Monthly Economic Indicators September 2008

Executive Summary#

Commentary#

The month of September provided confirmation that economic activity in New Zealand declined in the first two quarters of 2008. Indicators relating to the September quarter also suggest that a further contraction is probable. Considerable uncertainty surrounds the outlook for the world economy with significant financial market turmoil again coming to the fore. This month’s special topic focuses on these international financial market developments.

Amidst these developments, Treasury has prepared its Pre-election Economic and Fiscal Update. This highlights a much weaker outlook for the economy than was contained in the Budget Update. The economic forecasts were finalised in late August when we made some allowance for the likelihood of weaker world growth. We still expect the New Zealand economy to evolve broadly in line with the Pre-election Update forecasts. However, given recent global financial market developments, considerable uncertainty exists around this outlook, with the risks increasingly moving to the downside.

New Zealand has experienced two consecutive quarterly declines in GDP#

Real production GDP fell 0.2% (seasonally adjusted) in the June quarter, after a fall of 0.3% in March. The decline was not as large as the market and we were predicting. Annual average growth eased to 2.6% in the year ended June 2008 from 3.2% (revised up from 3.0%) in the year ended March 2008.

Figure 1 – Real production GDP

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Source:  Statistics NZ

The decline reflected easing household demand and increasingly cautious behaviour by businesses, with lower construction and wholesale and retail trade making the largest negative contributions to the June quarter result.

The fall in retail and wholesale trade, together with a decline in the finance, insurance and business services industry (driven partly by a fall in real estate services), meant that the overall services sector made its first negative contribution to growth since September 2002.

Drought played an important role#

The 2007/08 drought continued to affect the performance of some industries in the June quarter. Agricultural production fell, but additional drought-induced slaughter of stock contributed to a rise in primary food manufacturing, meaning that in aggregate the agriculture and primary food manufacturing sector made no contribution to growth. Electricity gas and water production were also affected as electricity production was switched from hydro to other higher cost (hence lower value added) methods.

Real expenditure GDP fell 0.5% in the June quarter. Theoretically, the expenditure and production measures should be the same, but they often differ due to the use of different data sources. The largest fall came from residential investment, illustrating the current weakness in the housing market.

First successive consumption decline in 16 years#

The fact that households have been under pressure from rising living costs, including higher food and petrol prices, as well as rising debt servicing costs, was reflected in the private consumption figures. Real private consumption fell 0.3% in the quarter following a 0.4% decline in March. The previous time two consecutive declines in private consumption occurred was in 1992.

Business investment increased 6.1% in the quarter to contribute 0.9%pts to growth. Much of this investment was due to the purchase of an oil rig and floating platform which contributed to plant and machinery investment increasing by 15.6% in the June quarter. However, the fact that these large pieces of equipment were imported meant that higher investment did not contribute much to GDP growth in the quarter, once imports are netted off. Import volumes increased 3.3% in the quarter to subtract 1.3%pts from GDP.

Drought-affected dairy production had a major influence on goods export volumes which fell 1.8%, including a 17.7% decline in dairy exports. This was partly offset by a slight increase in services exports as exports of travel services recorded their first increase for a year.

Price falls also drove nominal GDP lower#

A 0.5% decline in the GDP deflator compounded the 0.5% fall in real expenditure GDP to mean that nominal GDP fell 1.0%. The fall in the deflator was largely associated with rising import prices and a small fall in export prices. Residential building prices also fell, down 0.2% in the quarter, the first decline since the start of 2002.

In an environment in which households are under pressure from high living and debt servicing costs, businesses are facing rising costs and more uncertain demand, as well as intensifying uncertainty in global financial markets, domestic demand growth is expected to remain weak during the next year.

We believe, as in the Pre-election Update forecasts, that GDP will decline slightly in the September quarter before quarterly growth returns to positive territory in the final quarter of 2008 due to the tax cuts and the recovery from the drought. The Pre-election Update forecasts predict that in the year to March 2009 real production GDP will experience minimal growth of 0.1%. With production GDP a little stronger than predicted in June but global conditions worsening, this still seems a reasonable estimate.

Current account deficit widens …#

In annual terms, the current account deficit widened to nearly $15.0 billion, or 8.4% of nominal GDP in June. In seasonally adjusted terms the quarterly deficit increased $1.1 billion to $4.6 billion. The deficit was larger than expected and fell outside the range of estimates of surveyed market participants.

The increase in the quarterly seasonally adjusted deficit was due to increases in each of the goods, services and investment income deficits. The goods deficit widened due to increasing imports, particularly capital equipment (including the oil rig and floating platform mentioned earlier) and petroleum-related products, while lower dairy exports contributed to a fall in total exports.

