in the current low-inflation environment where businesses may be reluctant to pass on higher costs to consumers. If one or both of these risks were to play out, all else equal, headline inflation would be softer than forecast.

Uncertainty surrounds the sensitivity of demand to monetary policy settings...

Slowing domestic demand growth in New Zealand, despite interest rates considered to be well below estimates of neutral, has led to a questioning of the response of demand to monetary policy. Possible reasons for this may be a lower neutral interest rate than is currently assumed or that businesses and consumers require more incentive to spend because of heightened uncertainty in the current environment. If businesses and consumers are less sensitive to monetary policy than in the past, it would lead to a smaller boost to investment and consumption growth from low interest rates than in the central forecast.

...and labour productivity growth

The assumptions concerning labour productivity growth have significant implications for potential growth and the medium-term real GDP forecasts. Labour productivity growth is comprised of investment in capital and multi-factor productivity (MFP). In the central forecast, MFP growth recovers gradually to its historical average but there is a risk that it remains slower over the medium term. If this were to play out, real income growth would be lower, consistent with the experience of recent years, leading to lower domestic demand and slower growth in both real and nominal GDP (see Composition of growth box in the Economic Outlook chapter). Low productivity growth may reflect a combination of low inflation, interest rates and economic growth (sometimes referred to as ‘secular stagnation’).

Risk remains around the extent of the current migration cycle...

Net migration inflows remain elevated and judgements around the size of the current cycle are a risk to the forecast. Net annual gains are assumed to begin declining from a forecast peak of 62,700 in December 2016 as the weaker outlook for the New Zealand economy reduces its attractiveness for those on work visas and returning New Zealand citizens. It is difficult to gauge the strength and timing of these effects and risks appear biased towards higher migration, particularly with the inflow of students which may lead to structurally higher net migration gains. That said, with the New Zealand labour market and economic outlook materially weaker than a year ago, there is a risk that net migration inflows decline more sharply than in the central forecast, particularly if the Australian labour market materially improves.

Visitor arrivals have also been at all-time highs, leading to robust growth in travel services exports over the first half of 2015. There is a risk that the depreciation of the New Zealand dollar in the middle of 2015 has a larger effect and that higher-than-expected visitor arrivals and/or spending per visitor, particularly from China, lead to stronger export services volumes than incorporated in the central forecast. Similarly, arrivals on student visas are at high levels, with risks biased towards further gains, which would lead to increased education services export volumes.

...with high net migration expected to support housing demand

Housing demand is expected to be supported by net migration and low mortgage rates in the year ahead. However, housing demand might be weaker or stronger than in the main forecast, particularly given the risks around migration inflows. Declining nationwide house prices would reduce growth in residential investment and erode some households' wealth. Faster nationwide house price growth than in the central forecast would boost household wealth and consumer confidence, possibly leading to higher residential investment.

The Canterbury rebuild may provide a smaller contribution to growth than in the central forecast. The residential rebuild appears to have peaked, earlier than previously forecast, and uncertainty persists over the total size of the residential rebuild.

Alternative Scenarios#

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The following scenarios show how the economy might evolve if some of the key judgements in the central forecast are altered (Table 3.1). They illustrate two of the many ways that the economy may deviate from the central forecast. Scenario One represents the economic impacts if productivity growth is weaker, demand is less responsive to monetary policy and inflation is less responsive to spare capacity than in the central forecast. Scenario Two shows the economic impact if dairy prices recover faster than in the central forecast and if net inward migration and visitor arrivals are higher.

Notes:

1. March quarter, seasonally adjusted.
2. June years.

Sources: Statistics New Zealand, the Treasury

Scenario One - Structurally Lower Nominal GDP

Slower potential growth...

In the first scenario, New Zealand's potential growth is slower than in the central forecast. Potential growth is the rate at which the economy can expand while maintaining stable inflation and depends on capital (eg, the number of buildings, machines and computers), labour (how many people are available to work and the hours they are willing to work) and MFP (the efficiency with which capital and labour are used). In the past few years MFP has made only small contributions to potential growth, but in the central scenario the contributions are expected to gradually increase. This scenario is based on what would happen if the contribution from MFP remains at its current low level, with potential growth averaging 2.1% over the next five years instead of around 2.5% (Figure 3.1).

Figure 3.1 - Potential growth

Source:  The Treasury

...change in responsiveness of demand...

Domestic demand is assumed to be less responsive to monetary policy than in the central scenario. This means that, for a given interest rate, the impulse to spend for consumers and businesses is lower. Possible reasons for this may be a lower neutral interest rate than in the central scenario (associated with lower potential growth) or that businesses and consumers require more incentive to spend because of heightened uncertainty in the current environment. If the current level of interest rates is not stimulatory enough to boost growth, real investment (both business and residential) and private consumption growth would be weaker than in the central forecast (Figure 3.2 and Figure 3.6). Therefore, the scenario assumes the Reserve Bank reduces the OCR by an additional 0.5 percentage points in the second half of 2016 and interest rates remain lower by that amount for the remainder of the forecast period. This provides a boost to investment and private consumption growth, although it remains below the central track.

Figure 3.2 - Real residential investment

Source: Statistics New Zealand, the Treasury

...and inflation less responsive to spare capacity…

The historical relationship between non-tradables inflation and the output gap is assumed to not re-assert itself until mid-way through the forecast period. This means that non-tradables inflation is weaker for any given level of spare capacity in the interim. As the output gap estimate is similar to the central scenario (weaker supply is offset by weaker demand), non-tradables inflation slows to 0.8%, compared with 1.3% in the central forecast (Figure 3.3).

Figure 3.3 - Non-tradables inflation

Source: Statistics New Zealand, the Treasury

The pass-through from the lower New Zealand dollar to tradables inflation is also subdued relative to the central forecast, although a lower New Zealand dollar than in the central forecast (owing to lower interest rates) leads to slightly higher tradables inflation in 2016. Weaker non-tradables inflation more than offsets stronger tradables inflation, resulting in softer headline inflation over the forecast period. When non-tradables inflation becomes more responsive to the closing output gap in mid-2017, inflation starts to pick up but it does not return to 2.0% until 2020.

…lead to softer real and nominal GDP

Over the forecast period, weaker real investment and private consumption, coupled with lower potential growth, lead to weaker real GDP growth throughout the forecast period. Softer demand also leads to weaker jobs growth which, along with weaker inflation, leads to lower wage growth. As consumers have less income, real private consumption growth only picks up slightly with the boost from lower interest rates. Real GDP growth peaks at 2.9%, compared to 3.7% in the central forecast. Weaker real growth, combined with lower inflation, leads to softer nominal GDP growth. Over the course of the forecast period, nominal GDP is a cumulative $25.5 billion lower than in the central forecast.

Core Crown tax revenue is a cumulative $8.8 billion lower over the forecast period in this scenario. Lower nominal consumption and residential investment reduce GST revenue by a cumulative $2.1 billion over the forecast period. A lower value of output in the economy means business profits are reduced, resulting in corporate taxes being a cumulative $2.5 billion lower. The weaker labour market and lower labour incomes reduce source deductions revenue by $3.2 billion over the forecast period.

Core Crown expenses are moderately higher than in the central forecast, largely owing to increased debt financing costs. Fiscal policy is assumed to remain unchanged from the central forecast. In this scenario, OBEGAL does not return to surplus again until the June 2019 year (Figure 3.4), two years later than in the central forecast. As a consequence, net core Crown debt peaks at 28.7% of nominal GDP in the June 2018 year, rather than peaking at 27.7% a year earlier, as in the central forecast (Figure 3.8).

Figure 3.4 - Operating balance (before gains and losses)

Source:  The Treasury

Scenario Two - Stronger Dairy Prices and Export Services

Higher dairy prices...

In the second scenario, global dairy prices recover faster than in the central forecast, which may be owing to faster-than-expected recovery in Chinese dairy demand. Higher export prices for New Zealand, without an offset from higher import prices, leads to the terms of trade not declining as far and recovering earlier (Figure 3.5).

Figure 3.5 - SNA terms of trade

Source:  Statistics New Zealand, the Treasury

...and more arrivals to New Zealand...

At the same time, international demand is more responsive to the low New Zealand dollar than in the central scenario, leading to stronger services export growth. This is partly from higher tourist arrivals, particularly from China, supported by a continuing increase in flights to New Zealand, and boosted by increased spending per visitor. The low New Zealand dollar also makes New Zealand a more attractive international study destination, increasing the number of international students and boosting export education services growth.

As well as increased student arrivals, the scenario includes increased work visa and New Zealand citizen arrivals, which may be motivated by a weaker Australian labour market and attracted by the stronger growth in the New Zealand economy as a result of increased tourism activity and higher dairy prices. Annual net migration inflows remain around 63,000 until June 2016, providing a cumulative 11,000 more net migrants than in the central forecast.

...support a lift in private consumption and investment...

