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1 B.3 ISBN: (print) (online) The Persistent URL for the BEFU 2015 is

2 Guide to the Budget Documents A number of documents are released on Budget day. The purpose of these documents is to provide information about the Government s spending intentions for the year ahead and the wider fiscal and economic picture. The Budget documents are as follows: Executive Summary The Executive Summary is the overview of all the Budget information and contains the main points for the media and public. This summarises the Government s spending decisions and key issues raised in the Budget Speech, the Fiscal Strategy Report, and the Budget Economic and Fiscal Update. Budget Speech The Budget Speech is the Budget Statement the Minister of Finance delivers at the start of Parliament's Budget debate. The Budget Statement generally focuses on the overall fiscal and economic position, the Government s policy priorities and how those priorities will be funded. Fiscal Strategy Report The Fiscal Strategy Report sets out the Government s fiscal strategy in areas such as the balance between operating revenues and expenses, and its debt objectives. The report includes the Government s long-term fiscal objectives and short-term fiscal intentions plus fiscal trends covering at least the next 10 years. The Government must explain changes in the Fiscal Strategy Report from the Budget Policy Statement and the previous year s Fiscal Strategy Report and any inconsistencies between these documents. Budget Economic and Fiscal Update The Update includes Treasury s economic forecasts and the forecast financial statements of the Government incorporating the financial implications of Government decisions and other information relevant to the fiscal and economic outlook. The Estimates of Appropriations The Estimates outlines for the financial year about to start (the Budget year) expenses and capital expenditure the Government plans to incur on specified areas within each Vote, and capital injections it plans to make to individual departments. The Estimates is organised into 10 sector volumes, with each Vote allocated to one sector. Supporting information in the Estimates summarises the new policy initiatives and trend information for each Vote and provides information on what is intended to be achieved with each appropriation in a Vote and how performance against each appropriation will be assessed and reported on after the end of the Budget year. Also released on Budget day: The Supplementary Estimates of Appropriations The Supplementary Estimates outlines the additional expenses, capital expenditure and capital injections to departments required for the financial year about to end. Supporting information for each Vote provides reasons for the changes to appropriations during the year, related changes in performance information and full performance information for new appropriations. NZ Budget App Smartphone and tablet users can also access the Budget documents through the NZ Budget App. The App is available on the Apple Store for ios devices and the Google Play store for Android devices or see Websites These documents are available at and Crown copyright This copyright work is licensed under the Creative Commons Attribution 4.0 International licence. In essence, you are free to copy, distribute and adapt the work, as long as you attribute the work to the Crown and abide by the other licence terms. To view a copy of this licence, visit Please note that no departmental or governmental emblem, logo or Coat of Arms may be used in any way which infringes any provision of the Flags, Emblems, and Names Protection Act 1981 or would infringe such provision if the relevant use occurred within New Zealand. Attribution to the Crown should be in written form and not by reproduction of any such emblem, logo or Coat of Arms.

3 Contents Statement of Responsibility... 1 Executive Summary... 3 Economic Outlook... 7 Overview... 7 Recent Developments and Near-term Outlook Medium-term Outlook Fiscal Outlook Overview Core Crown Tax Revenue Core Crown Expenses Operating Balance Residual Cash Net Core Crown Debt Total Crown Balance Sheet Comparison to the Half Year Update Fiscal Assumptions Risks and Scenarios Overview Economic Risks Alternative Scenarios General Fiscal Risks Specific Fiscal Risks Overview Statement of Specific Fiscal Risks Contingent Liabilities and Contingent Assets Financial Statements Statement of Accounting Policies Government Reporting Entity as at 1 May Financial Statements Notes to the Financial Statements Statement of Segments Core Crown Expense Tables Glossary of Terms Time Series of Fiscal and Economic Indicators B.3 i

4 CONTENTS Other Information On the Treasury's website is a series of other information that provides users of the Budget Economic and Fiscal Update with further detail. This other information should be read in conjunction with the published document. Additional Budget Update information includes: Detailed economic forecast information tables providing breakdowns of the economic forecasts. Treasury and Inland Revenue tax forecasts detailed tax revenue and receipts tables comparing Treasury s forecasts with IRD s forecasts. Tax policy changes an analysis of the effect of changes in tax policy on forecasts for tax revenue since the Half Year Update. Additional fiscal indicators estimates of the cyclically-adjusted balance and fiscal impulse. Government Finance Statistics (GFS) for central government fiscal tables presented under a GFS presentation framework to help with cross-country comparisons. Accounting policies outline of the specific Crown accounting policies. The published forecast financial statements only provide a summary. This other information can be accessed at: ii B.3

5 Statement of Responsibility On the basis of the economic and fiscal information available to it, the Treasury has used its best professional judgement in supplying the Minister of Finance with this Economic and Fiscal Update. The Update incorporates the fiscal and economic implications both of government decisions and other circumstances as at 1 May 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 1 May 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 11 May 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 1 May 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 Hon Bill English Minister of Finance 11 May 2015 B.3 1

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7 Executive Summary New Zealand s economic expansion has continued to strengthen. Real gross domestic product (GDP) grew 3.3% in the year ended December 2014, the fastest pace of growth since 2007 and one of the strongest growth performances in the Organisation for Economic Cooperation and Development (OECD). Looking forward, real GDP growth is forecast to average 2.8% per year over the four years to 2019, consistent with the forecasts in the Half Year Update. Low interest rates, robust investment activity, strong population growth and historically high terms of trade remain the key factors supporting the growth outlook. Sluggish global growth, drought and restraint in government spending provide partial offsets. The high New Zealand dollar acts as a constraint on export growth, although households and businesses benefit from increased purchasing power. Nominal GDP growth is forecast to soften during 2015, reaching a low of 2.0% in the year to September, before strengthening later this year to average 4.3% per year over the four years to 2019 (Figure 1). Compared to the Half Year Update, nominal GDP growth is weaker in 2016 and 2017 owing to a softer outlook for inflation, but is stronger in 2018 and Figure 1 Real and nominal GDP growth Annual average % change Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10 Mar-12 Mar-14 Mar-16 Mar-18 Real production GDP Quarterly Nominal expenditure GDP The fiscal position continues to Sources: Statistics New Zealand, the Treasury strengthen, although at a more modest rate than forecast in the Half Year Update. A slightly larger deficit is forecast for the current 2014/15 fiscal year, while surpluses from 2015/16 are smaller than previously anticipated. On average, the Government s fiscal stance is mildly contractionary over the forecast horizon. Several economic judgements underpin this Budget Update. The most significant relate to the prospects for trading partner growth, the future path of oil and dairy prices, the extent and duration of the current net migration boom and the amount of spare capacity in the economy and its relationship with inflation. The global economic recovery is forecast to continue at a gradual pace. The recovery remains on track in the US, and growth is picking up from a slow pace in the euro area and Japan. However, Australian growth is expected to remain below trend for longer, while China s growth is forecast to slow as housing demand weakens further. B.3 3

8 2015 BUDGET ECONOMIC AND FISCAL UPDATE After remaining low for most of this year, oil prices are assumed to rise gradually and by the end of the forecast period are back at levels similar to those forecast in the Half Year Update. Dairy prices are forecast to recover from current low levels in the second half of 2015, in line with the Half Year Update. Recent oil and dairy price movements are broadly consistent with this outlook. Net migration inflows reached a record high in March this year, and have exceeded the forecasts in the Half Year Update. Annual net inflows are now expected to peak at around 57,000, before returning to the long-run average net inflow of 12,000 by Solid growth in economic activity Figure 2 CPI inflation has reduced the amount of spare % capacity in the economy, with 6 several indicators suggesting it is 5 now mostly exhausted. Even so, 4 annual consumer price inflation has 3 weakened, slipping to 0.1% in the 2 March 2015 quarter. A mix of factors have contributed to the 1 recent low inflation outturns, 0 Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10 Mar-12 Mar-14 Mar-16 Mar-18 including falling oil prices, the high Quarterly New Zealand dollar and heightened Budget Update Half Year Update retail competition. Overall, inflation Sources: Statistics New Zealand, the Treasury is now expected to be much weaker in 2015 and 2016 relative to the Half Year Update, before rising to 2.0% in late 2016 as capacity pressures develop (Figure 2). Low inflation and further increases in labour supply are expected to lead to subdued nominal wage growth over the coming year. However, lower inflation means that, in real terms, purchasing power increases more rapidly in the near term compared to the Half Year Update. Over time, wage growth is forecast to strengthen as employment growth continues and the unemployment rate falls. A weaker outlook for inflation means interest rates are expected to remain lower for longer than anticipated in the Half Year Update, with recent developments raising the prospect of interest rate reductions in the coming year. However, New Zealand s relatively strong growth and high Figure 3 Core Crown revenue and expenses interest rates are assumed to keep % GDP upward pressure on the exchange 37 rate, with the trade-weighted index 35 (TWI) higher than in the Half Year 33 Update across the forecast horizon. Core Crown tax revenue is 29 expected to rise in each of the next 27 four years, reaching $80.5 billion or 25 just above 28% of GDP in 2018/19. Years ended 30 June With the exception of 2014/15, Core Crown expenditure Core Crown revenue growth in tax revenue is expected to be slower than in the Half Year Source: The Treasury Update owing largely to downward revisions to the outlook for nominal GDP growth, wage growth and interest rates B.3