Oil-related activity also contributed to the higher services deficit due to an increase in oil exploration and production services purchased from abroad. Higher income earned by foreign investors from their New Zealand investments was the main driver of the increase in the investment income deficit.

Figure 2 – Current account

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Source:  Statistics NZ,

… and debt increases#

New Zealand’s net international investment position was a net debtor position of $159 billion, or 89% of GDP. In June 2007, New Zealand had a net debtor position of $149 billion. The biggest contributor to this change was an increase in net debt, which now accounts for 93% of New Zealand’s net international investment position.

The annual current account deficit is likely to show small increases over 2008 prior to a narrowing over the medium term as a weak outlook for domestic demand lowers imports and export values recover as the exchange rate declines. However, rising debt servicing costs stemming from the current financial market turmoil suggest that the balance of risks is tilted to the current account deficit remaining higher for longer given there is likely to be limited scope for short-term reductions in the investment income deficit.

At $750 million, the merchandise trade deficit for the month of August took the annual trade deficit to $4.3 billion, $2 billion smaller than the annual deficit in August 2007. We expect the annual goods deficit in the current account to narrow slightly in the September quarter, before increasing in the final quarter of 2008.

Terms of trade fall#

After reaching their highest level in over thirty years following a run of six quarterly increases, the merchandise terms of trade fell 0.5% in the June 2008 quarter. The fall was the result of import prices (up 4.8%) increasing at a faster rate than export prices (up 4.4%). Higher prices for oil and petroleum products were the main driver of higher import prices. In addition to higher oil prices, higher prices for food and beverages drove the increase in export prices.

With both exports and imports equivalent to just over 30% of nominal GDP, movements in export and import prices (and consequently the terms of trade) are an important influence on nominal GDP and tax revenue. The terms of trade are also one channel through which global developments can be transmitted to the NZ economy. We will continue to monitor terms of trade developments as concerns mount about the extent to which financial market developments will impinge on real activity.

The terms of trade appear to have peaked in the March 2008 quarter, with further falls likely, as recent declines in international dairy prices are reflected in the price received for New Zealand’s dairy exports. Nevertheless continuing demand for protein from developing countries is likely to mean that despite falling over time, the terms of trade are likely to remain at relatively high levels by historical standards.

Figure 3 – Merchandise terms of trade

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Source:  Statistics NZ

A weakening outlook for world growth was one factor behind the ANZ commodity price index (in world price terms) recording a 4.9% fall in September, including a 7.9% decline in dairy prices.

Protracted downturn in domestic demand#

The Pre-election Update forecasts predict that domestic demand will face a protracted period of weakness. Key components of domestic demand such as private consumption, and residential and market investment are not expected to show a sustained acceleration in quarterly growth until the 2010 calendar year and even then private consumption growth will remain modest. Factors behind this weakness have been well canvassed in previous MEIs. They include rising living costs (with poor growing conditions the latest, but temporary, contributor to rising food prices which increased 10.6% between August 2007 and 2008), high debt levels and debt servicing costs, falling housing and financial wealth and decreased job security. This flows through to a weak demand environment for firms who are at the same time facing rising costs.

Retail sales fall in July#

Total retail sales fell 0.8% in the month of July, driven lower by weaker supermarket and grocery store sales as well as lower motor vehicle retail spending. Core sales, which exclude automotive related industries, also fell (down 0.2%). On a more positive note, total retail store spending on electronic cards increased 1.1% in August. However, given the weak start to the quarter and that a reasonable part of the August increase will have reflected higher prices, it is unlikely that real private consumption will experience much growth in the September quarter.

Consumer confidence rebounds#

Consumer confidence rebounded into optimistic territory in the September quarter with the Westpac McDermott Miller measure increasing to 104.8 from 81.7 in June, a record increase for this measure.

The increase in confidence can be attributed to several factors. Petrol prices have eased back below $2 per litre from their peak of around $2.20 in July, the Reserve Bank has begun cutting interest rates, and tax cuts were not too far away when participants were surveyed. However, the survey was taken before the most recent US financial market events, which are likely to dent confidence throughout much of the world. Even with the latest rebound, consumer confidence is still significantly below the average level of the last decade. While we expect a 0.6% increase in private consumption in the December quarter as the tax cuts take effect, we are not predicting much further growth over 2009.

Business confidence also surged in September according to the National Bank Business Outlook. Headline business confidence turned positive for the first time since May 2002. Firms’ own activity expectations also climbed with a net 16.7% of firms expecting their own activity to increase, up from 4.7% in August. We place low weight on these confidence figures given most responses were received prior to the recent escalation of global events.

