NEW ZEALAND ECONOMICS ANZ ECONOMIC OUTLOOK

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1 ANZ RESEARCH NEW ZEALAND ECONOMICS ANZ ECONOMIC OUTLOOK MARCH 214 INSIDE Key Economic Forecasts 2 NZ Economic Outlook 3 Global Outlook 7 Commodity Prices 8 Labour Market 9 Fiscal Policy 1 Inflation 11 Exchange Rate 12 Interest Rates 15 Economic Forecasts 18 Key Economic Indicators 19 NZ ECONOMICS TEAM Cameron Bagrie Chief Economist Telephone: Cameron.Bagrie@anz.com David Croy Head of Global Markets Research, NZ Telephone: David.Croy@anz.com Mark Smith Senior Economist Telephone: Mark.Smith2@anz.com Sharon Zöllner Senior Economist Telephone: Sharon.Zollner@anz.com Carrick Lucas Strategist Telephone: Carrick.Lucas@anz.com Steve Edwards Economist Telephone: Steve.Edwards@anz.com Con Williams Rural Economist Telephone: Con.Williams@anz.com Sam Tuck Senior FX Strategist Telephone: Sam.Tuck@anz.com JOYRIDE NEW ZEALAND ECONOMIC OUTLOOK The economy is firmly into a broad-based economic expansion and we re picking 3 percent plus growth over the coming 2 years. Prospects for strong growth mask frictions and tensions, a fact that means attention must be paid to the microeconomic picture. One of the economy s biggest challenges over coming years will be expanding its supply-side capacity and restraining consumption spending. Productivity growth also needs to lift: we re positive on this front. GLOBAL OUTLOOK The global economy is expanding solidly but this masks disparate performances. We ve pencilled in respectable growth in aggregate. Emerging market economies with weak fundamentals will remain under the spotlight as liquidity-driven support is removed. There will be wobbles. COMMODITY PRICES The outlook for farm-gate prices remains solid for most primary sectors. Just about all the main sectors are set to record a decent lift in farm-gate prices in 213/14. Dairy prices in 214/15 are expected to moderate somewhat from this year s record, but most other sectors are expected to experience further incremental lifts. LABOUR MARKET The labour market improvement is broadening through the economy, though the construction sector is likely to continue to lead the charge for quite some time yet. We expect the unemployment rate to gradually trend lower over the next year or so, with a mismatch of skills the primary roadblock to a more marked fall. Modest employment and wage growth will underpin moderate rates of consumer spending. FISCAL POLICY NZ s Crown accounts remain on track to return to surplus by 214/15, with solid revenue growth and ongoing spending restraint helping to contain net debt, now projected to peak below 27 percent of GDP. We expect the fiscal stance to remain tight for years to come, though some election sweeteners (funded via reprioritised spending) are likely pre-budget. INFLATION Inflation is expected to drift higher over the next couple of years. The strengthening domestic expansion remains the dominant driver of the rising trajectory, with a productivity uplift and proactive central bank capping the magnitude. However, risks look skewed to the upside. EXCHANGE RATE We expect the NZD to remain elevated on domestic support factors (high yield), but the domestic crutch to be progressively usurped by a re-assertive USD over the projection period. The highs in NZD/AUD are in, but we expect the cross to remain elevated until solid evidence of Australian economy turning the corner emerges. INTEREST RATES We expect three OCR hikes by mid year, a stop-start tightening profile thereafter, and a relatively low OCR endpoint by historical standards. That s a reflection of the punch monetary policy will achieve, and also recognition of imbalances across the wider economy. Local bond yields are expected to rise gradually in coming years, albeit outperform the anticipated normalisation in global bond yields as major central banks begin lifting official interest rates from 215.

2 ANZ Economic Outlook / March 214 / 2 of 21 KEY ECONOMIC FORECASTS Calendar Years (e) 214(f) 215(f) 216(f) 217(f) NZ Economy (annual average % change) Real GDP Employment Unemployment Rate (Dec qtr) Terms of trade (SNA basis) Global Growth (annual average % change) US Eurozone Australia Japan China Trading Partners NZ Inflation (annual % change) CPI Inflation Non-tradable Inflation Tradable Inflation NZ Financial Markets (end of December quarter) TWI NZD/USD NZD/AUD Official Cash Rate day bank bill rate year bond rate Fiscal and External Balance Current Account Balance ($bn) as % of GDP Government OBEGAL ($bn)* as % of GDP * Operating balance excluding gains and losses, June years. Forecasts and text finalised 6 March 214. KEY FORECAST ASSUMPTIONS: The value of earthquake reconstruction work is equivalent to $4bn in 213 dollars. This will be spread across residential ($2bn), commercial and social assets ($15bn), and infrastructure ($5bn). Slightly less than half of this work is assumed to take place by the end of 216. This will be partly diluted by contractionary fiscal policy, equivalent to around 4 percent of GDP over the projection period. The NZD is assumed to gradually ease from around 84 US cents at present, ending 214 at around 78 cents and 215 at 76 cents. The NZD is assumed to hover around 9 Australian cents, ending 214 at 93 cents, and 215 at 89 cents. The NZD TWI is projected to fall from 78.5 at present to 71.1 by late 215. Dubai oil prices are assumed to trade within a US$95 to US$115 per barrel range over the forecast period. Net annual permanent and long-term (PLT) migration inflows are assumed to peak at just over 3, persons over 214, before tapering off progressively over the projection period and ending 217 slightly below 2, persons. Medium-term potential growth is expected to remain around 2½ percent. Bank funding costs are assumed to continue to gradually decline from current levels. This will push the neutral OCR from around 4 percent at present towards 4½ percent by the end of the projection period.