In rural regions most exposed to the dairy export sector, the earlier recovery in dairy prices increases income levels, leading to higher private consumption growth than in the central forecast (Figure 3.6). This momentum carries through to other parts of the country and stronger private consumption growth continues, compounded by more immigrants. Higher population growth also leads to stronger housing demand, higher house prices and subsequently increased residential investment. In response to buoyant trading conditions, businesses increase capital investment and employment. Stronger growth in labour demand leads to the unemployment rate declining below 6.0% in early 2017, slightly earlier than in the central forecast.

Figure 3.6 - Real private consumption growth

Source:  Statistics New Zealand, the Treasury

...while pressure in non-tradable sectors leads to higher inflation

Stronger domestic demand results in higher inflation over 2016 than in the central forecast, owing to higher non-tradables inflation. Annual inflation rises to 2.0% by the middle of 2016, one quarter earlier than in the central forecast. Higher domestic demand and increased inflationary pressures in the economy lead the Reserve Bank to begin tightening monetary policy three quarters earlier than in the central forecast (Figure 3.7). Higher interest rates cause private consumption, house price and residential investment growth to slow from 2018, with growth slightly below the central forecast at the end of the projection.

Figure 3.7 - 90-day interest rates

Source:  Statistics New Zealand, the Treasury

Real GDP growth over the next two years is faster than in the central forecast, at 2.3% and 2.8% in the March 2016 and 2017 years respectively. The higher terms of trade and slightly stronger inflation boost nominal GDP growth further. Nominal GDP is a cumulative $15.1 billion higher than in the central forecast by the end of June 2020, with most of this occurring over the first three years of the scenario.

Higher nominal GDP lifts tax revenue and the operating balance

Core Crown tax revenue is a cumulative $5.5 billion higher than in the central forecast over the period to June 2020. Increased nominal consumption and residential investment boost GST revenue by a cumulative $0.8 billion over the forecast period. Greater business profitability results in corporate taxes being a cumulative $1.3 billion higher. The stronger labour market and higher wage growth lift source deductions revenue by $1.9 billion over the forecast period. An earlier increase in short-term interest rates flows through to a cumulative $0.6 billion rise in RWT.

Core Crown expenses are lower than in the central forecast owing to a lower number of recipients of unemployment-related benefits. OBEGAL remains in surplus over the entire forecast period, rather than a deficit in the 2016 year in the central forecast (Figure 3.4). The OBEGAL surplus remains larger than in the central forecast over the later years. Net core Crown debt peaks at a lower level of 26.6% of GDP in the June 2017 year, and it subsequently declines faster to 21.7% of GDP in the June 2020 year (Figure 3.8).

Figure 3.8 - Net core crown debt

Source:  The Treasury

General Fiscal Risks#

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The remainder of this chapter focuses on the links between the economic risks and the Crown's fiscal position. For more on fiscal risks, see the Specific Fiscal Risks chapter.

Revenue Risks

One of the major sources of risk to the fiscal position arises from the inherent uncertainty about future tax revenue. The amount of tax revenue that the Crown receives in a given year is closely linked to the performance of the economy.

Figure 3.9 plots the central tax revenue forecast, along with confidence intervals around these forecasts based on the Treasury's historical tax forecast variances and the assumption of an even balance of risks around the central forecast.[20] The outermost shaded area captures the range ±$7.2 billion in the June 2020 year, within which actual tax outturns are expected to fall 80% of the time.[21]

Figure 3.9 - Core Crown tax revenue uncertainty

Source:  The Treasury

The tax revenue forecasts from the two scenarios are also shown in Figure 3.9. The 2008/09 global financial crisis showed that exogenous shocks can have severe impacts on government revenue. Should any of the uncertainties outlined in the Economic Riskssection eventuate, Crown revenue would be different from forecast, with Scenarios One and Two being examples of possible outcomes.

Based on average historical forecast variances, Figure 3.9 suggests that an annual tax revenue outturn associated with Scenario One lies between the 25th and 50th percentiles in most years. An annual tax revenue outturn associated with Scenario Two lies between the 50th and 75th percentiles in each year. On this basis, actual tax outcomes would be expected to fall within the range of the two alternative scenarios approximately half of the time, with greater or lesser outcomes also expected approximately half of the time.

Fiscal Sensitivities

Table 3.2 provides some rules of thumb on the sensitivities of the fiscal position to small changes in specific variables. For example, if nominal GDP growth is one percentage point higher than forecast in each year up to June 2020, tax revenue would be around $4.4 billion higher than forecast in the June 2020 year as a result. The sensitivities are broadly symmetric and if nominal GDP growth is one percentage point lower each year than expected, tax revenue would be around $4.2 billion lower than forecast in the June 2020 year. The figures are indicative and can be influenced by the composition of growth as different types of activity have different effective tax rates.

A different interest rate path from that forecast would also impact on the fiscal position. A one percentage point lower interest rate would result in interest income on funds managed by the Treasury's NZDMO being $110 million lower in the June 2020 year. This would be more than offset by interest expenses $450 million lower in the June 2020 year.

Note: 1 Funds managed by the Treasury's NZDMO only.

Source: The Treasury

Expenditure Risks

One-off and unexpected expenditure shocks can have a large impact on the Crown's operating balance in the year that they occur. Over-forecasting of expenditure leads to policy being tighter than otherwise, and uncertainty is inherent in forecasting the cost of new policy initiatives.

There is also considerable uncertainty regarding the effect of the performance of the economy on Crown expenditures. This uncertainty relates largely to the operation of the so-called automatic stabilisers. For example, if the economy performs better (worse) than expected in a given year, official expenditures on social programmes may be lower (higher) than planned.

In recent years, earthquakes have underlined the inherent exposure of the Crown's fiscal position to unexpected events. The Crown's fiscal position would be affected if another catastrophic earthquake were to occur or if the costs associated with prior events exceed the updated estimates.

The ageing population also presents risks to the medium-term fiscal position, particularly to the extent that demographic forecasts may prove to be too low or too high. An ageing population implies increased public expenditure, especially for health and superannuation spending.

Balance Sheet Risks

In addition to risks around revenue and expenditure, which appear in the balance sheet through their impact on the operating balance, the Crown's financial position is also exposed to risk. These risks manifest themselves through change in the value of the Crown's assets or liabilities. The balance sheet is also affected owing to the Crown having both explicit and implicit obligations (a strong expectation that the Crown would respond to an event) as a result of policy settings.

A large source of balance sheet risk can be attributed to volatility in the value of the Crown's assets and liabilities owing to movements in market variables such as interest rates, exchange rates and equity prices. This can also result in changes to the Crown's operating balance. Of the Crown's aggregate financial risk, a significant proportion can be attributed to market risk. Three areas of the balance sheet are particularly susceptible to market risk:

• Financial assets held by the Crown Financial Institutions (CFIs) are sensitive to financial-market volatility. CFIs tend to diversify their portfolios across a range of financial assets to manage exposures to specific market risks.
• Insurance and retirement liabilities and provisions are prone to market volatility through their actuarial valuations, which are sensitive to assumptions about variables such as interest and inflation rates.
• Physical assets such as land, buildings, state highways and military equipment are susceptible to valuation movements through changes in property market conditions, interest rates and changes in the costs of construction.

Other large sources of balance sheet risk are contingent and implicit liabilities relating to natural disasters and financial system stress. These are discussed in specific detail in the Specific Fiscal Risks chapter.

Business risks, relating to the broader commercial environment, may also affect the Crown's balance sheet. A number of entities owned by the Crown, including commercial and social entities, have their financial performance and valuations impacted by these external factors.

While the Crown's exposure to risks is sometimes unavoidable, the Crown's general approach is to identify, measure and treat these risks where practicable. When a risk cannot be avoided or reduced, the Government's response has been to increase the Crown's resilience by reducing debt ahead of the time when financial resources could be needed, or increase sustainability through achieving higher levels of net worth. This helps to absorb the impact of the risk through the balance sheet so that the wider economy need not adjust immediately at a greater economic cost.

The New Zealand government remains amongst the top-rated sovereigns globally, with the top Aaa foreign-currency rating from Moody's and AA foreign-currency ratings from Standard & Poor's and Fitch. Ratings outlooks are stable for Standard & Poor's and Moody's, and the rating outlook from Fitch is positive.

In the case of an increase in global risk aversion and in the absence of a marked improvement in the external position, New Zealand may face increased funding pressure in the future. All else being equal, deterioration in the ratings outlook could raise debt-servicing costs and lessen the funding capability for the Crown. On the other hand, additional downward pressure on borrowing rates is possible if diversification flows, particularly away from Europe, continue in the future.

The Crown is also susceptible to ‘liquidity risk' with respect to its ability to raise cash to meet its obligations. This risk is relatively small and managed by each agency to meet their specific liquidity risk requirements and by NZDMO to manage the Crown's liquidity requirements.

For additional detail, refer to the 2014 Investment Statement which provides information on the shape and health of the Crown's portfolio of assets and liabilities at the end of the 2013/14 financial year.[22] It outlines how the balance sheet has changed in recent years and includes forecasts of its anticipated composition and size through to 30 June 2018.