9 EXECUTIVE SUMMARY Core Crown expenses are forecast to continue to decline as a share of GDP, falling from 30.5% in 2013/14 to 29.2% in 2018/19. Future operating allowances remain unchanged from the Half Year Update at $1.0 billion for Budget 2016, rising to $2.5 billion in Budget 2017 and reducing to $1.5 billion in Budget In addition to the Budget 2015 package, the Government has also signalled further reductions in Accident Compensation Corporation (ACC) levy rates of around $1.5 billion across the forecast period. On average, the reductions are expected to lower the operating balance before gains and losses (OBEGAL) by $0.6 billion per year from 2016/17. OBEGAL is forecast to move from a deficit of $0.7 billion this fiscal year, to a surplus of $0.2 billion in 2015/16 and $3.6 billion in 2018/19 (Figure 4). Net capital spending is forecast to exceed operating cash flows until /19, while core Crown residual cash returns to surplus in the 2018/19 year. Over the entire forecast period, a residual cash Years ended 30 June shortfall of $6.9 billion is expected Residual cash OBEGAL Net debt (RHS) and is funded through additional borrowing and reductions in Source: The Treasury financial assets. Net core Crown debt is expected to peak at 26.3% of GDP in 2015/16, before reducing to 22.9% of GDP in 2018/19. The government bond programme is expected to raise funds of $36.5 billion over the forecast period, while $34.8 billion of existing debt will be repaid, providing net cash proceeds of $1.7 billion. Following a decline over recent years, the Crown s net worth is expected to increase modestly over the forecast period as the Government begins to record surpluses and the growth in assets outpaces liabilities. Net worth is forecast to be $93.6 billion in 2018/19 or 32.8% of GDP. Within the balance sheet, financial assets are forecast to increase (particularly the Crown s investment portfolios) to around 50% of total Crown assets and around 50% of GDP. Liabilities begin to fall in Figure 5 OBEGAL scenarios nominal terms by the end of the % of GDP forecast period as earthquake obligations are settled and the Crown begins to reduce debt. The main economic and fiscal risks associated with the central forecast relate largely to the key judgements in this Budget Update. The Risks and Scenarios chapter provides two scenarios to illustrate how sensitive the central forecasts are to some of these judgements (Figure 5). Figure 4 OBEGAL, core Crown residual cash and net core Crown debt $billions $billions Source: The Treasury Years ended 30 June Budget 2015 Scenario one Scenario two B.3 5

10 2015 BUDGET ECONOMIC AND FISCAL UPDATE Scenario one is based on a larger fall in New Zealand s export commodity prices, and consequently a lower terms of trade, and weaker global inflation. In this scenario, the OBEGAL does not return to surplus until the June 2018 year, two years later than the central forecast. Scenario two considers the domestic demand impact from a larger household spending response to the low inflation environment and higher net migration. In this scenario, the OBEGAL returns to surplus in the 2015/16 year, the same as in the central forecast, but the surplus is larger. In addition to the fiscal impact of changes to economic activity, the Government is exposed to other fiscal risks that could impact both the operating balance and the balance sheet. For example, the Crown s financial position is susceptible to market movements in variables such as interest rates, exchange rates and equity prices. The final fiscal cost of the Canterbury earthquakes is also still uncertain. A number of contingent liabilities and fiscal risks are outlined in the Specific Fiscal Risks chapter. Table 1 Summary of the Treasury s main economic and fiscal forecasts 2014 Actual Economic (March years, %) Real GDP growth Unemployment rate CPI inflation Current account balance Fiscal (June years, % of GDP) Total Crown OBEGAL Net core Crown debt 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 % 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 Budget Update Economic data 10 April 2015 Economic forecasts 10 April 2015 Tax revenue forecasts 17 April 2015 Fiscal forecasts 1 May 2015 Specific fiscal risks 1 May 2015 Text finalised 12 May 2015 Note: Data releases since the finalisation of the economic forecasts show that in the March 2015 quarter annual Consumers Price Index (CPI) inflation was 0.1% and that the unemployment rate was steady at a revised 5.8%. These and other recent developments have not significantly changed the outlook presented in this Budget Update. The changes to ACC levies announced on 11 May 2015 were decided in time to be included in the fiscal outlook but not the economic outlook. The economic impact of the ACC levy reduction is not expected to significantly alter the economic outlook. 6 B.3

11 1 Economic Outlook Overview Economic growth was 3.3% in the year ended December Growth of over 3.0% is expected in the year ahead, supported by net migration inflows, labour income growth, stimulatory interest rates and construction activity. Drought is likely to have had a small negative impact on GDP growth in the first half of Real GDP growth is expected to moderate as migration inflows ease, construction growth slows and interest rates rise in response to increasing capacity pressures. Government expenditure growth is forecast to remain subdued, exerting a mild constraining influence on demand in most years of the forecast. The high exchange rate remains a headwind for export growth but households benefit from increased purchasing power. Global oil prices have fallen considerably since the Half Year Update, reflecting ongoing increases in supply and an easing in demand. Lower oil import prices are feeding through to the economy via lower inflation and increased purchasing power, providing a partial offset to the reduced income associated with lower dairy prices. This is reflected in a smaller fall in the terms of trade than was forecast in the Half Year Update. Lower fuel prices, particularly in the March quarter, and an appreciating exchange rate have contributed to lower tradables inflation. Non-tradables inflation has eased as the economy has operated with a degree of spare capacity and non-tradables inflation is expected to remain low in the near term. Looking forward, continued above-trend growth is expected to generate greater upward pressure on non-tradables prices. In addition, tradables inflation is forecast to increase as international oil prices rise and the exchange rate stabilises, causing headline inflation to rise to around 2.0% in late The weaker domestic price outlook is reflected in a lower level of nominal GDP over the forecast period compared to the Half Year Update. Nominal GDP growth is forecast to be slower in the years ending June 2016 and 2017, but faster in the later years of the forecast period. Over the five-year forecast period, nominal GDP is forecast to be a cumulative $5.0 billion lower compared to the Half Year Update. B.3 7

12 2015 BUDGET ECONOMIC AND FISCAL UPDATE Table 1.1 Economic forecasts 1 (Annual average % change, March years) 2014 Actual Private consumption Public consumption Total consumption Residential investment Market investment Non-market investment Total investment Stock change Gross national expenditure Exports Imports GDP (expenditure measure) GDP (production measure) Real GDP per capita Nominal GDP (expenditure measure) GDP deflator Potential GDP Output gap (% deviation, March year average) Employment Unemployment rate Participation rate Nominal wages CPI inflation Terms of trade House prices Current account balance $billions % of GDP Net international investment position % of GDP TWI day bank bill rate year bond rate Notes: 1 s finalised 10 April 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 Average for the March quarter actual. Longer time series for these variables are provided on page B.3