3 ANZ Economic Outlook / March 214 / 3 of 21 NEW ZEALAND ECONOMIC OUTLOOK SUMMARY The economy is firmly into a broad-based economic expansion and we re picking 3 percent plus growth over the coming 2 years. Despite a robust outlook, risks and vulnerabilities remain. The global expansion remains finely balanced. Our national balance sheet is still weak and there is limited scope for a borrowand-spend upswing. Prospects for strong growth mask frictions and tensions, a fact that means attention must be paid to the microeconomic picture. One of the economy s biggest challenges over coming years will be expanding its supply-side capacity and restraining consumption spending so as to prolong the expansion. Productivity growth also needs to lift: we re positive on this front. IN ALIGNMENT Economic indicators are in agreement that NZ s economic momentum is lifting. There are obvious drivers in the form of accommodative financial conditions, the $4bn Canterbury rebuild, our increased purchasing power as a nation provided by a goods terms of trade at 4-year highs, and record commodity export prices. A net immigration assisted pick-up in population is also providing a boost. Business confidence is at 2-year highs and consumers are also in a positive frame of mind. What is particularly striking is the sheer number of positives out there, but these should be read in conjunction with some of the more fundamental influences shaping the medium-term outlook: The national balance sheet is still weak: net external debt at around two-thirds of GDP is world class at the wrong end of the spectrum. The household saving rate is a big doughnut. That means limited scope for a pro-cyclical borrow-andspend recovery. The economy still needs to deleverage; we don t need to scrimp, but income growth needs to exceed spending growth, given the realities of a poor national and household saving performance. Fiscal policy is contractionary. The NZ Government is on track to deliver a surplus in 214/15. That means more money will be taken out of the economy in taxes than the Government puts back in. That s an economic headwind. The NZD is a drag on activity. The TWI is around 25 percent above historical averages, presenting a significant headwind to tradable sector firms that are not benefiting from high commodity prices. While much is penned about the NZD/USD, the NZD/AUD has rocketed from significantly under-valued to significantly overvalued within a year, and we suspect it will remain high, kicking away an important crutch of support to the wider export sector. The connectivity story with Asia is ongoing. Soft commodity prices are elevated, China has surpassed Australia as our #1 merchandise export destination, and visitor arrivals from China increased by 2 percent in 213. There are wider opportunities in South America and wealthier parts of the Middle East, as well as the broader Asia region. The global scene may appear stable, but risks of an accident are clear as the exceptional policy stimulus experiment is wound down. Markets are nervously eyeing emerging markets including China, New Zealand s largest trading partner. A concerted period of strong demand in one sector of the economy. The combination of the $4bn Canterbury rebuild, addressing housing shortages in Auckland and Christchurch, in addition to demand elsewhere, represent a huge construction growth pipeline. Meeting the demands will entail trade-offs, but these will ultimately provide the means through which a more sustainable balance to growth can be achieved. Other forces are material too, but don t make the top list. The leaky homes crisis is still hugely relevant. There is the lagged effect of kiwifruit Psa still being worked through. Many sectors have outstanding trade issues with China and other emerging markets that need to be worked through. 214: TAKE-OFF We estimate that the economy ended 213 with a reasonable degree of momentum, with the expansion broadening from construction and agriculture to include manufacturing and parts of the services sector. Household spending has also picked up as incomes have lifted, but as we shall see, not going on a debtfuelled spending binge holds the key to prolonging the expansion. We have pencilled in around 3½ percent growth for 214. Growth is being led by the pro-cyclical parts of the economy, which are recovering from multi-year lows. Pent-up demand is starting to be unleashed. Despite the economy having been on the expansion path since 211, per-capita GDP is only back to where it was at the end of 27. The level of business investment has increased by close to 5 percent since its 29 trough but is only back to

4 ANZ Economic Outlook / March 214 / 4 of 21 NEW ZEALAND ECONOMIC OUTLOOK where it was in 27 and is a smaller share of economic activity. A similar recovery has been evident for residential investment, but levels are still below where they were a decade ago. Percent of GDP Construction shares of GDP Share (LHS) Sources: ANZ, RBNZ, Statistics NZ Rebuild (RHS) Percent of GDP The $4bn Canterbury rebuild and more housing for Auckland represents a long pipeline to fill. A concerted period of under-building relative to resident population growth and the Canterbury earthquakes has left housing shortages in our two largest centres that need to be addressed. The additional construction work will generate work in other sectors, with the manufacturing sector set to be a major beneficiary. The goods terms of trade are at 4-year highs, with our spending power as a nation at generational highs. Export commodity prices are at historically elevated levels, with dairy incomes set to lift more than $4bn from the previous season hardly small change. Low (but lifting) interest rates and strengthening net immigration add to the mix. The news is not so good for the rest of the tradable sector, with the high NZD ensuring some of the benefits are conferred on importers and the spending side of the economy. Despite this, however, overall financial conditions remain accommodative. Little wonder that confidence is high on both sides of the income and spending equation. Consumer and business confidence are strong: our composite growth indicator that merges the two flags booming prospects. It is not just a construction or a dairy story; what we are seeing is a broad-based uplift in sentiment across regions and sectors. Capacity-enhancing as well as efficiency-enhancing investment will be the order of the day, with firms increasing employee headcount Annual % change GDP vs Confidence Composite vs FCI Standardised ANZ-RM Current Conditions and ANZBO Composite (adv 5m,LHS) GDP (LHS) FCI (adv 1m, RHS) Sourc es: ANZ, Roy Morgan, Statistics NZ, Westpac McDermott Miller The household sector is benefiting from a combination of tailwinds, with the labour market well advanced and net immigration on a strengthening trajectory. Net migration inflows have been concentrated in Auckland and Canterbury, further exacerbating housing shortages in these regions and underpinning significant lifts in house prices. We are of the view that the high-lvr speed limits put in place by the RBNZ have been effective in slowing housing market activity and will help slow house price inflation. But encouragingly, the lift in retail spending has been funded out of rising household incomes. Spending will need to remain below income growth so as to help rebuild nationwide saving and ensure that the economy can absorb the construction boom. Net balance Factor constraints 1 2 Labour (RHS) Sources: ANZ, Statistics NZ, NZIER Capacity (RHS) Sales (LHS) Net balance The major issue facing the economy these days is not whether the demand is there, but whether there will be sufficient labour, capital and expertise to translate good intentions into action. Our productivity track record has not been particularly flash, and while we are confident that firms have been achieving greater efficiencies behind the scenes and