Specific Fiscal Risks#

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The Statement of Specific Fiscal Risks is required by the Public Finance Act 1989 to set out, to the fullest extent possible, all government decisions and other circumstances known to the Government at the date of the finalisation of the fiscal forecasts that may have a material effect on the fiscal and economic outlook, but are not certain enough in timing or amount to include in the fiscal forecasts. Although the process for disclosure of specific fiscal risks involves a number of parties, including government departments, the Treasury and the Minister of Finance, there remains a possibility that not every significant risk is identified. Disclosure of known risks is also subject to specific requirements and materiality thresholds, which are described after the Statement of Specific Fiscal Risks.

Overview#

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Specific fiscal risks can be positive or negative and can affect revenue or spending or the balance sheet. The links between external events and spending are indirect because new policies that change spending and revenue usually require a decision by the Government and approval from Parliament. The approach taken in this chapter is to disclose those potential policy decisions and key areas of uncertainty that may have a material effect on the fiscal outlook.

Established practice is that the Government sets aside allowances of new funding for future Budgets to manage uncertainty and cost pressures. These allowances are included in the fiscal forecasts. Current fiscal management policy is for future policy decisions affecting expenses or capital expenditure to be met through reprioritisation or from within existing allowances included in the fiscal forecasts. Future policy decisions are risks to the fiscal forecasts only to the extent they cannot be managed from within:

• for operating expenditure, existing baselines or the allowance in the fiscal forecasts for forecast new operating expenditure, or
• for capital, the existing Crown balance sheet or the allowance in the fiscal forecasts for forecast new capital spending.

Notwithstanding this, known material policy risks are identified as specific fiscal risks, even though the Government has more control in managing such risks through reprioritisation within existing baselines, the existing Crown balance sheet and the Budget allowances. This is done to ensure a prudent approach to the disclosure of risks, improve transparency and not pre-judge future decisions by governments.

The specific fiscal risks are categorised into:

• Potential policy decisions affecting revenue: For example, changes to tax policy or ACC levies could reduce or increase government income.
• Potential policy decisions affecting expenses (expected to be funded from reprioritisation or the Budget operating allowance): Costs of policy proposals could increase or decrease expenses depending on decisions taken, and they are risks to the fiscal forecasts only to the extent that they cannot be managed within existing baselines or Budget allowances.
• Potential capital decisions (expected to be funded from the existing Crown balance sheet or the Budget capital allowance): Capital investment decisions are risks to the fiscal forecasts only to the extent that they cannot be managed within the existing Crown balance sheet, or the Budget capital allowance.
• Matters dependent on external factors: The Crown's liability for costs is sometimes dependent on external factors such as the outcome of negotiations or international obligations.

A range of generic risks to the fiscal forecasts are not recognised as specific fiscal risks:

• Risks from changes to economic assumptions; the most significant economic risks have been identified in Chapter 3.
• Business risks and volatility in the returns from the Crown's investments relating to the broader economic and commercial environment.
• General cost pressures, such as those associated with demographic changes (eg, an ageing population).
• Potential risks from changes in demand for government services or transfer payments owing to underlying structural factors (such as changes in demand for Jobseeker Support).
• The costs of future individual natural disasters, and other major events, as they usually occur infrequently and their occurrence, nature and timing cannot be predicted. Once a disaster does occur, a number of choices arise about how to respond and when potential liabilities are recognised (eg, through setting aside an allocation of funding). Specific risks are disclosed at this point based on the range of possible responses.

The final part of the chapter contains a current list of contingent liabilities and contingent assets. Contingent liabilities are costs that the Crown will have to face if a particular event occurs or are present liabilities that are unable to be measured. Typically, contingent liabilities consist of guarantees and indemnities, legal disputes and claims on uncalled capital. The largest quantified contingent liabilities are to international financial organisations and mostly relate to uncalled capital and promissory notes. Contingent assets are possible assets that have arisen from past events but the value of the asset, or whether it will eventuate, will not be confirmed until a particular event occurs.

Statement of Specific Fiscal Risks#

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Summary Table

The matters listed below are disclosed as specific fiscal risks because they meet the rules for disclosure outlined after this Statement. Full descriptions of the risks listed below are set out in the next section. Where quantification is possible, this is included in the description of the risk.

Potential Policy Decisions Affecting Revenue

Labour Market - ACC Levies (Changed)

Indicative future levy rates for the Work, Earners' and Motor Vehicle accounts are based on ACC's funding policy. This policy has been agreed by Cabinet but remains subject to final confirmation. The indicative levy path based on the policy has been included in the forecasts. However, final levy decisions are made by the Government, and may differ from the forecast levy path if the Government chooses levy rates that do not reflect the funding policy or if it subsequently changes the funding policy. In addition, revenue from the levies set for these accounts may be more or less than is required to cover the cost of claims. If factors such as claims experience, ACC performance and economic assumptions (particularly discount rates) turn out differently from what has been forecast, any variance will have a corresponding impact on the operating balance.

Revenue - Business Tax Simplification (New)

The Government is considering options for simplifying tax for businesses, as set out in the Government Green Paper on Tax Administration. Some of the options being considered may have a material fiscal impact (positive or negative).

Revenue - Income-sharing Tax Credits (Unchanged)

The Government has introduced legislation to establish an income-sharing tax credit. If passed as introduced, the legislation will allow couples with children under the age of 18 to pool their earnings for income tax purposes if they meet certain criteria. The best estimate at the time the Bill was introduced in 2010 was that the changes will reduce tax revenues by $500 million per year once the scheme is fully operational. The Finance and Expenditure Committee has recommended that the significant fiscal cost of the package be addressed before the Bill proceeds further.

Revenue - Potential Tax Policy Changes (Unchanged)

Some of the items on the tax policy work programme could each have a significant positive impact on operating revenue: review of GST on goods and services purchased online, ensuring that withholding tax is paid on interest income derived from related New Zealand entities and accruing to non-residents, and work on Base Erosion and Profit Shifting including interest allocation rules and the taxation of foreign hybrid instruments and entities.

Services Funded by Third Parties (Unchanged)

A wide range of government services are funded through third-party fees and charges. Demand for these services can vary with a direct effect on revenue received. There is a risk the Government may need to provide additional funding if revenue collected is lower than the total costs of providing the service. There is also a risk that changes will be required to the way government services are delivered, which could result in costs to the Crown.

Potential Policy Decisions Affecting Expenses (expected to be funded from reprioritisation or the Budget operating allowance)

Budget Operating Initiatives (Unchanged)

Future Budgets may well include new operating initiatives other than those identified in other specific fiscal risks. Such new operating initiatives are risks to the fiscal forecasts only to the extent they cannot be managed through reprioritisation or from within the existing provision in the fiscal forecasts for forecast new operating spending. The Government's stated intention is that all new operating initiatives and cost pressures will be managed through these mechanisms.

Building and Housing/Social Development - Social Housing Reform (Changed)

The Government is progressing the Social Housing Reform programme. This programme aims to improve the services and assistance provided to those in housing need, build the social housing market and fully recognise the costs of social housing. Specific fiscal risks associated with this reform programme are that:

• the Tāmaki Redevelopment Company Limited's construction costs over the next 10 to 15 years will not be recovered from the proceeds of properties sold. Over this time, 7,500 new houses are planned to be built in place of approximately 2,500 existing houses
• the Government has set a target to fund 65,000 social housing places by 2017/18. This will require new funding over and above the current Income Related Rent Subsidy appropriation cap
• there may be costs to HNZC arising from the Social Housing Reform Programme, and
• proceeds from the Tauranga/Invercargill transfers programme may differ from book value leading to losses on transfer.

The Government is also developing housing on underutilised Crown land in Auckland. There is a risk that delivering social and affordable housing as part of this programme requires additional operating and/or capital expenditure.

Business, Science and Innovation - Ultra-fast Broadband Initiative Phase One (Unchanged)

The Government's expectation is that the current funding envelope for the roll out of Ultra-fast Broadband (UFB) Phase One will not be breached and that the objective of rolling out UFB to 75% of New Zealanders by the end of 2019 will be met. Until the Commerce Commission issues a final decision on the pricing of the copper network, the largest partner in the roll out, Chorus, will face some degree of funding uncertainty which could give rise to a fiscal risk in achieving these targets.

Canterbury Earthquake Recovery - Christchurch Central Recovery Plan - Anchor Projects (Unchanged)

The Crown is partially funding the construction of Anchor Projects as part of the Christchurch Central Recovery Plan as set out in the cost-sharing agreement with the Christchurch City Council. Funding will vary from project to project, dependent on final scope, ownership decisions, implementation and project costs, and will to some extent eventually be recovered. Business cases are progressing through the decision-making process and construction costs will become increasingly clear during the business case process and the subsequent procurement phase. The Crown's contribution may differ from that included in the fiscal forecasts.