13 ECONOMIC OUTLOOK Key economic forecast assumptions and judgements Net permanent and long-term migration inflows are assumed to rise from 55,800 in the year ended March 2015 to 56,600 in the year ended June 2015 and to return to the longrun assumption of 12,000 per year in the year ended June West Texas Intermediate (WTI) oil prices are assumed to rise from US$49 per barrel in the March 2015 quarter to US$78 in the March 2019 quarter. Dairy prices are expected to recover at a modest rate, returning towards the long-term levels forecast by the OECD-FAO of US$3,900/mt towards the end of Trading partner growth is assumed to increase in 2015 and 2016 as growth picks up in the US, euro area and Japan, offset by slightly slower growth in Australia and China. Growth in potential output is assumed to increase from 2.3% in the year ended December 2014 to a peak of 2.9% in the year ended September 2017 and to ease to 2.6% by the end of the forecast period. The output gap (spare capacity) is currently around zero and is estimated to become increasingly positive over the next year or so, contributing to higher inflation. Economy-wide labour productivity growth is estimated to average 1.2% per year between the years ending March 2015 and March Average hours worked per week per person are estimated to decline from around 33.4 in the year to December 2014 to around 32.9 by the end of the forecast period. The labour force participation rate is estimated to be 68.8% for most of 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. Ninety-day interest rates are estimated to remain stable around 3.6% until the end of 2016 before rising to 4.9% in the June 2019 quarter. Ten-year interest rates are estimated to rise from 3.3% in the March 2015 quarter to 5.2% in the June 2019 quarter. The trade weighted exchange rate index (TWI-17) is assumed to hold at around 77.9 until late 2018, when it begins to decline, reaching 76.4 in the June 2019 quarter. 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 ($18 billion), commercial property ($9 billion) and infrastructure and social assets ($11 billion). The tobacco excise tax increase in the March quarter 2016 adds 0.2 percentage points to annual inflation. The reduction in ACC vehicle levies in September 2015 quarter is estimated to reduce consumer price inflation by 0.25 percentage points. B.3 9

14 2015 BUDGET ECONOMIC AND FISCAL UPDATE Recent Developments and Near-term Outlook The economic expansion has gathered pace... The pace of economic expansion strengthened over the second half of 2014 owing to strong domestic demand and a surge in tourism expenditure. Rapid migration-led population growth, increases in labour income, low interest rates and increased construction activity are expected to continue to support domestic demand, and underpin the outlook for growth over Although real production GDP grew as expected over the second half of 2014, Sources: Statistics New Zealand, the Treasury revisions to previous quarters by Statistics New Zealand meant that growth in the year ended December was lower than expected at 3.3% but still the fastest pace since late 2007 (Figure 1.1). with several developments impacting the economy and its outlook Several key developments have shaped the economic outlook and have reinforced the key themes of strong real activity and relatively weak price inflation presented in the Half Year Update. These developments include the sharp falls in international oil prices since late last year, higher than forecast net migrant inflows and the impacts of the summer drought. Judgements around the future path of commodity prices, trading partner growth, the extent and duration of the current migration cycle and the amount of spare capacity and its relationship with inflation remain the key factors influencing the economic outlook. International oil prices fell sharply Figure 1.1 Real GDP growth Annual average % change Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10 Mar-12 Mar-14 Mar-16 Mar-18 Budget Update Quarterly Half Year Update Oil prices have fallen sharply since the Figure 1.2 WTI oil price Half Year Update was finalised in $US per barrel November. WTI prices have fallen 140 from around US$80 per barrel in 120 November 2014 to around $US50 per 100 barrel in March 2015 (Figure 1.2). 80 Brent and Dubai crude oil prices have 60 followed a similar pattern. The price 40 falls are primarily a result of increased 20 supply from US shale oil production 0 and the Organisation of Petroleum Quarterly Exporting Countries decision to Budget Update maintain production levels despite falling prices. At the same time, Sources: Haver Analytics, the Treasury international demand has eased, partly reflecting a slowdown in growth in China. Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10 Mar-12 Mar-14 Half Year Update 10 B.3

15 ECONOMIC OUTLOOK Changes in oil prices directly affect consumer prices through lower fuel prices and indirectly through lower input costs for domestic firms. In addition, New Zealand s major trading partners are net oil importers so the positive impacts on domestic demand in those economies, all else equal, support demand for New Zealand s exports. contributing to weaker than forecast inflation Falling fuel prices provided the largest negative contribution to the 0.3% fall in quarterly inflation in the March 2015 quarter. Annual consumer price Figure 1.3 Consumer price inflation % 8 6 inflation eased to 0.1% from 0.8% in 4 the December quarter (Figure 1.3) 2 considerably lower than the 1.3% forecast in the Half Year Update. Even excluding the impacts of lower fuel 0-2 prices, inflation is low and inflation expectations are subdued. Although -4 Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10 Mar-12 Mar-14 Quarterly some slack remains in the labour Headline inflation Tradables inflation Non-tradables inflation market, capacity utilisation is generally quite high, indicating that, in Source: Statistics New Zealand aggregate, spare capacity has largely been absorbed. Capacity pressures take some time to influence inflation and inflation is expected to remain low this year. and providing a partial offset to lower export prices The near-term outlook for the terms of trade has improved as lower import prices have provided a partial offset to lower export prices. Lower export prices result in a direct fall in national income and lower inflation. However, lower import prices, which result in a higher terms of trade, increase real national disposable income. The overall impact on nominal GDP depends on the extent to which households and businesses respond to the additional real income and how lower import prices affect domestic prices. See the box Commodity prices (page 12) for details on how recent commodity price movements and the judgements around their future paths have impacted the outlook for the terms of trade and nominal GDP. B.3 11

16 2015 BUDGET ECONOMIC AND FISCAL UPDATE Commodity prices Nearly three-quarters of New Zealand s goods exports are primary products in raw commodity or further processed form and around 15% of goods imports are crude and refined oil and petroleum products. As a result, New Zealand s trade balance and terms of trade are heavily influenced by developments in world commodity prices. This box focuses on recent developments in key commodities and the outlook for dairy and crude oil prices, two key judgements for the macroeconomic forecasts. Recent commodity price movements From US$107/barrel in June 2014, WTI crude oil prices fell to around US$80/barrel in November when the Half Year Update was finalised and to US$45/barrel in early 2015, a five-year low. 1 Since then they have traded in a US$45/barrel to US$60/barrel range. The initial catalyst for the fall was a growing surplus of crude oil production (and therefore increasing inventories), driven by shale oil extraction in the US and, to a lesser extent, oil sands production in Canada. At the same time, OPEC maintained production Figure 1.4 Petroleum and other liquids production and consumption Million barrels per day Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 Quarterly OECD Stocks (RHS) Production Consumption Source: US Energy Information Administration Million barrels levels. This overall increase in supply was coupled with subdued demand from Europe and Japan and slowing growth in China (Figure 1.4). As a net importer of approximately 25 million barrels of crude oil per annum, 2 as well as other mineral fuels, the fall in crude oil prices has been beneficial to New Zealand s trade balance and terms of trade. The global dairy market is little changed from the Half Year Update. Dairy production remains high in the key exporters including New Zealand, the European Union (EU) and the US. Meanwhile, demand from the two largest dairy importers, China and Russia, remains subdued owing to increased domestic production and high inventories in China and the ban on EU and US imports by Russia. GlobalDairyTrade (GDT) prices for New Zealand s key dairy export, whole milk powder, reached a low of US$2,229/mt in December 2014 and have only recovered modestly since then to around US$2,385/mt. The GDT index, reflecting a basket of dairy commodities, fell to a six-year low at the first GDT auction in May Forestry prices have followed a similar pattern to dairy prices, falling throughout most of 2014 from record highs early in the year as demand from China has slowed. Prices for other export commodities have fared better. Meat prices, driven by beef, reached record levels in November 2014, largely owing to high US demand. Although meat prices have subsequently eased, they remain at high levels. Prices for horticultural products, including apples and kiwifruit, and for wine and seafood have held up well WTI is used as a proxy for the world oil price. Brent and Dubai crude oil prices followed a similar pattern. Ministry of Business, Innovation & Employment. In million barrels of crude oil were imported and 13.4 million exported. 12 B.3