5 ANZ Economic Outlook / March 214 / 5 of 21 NEW ZEALAND ECONOMIC OUTLOOK that the Government s reform agenda will generate incremental improvements, a prolonged period of 3+ percent growth will have consequences for the degree of resource stretch within the economy and hence the degree of inflationary pressure. 215: BUILDING ON THE FOUNDATIONS We are pencilling in slightly more than 3 percent growth for 215. With the expansion already well advanced, what happens over the next year or so will have a crucial bearing on the longevity of the domestic expansion. Firms, the Government and households face a choice. Do we pop the champagne corks now, or do we continue to focus on extracting greater efficiencies and improving execution? We are assuming NZ.Inc has learned a thing or two since the GFC. Our projections assume that household and government consumption will decline as a share of income over the next few years, i.e. grow more slowly than the rest of the economy. Not only will this help to partly rectify our shortfall of nationwide saving relative to our investment needs, but it will also free up resources that can be used to improve growth prospects and allow the economy to absorb the resource demands associated with a surge in investment activity. If this key assumption doesn t hold, prepare for the current account to blow out and inflation to ramp up. Percent of GDP 3 Total investment and consumption shares Investment (LHS) Percent of GDP 85 We expect construction sector activity to peak in late 216 as a share of GDP as the rebuild effort tops out. Providing that the necessary capacity can be found, construction sector activity will account for about one third of growth over the next few years. Canterbury Rebuild vs Fiscal Tightening Profiles (Contribution to Annual GDP) Annualised.8%.4%.% -.4% Rebuild Stimulus Assumed Multipliers +.75 Spending Fiscal Tightening -.25 Revenue -.8% Jun-12 Jun-13 Jun-14 Jun-15 Jun-16 Jun-17 Jun-18 Jun-19 Sources: ANZ, RBNZ, Treasury With the construction sector historically having tended to be one of the weaker productivity performers and an inflation hotspot, the rebuild will not be a win for all. Resources, particularly in the construction sector, will be stretched. Government priorities will put some projects at the head of the queue, and higher prices are the mechanism by which resources will be allocated to the remaining projects with the highest returns. Crowding out will occur. Current account balance and the terms of trade 25 8 Index 1,6 1,4 Current account (RHS) % of GDP (annual) ,2-2 Consumption (RHS) 1, Sources: ANZ, Statistics NZ Investment will be a major growth driver in the New Zealand economy over the medium term. This will take the form of not only construction sector investment, but also building up New Zealand s productive capital stock. As well as businesses, the Government will also be playing a key role, with the National Infrastructure Unit earmarking more than 3, infrastructure projects over the next 1 years, with a total spend of around $92bn Terms of Trade (LHS) Sources: ANZ, Statistics NZ Our high goods terms of trade and strengthening agricultural production will temporarily mitigate the impact of the high NZD on our external accounts, with sub-3 percent current account deficits in prospect over the early part of the projection period. However, the pipeline of rebuild growth is investment-centric not the export-led growth that

6 ANZ Economic Outlook / March 214 / 6 of 21 NEW ZEALAND ECONOMIC OUTLOOK New Zealand needs to restore its balance sheet and pave the way for a more sustainable upturn. Our projections assume that our current account deficit is largely capped by income growth. A bringing forward of consumer spending in anticipation of higher incomes would have implications for the mix of monetary conditions, and eventually the mix of growth. FRICTIONS While New Zealand can look forward to an enviable economic performance over the coming two years, the uplift masks frictions and tensions. There is a complex interplay of structural and secular influences impacting upon the outlook intertwined with cyclical stimulus such as monetary policy. The national balance sheet is telling us to save, whereas low interest rates are encouraging the reverse. Rising connectivity with Asia is allowing NZ to improve its balance sheet (debt to GDP ratio) via the denominator, namely GDP growth. A high NZD is going head to head with a 4 year high in the terms of trade; not all exporters benefit from high commodity prices. A city rebuild is up against contractionary fiscal policy. New Zealand s balance sheet is already housing-centric, and we need to build a lot more of them. This gives the economy something of a pushme-pull-you feel. Despite the broadening upturn, there are winners and losers, and question marks about the sustainability of the upturn should New Zealand not make wise choices. In such an environment attention needs to turn to the microeconomic picture. Today s smart decisions by firms, households and the Government are tomorrow s improved productivity statistics. In the end, productivity growth is a hugely important determinant of wealth and wellbeing. On the whole, we are encouraged by what we are seeing on the ground. The Government has realised it has a proactive role to play in managing the supply side response to both the Christchurch rebuild and Auckland housing shortages. Enhanced apprenticeships schemes, enquiries into construction costs, efforts to free up land for development these examples are encouraging. On the firm side, after the lean years of tepid growth following the recession, firms are fighting fit. Labour productivity has risen, and firms are now investing in both labour-saving and capacityenhancing capital. The last thing NZ needs right here and now is for complacency to set in. Don t be fooled by rock star connotations towards the New Zealand economy. We re still navigating a complex interplay of forces. NEW ZEALAND NATIONAL ACCOUNTS FORECAST Calendar years (average annual percent change) (e) 214(f) 215(f) 216(f) 217(f) Total Consumption Private Consumption Public Consumption Total Investment Residential investment Other investment Stockbuilding Gross National Expenditure Total Exports Goods Services Total Imports Goods Services Expenditure on GDP GDP (production based) Percentage point contribution to growth