Concessionary Loans (Unchanged)

The Crown has provided loans to local government and iwi-based organisations on a concessionary basis to achieve public policy purposes. Because of their concessionary nature, these loans are written down on draw down to reflect existing market conditions. There is a risk that future market conditions may require a different adjustment. The current carrying value of these loans on the Crown's balance sheet is $616 million.

Defence Force - Operating and Capital Costs (Unchanged)

In 2013, the Government reconsidered New Zealand Defence Force (NZDF) funding, output requirements and capability intentions, through the Defence Mid-point Rebalancing Review. The review has resulted in increased funding for NZDF in Budget 2014 and Budget 2015. Further operating and capital investment decisions may be made to achieve Defence White Paper 2015 policy over the forecast period.

Government Response to Wai 262 (Unchanged)

The Waitangi Tribunal's report on the Wai 262 claim focuses on the protection of Māori culture and identity, with a particular focus on mātauranga Māori and associated taonga. The Tribunal's recommendations are directed towards a number of government agencies individually, as groups and across sectors. The Government has yet to respond to the Tribunal's report and recommendations.

Labour Market - ACC: Work-related Gradual Process Disease and Infection (Unchanged)

Under current legislation, the Government incurs an obligation for Work-related Gradual Process Disease and Infection claims when the claim is made, and an expense is recognised at this point. The liability for commercial accident and sickness insurance contracts would usually be recognised when exposure to conditions that will give rise to a claim occurs. An amendment to legislation would be required to recognise claims at the same time as for commercial contracts. An initial adjustment to the liability and an expense of about $1.0 billion to $1.5 billion would need to be reported if such an amendment were to be enacted.

Revenue - Transformation and Technology Renewal (Changed)

The Business Transformation programme has been agreed by Cabinet and is reflected in forecasts. There are risks that the expected implementation costs, revenue gains and operating costs savings may differ from forecasts. In addition, the Government is considering possible policy changes affecting the way Inland Revenue manages its processes and data. Any changes could materially impact the programme's cost, and the additional revenue collected.

Social Development - Child, Youth and Family Modernisation (Unchanged)

An External Advisory Panel is overseeing the development of a new operating model for Child, Youth and Family that sets outs the structure, systems and resources needed to help improve the outcomes for children and young people by strengthening and enhancing the way it operates. While funding for 2015/16 has been included in the fiscal forecasts, the future costs of the proposal are still being developed. To the extent that these cannot be funded from reprioritisation, additional funding from the operating allowance may be required.

Social Development - Welfare Reform Costs (Unchanged)

The Welfare Reform package of changes to the benefit system was introduced from July 2013, following amendments to the Social Security Act 1964. The current phase is to review programmes with a view to reducing future benefit dependency and long-term liability. An additional $100 million over four years was appropriated in Budget 2014 and $24 million over four years in Budget 2015. It is likely that there will be further costs associated with the ongoing implementation of the Investment Approach in order to achieve Better Public Services Result One.

Social Development - Welfare Reform Forecast Benefit Savings (Unchanged)

A conservative estimate of the likely benefits from Welfare Reform has been included in the fiscal forecasts. The actual impact may differ owing to behavioural factors of benefit recipients and the complexity in implementing the reforms, with a corresponding impact on benefit expenditure.

Social Development - Youth Service Extension (New)

An amendment Bill providing the enabling framework for extension of the Youth Service is currently being considered by the Social Services Select Committee. The intent is that, subject to funding and IT changes being in place, the extension would be implemented from March 2016. It is intended that funding options will be identified following the Youth Funding Review. The expected operating cost of the Youth Service Extension is $25 million per annum.

State Sector Employment Agreements (Unchanged)

A number of large collective agreements are due to be renegotiated in the short-to-medium term. As well as direct fiscal implications from any changes to remuneration, the renegotiation of these agreements can have flow-on effects to remuneration in other sectors. The Government has signalled an expectation of restraint given its current fiscal stance and that agreements will be managed within the current fiscal forecasts.

Potential Capital Decisions (expected to be funded from the existing Crown balance sheet or the Budget capital allowance)

Agency Capital Intentions (Unchanged)

Future Budgets may well include new capital investments other than those identified in other specific fiscal risks. Such investments are most likely to be developed by the 24 investment-intensive agencies that are required to identify their capital spending intentions over the next 10 years based on current policy settings and certain demographic and inflation assumptions. The Government expects that these intentions will be managed back through a range of measures such as prioritisation, improvements in asset performance, alternative methods of service delivery and changes to policy settings. New investments are risks to the fiscal forecasts only to the extent they cannot be managed through existing balance sheets, or the provision in the fiscal forecasts for forecast new capital spending.

Earthquake Strengthening for Crown-owned Buildings (Unchanged)

There is a possibility that the Crown will incur costs for earthquake strengthening some of the buildings that it owns which may not meet modern building standards. The Government is currently undertaking a stock-take of Crown-owned earthquake-prone buildings. The likelihood, timing and fiscal impact of any earthquake strengthening are uncertain.

Finance - Crown Overseas Properties (Unchanged)

The Government holds New Zealand House in London on a long-term lease from the Crown Estate (UK). Depending on the outcome of ongoing discussions with the Crown Estate an upgrade to the building may be required. Should a decision be taken to refurbish the property, a rough-order cost estimate for this upgrade is $100 million over the forecast period.

Lands - Upgrading Landonline (Unchanged)

Land Information New Zealand (LINZ) is currently exploring options around the upgrade of Landonline to replace its outdated technology platform and to meet the changing business and technology needs of users. LINZ has now completed a detailed business case which Cabinet endorsed in 2015. They will also submit a capital initiative through Budget 2016. There may be insufficient accumulated depreciation funding to cover the replacement and enhancement cost.

Parliamentary Service - Parliamentary Accommodation (Unchanged)

With the expiry of the lease on Bowen House in December 2018, the Parliamentary Service is reviewing how it provides accommodation for Parliament to ensure that accommodation meets the needs of future Parliaments at best economic value. Options for future accommodation may require capital expenditure with estimates ranging from $36 million to $97 million.

Primary Industries and Food Safety - Investment in Water Infrastructure (Unchanged)

The Government has made a public statement that it will invest up to $400 million in equity of irrigation schemes. In addition to $120 million already appropriated, the Government will consider providing further capital of up to $280 million in future Budgets to Crown Irrigation Investment Limited as schemes reach the ‘investment-ready' stage.

Transport - Auckland Transport Projects (Unchanged)

The Government has signalled its intention to accelerate transport projects in the Auckland Council's Auckland Plan, including Auckland Manukau Eastern Transport Initiatives, the East-West Link and support for the City Rail Link and a second Waitemata Harbour Crossing. NZTA has advised that it can fund the Auckland Manukau Eastern Transport Initiatives without further Crown funding. Decisions on further Crown financial assistance for the East-West Link and other projects will be made as part of future Budgets.

Transport - Regional State Highways (Unchanged)

A regional state highway acceleration package of $212 million was announced by the Government in June 2014; $115 million of this is subject to the outcome of further investigations. Further funding decisions will be considered as part of Budget 2016.

Transport - Support for KiwiRail (Unchanged)

The Government in Budgets 2010 to 2015 supported KiwiRail Holdings Limited (KiwiRail) with around $1.5 billion invested in the New Zealand freight rail system. Further funding will be sought by KiwiRail in future Budgets.

Matters Dependent on External Factors

Building and Housing - Divestment and Development of HNZC Housing (Unchanged)

The forecasts reflect divestments and redevelopments of some housing property as part of HNZC's asset management strategy. Property sales are subject to market conditions and therefore there is an inherent level of uncertainty about the return to the Crown associated with forecast divestments and about the proposed funding of developments.

Business, Science and Innovation - Crown Revenue from Petroleum Royalties (Unchanged)

The Crown Revenue from Petroleum Royalties is dependent upon extraction rates, the US dollar value per barrel and the US/NZ dollar exchange rate. Movements up or down in any of these variables could result in a significant decrease or increase in the Crown revenue. The overall impact for the Crown could be negative or positive.

Business, Science and Innovation - Impairment in Value of Broadband Investment (Unchanged)

The Government has set aside approximately $1.6 billion to progressively capitalise Crown Fibre Holdings so that it can invest with private partners in a new network delivering ultra-fast broadband services. Given the contracts entered into, the extent of the recovery of this investment is somewhat dependent on the number of connections made to the network. The fiscal forecasts include a provision for impairing this investment, but the final amount of the impairment may vary from this provision.

Canterbury Earthquake Recovery - Residential Red Zone (Unchanged)

Some recoveries from EQC and private insurers remain outstanding and there is a risk that final recoveries may be greater or less than forecast. In addition, potential costs, revenues or recoveries associated with the future use of residential red zone are uncertain. The future value may change depending on any future alternate uses of the land. The fiscal impact of this is not yet certain.