Net migration eases#

The annual gain from permanent and long term migration slipped back in August to 4,900 from 5,200 in the 12 months to July. In the year to August 2007, net migration added 8,700 people to New Zealand’s population. The main reason for this fall has been a faster increase in departures of New Zealand residents than in arrivals of overseas migrants and returning New Zealanders. The increase in departures has been particularly to Australia.

Housing market continues to weaken#

Housing market data released in September shows an ongoing weakening is occurring. Data released by the REINZ showed the weakest monthly house sales in 26 years. In the first 8 months of 2008, REINZ members have sold 38,500 houses, down from 65,900 over the same period in 2007, with the implications for incomes and jobs in this sector obvious. Housing wealth is also beginning to be hit at an accelerating rate with the REINZ recording a fall in its median sales price of 5.7% in the last 12 months and QVNZ data showing that the average selling price in the 3 months to August 2008 was down 4.5% compared to the same 3 months last year.

Figure 4 – House sales

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Source:  REINZ

Consents for new dwellings experienced their fourth successive monthly decline in August, down nearly 8% (including apartments). This indicates that residential investment is likely to remain in decline for some time. The Pre-election Update forecasts incorporate a view that quarterly residential investment growth will remain negative until the end of 2009.

OCR cut by 50 basis points#

On 11 September, the Reserve Bank cut the official cash rate (OCR) from 8.0% to 7.5%. The 50 basis point cut was larger than the 25 basis point cut the market was generally expecting. The larger cut reflected the Bank’s desire to accelerate the flow-on effects of a lower OCR to the interest rates that influence the household and business sectors, particularly in light of a correctly perceived further deterioration in international financial markets. Market participants are now predicting a similar sized cut in the next OCR announcement.

Ninety-day bank bill yields fell from near 8.1% to around 7.8% following the larger than expected cut in the OCR but rose back to around 8.1% later in the month as risk premiums increased due to the increased financial market turmoil. Volatility was also apparent in foreign exchange markets where the New Zealand dollar fell from just above 65 on a trade weighted basis at the start of the month to just over 63 by month end. The greatest depreciation was against the Japanese Yen, but the dollar also fell against the US dollar, British Pound and Euro, but gained around 2 cents against the Australian dollar.

Oil prices trend down but remain volatile#

West Texas Intermediate oil prices began September at around US$116 per barrel and fell to US$91 per barrel amidst concern of weaker world growth stemming from deteriorating financial market conditions. A degree of confidence returned to markets as the US government worked its way through the originally proposed US$700 billion rescue package and oil prices regained some of their lost ground, only to fall sharply when the proposed package failed to be passed by the House of Representatives. Oil prices ended the month around US$101. However, prices remain volatile with the price of oil experiencing both its largest daily decline ever and its largest daily increase during September.

Financial market developments to remain to the fore#

Developments in global financial markets will remain the focus of attention in October as markets respond to any assistance package that is passed in the US. In New Zealand, key pieces of economic data to be released include the NZIER’s Quarterly Survey of Business Opinion and the September quarter CPI. Market participants will also be keeping a keen eye on how the Reserve Bank responds to recent developments when it announces its review of monetary policy on 23 October.

Special Topic: Global financial developments#

This special topic briefly discusses the main developments in the global financial crisis which intensified in September and their likely impact on the New Zealand economy.

Crisis of confidence in financial markets …#

The background to the crisis lies in the sustained period of rapid credit growth, fuelling booms in housing and other asset prices, which occurred in the US and many other countries, including New Zealand, over the past decade. The trigger for the recent developments was a series of defaults on sub-prime mortgages in the US a year ago, but the crisis is now affecting a broader range of financial assets and has spread to a large number of other countries as the global housing boom begins to unwind.

The crisis is spreading because of a loss of confidence in the value of financial and other assets. Financial intermediaries are unwilling to lend to each other because they are not sure of the solvency of those they are dealing with. This has resulted in financial markets becoming dysfunctional, with limited or no funds available for borrowing and lending and central banks in many countries becoming a “lender of first resort”.

… led to higher market interest rates …#

Although several central banks have lowered official interest rates, many market interest rates have actually increased to reflect the heightened risk of default. This is affecting all borrowers, including New Zealand banks seeking funding in global markets. At the same time, interest rates on government bonds (which carry a low probability of default) have fallen as investors have rushed to buy them and so the return which can be earned on funds is low. So far, exchange rates have not changed significantly, perhaps because all of the major currencies and economies are affected.