17 ECONOMIC OUTLOOK Commodity price outlook The supply overhang in the market is expected to keep crude oil prices at low levels throughout This overhang is expected to be eroded as production is cut back. Prices are currently still at levels that allow most production to be maintained in the short term. However, current prices are below long-term average costs for many producers, particularly those operating under more technologically challenging conditions, which has led to a sharp reduction in exploration and investment and will lead to slower production growth in the future. The macroeconomic forecasts assume that oil prices will gradually return to around US$80/barrel, which approximately reflects long-term costs of production. Dairy export prices are forecast to recover from the second half of 2015 onward at a relatively modest pace (Figure 1.5). Demand for dairy products is expected to pick up as imports into China return to more normal levels. There could be a larger increase in global dairy demand if Russia returns to global markets. However, global inventories of dairy products are high, particularly in the EU, and there is considerable uncertainty over the supply response of EU producers following the removal of milk production quotas. Dairy prices are assumed to recover towards the long-term levels forecast by the OECD-FAO of around US$3,900/mt towards the end of 2016 as supply and demand become more balanced. 3 Impact on the New Zealand economy Figure 1.5 Dairy prices Index ,100 Mar-09 Mar-11 Mar-13 Mar-15 Mar-17 Mar-19 Quarterly The combined impacts of movements in export and import commodity prices are captured in the terms of trade, which have an important influence on New Zealand s income growth. Lower export prices reduce producer incomes and therefore influence their consumption, investment and saving decisions. Lower import prices have the opposite effect but it is less direct. That is, lower import prices enable producers and consumers to buy more of the lower priced goods or other goods for an unchanged income. At a national level, the fall in dairy prices is mainly reflected in lower export receipts (reduced income), while the fall in oil prices is mainly reflected in lower consumer and intermediate input prices (increased purchasing power), and both are reflected in lower nominal GDP. The outlook for dairy and other export commodities is similar to the Half Year Update but oil prices are considerably weaker. Although still expected to decline in the short term, the terms of trade are expected to trough at a higher level and remain higher than the Half Year Update throughout the forecast, chiefly as a result of lower import prices (Figure 1.12). 6,000 5,300 4,600 3,900 3,200 2,500 1,800 Budget Update Half Year Update GDT Average Price (Lagged 1 qtr, RHS) Sources: GlobalDairyTrade, Statistics New Zealand, the Treasury $US/mt 3 OECD-FAO Agricultural Outlook 2014, weighted to reflect New Zealand s export mix. B.3 13

18 2015 BUDGET ECONOMIC AND FISCAL UPDATE Net migration continues to surge The net inflow of permanent and longterm (PLT) migrants in the March 2015 year rose to 55,800 surpassing the peak inflow of 52,400 forecast in the Half Year Update. These inflows have supported both domestic demand and productive capacity through increased labour supply. Initially fewer departures were the key driver, although increased arrivals are now the larger factor accounting for around two-thirds of the increase in the past year. The net inflow is now expected to peak at 56,600 in the year to June 2015 (Figure 1.6). Figure 1.6 Net PLT migration Annual total (000's) Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10 Mar-12 Mar-14 Mar-16 Mar-18 Quarterly Budget Update Half Year Update Sources: Statistics New Zealand, the Treasury contributing to renewed activity in the housing market The resurgence in housing market activity from late last year has continued in early Housing demand is being supported by lower fixed-term mortgage rates as long-term interest rates fall and by continued migration inflows. The housing supply response in the Auckland market remains gradual. Consequently, national house price inflation is expected to increase throughout 2015, supported by rapid house price inflation in Auckland. The resultant wealth effect is expected to provide additional support to household expenditure growth. Solid labour demand The number of people employed increased by 80,000 (3.5%) in the December 2014 year led by growth in full-time staff. 4 Almost a third of national employment growth was in the construction industry, underscoring the strong growth impetus from the sector. Employment growth was stronger than forecast in the Half Year Update in the December quarter and employment indicators suggest employment growth will be stronger than previously forecast in the near term. Figure 1.7 Unemployment and participation rates % of working-age population 70 % of labour force 9 Labour supply has also grown rapidly through high net inflows of migrants and increased participation in the labour force, tempering the declines in the unemployment rate. The unemployment rate declined through 2014 but increased to 5.7% in the December quarter as the participation rate rose to 69.4% from 68.8% in the September quarter (Figure 1.7). The Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10 Mar-12 Mar-14 Quarterly Participation rate Source: Statistics New Zealand Unemployment rate (RHS) unemployment rate is expected to resume its downward trend as employment growth remains robust and labour supply growth begins to ease as net migration inflows slow Latest data released after finalisation of the economic forecasts show employment growth of 0.7% in the March quarter, a further rise in the participation rate to 69.6% and the unemployment rate remaining at a revised 5.8%. 14 B.3

19 ECONOMIC OUTLOOK and income growth support household expenditure Further increases in labour supply and 8 low inflation are expected to keep annual growth in weekly earnings 6 subdued throughout most of 2015 at 4 around 2.1%. Despite that, total labour income growth is initially higher than in 2 the Half Year Update reflecting solid 0 employment growth over the year ahead (Figure 1.8). Real household Quarterly Budget Update Half Year Update income growth, which has been boosted by low inflation, is expected to Sources: Statistics New Zealand, the Treasury provide greater support to private consumption growth than previously forecast in the near term. Investment is supported by construction activity and low interest rates Business sentiment and activity surveys point to solid investment growth over the year ahead as construction activity increases, the high NZ dollar makes capital goods imports cheaper and relatively low interest rates make investment more profitable. In addition, rapid population growth is adding to demand and supporting investment. Real business investment rose steadily over the latter half of 2014 rising 7.5% in the year ended December and is expected to continue growing at a slower but still robust rate of 5.0% to 6.0% over the next four to six quarters. Residential investment is at historically high levels, following a 16.7% rise in the December 2014 year. Despite a recent slowing in building consent issuance, strong housing demand in Auckland and ongoing high levels of reconstruction activity in Canterbury continue to underpin the outlook for solid residential investment growth. but agricultural production is impacted by drought Figure 1.8 Compensation of employees Annual average % change Drought in parts of the South Island and dry conditions elsewhere are likely to have slowed GDP growth in the first half of This has been reflected in Fonterra revising down its milk production growth estimates for the 2014/15 season from a 3.3% increase earlier in the season to an increase of only 1.5%. Growth momentum is expected to continue in the year ahead 10 Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10 Mar-12 Mar-14 Mar-16 Mar-18 Solid labour income growth, increasing house prices and low debt-servicing costs, combined with low inflation which boosts real incomes, are supporting the outlook for household consumption expenditure. Low interest rates, a high NZ dollar and improved business sentiment also support a solid outlook for business investment. Residential investment is forecast to continue rising in the year ahead, driven by strong demand for housing in Auckland and a high level of rebuilding in Canterbury. Net exports will be a drag on activity reflecting the impacts of drought, solid import growth as a result of strong domestic demand and an expected pull-back in tourism expenditure following the Cricket World Cup in the March quarter. Overall, annual average growth in real GDP is forecast to remain similar to recent quarters at close to 3.3% for most of B.3 15

20 2015 BUDGET ECONOMIC AND FISCAL UPDATE with further widening in the annual current account deficit The annual current account deficit widened to 3.3% of GDP in December 2014 from 2.6% in the previous quarter, as lower commodity export prices flowed through to a smaller goods surplus. A surge in tourism expenditure driven by higher tourist arrivals in the December 2014 quarter drove an increase in the annual services surplus. The current account deficit is expected to widen further over coming quarters as lower commodity export prices continue to reduce export values. However, lower import prices, higher tourism receipts and lower income outflows are expected to temper the widening in the current account deficit compared to the Half Year Update. The current account deficit is forecast to widen to 5.6% of GDP in March 2016 compared to 6.3% previously. Subdued domestic inflation and further declines in the terms of trade result in slower nominal GDP growth A sharp fall in the terms of trade, mainly reflecting falls in dairy export prices, and low domestic inflation contributed to nominal GDP growth of just 0.4% in the December 2014 quarter, reducing annual average growth to 5.7% from 7.6% in the previous quarter. Low domestic inflation and further pass-through of falls in export prices are expected to result in nominal GDP growth slowing to 2.4% in the June 2015 year. 16 B.3