7 ANZ Economic Outlook / March 214 / 7 of 21 GLOBAL OUTLOOK SUMMARY The global economy is expanding solidly but this masks disparate performances. We ve pencilled in respectable growth in aggregate. The US is expanding nicely, though this will bring associated challenges as extraordinarily levels of stimulus are wound back. Emerging market economies with weak fundamentals will remain under the spotlight as liquidity-driven support is removed. There will be wobbles. SOLDIERING ON The global economy is on an expansion path. The US is getting reasonable growth amidst fiscal austerity. Europe has emerged from recession. China is still growing strongly though at a less impressive pace. Incredibly supportive financial conditions continue to underpin growth trajectories. We ll gladly take the expansion, but deeprooted frictions remain. Quantitative Easing (QE) is being wound back in the US the bellwether for the global cost of capital. Markets need to transition from liquidity-driven support to valuations based on economic fundamentals as risk-free assets fall in price (i.e. rise in yield). Tapering is not tightening. However, markets must eventually start to price in Fed rate hikes. This will turn attention to those who borrowed heavily during the era of low interest rates. Various emerging market economies with poor domestic fundamentals will come under the spotlight. We re not expecting volatility to remain low in this environment. Europe is still growing insufficiently to satisfy fiscal solvency constraints. Fiscal austerity needs to be matched by reforms to lift growth. Our eyes are on Italy and France. China continues to transition from investment to consumption-centric growth. The adjustment is unlikely to be smooth. This combination is leading to inevitable flip-flops across markets from day to day. The central scenario is an orderly unwind of stimulus amidst major structural challenges. But a lot needs to go right. Risks of a black swan event are non-trivial. Across the key regions we expect: A strengthening US outlook after the adverse weather impact abates. Despite the partial government shutdown, the US economy managed to stay on the expansion path at the end of last year. Poor weather conditions have contributed to recent volatility in the dataflow, but this is not expected to derail the US expansion. Interest rates remain low, deleveraging is well advanced outside of the Government sector. The business sector is generating strong cash-flow, and the labour market recovery is expected to continue. European growth to remain sub-par. The Eurozone economy emerged from recession last year, but the economy is hardly booming, with high indebtedness and a lack of economic flexibility constraining growth. Prospects in the UK economy are more upbeat, with low interest rates providing support. Moderate growth in Australia. A commodity price boom is now being replaced by a volume equivalent. Domestic demand is responding to lower interest rates. However, some deeper challenges remain: productivity has been poor and cost structures need to be addressed. Both will cap Australia s momentum. Our forecasts assume sub 7½ percent growth in China over the next few years. This still represents an incredible rate of growth, though the clear risk is of a more marked slowdown than assumed in our forecasts if investment misallocation is exposed. Trading partner growth is expected to average just under 4 percent over the next few years. Risks remain tilted to the downside. GLOBAL ECONOMIC GROWTH FORECAST Calendar years (f) 215(f) 216(f) 217(f) United States Australia Japan Eurozone China Trading Partner Growth