Defence Force - Potential Rationalisation, Revaluation and Disposal of NZDF Assets (Unchanged)

The Government is considering the potential to dispose of a number of NZDF assets. Depending on market conditions, the timing of disposal and sale price received could have an impact on the Government's overall financial position. NZDF is also completing an analysis of inventory that is surplus to requirements and is over and above the existing provision for obsolescence. The existing provision is also being reviewed to ensure that all items comprising the provision are still relevant.

Finance - EQC (Changed)

An actuarial estimate of the net claims liability and the rate of settlement has been included in the Crown's fiscal forecasts. This includes a cash forecast for EQC. At the last fiscal update, EQC had forecast a future cash shortfall of $375 million to be funded by the Crown under Section 16 of the Earthquake Commission Act 1993 - the Crown Guarantee. The most recent valuation of EQC's Canterbury Earthquake settlements has seen the central estimate of the total cost reduce from $11.543 billion to $11.249 billion. Consequently, EQC has reduced its forecast cash shortfall and is not currently expecting to call on the Crown Guarantee. There still remains some risk that EQC's remaining settlement expenditure relating to the Canterbury earthquakes will be significantly different (higher or lower) from forecast.

Finance - Goodwill on Acquisition (Unchanged)

As at 30 June 2015, the Government had goodwill on acquisition of a number of sub-entities totalling $592 million. Under New Zealand accounting standards (PBE IPSAS 26), such goodwill items are required to be assessed annually for impairment. If there is any indication that the goodwill may be impaired, the recoverable amount of the cash generating units to which the goodwill is allocated is required to be estimated. If the recoverable amount is less than the carrying amount of those units, the units and the goodwill allocated to them are regarded as impaired and the Government is required to recognise impairment losses in the operating statement. Such assessments will be conducted at the end of the financial year, and the fiscal forecasts currently make no allowance for such impairment losses.

Finance - Southern Response Earthquake Services Support (Unchanged)

The ultimate cost to the Crown of settling earthquake claims remains subject to significant uncertainty. Forecasts assume that the actual cost to settle claims will align with the actuary's central estimate of the claims provision. There is a risk that the actual cost could vary from this estimate which is sensitive to its underlying assumptions such as damage estimates, legal challenges, reinsurance recoveries and the forecast profile of claims settlement. The Crown's financial position may be adversely impacted as these assumptions are modified over time. Because the net claims liability is large, small percentage changes in the liability can have a material impact on costs and forecasts.

Labour Market - ACC Non-earners' Account (Unchanged)

The amount of funding provided by the Crown (and included in the fiscal forecasts) for the Non-earners' Account may be more or less than is required to cover the cost of claims, if factors such as claims experience, ACC performance and economic assumptions (particularly discount rates) turn out differently from what has been forecast. Any such variance will have a corresponding fiscal impact.

Pay Equity and Caregiver Employment Conditions (Changed)

Several cases and funding claims in the disability support and aged care sectors relating to interpretation of the Minimum Wage Act 1983, the Equal Pay Act 1972 and the Government's policy of paying certain family members through its Funded Care Policy may involve significant costs to the Crown. The Government has announced it will be entering negotiations over pay rates for care and support workers which will cover around 50,000 workers. A Joint Working Group has been established to develop principles for dealing with claims of pay equity under the Equal Pay Act. The group will recommend to Ministers agreed principles on pay equity that could be applied in all sectors in the economy. The result of both of these could require additional funding.

Revenue - Cash Held in Tax Pools (Unchanged)

Funds held in tax pools are recognised as a Crown asset. There is a risk that funds held in these pools, over and above a taxpayer's provisional tax liability, may be withdrawn by that taxpayer, resulting in a reduction in the Crown's available cash reserves.

Revenue - Student Loans (Unchanged)

The value of student loans is sensitive to assumptions such as the borrower's future income, and general economic factors such as interest rates, unemployment levels, salary inflation and the CPI. As new lending occurs, an initial write-down to fair value will be made, and an expense will be incurred, reflecting the cost the Crown incurs in making an interest free loan and the risk that borrowers may not repay their loans. However, the assumptions made at the time of lending are volatile and are subject to change.

Treaty Negotiations - Treaty Settlement Forecasts (Unchanged)

The fiscal forecasts include provision for the cost of future Treaty settlements. Given settlements are finalised through negotiations, there is a risk that the timing and amount of the settlements could be different from the profile included in the fiscal forecasts.

Treaty Negotiations - Relativity Clause (Unchanged)

The Deeds of Settlement negotiated with Waikato-Tainui and Ngāi Tahu include a relativity mechanism. Now that the total redress amount for all historical Treaty settlements exceeds $1.0 billion in 1994 present-value terms, the mechanism provides that the Crown is liable to make payments to maintain the real value of Ngāi Tahu's and Waikato-Tainui's settlements as a proportion of all Treaty Settlements. The agreed relativity proportions are 17% for Waikato-Tainui and approximately 16% for Ngāi Tahu. There is a risk that the timing and amount of the expense for the relativity payments may differ from that included in the fiscal forecasts. There is also uncertainty on how various disputes concerning the interpretation of the mechanism will be resolved.

Risks Removed Since the 2015 Budget Update

The following risks have been removed since the 2015 Budget Update:

Criteria and Rules for Inclusion in the Fiscal Forecasts or Disclosure as Specific Fiscal Risks

The Public Finance Act 1989 requires that the Statement of Specific Fiscal Risks sets out all government decisions, contingent liabilities and other circumstances known to the Government and subject to specific requirements that may have a material effect on the economic or fiscal outlook.[24]

The criteria and rules set out below are used to determine if government decisions or other circumstances should be incorporated into the fiscal forecasts, disclosed as specific fiscal risks or, in certain situations, excluded from disclosure.

Criteria for Including Matters in the Fiscal Forecasts

Matters are incorporated into the fiscal forecasts provided they meet the following criteria:

• The matter can be quantified for particular years with reasonable certainty.
• A decision has been taken, or a decision has not yet been taken but it is reasonably probable[25] the matter will be approved, or it is reasonably probable the situation will occur.

Additionally, any other matters may be incorporated into the forecasts if the Secretary to the Treasury considers, using best professional judgement, that the matters may have a material effect on the fiscal and economic outlook and are certain enough to include in the fiscal forecasts.

Rules for the disclosure of specific fiscal risks

Matters are disclosed as specific fiscal risks if:

• the likely impact is more than $100 million over five years, and either
• a decision has not yet been taken but it is reasonably possible[26] (but not probable) that the matter will be approved or the situation will occur, or
• it is reasonably probable that the matter will be approved or the situation will occur, but the matter cannot be quantified or assigned to particular years with reasonable certainty.

Additionally, any other matters may be disclosed as specific fiscal risks if the Secretary to the Treasury considers, using best professional judgement, that the matters may have a material effect (more than $100 million over five years) on the fiscal and economic outlook but are not certain enough to include in the fiscal forecasts.

Exclusions from Disclosure

Matters are excluded from disclosure as specific fiscal risks if they fail to meet the materiality criterion (ie, are less than $100 million over five years), or if they are unlikely[27] to be approved or occur within the forecasting period.

Additionally, the Minister of Finance may determine, under section 26V of the Public Finance Act 1989, that a matter not be included in the fiscal forecasts or a specific fiscal risk not be disclosed, if such disclosure would be likely to:

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

If possible, the Minister of Finance should avoid withholding the matter, either by making a decision on it before the forecasts are finalised, or by disclosing it without quantifying the risk.

Contingent Liabilities and Contingent Assets#

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Contingent liabilities are possible costs that have arisen from past events, but the amount of the liability, or whether it will eventuate, will not be confirmed until a particular event occurs or present liabilities that are unable to be measured with sufficient reliability to be recorded in the financial statements (unquantifiable liabilities).

Typically, contingent liabilities consist of guarantees and indemnities, uncalled capital and legal disputes and claims. 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, or the amount becomes sufficiently reliable to record as a liability, it would reduce the operating balance and net worth and increase debt. In the case of contingencies for uncalled capital, the negative impact would be restricted to core Crown net debt because the cost would be offset by the acquisition of capital.

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 amount of any award against the Crown.

Contingent assets are possible assets that have arisen from past events but the amount of the asset, or whether it will eventuate, will not be confirmed until a particular event occurs.

Only contingent liabilities and contingent assets involving amounts of over $100 million are separately disclosed. Quantifiable contingencies less than $100 million are aggregated in the ‘other quantifiable' total.

Some contingencies of the Crown are not able to be quantified. We have disclosed all unquantifiable contingent liabilities and unquantifiable contingent assets that are not expected to be remote.[28]

The contingencies have been stated as at 31 October 2015, being the latest set of reported contingencies.

Quantifiable Contingent Liabilities and Contingent Assets

Unquantifiable Contingent Liabilities and Contingent Assets

Description of Contingent Liabilities

Quantifiable contingent liabilities over $100 million

Guarantees and indemnities

Guarantees are legally binding promises made by the Crown to assume responsibility for a debt, or performance of an obligation of another party, should that party default. Guarantees generally relate to the payment of money but may require the performance of services. Guarantees given under section 65ZD of the Public Finance Act 1989 are disclosed in accordance with section 26Q(3)(b)(i)(B) of the same Act.