21 ECONOMIC OUTLOOK Medium-term Outlook Growth moderates gradually in the medium term Growth in output from 2016 onwards is a little stronger than in the Half Year Update. Annual average growth for the year to March 2016 is expected to be 3.1%, and is then forecast to ease gradually to 2.4% at the end of the forecast period. Consumption and investment growth moderate as population and labour income growth ease, construction activity slows and interest rates rise. Relative to the Half Year Update, growth is forecast to be slightly slower in the first part of the forecast period reflecting the downward revisions to historical growth by Statistics New Zealand. Growth is higher later in the forecast period chiefly reflecting faster private consumption growth, largely as a consequence of lower import prices Figure 1.9 Actual and potential GDP growth and interest rates. Higher population growth compared to the Half Year Update contributes to a small upward revision to the economy s potential growth rate over the forecast period. 5 The annual average rate is estimated to increase from around 2.5% currently to 2.8% in mid-2017 as productivity growth rises from low levels with labour productivity growth rising towards trend. Potential growth averages around 2.6% over the forecast period (Figure 1.9). as population growth eases Annual average % change Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10 Mar-12 Mar-14 Mar-16 Mar-18 Actual GDP Quarterly Potential GDP Sources: Statistics New Zealand, the Treasury The annual net inflow of migrants is expected to ease from a peak of 56,600 in June 2015 as departures increase and arrivals decline from record high levels in line with an improving Australian economy. Net inflows return to the long-run assumption of 12,000 a year by mid The change in the profile of migration results in an additional 11,400 people over the forecast period compared to the Half Year Update. Risks remain around the duration and size of migration flows. Scenario two in the Risks and Scenarios chapter assesses the potential impact of stronger domestic demand, in part driven by a larger than expected migration cycle. 5 Potential growth is the rate at which the economy can expand while maintaining stable inflation. It depends on how many people are available to work and how many hours they are willing to work (labour); the number of buildings, machines and computers (capital); and the efficiency with which they are used (total factor productivity). B.3 17

22 2015 BUDGET ECONOMIC AND FISCAL UPDATE and employment and income growth slows Annual employment growth is forecast to moderate from its 3.5% pace in the December 2015 quarter (Figure 1.10). The unemployment rate declines gradually to 4.5% in late 2017 as the contribution to the labour force from migration eases and labour force participation stabilises at slightly lower levels. Figure 1.10 Employment, labour force and unemployment rate Annual average % change % of labour force 8-3 Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10 Mar-12 Mar-14 Mar-16 Mar-18 Quarterly Employment Labour force Unemployment rate (RHS) As the labour market tightens and inflation begins to rise, average hourly Sources: Statistics New Zealand, the Treasury wage growth picks up gradually to 3.3% in the March quarter of 2019 from 2.5% in March Beyond June 2016, total labour income growth is slightly softer than previously forecast, mainly reflecting slower wage growth Household expenditure growth eases Private consumption is forecast to grow by 3.9% in the March 2016 year (contributing 2.3 percentage points to GDP growth [Figure 1.11]), before easing to 2.8% as support from population and labour income growth moderates and interest rates increase. Growth is stronger in later years compared to the Half Year Update given lower consumption import prices and lower interest rates. Figure 1.11 Contributions to real GDP growth %-point contribution to growth Years ended 31 March Private consumption Government consumption Residential investment Business investment Inventories Exports less imports Sources: Statistics New Zealand, the Treasury while residential investment peaks Residential investment is expected to rise further, albeit at a slower rate than over recent years with activity peaking in early Investment is driven by strong population growth and housing demand in the Auckland market. A high level of activity in Canterbury is expected to be sustained for some time providing a solid base, although recent data have shown a decline in residential consents in the Canterbury region, posing some downside risk. and business investment slows as interest rates rise Firms are forecast to expand their investment as output grows, supported by low interest rates and a high NZ dollar. Annual average growth in business investment is expected to remain over 5.0% until the March 2017 year, before easing to 2.4% in the March 2019 year as interest rates begin to rise and Canterbury rebuild-related growth slows. 18 B.3

23 ECONOMIC OUTLOOK Government expenditure growth remains subdued Fiscal policy is forecast to exert a mild constraining influence on demand over most of the forecast period with operating allowances unchanged from the Half Year Update. Government consumption growth is expected to ease over the next few years before picking up in the 2017 fiscal year reflecting a larger operating allowance. Operating allowances are added to government expenditure as a technical assumption in the forecasts, but in practice are available for a combination of expenditure and revenue initiatives. Trading partner growth is uneven Trading partner growth is expected to increase in 2015 and 2016 as growth remains on track in the US and picks up from a slow pace in the euro area and Japan (Table 1.2). Australian growth is expected to remain below trend for longer as the rebalancing from mining investment to other sectors of the economy progresses slowly. In addition, China s growth is slowing as investment growth eases. A greater weighting to higher growth economies means trading partner growth is slightly stronger than previously forecast in the longer term. Table 1.2 Trading partner growth forecasts (annual % change) weights Estimate China 25% Australia 24% Other Asia* 22% United States 11% Euro area 7% Japan 7% United Kingdom 4% Canada 1% Trading Partner Growth (TPG) 100% TPG - Consensus (April 2015) TPG - IMF WEO (April 2015) TPG - The Treasury (2014 Half Year Update ) * South Korea, Taiwan, Hong Kong, Singapore, Malaysia, Indonesia, Thailand, Philippines, India Sources: IMF, Consensus s, Haver Analytics, the Treasury with more accommodative monetary policy... Low inflation and in some cases falling prices have been a global phenomenon recently with many central banks adopting more accommodative monetary policy stances since the Half Year Update. The European Central Bank introduced quantitative easing and the Bank of Japan expanded its quantitative easing programme while the Japanese government postponed a second sales tax hike. China has eased monetary policy in view of risks to its lower growth target of 7% this year, and Australia reduced its cash rate again in May, to 2.0%. Long-term interest rates have fallen given the increased demand for sovereign debt from the large quantitative easing programmes and postponement of policy rate increases. However, interest rates are expected to increase later in the forecast period as world growth strengthens and central banks reduce monetary stimulus. B.3 19

24 2015 BUDGET ECONOMIC AND FISCAL UPDATE and recovery in the terms of trade The terms of trade are assumed to Figure 1.12 Goods terms of trade increase as commodity supply and Index 1400 demand come back into balance 1300 (Figure 1.12). Oil prices are assumed to rise steadily to around $US80 per 1200 barrel. As oil prices increase, they 1100 partially offset the benefits of rising 1000 dairy prices. Compared to the Half Year Update, weaker consumption 900 and intermediate goods import prices 800 as a result of the weaker global Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10 Mar-12 Mar-14 Mar-16 Mar-18 Quarterly inflation environment provide less of a Budget Update Half Year Update drag on the terms of trade over the Sources: Statistics New Zealand, the Treasury latter years of the forecast period. These developments result in higher terms of trade than forecast in the Half Year Update. leading to a higher NZ dollar The strong relative performance of the New Zealand economy, high terms of trade and positive international interest rate differentials exert upward pressure on the NZ dollar. The NZ dollar reached post-float highs against the euro and Australian dollar in April 2015 which have more than offset declines against the US dollar since July 2014 as expectations of interest rate increases build in that economy. The trade-weighted exchange rate index is higher than forecast in the Half Year Update and is expected to remain steady at an elevated level as these different forces continue to balance each other. A higher NZ dollar places downward pressure on tradables inflation and constrains export growth; however, households benefit through increased purchasing power. and the current account deficit stabilising The annual current account deficit is forecast to stabilise around 5.0% to 5.5% of GDP from the March 2016 quarter until the end of the forecast period (Figure 1.13). Overall, the deficit Figure 1.13 Current account components % of GDP (annual) 3 0 is narrower by around half a percentage point compared to the Half Year Update, reflecting lower oil import prices and slower growth in intermediate and -3-6 consumption import goods prices. -9 Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10 Mar-12 Mar-14 Mar-16 Mar-18 Increased visitor arrivals result in a Quarterly wider services surplus. Lower Current account balance Income balance Goods balance Services balance international interest rates moderate Sources: Statistics New Zealand, the Treasury income outflows, leading to a narrower annual income deficit. As a consequence, net international liabilities are lower at 74.8% of GDP in the March 2019 quarter compared to 79.8% of GDP in the Half Year Update. 20 B.3