8 ANZ Economic Outlook / March 214 / 8 of 21 EXPORT COMMODITY PRICES SUMMARY The outlook for farm-gate prices remains solid for most primary sectors. Just about all the main sectors are set to record a decent lift in farm-gate prices in 213/14. Dairy prices in 214/15 are expected to moderate somewhat from this year s record, but most other sectors are expected to experience further incremental lifts. In-market prices are expected to hold up for the majority, with intensifying inter-market competition between China and Western markets expected as economic conditions improve. An additional boost to returns is expected from a marginally lower NZD/USD. We expect a milk price in the low-mid $7/kg MS range in 214/15. THE CONTINUED RISE OF CHINA NZ Commodity Price Indices (World currency terms) Index (Jan 1986=1) Forestry Meat, skins & wool Source: ANZ Other Dairy Improved economic conditions in some Western markets offers renewed opportunities in 214/15. However, just about all the major primary sectors have experienced a further increase in the proportion of their earnings derived from China over the past year. In some cases the increase has been substantial. For example, dairy exports sent to China increased from 21 percent of total dairy exports in 212 to 32 percent in 213. Improving Western markets and continued demand from China and the wider Asian region are expected to further lift inter-market competition for many products, supporting in-market prices. This will especially be the case where supplies (seasonal production and inventories) are more limited. With increasing exposure to China many companies are now actively discussing what proportion of earnings they should have exposed. For many sectors the change started with a rush of secondary and lower grade/quality products making their way to China and other emerging markets. But once confidence and experience has been acquired, along with increasing market penetration into new marketing channels (such as food service), higher grade/quality products have begun to be sold. While this is now providing new opportunities and increased inter-market competition with wealthier markets, it means a deeper understanding of the regulatory framework, business practices, and local culture which affect consumer trends, tastes and customer service requirements is needed. This is likely to imply slower incremental growth NZ still has a way to go to develop a critical mass of institutional knowledge and expertise in these fields as they relate to China and the broader Asian theatre. While these dynamics and still-tight supply/inventories in many sectors are expected to support in-market prices, competition is expected to build as others use better producing conditions, terms of trade (i.e. lower feed costs) and improved market access to try to gain market share. For NZ s main soft commodities this will provide some downward pressure on in-market prices as supplies increase and the price competitiveness of substitute products improves. The Fonterra milk price of $8.65/kg MS in 213/14 represents a sizeable lift on the previous season, adding $4.5bn to dairy incomes. In 214/15 we expect a moderation in the milk price into the low-mid $7/kg MS range. Lamb prices are expected to improve, averaging around $95/head in 213/14 and ranging between $1-$11/head thereafter. Demand is expected to be stable in Europe, but inter-market competition for higher-value cuts with China and the Middle East is expected to intensify as market penetration increases. Beef markets look promising over the next months. A shortage of US supply should support import demand. Lower Australia supply (depending on weather) is expected to ease competition in key Asian markets. We have lifted our strong wool price to $3.75/kg (greasy). This is a 3 percent improvement on last year as tighter supply, low inventory levels, a continued uptick in US demand for carpets, and growth in domestic Chinese demand support prices. Kiwifruit prices are expected to remain buoyant, especially for Green, with a dramatic decrease in Chilean production due to frosts. Pipfruit growers are optimistic the 2 percent lift in FOB returns from the 213 harvest can be sustained. Combined with a good growing season, this should support another profitable harvest. Forestry and specifically log prices continue to post new highs. Demand in China is driving very high prices and excellent returns for logs heading overseas. This has also dragged up domestic prices for industrial and utility grades, while structural and framing logs are in high demand for the Canterbury rebuild and the growing Auckland housing market.

9 ANZ Economic Outlook / March 214 / 9 of 21 LABOUR MARKET OUTLOOK SUMMARY The labour market improvement is broadening through the economy, though the construction sector is likely to continue to lead the charge for quite some time yet. We expect the unemployment rate to gradually trend lower over the next year or so, with a mismatch of skills the primary roadblock to a more marked fall. Modest employment and wage growth will underpin moderate rates of consumer spending. We re expecting lifts in the productivity arena to keep unit labour cost pressures in check despite nominal wages rising. GOOD JOB The labour market is improving. The unemployment has dropped from a peak of 7.2 percent in Q3 212 to just 6 percent at the end of last year. Solid quarters of growth in both HLFS and QES measures of employment/filled jobs have accompanied more than respectable GDP numbers. Labour force participation is up: more people are returning to the labour force and in jobs. Canterbury and Auckland have been leading the charge, outpacing the nationwide average, but many regions are catching up only the very top and the very bottom of the nation have experienced a meaningful fall in employment in the last year. Northland Auckland Waikato BoP Gisborne/Hawke's Bay Taranaki Manawatu-Wanganui Wellington Tasman/Nelson/Marlb./W. Coast Canterbury Otago Sources: ANZ, Statistics NZ Regional HLFS employment growth Southland The demand for labour is projected to continue to strengthen from here, albeit at a more moderate pace. Still-strong business confidence and hiring intentions and a steady increase in job ads bode well for the sustainability of the labour market upturn. However, progress to this point has not been smooth, and given the ongoing stresses and strains we expect to emerge as the economy grows, it is unlikely to be smooth sailing from here either. In particular, we still harbour concerns about the ability of the supply side of the labour market to step up to the mark. The Reserve Bank is forecasting the construction sector to reach a size relative to the rest of the economy that has not been seen since the heady days of the housing boom in the middle of last decade. We anticipate a large degree of regional and sector mismatch between vacancies and available labour that are unlikely to be resolved any time soon. The labour demands that accompany rebuilding Christchurch and growing Auckland are likely to make it harder for other sectors (such as agriculture and manufacturing) to find the people they need. Indeed, in business surveys the proportion of firms identifying labour as a constraint on increasing production is already rising. That dynamic is part of the reason that our projections have a strong outlook for business investment a need to save labour in the production process where possible. % Unemployment rate and difficulty finding labour Net % Less 8 difficult Unemployment rate (LHS) 3-4 More difficult Sources: ANZ, NZIER, Statistics NZ QSBO difficulty finding unskilled labour (adv 3 qtrs, RHS) All up, given the supply headwinds, we see annual employment growth of 1.7 percent in 214 and 1.2 percent in 215 only slightly outpacing the growth in working age population. We are assuming we don t see a big run-up in debt, but that we will see an ongoing focus on productivity. Given we see the supply side as a key constraint on employment growth, modest employment growth is no guarantee wage pressure will not emerge. We are forecasting moderate wage growth of around 3 percent over coming years, which along with steady growth in employment should provide a sound earnings platform for consumer spending without threatening the inflation target. But should general wage growth start to outpace productivity, we can expect a more aggressive monetary policy tightening cycle, all else equal