… and falls in equities and commodities#

Share and commodity prices have been highly volatile and have fallen as the outlook for world growth is re-assessed. The Dow Jones index of the US share market lost 6% over the month (including experiencing its largest one-day fall and increase since September 2001) and other markets declined similarly. Share prices for financial institutions have been marked down most heavily.

Commodity prices have also fallen as the prospects for world growth have been revised downwards. Prices for West Texas Intermediate oil declined from around US$110 at the beginning of September to a low of US$91 mid-month; they spiked a couple of days later as traders scrambled to close out their positions before a contract was settled, but declined again to US$100 at the end of the month. Commodity prices declined generally, including international dairy prices.

In the past month, an increasing number of financial institutions have failed, both in the US and Europe, as falling asset values undermined investor confidence and made it difficult for those institutions to obtain funding, especially in wholesale markets.

Range of responses to financial failures …#

Governments have adopted a range of responses to financial firms experiencing difficulties. In the US, investment bank Lehmans was allowed to fail. In other cases, governments have arranged takeovers by other financial institutions. In the US, Merrill Lynch was sold to Bank of America, Washington Mutual to JP Morgan, and Wachovia to Citigroup. In the UK, Lloyds has agreed to take over Halifax Bank of Scotland (HBOS).

A third response of governments was to directly re-capitalise threatened firms. This was the approach the US government adopted with the federal mortgage agencies, Fannie Mae and Freddie Mac, as well as for insurer AIG. This approach has also been widely adopted in Europe, for example Bradford & Bingley (a mortgage lender in the UK), Fortis (a financial services firm in northern Europe), Dexia (a French-Belgian bank) and a number of others. In Ireland, the government guaranteed the deposits of four banks and two building societies.

Central banks in the US and elsewhere have reacted to these developments by increasing liquidity and accepting a wider range of securities. In New Zealand, the Reserve Bank extended its liquidity arrangements and has lowered the Official Cash Rate (OCR) by 75 points to offset some of the higher finance costs for NZ banks.

… including a plan to support markets#

The most significant response so far is the development of a plan by the US Treasury to purchase “troubled assets” in the residential and commercial mortgage sector. The plan aims to restore confidence and the functioning of credit markets. The purchase of such assets is intended to underpin financial markets by setting a price for them and bring confidence to both housing and financial markets, limiting further falls in house prices and removing some of the uncertainty in financial markets. The plan, which looks likely to be approved by the US legislature, may make a helpful contribution to gradually restoring confidence in these markets. However, it will take time to implement, is limited to the US and is unlikely to end the crisis on its own.

Implications for New Zealand#

The most direct impact of the current financial crisis on the New Zealand economy is through access to and the cost of credit. Local banks are dependent upon overseas markets for around one third of their borrowing and much of this is relatively short term and has to be re-financed regularly. At present, markets for these funds are highly illiquid and when funds are available, their cost is higher. The pressures are likely to be greatest on institutions with high rates of household lending and extensive exposure to wholesale funding. Banks will pass on higher borrowing costs which will affect firms’ investment plans and households’ expenditure decisions. Borrowing rates facing NZ firms and households are now higher relative to wholesale rates than a year ago before the crisis began (Figure 5).

The effects of the crisis on local firms can already be seen with two companies postponing developments in primary processing at least partly because of the difficulty of raising funds and/or uncertainty about the state of global markets. With a high rate of foreign ownership of the NZ corporate sector, investment plans could be put on hold if foreign parents face credit constraints in their own markets.

In the medium term, the main impact of the crisis will be on world growth and demand for NZ’s exports, both goods and services. A weaker outlook for world growth is already being reflected in sharply lower prices for dairy products. It should be noted that there was rapid credit growth in the dairy industry in recent years to purchase land for conversions, much of it at values related to previous high prices.

Figure 5 – NZ interest rates

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Source:  Reserve Bank of New Zealand

A key channel for the transmission of the financial crisis to New Zealand will be the Australian economy with which NZ is closely integrated. Lower demand for Australian resource exports, largely dependent on demand from Asia, would be reflected in lower demand from Australia for a range of NZ goods and services. In addition, New Zealand has strong links to Australia through Australian ownership of the four main NZ banks.

In the Pre-election Update, which was completed some weeks ago, it is assumed that world economic growth will be weaker than in the latest Consensus forecasts, but that the financial crisis will be resolved relatively quickly. The Pre-election Update includes an alternative scenario to capture the risk of even lower world growth and greater financial dislocation and its effects on the New Zealand economy. In that scenario, growth in real GDP would be 0.3 and 0.6 percentage points lower in the March 2009 and 2010 years respectively, commodity prices would decline further and the exchange rate would be lower.

New Zealand Key Economic Data#

Quarterly Indicators#

Monthly Indicators#