25 ECONOMIC OUTLOOK Inflation rises as cyclical factors pass Annual inflation is expected to remain low throughout 2015 and rise gradually to 2.1% by the end of 2016 (Figure 1.14), remaining close to the mid-point of the Reserve Bank s target band thereafter. Tradables inflation is expected to rise to 0.2% in early 2016, from an estimated -2.4% in the March 2015 year, remaining around that level over the rest of the forecast period. Quarterly Until recently the output gap has been Budget Update Half Year Update negative but is now estimated to be around zero. Past spare capacity is Sources: Statistics New Zealand, the Treasury reflected in current low non-tradables inflation and with inflation expectations and nominal wage growth also subdued, non-tradables inflation is expected to ease further to 2.0% over coming quarters. Non-tradables inflation is expected to rise to over 3.0% at the end of 2016 as capacity pressures develop. Consumer price inflation is considerably lower than forecast in the Half Year Update. Scenario one of the Risks and Scenarios chapter looks at the impacts of lower terms of trade than in the central forecast and a prolonged period of low global inflation. See the box Why has inflation been surprisingly low? (page 22) for details on the main factors that are contributing to low inflation and a discussion of the inflation outlook. supported by a period of low interest rates Figure 1.14 Consumer price inflation Annual % change 0 Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10 Mar-12 Mar-14 Mar-16 Mar-18 Short-term interest rates are forecast to remain around current levels of 3.6% until late 2016 owing to the low inflation outlook. Short-term rates then begin to rise, reaching 4.8% in the March quarter of Long-term rates, which have fallen globally as a result of more accommodative monetary policy, are expected to increase gradually in line with international rates reaching 5.1% by March Overall, low domestic inflation flows through to slower nominal GDP growth While the outlook for real activity remains positive, the weak domestic inflation outlook results in slower nominal GDP growth in the 2016 and 2017 fiscal years than in the Half Year Update, but growth is faster in 2018 and 2019 (Figure 1.15). Cumulatively across the forecast period, nominal GDP is lower by around $5 billion. Figure 1.15 Nominal GDP growth Annual average % change Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10 Mar-12 Mar-14 Mar-16 Mar-18 The downward revision to nominal Quarterly GDP growth forecasts reduces Budget Update Half Year Update forecast tax revenue from the Half Sources: Statistics New Zealand, the Treasury Year Update. In addition, lower shortterm interest rates as a result of downwardly-revised inflation contribute to a fall in tax revenue through lower interest resident withholding tax (see Fiscal Outlook chapter). B.3 21

26 2015 BUDGET ECONOMIC AND FISCAL UPDATE Why has inflation been surprisingly low? Recent CPI inflation outturns have been low and have undershot the Treasury s and the Reserve Bank s forecasts. The most recent outturn showed prices rose only 0.1% in the year to March 2015, a significant deceleration from March 2014 (1.5%). Although fuel prices fell significantly over the December and March quarters, annual inflation excluding fuel was still a subdued 1.0% in March. Tradables inflation excluding vehicle fuels has been negative for some time and relatively stable, falling only slightly from -0.7% a year ago to -0.9% in March. On the other hand, non-tradables inflation has fallen from 3.0% to 2.3% over the same period. There are a number of factors other than the fall in fuel prices that have contributed to low inflation, including: Retail competition in recent years around 15% of retail items have been discounted each quarter, compared to around 9% in 2009, despite strengthening private consumption growth. The ability of consumers to purchase overseas goods online also contributes to more intense competition. Quality adjustments quality-adjusted prices for electronic goods and communication services are continuing to decline as a result of improved technology and features. Supply chain management the Treasury s business talks suggested that firms have been negotiating lower prices with their suppliers, allowing them to minimise price increases. Low global inflation New Zealand s trading partners are experiencing low inflation, chiefly as a result of weak demand, which is contributing to lower import cost increases. This is also affecting prices for many non-tradable items as they include traded goods inputs. The high NZ dollar this has been dampening tradables inflation with imported items such as durable goods and clothing and footwear declining in price over the past several years. Another factor behind low inflation has been the presence of spare capacity in the economy. The output gap, a summary measure of the difference between actual output and its sustainable level, has been negative since That is, the economy has been capable of producing more, while leaving some resources less than fully employed. As a consequence, there has been less pressure on prices to rise. However, the Treasury s model estimates show the output gap has recently closed. Other indicators suggesting spare capacity has been largely exhausted include the Quarterly Survey of Business Opinion (QSBO) measure of capacity utilisation which is at its highest level in six years. The QSBO also showed supply factors are becoming more of a constraint on the expansion of output than demand. The Treasury expects the output gap to become increasingly positive over the next year which, all else equal, will lead to higher non-tradables inflation (Figure 1.16). The labour market has also experienced a reduction in spare capacity, with the unemployment rate declining from 6.0% to 5.8% over 2014, despite record rates of labour force participation and high net migration inflows. However, wage growth has been subdued at 2.1% in March 2015 year (partly reflecting the low inflation) and the unemployment rate remains above the level that would lead to an increase in inflation, indicating that there is still some spare capacity in the market. 22 B.3

27 ECONOMIC OUTLOOK Even with the reduction in spare capacity in the economy, inflation expectations and surveys of pricing intentions have been falling. In the Reserve Bank s Survey of Expectations, the 2-year ahead inflation expectation declined from 2.3% in the March 2014 quarter to 1.8% in the March 2015 quarter. Similarly, the March QSBO showed a decline in firms selling price expectations and cost price expectations to historically low levels. A net 6% of firms expect to raise prices while a net 19% of firms expect costs to increase in the June quarter. However, inflation expectations and pricing intentions tend to reflect recent outturns and the extent to which they influence future behaviour is uncertain (Figure 1.17). Figure 1.16 Non-tradables inflation and the output gap Annual % change % of potential Figure 1.17 Headline CPI and inflation expectations Annual % change Annual % change Quarterly Non-tradables inflation (ex-gst increase) Output gap (4 qtr ma, RHS) Sources: Statistics New Zealand, the Treasury Mar-99 Mar-01 Mar-03 Mar-05 Mar-07 Mar-09 Mar-11 Mar-13 Mar-15 Quarterly Annual CPI 2-year ahead inflation expectations (RHS) Sources: Statistics New Zealand, Reserve Bank of New Zealand The factors discussed above which have contributed to the recent low inflation outturns are a mix of temporary and permanent factors. Downward pressure on inflation will continue if retail competition, quality enhancements in communications technology and supply chain management intensify. The other factors, including the recent oil price fall and the appreciation in the exchange rate, are likely to be temporary. In these forecasts, inflation returns to the Reserve Bank s target mid-point as excess demand pressure builds. However, should low inflation persist there would be a case for interest rate cuts, as shown in the Reserve Bank s March Monetary Policy Statement. This would help to offset some of the weaker growth in nominal GDP and tax revenue which would eventuate from lower-than-forecast inflation. B.3 23

28

29 2 Fiscal Outlook Overview The fiscal outlook for the Crown is expected to continue to strengthen. The strengthening outlook reflects both expenditure restraint and a growing economy which is driving growth in tax revenue. While forecasts of expenditure are largely unchanged overall, tax revenue forecasts have generally been revised down since the Half Year Update primarily owing to weaker inflation and lower interest rates. Core Crown expenditure as a percentage of GDP is expected to be 30.5% in 2014/15, falling across the forecast period to be 29.2% in 2018/19. The Budget 2015 operating package of about $1.0 billion a year on average over the next four years is in line with that signalled in the Budget Policy Statement. Future operating allowances remain at $1.0 billion for Budget 2016, $2.5 billion in Budget 2017 and $1.5 billion in Budget In addition to the Budget 2015 package, the Government has also signalled further reductions in ACC levy rates, resulting in a structural reduction in OBEGAL of around $0.6 billion from 2016/17. The total Crown OBEGAL deficit has reduced from $18.4 billion in 2010/11 to a forecast of $684 million in 2014/15, with growing OBEGAL surpluses forecast thereafter, reaching $3.6 billion in 2018/19. Capital spending by the core Crown is estimated to be $24.0 billion over the forecast period. This is an increase of $1.0 billion since the Half Year Update, mainly owing to new spending decisions. Capital allowances of $0.7 billion are forecast in Budget 2016 before rising 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 now expected to peak at 26.3% of nominal GDP in 2015/16, before dropping to 22.9% of nominal GDP by 2018/19. Overall, forecast net core Crown debt is similar to the Half Year Update. The Crown s net worth is expected to increase over the forecast period, reaching around $93.6 billion by 2018/19, following surpluses from 2015/16 as the growth in assets outpaces liabilities. B.3 25