Indemnities are legally binding promises where the Crown undertakes to accept the risk of loss or damage that another party may suffer and to hold the other party harmless against loss caused by a specific stated event.

New Zealand Export Credit Office guarantees

The New Zealand Export Credit Office (NZECO) provides a range of guarantee products to assist New Zealand exporters manage risk and capitalise on trade opportunities around the globe.  The obligations to third parties are guaranteed by the Crown and are intended to extend the capacity of facilities in the private sector. 

$208million at 31 October 2015 ($177 million at 30 June 2015)

Uncalled capital

As part of the Crown's commitment to a multilateral approach to ensure global financial and economic stability, New Zealand, as a member country of these organisations, contributes capital by subscribing to shares in certain institutions.

The capital (when called) is typically used to raise additional funding for loans to member countries or, in the case of the quota contributions, to directly finance lending to members. For New Zealand and other donor countries, capital contributions comprise both ‘paid in' capital and ‘callable capital or promissory notes'.

The Crown's uncalled capital subscriptions over $100 million are as follows:

In addition to the uncalled capital above, the Crown Support Deed agreed with Southern Response Earthquake Services Ltd includes two capital subscriptions:

• a $500 million preference share facility under the Crown's agreement dated 5 April 2012 of which $140 million has already been called and paid, with the other $360 million called but unpaid as at 31 October 2015. The balance is forecast to be paid progressively through the 2016/17 financial year, and
• $500 million of uncalled ordinary shares under an amended Crown Support Deed dated 30 January 2013 by which Southern Response may issue a call notice but only after Southern Response's investments, reinsurance and existing Crown support (the remaining $400 million convertible preference share facility discussed above) is exhausted.

As at 31 October 2015, no call has been made on the uncalled ordinary capital facility. However, it is now considered probable that approximately $347 million of this subscription will be called and paid for in the near future. There is also a possibility that the remaining $153 million will be called owing to significant complexities that exist in settling Christchurch earthquake claims. The extent to which the subscription is called and paid depends on the ultimate cost of settling earthquake claims, which continues to be subject to significant uncertainty.

If this Crown Support Deed were to crystallise, the Crown would compensate the individual entity for the loss and there would likely be an adverse impact on core Crown expenses and core Crown net debt. However, as Southern Response is part of the Crown there would be no impact on the overall Crown operating balance.

Legal proceedings and disputes

Tax disputes

When a taxpayer disagrees with an assessment issued following the dispute process, the taxpayer may challenge that decision by filing proceedings with the Taxation Review Authority or the High Court. This contingent liability represents the maximum liability Inland Revenue has in respect of these cases.

$156million at 31 October 2015 ($148 million at 30 June 2015)

Other quantifiable contingent liabilities

AIIB

The Government has agreed to become a regional member of the Asian Infrastructure Investment Bank (AIIB). The AIIB is a multilateral development bank focused on supporting the development of infrastructure in the Asian region. The Government has completed the necessary parliamentary and legislative processes and expects New Zealand to formally ratify the Bank's Articles of Agreement in December 2015[30]. It is anticipated that the threshold for entry into force of the treaty establishing the AIIB will also be met in December 2015.

The Government has agreed to subscribe to 4,615 shares in the authorised capital stock of the AIIB with a value of US$461.50 million (NZ$693.6 million). On entry into force of the agreement and ratification by New Zealand paid-in capital of 20% (US$92.3 million (NZ$144.8 million based on forward contracted exchange rates)) will be paid in five equal instalments over five years. The payments of the called portion are included in the fiscal forecast. The remaining 80% (US$369.2 million (NZ$548.8 million)) will be called only as and when required by the AIIB to meet its liabilities.

$694 million at 31 October 2015 ($nil at 30 June 2015)

Unclaimed monies

Under the Unclaimed Money Act 1971, entities (eg, financial institutions, insurance companies) hand over money not claimed after six years to Inland Revenue. The funds are repaid to the entitled owner on proof of identification.

$121 million at 31 October 2015 ($120 million at 30 June 2015)

Unquantifiable contingent liabilities

This part of the Statement provides details of those contingent liabilities of the Crown that are not quantified, excluding those that are considered remote, reported by the following categories:

a) Indemnities

b) Legal disputes, and

c) Other contingent liabilities.

a)  Indemnities

A number of these indemnities are provided to organisations within the Crown's control. If these indemnities were to crystallise, the Crown would compensate the individual entity for the loss and there would likely be an adverse impact on core Crown expenses and core Crown net debt.

b)  Legal claims and proceedings

There are numerous legal actions that have been brought against the Crown. However, in the majority of these actions it is considered a remote possibility that the Crown would lose the case. Based on these factors, not all legal actions are individually disclosed. The claims that are disclosed individually, while they cannot be quantified, have the potential to exceed $20 million in costs and not considered to be remote.

Accident Compensation Corporation litigation   

Litigation involving ACC arises almost exclusively from challenges to operational decisions made by ACC through the statutory review and appeal process. No accrual has been made for contingent liabilities which could arise as these disputes are issue based and ACC's active management of litigation means that it will be either settling or defending, depending on the merits of the issue in dispute.

Air New Zealand litigation

Air New Zealand is defending two class actions in the US. One makes allegations of anti-competitive conduct against many airlines in relation to pricing in the air cargo business. Following settlements, four airlines including Air New Zealand continue to defend the claim. A similar, previously reported class action filed in Australia was discontinued against Air New Zealand in June 2014 resulting in legal costs of over $3 million being recovered by Air New Zealand.

A second class action in the US alleges that Air New Zealand together with other airlines acted anti-competitively in respect of fares and surcharges on trans-Pacific routes.

Allegations of anti-competitive conduct in the air cargo business in Hong Kong and Singapore were the subject of proceedings by the Australian Competition and Consumer Commission (ACCC). Following a defended hearing, the Federal Court released its decision in October 2014, finding in favour of Air New Zealand. The ACCC has appealed the decision and the appeal was heard in August 2015. A decision is awaited.

In the event that a Court determined that Air New Zealand had breached competition laws, the Group would have potential liability for damages or (in Australia) pecuniary penalties. No other significant contingent liability claims are outstanding at balance date.

Kiwibank

In June 2013, a group called Fair Play on Fees announced plans for a representative action against banks in New Zealand in relation to certain default fees charged to New Zealand customers. In November 2013, the group issued proceedings against Kiwibank. The potential outcome of the proceedings cannot be determined with any certainty at this stage.

Ministry for Primary Industries - Kiwifruit vine disease

In November 2014, 42 kiwifruit growers and post-harvest owners filed a claim against the Ministry for Primary Industries alleging it is liable for damages they suffered from the kiwifruit vine disease Psa-V. The plaintiffs have not quantified their losses, but have publicly claimed it is in the vicinity of $250 million, citing total industry losses of $885 million. Plaintiffs of the proceedings must provide details of their claims by 4 December 2015. At that point it may be possible to provide a more accurate assessment of the contingent liability. The Ministry is defending the claim and currently it remains unquantifiable.

Treaty of Waitangi claims

Under the Treaty of Waitangi Act 1975, any Māori may lodge certain claims relating to land or actions counter to the principles of the Treaty with the Waitangi Tribunal. Where the Tribunal finds a claim is well founded, it may recommend to the Crown that action be taken to compensate those affected. The Tribunal can make recommendations that are binding on the Crown with respect to land which has been transferred by the Crown to a State-owned Enterprise or tertiary institution, or is subject to the Crown Forest Assets Act 1989.

c)  Other unquantifiable contingent liabilities

Criminal Proceeds (Recovery) Act 2009

The Ministry of Justice is responsible for administering the Criminal Proceeds (Recovery) Act 2009. The Act requires the Crown to give an undertaking as to damages or costs in relation to asset restraining orders. In the event that the Crown is found liable, payment may be required.

Environmental liabilities

Under common law and various statutes, the Crown may have responsibility to remedy adverse effects on the environment arising from Crown activities. Departments managing significant Crown properties have implemented systems to identify, monitor and assess potential contaminated sites.

In accordance with PBE IPSAS 19: Provisions, Contingent Liabilities and Contingent Assets any contaminated sites for which costs can be reliably measured have been included in the Statement of Financial Position as provisions.

Treaty of Waitangi claims - Settlement Relativity Payments - see page 82.

Description of Contingent Assets

Quantifiable contingent assets over $100 million

Legal proceedings and disputes

Tax disputes

A contingent asset is recognised when Inland Revenue has advised a taxpayer of a proposed adjustment to their tax assessment. The taxpayer has the right to dispute this adjustment and a disputes resolution process can be entered into. The contingent asset is based on the likely cash collectable from the disputes process based on experience and similar prior cases, net of losses carried forward.

$103 million at 31 October 2015 ($103 million at 30 June 2015)

Forecast Financial Statements#

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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 Risks and Scenarios and Specific Fiscal Risks chapters discuss the risks to the fiscal forecast in more detail.