10 ANZ Economic Outlook / March 214 / 1 of 21 FISCAL POLICY SUMMARY New Zealand s Crown accounts remain on track to return to surplus by 214/15 on the back of a strong economy. Outperforming revenue growth and ongoing spending restraint are helping to contain net debt, which is now projected to peak below 27 percent of GDP. We expect the fiscal stance to remain tight for years to come, though some election sweeteners (funded via reprioritised spending) are likely pre-budget. ON TRACK FOR A RETURN TO SURPLUS IN 215 AND BEYOND The Government remains on track to comfortably return to surplus in 214/15 via spending restraint and rising tax revenues courtesy of an improving economy. Government spending is projected to fall below 3 percent of GDP in 217 (from 35 percent in 211). Net debt is expected to peak at under 27 percent of GDP, well below levels that would see New Zealand come under scrutiny from rating agencies. New Zealand remains in an enviable fiscal position, looking decidedly rock star versus fiscally profligate global peers. The average level of net public debt across the OECD was 71 percent of GDP in 213. % of GDP Expansionary Fiscal Impulse (June years) Budget 213 HYEFU Fiscal restraint will be around for some time. That s the realities of a) high level of private sector debt continuing to irk rating agencies (alongside a persistent current account deficit) NZ needs to be whiter than white in the fiscal arena; b) building up a buffer for other potential adverse shocks down the track; and c) preparing for structural demographic changes including rising superannuation and healthcare costs. We re expecting the fiscal stance to be contractionary to the tune of 3½-4 percent of GDP over the forecast period. WIDER SUPPORT The fiscal story is under-appreciated on three levels. While fiscal retrenchment crimps growth, there are wider issues at play. Tighter fiscal policy is leaning against the Canterbury rebuild, helping to keep interest rates lower than would otherwise be the case. NZ benefitted from counter-cyclical fiscal policy during the downturn; we re now seeing the reverse. Businesses need political certainty and stability if they are to invest. Relative to a host of other countries, our political parties are largely in agreement on fiscal consolidation and NZ s political institutions and frameworks better than most. We re not saying it s perfect, but eyeing Europe, the US and Australia, we seem well placed on the leadership-populism spectrum. We ll see some electioneering uncertainty over the year ahead, but don t expect it to amount to much Contractionary Sources: ANZ, Treasury FISCAL FORECASTS Microeconomic reform efforts are starting to pay dividends for the macro economy. We re talking tweaks to the tax system, asset sales, welfare reform, reprioritised spending, proactive balance sheet management, a multi-pronged attack on housing affordability, and progress unlocking our abundant natural resource base. And in some instances we like nuances coming out of the opposition parties (i.e. a capital gains tax and lifting the retirement age). June years (f) 215(f) 216(f) 217(f) 218(f) Operating Balance ($bn) as % of GDP OBEGAL ($bn) as % of GDP Net Core Crown Debt ($bn) as % of GDP Core Crown residual cash ($bn) Bond Tender Programme ($bn)

11 ANZ Economic Outlook / March 214 / 11 of 21 INFLATION SUMMARY Inflation is expected to drift higher over the next couple of years but we expect the inflation genie to remain in the bottle. The strengthening domestic expansion remains the dominant driver of the rising trajectory, with a productivity uplift and proactive central bank capping the magnitude. However, risks look skewed to the upside. ON THE UP Having been below the midpoint of the 1 to 3 percent inflation target since late 211, annual CPI inflation ended 213 at a modest 1.6 percent. Since mid 213, however, annual inflation has been rising. A diminishing amount of spare capacity, margin rebuilding, and waning incremental deflationary pressure from the high NZD appear to be the major catalysts. As the expansion continues, the expectation is that annual CPI inflation will gradually drift above the inflation target midpoint by the end of the year. Growth of around 3½ percent is well in advance of supply side capacity, and with a limited margin of available slack, core inflation is likely to move higher. Modest (but strengthening) wage inflation in combination with better productivity performance is likely to cap the extent of rises. Annual non-tradable inflation is expected to move above 3 percent over the early part of the projection period, and remain there over the next few years. During this period the economy will be running a positive output gap, with a slowing pace of momentum in the latter part of the projections seeing domestically generated inflation moderate somewhat. Pricing pressures will be more acute in sectors where capacity bottlenecks will be encountered, with the construction sector an inflation hotspot for years to come. The annual inflation profile is also lifted by administrative price increases over the next few years, with the lift in tobacco and fuel excise adding.3 percentage points. Rising prices for domestic goods are in contrast to a generally benign global pricing environment. Despite this and the high NZD, we expect to see overall tradables prices move from being an inflation suppressant, to making a small positive contribution to price rises. Surging commodity export prices are expected to continue flowing through into retail prices. Despite this, inflation from this sector is expected to remain well below that of domestically generated inflation. The disinflationary impact of the NZD may well be waning, but will still be evident in some pockets, with vehicle prices expected to ease on account of earlier NZD/JPY strength. Eventually the upward drift in inflation will be arrested. A declining positive output gap is the major driver as the economy slows in relation to its trend rates. No further tobacco excise increases from the March 216 quarter will also help temper subsequent non-tradable CPI outturns. Annual tradable inflation is expected to remain below the midpoint of the inflation target, consistent with a contained global inflationary environment. We continue to expect the central tendency of inflation outcomes and expectations of wage and price setters to remain consistent with inflation target midpoint, with the RBNZ s inflation targeting credibility assumed to remain intact. Annual % change CPI forecasts Sources: ANZ, Statistics NZ CPI FORECAST CPI Non-tradable Tradable Quarter Qtr % chg Ann % chg Dec Mar-14 (f) Jun-14 (f).5 2. Sep-14 (f) Dec-14 (f) Mar-15 (f) Jun-15 (f) Sep-15 (f) Dec-15 (f) Mar-16 (f) Jun-16 (f) Sep-16 (f) Dec-16 (f) Mar-17 (f) Jun-17 (f) Sep-17 (f) Dec-17 (f).3 2.1