30 2015 BUDGET ECONOMIC AND FISCAL UPDATE Within the balance sheet, total assets are forecast to be $296.3 billion by 2018/19, with financial assets (particularly the Crown s investment portfolios) forecast to increase by $12.9 billion to $87.9 billion. Liabilities begin to fall in nominal terms by the end of the forecast period as earthquake obligations are settled and the Crown begins to pay down debt. Total liabilities are expected to stand at $197.3 billion at the end of 2018/19, with borrowings making up $115.6 billion of that. 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. Table 2.1 Fiscal indicators Year ended 30 June 2014 Actual $billions Total Crown OBEGAL 1 (2.9) (0.7) Core Crown residual cash (4.1) (2.7) (4.2) (1.6) (0.2) 1.7 Net core Crown debt Net worth attributable to the Crown % of GDP Total Crown OBEGAL 1 (1.3) (0.3) Core Crown residual cash (1.8) (1.1) (1.7) (0.6) (0.1) 0.6 Net core Crown debt Net worth attributable to the Crown Notes: 1 Operating balance before gains and losses. 2 Net core Crown debt excluding the New Zealand Superannuation Fund (NZS Fund) and advances. Source: The Treasury Table 2.2 Reconciliation between OBEGAL and net core Crown debt Year ending 30 June $billions 2014 Actual Core Crown revenue Core Crown expenses (71.5) (73.1) (74.9) (77.1) (80.8) (83.4) Net surpluses/(deficits) of SOEs and CEs (0.3) (0.7) (0.4) Total Crown OBEGAL (2.9) (0.7) Net retained surpluses of SOEs, CEs and NZS (0.8) (0.6) (0.1) Fund Non-cash items and working capital movements Net core Crown cash flow from operations (3.0) Net purchase of physical assets (1.9) (2.1) (2.6) (2.5) (1.6) (1.5) Advances and capital injections (1.5) (2.2) (3.4) (2.4) (1.8) (1.7) for future new capital spending - - (0.3) (0.4) (0.7) (0.9) Proceeds from government share offers Net core Crown capital cash flows (1.1) (3.7) (6.3) (5.3) (4.1) (4.1) Core Crown residual cash (deficit)/surplus (4.1) (2.7) (4.2) (1.6) (0.2) 1.7 Opening net core Crown debt Core Crown residual cash deficit/(surplus) (1.7) Valuation changes in financial instruments - (0.9) (0.2) (0.1) - - Closing net core Crown debt As a percentage of GDP 25.6% 25.7% 26.3% 25.5% 24.4% 22.9% Source: The Treasury 26 B.3

31 FISCAL OUTLOOK 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, 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 additional future new spending or revenue reductions will be limited to the operating and capital allowances set by the Government. Reductions to ACC levies will be implemented (refer page 37). 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 is uncertain and therefore not included in the forecasts, with the exception of funding to the Tāmaki Redevelopment Company, which is included. returns of the large investment portfolios managed by ACC and the NZS Fund are based on long-term benchmark rates of return for each portfolio. The valuations of the student loan portfolio, ACC claims liability and the Government Superannuation Fund (GSF) retirement liability are based on underlying assumptions made at the time the valuations were prepared. Further information on the fiscal forecast assumptions can be found on pages 49 to 51. B.3 27

32 2015 BUDGET ECONOMIC AND FISCAL UPDATE Core Crown Tax Revenue Tax revenue grows over the forecast period... Core Crown tax revenue (Table 2.3) is forecast to rise in each year of the forecast period. By 2018/19, core Crown tax revenue is expected to reach $80.5 billion, $19.0 billion higher than in 2013/14. tax revenue increases as a percentage of nominal GDP, from 26.3% in 2013/14 to 28.2% at the end of the forecast period (Figure 2.1). The main driver for the increase in tax revenue is forecast growth in nominal GDP (Figure 2.2). Factors that influence tax revenue are 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), the interest rate forecast (affecting Resident Withholding Tax (RWT)), Consumers Price Index (CPI) indexation of excise rates and assumptions regarding such things as the timing of tax revenue recognition and the accumulation, and subsequent utilisation, of tax losses....with 2014/15 particularly strong... Figure 2.1 Core Crown tax revenue $billions Year ending 30 June Core Crown tax revenue % of GDP Source: The Treasury Figure 2.2 Core Crown tax revenue and nominal GDP growth % % of GDP Year ending 30 June Tax revenue growth Nominal GDP growth Source: The Treasury Year-to-date core Crown tax outturns to March 2015 are around 8.0% up on last year, mainly owing to growth in: source deductions, caused in roughly equal parts by growth in employment and wages, and with a contribution from fiscal drag too corporate tax, in which unusually large terminal tax from the 2014 tax year is boosting the growth rate, and goods and services tax (GST), where strong growth in residential investment, partly owing to the Canterbury rebuild, is complementing growth in nominal private consumption. The year-on-year growth in core Crown tax revenue in 2014/15 is expected to reduce to around 7.5% by June, as some of the strength in year-to-date results is expected to soften, mainly owing to seasonal variation in PAYE and the timing of corporate tax. However, some upside risk to the 2014/15 tax revenue outturn remains, particularly as the June quarter is typically the largest quarter for tax revenue each year. Individually, small variations in tax returns that are due in the June quarter (eg, annual income tax returns 28 B.3

33 FISCAL OUTLOOK from most large corporate and Portfolio Investment Entities (PIE) annual tax returns), can accumulate to large variances from forecast, presenting risks to the 2014/15 tax revenue outturn, both positive and negative. The expected 7.5% growth in tax revenue in 2014/15 is higher than the 2.4% forecast for growth in nominal GDP. The main reasons for this difference are: the components of nominal GDP that drive the underlying taxable bases for tax revenue are growing faster than total nominal GDP, for example, total employees compensation is forecast to grow by 5.2%, nominal private consumption is forecast to grow by 4.5% and nominal residential investment is forecast to grow by 18.2% tax revenue in the 2014/15 fiscal year has been boosted by higher-than-usual terminal tax, mainly from the 2014 tax year, and excise rate increases and fiscal drag have also added to tax revenue growth....while nominal GDP growth drives tax revenue growth in future years Through 2015/16 and 2016/17, total tax revenue is forecast to grow in line with nominal GDP, although there is considerable variation across the tax types: source deductions and GST are forecast to grow faster than nominal GDP owing to fiscal drag and to continued strong residential investment growth, but corporate tax and other persons tax are forecast to grow more slowly than nominal GDP (in fact, other persons tax is forecast to decline in 2015/16) owing to relatively weak growth in the underlying income drivers (operating surplus and entrepreneurial income) and an assumption that terminal tax will return to a more normal level in 2015/16. Through 2017/18 and 2018/19, tax revenue growth is forecast to outstrip nominal GDP growth owing to (in approximate decreasing order of significance): fiscal drag adding to the growth rate of source deductions increasing deposit interest rates providing a boost to interest RWT CPI indexation of excise rates, and an assumed tailing-off of earthquake-related GST refunds. Table 2.3 shows a complete breakdown of the drivers of growth in forecast tax revenue. B.3 29

34 2015 BUDGET ECONOMIC AND FISCAL UPDATE Table 2.3 Composition of growth in core Crown tax revenue over the forecast period Year ending 30 June $billions Total Movement in core Crown tax owing to: Employees' compensation Private consumption Corporate profits Fiscal drag Residential investment Indirect tax CPI inflation indexation Entrepreneurial income (0.1) Interest rates Interest bearing deposit base Budget 2015 policy initiatives Other factors 1.6 (0.2) (0.3) Total movement in core Crown tax revenue Plus: previous year's tax base Core Crown tax revenue Percentage of GDP 27.6% 27.6% 27.6% 27.9% 28.2% Note: Other factors in 2014/15 includes additional 2013/14 terminal tax recognised in 2014/15. Source: The Treasury Tax policy changes made by the Government have been included in these forecasts, with the largest effect being the provision of additional audit funding to Inland Revenue (IRD), which is expected to raise an additional $65 million of tax revenue in 2015/16 rising to $257 million in 2018/19. Table 2.4 Significant tax policy changes Year ending 30 June $millions Total 5 years Tax policy changes: Inland Revenue audit funding 2015 Budget bid Inland Revenue audit funding extension of Budget bid Child hardship package (PAYE effect) Total Inland Revenue has also prepared a set of tax forecasts based on the Treasury s macroeconomic forecasts. Inland Revenue s forecasts are close to Treasury s forecasts, with all the differences in the forecasts of total core Crown tax in any one year being less than $250 million (0.1% of GDP). This comparison is included in the Additional Information on the Treasury website 30 B.3