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 27 November 2015.

The finalisation dates and key assumptions that underpin the preparation of the Forecast Financial Statements are outlined in the Fiscal Outlook chapter (pages 54 to 56).

Statement of Accounting Policies#

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Significant Accounting Policies

The Forecast Financial Statements have been prepared in accordance with the accounting policies that are expected to be used in the comparable audited actual Financial Statements of the Government. They comply with generally accepted accounting practice (GAAP) as required by the Public Finance Act 1989 and have been prepared in accordance with Public Benefit EntityFinancial Reporting Standard 42: Prospective Financial Statements.

All forecasts use the accrual basis of accounting. Forecasts have been prepared for the consolidated Financial Statements of the Government reporting entity, which includes all entities controlled by the Government (as defined by GAAP).

The specific accounting policies are included within the 2015 Half Year Economic and Fiscal Update Additional Information document which can be found on the Treasury's website at www.treasury.govt.nz/budget/forecasts/hyefu2015

Forecast Assumptions

Key forecast assumptions are set out on pages 54 to 56.

The Forecast Financial Statements have been prepared on the basis of the Treasury's best professional judgement. Actual financial results for the periods covered are likely to vary from the information presented in these forecasts. Factors that may lead to a material difference between information in these Forecast Financial Statements and the actual reported results in future years are set out in the Specific Fiscal Riskschapter on pages 71 to 84.

Reporting and Forecast Period

The reporting periods for these Forecast Financial Statements are the years ended 30 June 2016 to 30 June 2020. The ‘2015 Actual’ figures reported in the statements are the audited results reported in the Financial Statements of the Government for the year ended 30 June 2015. The ‘2016 Previous Budget’ figures are the forecasts to 30 June 2016 as presented in the 2015 Budget.

Government Reporting Entity as at 27 November 2015#

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These Forecast Financial Statements are for the government reporting entity as specified in Part 3 of the Public Finance Act 1989. This comprises Ministers of the Crown and the following entities (classified in the three institutional components used for segmental reporting):

Core Crown segment

Departments

• Crown Law Office
• Department of Conservation
• Department of Corrections
• Department of Internal Affairs
• Department of the Prime Minister and Cabinet (includes Canterbury Earthquake Recovery Authority as a departmental agency)
• Education Review Office
• Government Communications Security Bureau
• Inland Revenue Department
• Land Information New Zealand
• Ministry for Culture and Heritage
• Ministry for Primary Industries
• Ministry for the Environment
• Ministry of Business, Innovation and Employment
• Ministry of Defence
• Ministry of Education
• Ministry of Foreign Affairs and Trade
• Ministry of Health
• Ministry of Justice
• Ministry of Māori Development
• Ministry of Pacific Island Affairs
• Ministry of Social Development
• Ministry of Transport
• Ministry of Women's Affairs
• New Zealand Customs Service
• New Zealand Defence Force
• New Zealand Police
• New Zealand Security Intelligence Service
• Office of the Clerk of the House of Representatives
• Parliamentary Counsel Office
• Parliamentary Service
• Serious Fraud Office
• State Services Commission
• Statistics New Zealand
• The Treasury

Offices of Parliament

• Controller and Auditor-General
• The Ombudsmen
• Parliamentary Commissioner for the Environment

Others

• New Zealand Superannuation Fund
• Reserve Bank of New Zealand

State-owned enterprises segment

• Airways Corporation of New Zealand Limited
• Animal Control Products Limited
• AsureQuality Limited
• Electricity Corporation of New Zealand Limited
• KiwiRail Holdings Limited
• Kordia Group Limited
• Landcorp Farming Limited
• Learning Media Limited (in liquidation)
• Meteorological Service of New Zealand Limited
• New Zealand Post Limited
• New Zealand Railways Corporation
• Quotable Value Limited
• Solid Energy New Zealand Limited
• Transpower New Zealand Limited

Mixed ownership model companies (Public Finance Act schedule 5 companies)

• Genesis Energy Limited
• Meridian Energy Limited
• Mighty River Power Limited

Others

• Air New Zealand Limited

Crown entities segment

• Accident Compensation Corporation
• Accreditation Council
• Arts Council of New Zealand Toi Aotearoa
• Broadcasting Commission
• Broadcasting Standards Authority
• Callaghan Innovation
• Careers New Zealand
• Children's Commissioner
• Civil Aviation Authority of New Zealand
• Commerce Commission
• Crown Irrigation Investments Limited
• Crown Research Institutes (7)
• District Health Boards (20) (including NZ Health Partnerships)
• Drug Free Sport New Zealand
• Earthquake Commission
• Education New Zealand
• Electoral Commission
• Electricity Authority
• Energy Efficiency and Conservation Authority
• Environmental Protection Authority
• External Reporting Board
• Families Commission
• Financial Markets Authority
• Government Superannuation Fund Authority
• Guardians of New Zealand Superannuation
• Health and Disability Commissioner
• Health Promotion Agency
• Health Quality and Safety Commission
• Health Research Council of New Zealand
• Heritage New Zealand Pouhere Taonga
• Housing New Zealand Corporation
• Human Rights Commission
• Independent Police Conduct Authority
• Law Commission
• Maritime New Zealand
• Museum of New Zealand Te Papa Tongarewa Board
• New Zealand Antarctic Institute
• New Zealand Artificial Limb Service
• New Zealand Blood Service
• New Zealand Film Commission
• New Zealand Fire Service Commission
• New Zealand Lotteries Commission
• New Zealand Productivity Commission
• New Zealand Qualifications Authority
• New Zealand Symphony Orchestra
• New Zealand Tourism Board
• New Zealand Trade and Enterprise
• New Zealand Transport Agency
• New Zealand Venture Investment Fund Limited
• New Zealand Walking Access Commission
• Office of Film and Literature Classification
• Pharmaceutical Management Agency
• Privacy Commissioner
• Public Trust
• Radio New Zealand Limited
• Real Estate Agents Authority
• Retirement Commissioner
• School Boards of Trustees (2,404)
• Social Workers Registration Board
• Sport and Recreation New Zealand
• Standards Council
• Takeovers Panel
• Te Reo Whakapuaki Irirangi (Māori Broadcasting Funding Agency)
• Te Taura Whiri i te Reo Māori (Māori Language Commission)
• Television New Zealand Limited
• Tertiary Education Commission
• Tertiary education institutions (29)
• Transport Accident Investigation Commission
• WorkSafe New Zealand

Organisations listed in schedule 4 of the Public Finance Act 1989

• Agricultural and Marketing Research and Development Trust
• Asia New Zealand Foundation
• Fish and Game Councils (12)
• Game Animal Council
• Leadership Development Centre Trust
• Māori Trustee
• National Pacific Radio Trust
• New Zealand Fish and Game Council
• New Zealand Game Bird Habitat Trust Board
• New Zealand Government Property Corporation
• New Zealand Lottery Grants Board
• Ngāi Tahu Ancillary Claims Trust
• Pacific Co-operation Foundation
• Pacific Island Business Development Trust
• Reserves Boards (20)
• Sentencing Council
• Te Ariki Trust

Non-listed companies in which the Crown is majority or sole shareholder (Public Finance Act schedule 4A companies)

• Crown Asset Management Limited
• Crown Fibre Holdings Limited
• Education Payroll Limited
• Fairway Resolution Limited
• Health Benefits Limited (ceased operations)
• Research and Education Advanced Network New Zealand Limited
• Southern Response Earthquake Services Limited
• Tāmaki Redevelopment Company Limited
• The Network for Learning Limited

Legal entities created by Treaty of Waitangi settlements Acts (Public Finance Act schedule 6)

• Te Urewera

Subsidiaries of SOEs, Crown entities and other government entities are consolidated by their parents and not listed separately in this table.

Forecast Financial Statements#

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Forecast Statement of Financial Performance for the years ending 30 June

The accompanying notes and accounting policies are an integral part of these Statements.

Forecast Analysis of Expenses by Functional Classification for the years ending 30 June

Below is an analysis of core Crown expenses by functional classification. Core Crown expenses include expenses incurred by Ministers, Departments, Offices of Parliament, the NZS Fund and the Reserve Bank, but not Crown entities and SOEs.

1. The classifications of the functions of the Government reflect current approved baselines. Forecast new operating spending is shown as a separate line item in the above analysis and will be allocated to functions of the Government once decisions are made in future Budgets.

The accompanying notes and accounting policies are an integral part of these Statements.

Forecast Statement of Comprehensive Income for the years ending 30 June

Forecast Statement of Changes in Net Worth for the years ending 30 June

The accompanying notes and accounting policies are an integral part of these Statements.

Forecast Statement of Cash Flows for the years ending 30 June

1. Excludes purchases by ACC and NZS Fund.
2. Further information on the proceeds and repayments of government bonds is available in note 23.

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 Financial Position as at 30 June

1. Tertiary education institutions constitute most equity accounted investments.

The accompanying notes and accounting policies are an integral part of these Statements.