12 ANZ Economic Outlook / March 214 / 12 of 21 EXCHANGE RATE SUMMARY We expect the NZD to remain elevated on domestic support factors (high yield), but the domestic crutch to be progressively usurped by a re-assertive USD over the projection period. The NZD/USD wanes to.75, still elevated by historical standards, testament to the powerful local support factors. Risks to the outlook go both ways further weak US data could undermine the USD, but intensification of emerging market and Chinese growth concerns could dent risk appetite. The highs in NZD/AUD are in, but expect the cross to remain elevated until we see solid evidence that the Australian economy has turned the corner. SHIFTING DRIVERS The NZD remains elevated and is likely to remain so. However, behind the scenes, the drivers of this strength are changing from local to global factors. In a nutshell, while New Zealand s economic outlook is best-in-class, it is also well known and understood by markets. New Zealand economic data has consistently surprised to the upside, but this is no longer news. If anything, the bigger surprise would be that future data disappoints, even if this is likely to reflect ramped-up expectations, as opposed to a marked slowing in the tempo of the economy. Business confidence certainly paints a solid picture. Index Level Citi Economic Surprise Index - New Zealand -8 More Negative Surprises Sources: ANZ, Citigroup, Bloomberg More Positive Surprises Annual % change GDP vs ANZBO composite Sources: ANZ, Statistics NZ ANZBO composite (adv 5 mths, RHS) GDP (LHS) Net % 4 The domestic story is bright in both outright and relative terms. But this is true only in a levels sense. In rate of change terms, the global story is the one that is now changing. Accordingly, our central scenario has the NZD falling gradually, with the solid domestic economic outlook cushioning the fall as the US economic recovery gathers momentum, supporting the USD. This is entirely consistent with our long-held reversification thematic. Recall that diversification out of the core (i.e. USD, EUR and GBP) into the periphery (Emerging Asia, AUD, NZD etc) was one of the key dynamics at play until 213. As the US economy recovers, we expect the flows to reverse. Upside risks are more near term in nature, and stem from weather-related distortions to US data. Of all the US data releases, the monthly nonfarm payroll and ISM reports are the most closely watched. Both have weakened since the US Federal Reserve s long-awaited decision to taper its QE programme. While this appears to be a weatherrelated distortion, ongoing severe weather in the US has made it difficult to ascertain underlying trends. If businesses read the signals incorrectly, the negative feedback loops could intensify. Some part of the decline in US confidence certainly appears to be driven by a pull-back in the pace of inventory accumulation, which spiked higher in Q3. But that is now showing signs of consolidation, suggesting some of the near-term pessimism has been overdone. Nonetheless, US data has disappointed, and if markets continue to take a dim view of the data flow, the risk is that a weaker USD (rather than stronger NZD) drives NZD/USD higher. That said, US data surprises have seen the US data surprise index collapse typically a sign that the next source of surprise will be to the upside (i.e. the opposite of what surprise indices say for NZ). While

13 ANZ Economic Outlook / March 214 / 13 of 21 EXCHANGE RATE a higher NZD has intuitive appeal, expecting material gains seems like a stretch. Index Level Sources: ANZ, Citigroup, Bloomberg Citi Economic Surprise Index - US More Positive Surprises -8 More Negative Surprises Our central scenario is not without its risks, which are largely global-centric. The first is emerging markets, which have experienced a reasonable degree of stress of late. However the issues are wide and varied, and don t seem to have a common theme. In Thailand and Ukraine it s political, in Argentina it s economic. The second downside risk is China. Recent PMI surveys have shown a marked softening, fanning fears of slower growth. Slower Chinese growth does pose serious risks for New Zealand now that China is our largest trading partner. But this is alleviated somewhat by the composition of the goods we export to China: milk powder prices are less tied to the economic cycle than iron ore. Nonetheless, talk of slower Chinese growth and EM concerns are both factors that weigh on risk appetite, and flare-ups tend to hurt the NZD. Index Level 58 Chinese Manufacturing PMI Data fewer foreign buyers. While offshore inflows helped prop up the NZD, now that they are tailing off that flow has dried up, and there is the ever-present risk of departure. Data to date shows that offshore holders have held their positions in NZ government bonds, which is encouraging. But the NZD is above.8, and NZD/AUD above.9: despite New Zealand s high yields, only the most optimistic investors would expect to make money out of the FX component. In short, for most investors, the horse has bolted: the NZD is simply too high and is no longer the value proposition it was. Indeed, in April 29, the NZD sat below.6 and NZ 1-year bond yields were close to 5.5 percent. That s a long way from where things sit now. NZGS Held by Non-Residents NZ$bn % 5 9% Sources: ANZ, RBNZ Face Value (LHS) % Total (RHS) 8% 7% 6% 5% 4% 3% 2% NZD/AUD: THE HIGH IS IN The NZD s appreciation against the AUD has been spectacular. This trend has had intuitive appeal: NZ is growing faster than Australia, and has higher interest rates, a more robust labour market, and rising relative commodity prices. But none of these measures justify the cross at current extremes, even if they do justify the direction. Cash Rate Spread and NZD/AUD Cross Rate HSBC/Markit Manufacturing PMI Official PMI Latest Flash PMI Spread (bps) 2 Cash Rate 15 Spread (LHS) 1 5 Market Expectations of Cash Spread Cross Rate Jul-5 Jul-7 Jul-9 Jul-11 Jul-13 Sources: ANZ, HSBC, China Federation of Logistics & Purchasing, Bloomberg Asset flows have been less intense than in the past, and remain consistent with an elevated rather than higher NZD. As the fiscal balance returns to surplus, fewer bonds are issued, requiring Sources: ANZ, Bloomberg NZD/AUD (RHS)