Forecast Statement of Borrowings as at 30 June

Notes on borrowings

Total borrowings can be split into sovereign-guaranteed and non-sovereign-guaranteed debt. This split reflects the fact that borrowings by SOEs and Crown entities are not explicitly guaranteed by the Crown. No debt of SOEs and Crown entities is currently guaranteed by the Crown.

1. Core Crown borrowings in this instance include unsettled purchases of securities (classified as accounts payable in the Statement of Financial Position).
2. Gross sovereign-issued debt (GSID) represents debt issued by the sovereign (the core Crown) and includes any government stock held by the other Crown reporting entities.
3. Core Crown financial assets exclude receivables.
4. Net core Crown debt represents GSID less financial assets. This can provide information about the sustainability of the Government's accounts, and is used by some international agencies when determining the creditworthiness of a country.
5. Adding back the NZS Fund assets provides the financial liabilities less financial assets of the core Crown, excluding those assets set aside to meet part of the future cost of New Zealand Superannuation.
6. Net core Crown debt (excluding NZS Fund and advances) excludes financial assets which are held for public policy rather than treasury management purposes.
7. The Reserve Bank has used $1.6 billion of settlement cash to purchase reserves that were to have been funded by the NZDMO borrowing. Therefore, the impact of settlement cash on GSID is adjusted by this amount.

Statement of Actual Commitments as at 31 October

Statement of Actual Contingent Liabilities and Assets as at 31 October

1. The increase of $639 million since 30 June 2015, largely reflects the Government's contingent liability as a result of recently agreeing to be a founding member of the Asian Infrastructure Investment Bank.

More information on contingent liabilities (quantified and unquantified) is outlined in the Specific Fiscal Risks chapter.

The accompanying notes and accounting policies are an integral part of these Statements.

Notes to the Forecast Financial Statements#

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NOTE 1: Sovereign Revenue (Accrual)

1. Customs excise-equivalent duty.

NOTE 1 (continued): Sovereign Receipts (Cash)

NOTE 2: Interest Revenue and Dividends

NOTE 3: Transfer Payments and Subsidies

NOTE 4: Personnel Expenses

NOTE 5: Depreciation and Amortisation

NOTE 6: Other Operating Expenses

NOTE 7: Finance Costs

NOTE 8: Insurance Expenses

NOTE 9: Forecast New Spending and Top-down Expense Adjustment

Unallocated contingencies represent expenses included in Budget 2015 and previous Budgets that have yet to be allocated. Forecast new spending indicates the expected spending increases from future Budgets.

The forecast for new operating spending for Budget 2016 is $1 billion. Some of this allowance has been pre-committed as at the forecast finalisation date of 27 November 2015, with only the unallocated portion of the allowance included in this note.

Unallocated contingencies represent capital spending from Budget 2015 and previous Budgets that has yet to be allocated. Forecast new spending indicates the expected capital spending increases from future Budgets.

The forecast for new capital spending for Budget 2016 is $1.7 billion, which includes $0.7 billion that was left in the Future Investment Fund. Some of the allowance has been pre-committed as at the forecast finalisation date of 27 November, with only the unallocated portion of the allowance included in this note.

NOTE 10: Net Gains and Losses on Financial Instruments

NOTE 11: Net Gains and Losses on Non-Financial Instruments

NOTE 12: Operating Balance (excluding Minority Interests)

NOTE 13: Financial Assets (including receivables)

NOTE 14: Student Loans

NOTE 15: Property, Plant and Equipment

1. Using a revaluation methodology unless otherwise stated.

1. Other mainly includes transfers to/from other asset categories.
2. These additions do not include any purchases which may result from the allocation of the forecast for new capital spending (separately disclosed in the Statement of Financial Position).

NOTE 16: Intangible Assets and Goodwill

NOTE 17:  NZ Superannuation Fund

NOTE 18: Payables

NOTE 19: Insurance Liabilities

ACC liability

Calculation information

PwC NZ has prepared an independent actuarial estimate of the ACC outstanding claims liability as at 30 June 2015. This estimate includes the expected future payments relating to accidents that occurred prior to balance date (whether or not the associated claims have been reported to, or accepted by, ACC) and also the expected future administrative expenses of managing these claims. The assumptions underpinning this valuation form the basis of the five-year forecast of the outstanding claims liability.

The key economic variables that impact on changes to the valuation are the long-term Labour Cost Index (LCI), average weekly earnings and the discount rate. Discount rates were derived from the yield curve for New Zealand Government bonds. For these forecast statements, the claims liability has been updated for the latest discount rates as at 30 September 2015. The equivalent single effective discount rate, taking into account ACC's projected future cash flow patterns, is 4.16% and allows for a long-term discount rate of 5.5% from 2052.

Other key variables in each valuation are the forecast increases in claim costs over and above the economic variables above, and the assumed rate at which long-term claimants will leave the scheme over the period. This assessment is largely based on scheme history.

Presentation approach

ACC has available to it a portfolio of assets that offset the claims liability. The assets below (less cross-holdings of NZ Government stock) are included as assets in the Statement of Financial Position.

EQC liability

Calculation information

Melville Jessup Weaver prepared an independent actuarial estimate of the EQC outstanding claims liability at 30 June 2015 by estimating the projected ultimate claims costs then deducting the payments made in relation to those claims on or before that date. Each component of the claims liability was split into separate groups depending upon the Canterbury earthquake event grouping or other "business as usual" claims. These event groups were further split into sub-claim valuation groups being land claims, building claims or contents claims. The assumptions underpinning the 30 June 2015 valuation form the basis of the five-year forecast of the outstanding claims liability.

Critical assumptions used in projecting the ultimate costs include apportionment of costs across earthquake events, the profile of claims settlement, claims inflation rate per annum, risk margins and claims handling costs.

There is a high level of uncertainty associated with the valuation of the outstanding claims liability, reinsurance recoveries and unexpired risk liability. Some of the key uncertainties are: a complex land claims environment as policy, engineering and legal difficulties are worked through and complexity of the remaining dwelling claims and the expectation that some claims will need to be reopened to rectify outstanding issues.

The actual claims outcome may differ from the one currently forecast.

Presentation approach

EQC reinsurance recoveries are included in receivables in the Statement of Financial Position.

NOTE 20: Retirement Plan Liabilities

The net liability of the Government Superannuation Fund (GSF) was calculated by GSF's actuary as at 30 September 2015. The liability arises from closed schemes for past and present public sector employees as set out in the Government Superannuation Fund Act 1956. A Projected Unit Credit method was used to calculate the liability as at 30 September 2015, based on membership data as at 30 June 2015 with adjustments for cash flows to 30 September 2015. The funding method requires the benefits payable from GSF in respect of past service to be calculated and then discounted back to the valuation date.

For these Forecast Financial Statements, the net GSF liability was updated for the latest discount rates derived from the market yield curve for New Zealand Government bonds as at 30 September 2015.

Other principal long-term financial assumptions were an inflation rate, as measured by the Consumers Price Index (CPI), of 1.28% for the year to 30 June 2016, increasing to 1.28% for the 11 years to 30 June 2026, then increasing gradually each year reaching to 2.5% from 2052 and remaining at 2.5% pa for all years after that. In addition an annual salary growth rate, before any promotional effects, of 3% (unchanged from 30 June 2014).

The 2015/16 projected decrease in the net GSF liability is $94 million, reflecting a decrease in the GSF liability of $209 million and a decrease in the GSF net assets of $115 million.

The decrease in the GSF liability of $209 million includes an actuarial loss between 1 July 2015 and 30 September 2015, of $171 million, owing to movements in the discount rates offset by the impact of movements in CPI rates and changes in the demographic assumptions. The remaining $10 million reduction is owing to lower than expected benefits to members (reduces the liability), offset by current service cost and interest unwind (increases the liability).

The decrease in the value of the net assets of GSF of $115 million includes a loss of $171 million reflecting the updated market value of assets at 30 September 2015. The balance of $56 million is the total of the expected investment returns and contributions received, offset by the benefits paid to members.

The changes in the projected net GSF liability from 2015/16 onwards reflect the net of the expected current service cost, interest cost, investment returns and contributions.

NOTE 21: Provisions

Provision for ETS credits

The Emissions Trading Scheme (ETS) was established to assist New Zealand in meeting its international climate change obligations and to reduce New Zealand's net emissions of greenhouse gases to below business-as-usual levels. The ETS creates a limited number of tradable New Zealand Units (NZUs) which the Government can allocate.

The allocation of NZUs creates a provision if allocated for free; the provision is reduced, and revenue recognised, as NZUs are surrendered to the Crown by emitters.

The prices for NZUs used to calculate the ETS provision are assumed to remain constant over the forecast period and are based on market prices during September 2015.

The ETS impact on the fiscal forecast is as follows:

NOTE 22: Changes in Net Worth

NOTE 23: Core Crown Residual Cash

1. Short-term borrowing consists of Treasury Bills and may include Euro-Commercial Paper.

Forecast Statement of Segments#

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