14 ANZ Economic Outlook / March 214 / 14 of 21 EXCHANGE RATE Relative Commodity Prices and NZD/AUD Cross Rate Index (Jan 2 = 1) 1.2 Cross Rate Apr 99 Apr 1 Apr 3 Apr 5 Apr 7 Apr 9 Apr 11 Apr 13 Sources: ANZ, Bloomberg Relative Commodity Prices (LHS) NZD/AUD (RHS) We fully expect the NZD to maintain its strength against the AUD, and do not expect the cross to fall back below.9 until we see clear evidence that the Australian economy has turned the corner. However, we do not expect NZD/AUD to make fresh post-float highs in 214 and the whole idea of parity seems a little far-fetched. NZ/AU unemployment gap and NZD/AUD Unemployment "Gap" (%) NZD/AUD Gap between NZ and 3. NZ Unemployment Lower AU Unemployment (LHS) Average of Economist.93 Forecasts on 1.5 Bloomberg AUD/NZD (RHS) -2.5 NZ Unemployment Higher Sources: ANZ Bank, Bloomberg, Stats NZ, ABS NEW ZEALAND DOLLAR FORECAST (END OF QUARTER) Quarter NZD/USD NZD/AUD NZD/JPY NZD/GBP NZD/EUR NZ TWI Dec Dec Dec Dec Mar-14(f) Jun-14(f) Sep-14(f) Dec-14(f) Mar-15(f) Jun-15(f) Sep-15(f) Dec-15(f) Mar-16(f) Jun-16(f) Sep-16(f) Dec-16(f)

15 ANZ Economic Outlook / March 214 / 15 of 21 INTEREST RATES SUMMARY We expect three OCR hikes by mid year, a stopstart tightening profile thereafter, and a relatively low OCR endpoint by historical standards. That s a reflection of the punch monetary policy will achieve, and also recognition of imbalances across the wider economy with the NZD still elevated and the housing market overvalued. Local bond yields are expected to rise gradually in coming years, albeit outperform the anticipated normalisation in global bond yields as major central banks begin lifting official interest rates from 215. The US Federal Reserve s QE asset purchase programme is expected to be wound down by the end of 214. ALL SYSTEMS GO The RBNZ has made it clear the OCR is heading higher, and we expect rate hikes to kick off this month. Barring a global shock we have three OCR hikes pencilled in for March, April and June. The economy demands it and in our view, RBNZ Governor Wheeler will want to get a few rate hikes under his belt before the election in late 214, thereby cementing his inflation-fighting credibility early on. The broader economy is booming business confidence is at near 2-year highs and ANZ s Confidence Composite Indicator is signalling GDP growth well above trend in the next few years. Ultimately, it s the inflation outlook that will determine the RBNZ s policy response. NZ s negative output gap is all but closed, while ANZ s monthly Inflation Gauge is signalling a lift in inflationary pressures as frothiness in the housing and construction sectors threatens to spill over into the broader economy. The NZD is also having less of an impact on tradables inflation than in the past. Percent OCR Expectations RBNZ (Dec) bill projections signal 2bps of rate hikes in the next two years, with recent upside surprises to GDP, CPI and employment data indicating minor upward revisions to the interest rate track are likely at the March Monetary Policy Statement. We re expecting a relatively stop-start tightening cycle and a moderate endpoint by historical standards (of around 4.75 percent). That s a reflection of the impact monetary policy tightening will achieve across various sectors of the economy. We re not pencilling in more aggressive rate rises for a number of reasons: OCR hikes will quickly gain traction in the housing market, with the average duration of bank mortgage debt at just 8 months (and 73 percent of mortgage debt is either floating or fixed for 12 months or less). We are already seeing signs of a cooling in the housing market following the introduction of RBNZ high-lvr lending restrictions in October 213. Household debt has been rising at a faster pace than income growth in recent years, while house prices remain overvalued on a number of metrics. Thus it makes sense for the RBNZ to adopt a hike, pause and assess strategy. The NZD remains elevated, with risk of a spike higher on sticker shock from RBNZ rate hikes. New Zealand can ill afford to get too far out of step with global peers if the NZD is not to be turbo-charged further. Global fragilities remain Europe continues to de-lever; China s growth path has slowed; and policy normalisation in Australia and the US is not expected to get underway until well into 215. A stronger NZD/AUD also now sees the TWI back to within 1 percent of all-time highs. NZ and the global economy are coupled which means financial variables can t be too far out of line with global nuances. Percent Forward Cash Rate Differentials Percent Market Pricing ANZ forecasts OCR less RBA Cash Target (LHS) OCR less Fed Funds (RHS) Feb-14 Aug-14 Feb-15 Aug-15 Feb-16 Aug-16 Sources: ANZ, RBNZ, Bloomberg Looking ahead, the big question now is the speed and scale of RBNZ rate hikes. RBNZ bank. Mar-14 Sep-14 Mar-15 Sep-15 Mar-16 Sep-16 Sources : ANZ, Bloomberg 2.