35 FISCAL OUTLOOK Impact of low inflation on the fiscal outlook As outlined in the Economic Outlook chapter, recent price inflation outturns have been lower than previously forecast (refer pages 22 and 23). Price inflation is an important component of a number of economic indicators (eg, nominal GDP, wages) that are used to prepare the Government s fiscal forecasts. A lower inflation track impacts on both the revenue and expenses of the Government. However, revenue is more sensitive to price inflation changes than expenses are, which means the impact on OBEGAL is not symmetrical. In addition, the impact on the fiscal outlook from low inflation will be influenced by the factors contributing to slow price growth. For example price movements such as dairy prices, can have significant impacts on the fiscal outlook but will not have much impact on price inflation since they represent only a small fraction of domestic consumers spending. Other price changes, such as sharp movements in the price of oil, can have a large impact on price inflation but only modest impacts on the fiscal outlook as consumers can switch their spending to other goods. It is difficult to quantify the effect low inflation has on the fiscal outlook, given the intricacy of its relationship with economic and fiscal aggregates. This box looks at summarising the fiscal impact we would expect from lower forecast price inflation, which is expected to be associated with weaker growth in nominal income and spending. Broadly speaking, at present the negative impact of lower inflation on revenue is larger than the positive impact on expenses, contributing to OBEGAL being lower than previously forecast. Core Crown tax revenue is forecast to be $66.1 billion for the year ended 30 June Most types of tax revenue are in some way sensitive to inflation either directly or indirectly. In an environment of low inflation, we would expect the following impacts on the critical economic indicators that underpin our tax revenue forecasts: Nominal consumption growth would be weaker, which in turn will result in a reduction in GST revenue. Nominal business profits may be marginally lower in a low-inflation environment, resulting in slower growth of business income taxes such as company tax and other persons tax. Interest rates will generally be low when inflation is low, thereby resulting in lower returns for depositors, which in turn reduces the level of taxable interest income and, hence, RWT on interest. Excise rates are CPI-indexed, so lower inflation would result in slower growth in excise duties. Wage growth would be lower and, as a result, the amount of source deductions collected by the Government would reduce. In addition, reduced wage growth also results in a slower rate of fiscal drag, reducing source deductions further. There will be a lag before low inflation effects source deductions, owing to timing of wage rounds. There are other revenue sources (eg, petroleum royalties resulting from lower oil prices and interest revenue owing to lower interest rates) also impacted by inflation, albeit to a lesser extent. B.3 31

36 2015 BUDGET ECONOMIC AND FISCAL UPDATE There are some positive impacts on the fiscal outlook from low inflation and consequential low interest rates through reductions in core Crown expenses. However, unlike core Crown tax revenue, only a portion of core Crown expenses, namely benefit expenses and finance costs, are particularly sensitive to price inflation. In some cases, expenses are impacted later than revenue. For the year ended 30 June 2015, benefit expenses and finance costs are expected to total $27.8 billion, which is just over a third of total core Crown expenses. Department baselines and new operating allowances are fixed in nominal terms, so are not sensitive to price inflation, but lower inflation should increase the Government s purchasing power. Specific impacts are as follows: New Zealand Superannuation (NZS) payments (forecast to be $11.6 billion in 2015) are indexed to at least 66% of the net average wage, so are not directly impacted by inflation. However, to the extent that lower inflation is reflected in lower wage growth, NZS payments would be expected to be lower. Given the indirect impact there will be a lag before inflation starts to influence net average wages. Most other benefits are indexed directly to CPI inflation (excluding the impact of tobacco product price increases), so low inflation would reduce benefit costs. However, although family tax credits are indexed to inflation, payments are fixed until the cumulative impact of inflation reaches 5%, so the increase in expenses is later. The yields on inflation-indexed bonds (approximately 20% of government stock) are linked directly to inflation, so lower inflation reduces finance costs. Lower interest rates result in a reduction in both finance costs and interest revenue. The majority of interest-bearing financial assets are short-term in nature, so are quick to respond to interest rate changes. In contrast, borrowings are generally longer term, so there is a lag before the impact of interest rates flows through to finance costs, as the existing stock of bonds are replaced by new bonds with lower yields. 32 B.3

37 FISCAL OUTLOOK Core Crown Expenses Core Crown expenses as a percentage of nominal GDP reduces... Growth in core Crown expenses is forecast to be at a slower rate than growth in the nominal economy, falling from 30.5% of GDP in 2013/14 to 29.2% of GDP at the end of the forecast period (Figure 2.3)....although nominal spending increases Nominal growth in core Crown expenses of $11.9 billion over the forecast period from $71.5 billion in 2013/14 to $83.4 billion in 2018/19 is largely attributable to new spending in the Budget 2015 operating package, new operating allowances in future budgets and increased social assistance spending (as shown in Figure 2.4). New operating allowances have been set at $1.0 billion for Budget 2016, rising to $2.5 billion in Budget 2017 before reducing to $1.5 billion in Budget The combined new spending totals $6.4 billion by 2018/19 (Figure 2.5). For forecasting purposes, the allowances beyond Budget 2015 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 as budget decisions are made. As a result, most functional expense areas (eg, health, education) in the Treasury tables remain flat beyond 2015/16 across the forecast period because specific decisions on where to allocate new spending have yet to be decided. Therefore comparisons are difficult at a functional level. Figure 2.3 Core Crown expenses $billions Year ending 30 June Source: The Treasury Core Crown expenses % of GDP % of GDP Figure 2.4 Increase in core Crown expenses $billions Net $1.6b Budget 2015 Finance costs Other Net $3.5b Source: The Treasury Net $5.6b Year ended 30 June Net $9.4b Net $11.9b Future allowances (operating) Social assistance Total net change Figure 2.5 Budget 2015 and future Budget allowances impact on expenses $billions Budget 2015 Budget 2016 Budget 2017 Budget 2018 Source: The Treasury Total: $6.4 billion B.3 33

38 2015 BUDGET ECONOMIC AND FISCAL UPDATE The following table summarises the impact of the Budget 2015 package on core Crown expenses. Table 2.5 Summary of changes in revenue and expenses arising from Budget 2015 operating package Year ending 30 June $millions Core Crown revenue Core Crown expenses 42 1,038 1,251 1,355 1,388 OBEGAL impact , ,031 Composition of core Crown expense increase: Child hardship package Health Education Other Social Sector Business Growth Agenda Canterbury Earthquake Recovery Authority Defence KiwiSaver kick-start (17) (175) (126) (106) (107) Other Reprioritisation (48) (92) (121) (94) (79) Contingencies Increase in core Crown expenses 42 1,038 1,251 1,355 1,388 Source: The Treasury Apart from new budget spending, social assistance spending is expected to increase by $3.9 billion across the forecast period. New Zealand superannuation payments grow by $3.5 billion with costs linked to wage growth and increasing recipient numbers (Figure 2.6). As a percentage of total social assistance spending, New Zealand superannuation is expected to rise from about 39% in 2008/09 to around 53% a decade later. Figure 2.6 Social assistance spending $billions Year ending 30 June NZ Superannuation Other benefits NZ Superannuation beneficiaries (RHS) Thousands 1,200 Source: The Treasury Apart from superannuation, other welfare expenditure grows by $0.4 billion over the five-year forecast horizon, including income-related rents subsidy, family tax credits and sole parent support. Overall workingage beneficiary numbers are expected to decline in every year, led by drops in Jobseeker Support and Sole Parent Support. In later years these reductions are largely offset by inflation-based rate indexation. The largest single year growth occurs between 2015/16 and 2016/17, with the introduction of the Child hardship package, particularly impacting Sole Parent Support. 1, B.3

39 FISCAL OUTLOOK Cost to the Crown of the Canterbury rebuild Table 2.6 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 $16.5 billion, $0.5 billion higher than the Half Year Update. $393 million of the increase since the Half Year Update relates to operating expenses while capital costs (mostly Crown assets) are $183 million higher. The largest increase in operating costs relate to Southern Response. An updated valuation of Southern Response s insurance claim costs estimated an increase in claim numbers (particularly in relation to the number of properties that exceed the Earthquake Commission (EQC) cap) and out of scope claim size, along with increased repair costs. As a result, Southern Response s earthquake related expenses are expected to reach just over $290 million in the current year, increasing the total cost to $800 million. The increase of $134 million in Crown assets mostly reflects additional capital spending on schools in the Canterbury region. Table 2.6 Net earthquake expenses (operating and capital) Year ended 30 June $millions Actual Outside forecast period Total Budget Update Total Half Year Update Local infrastructure 1, ,806 1,806 Crown assets ,158 2,024 Land zoning 1, ,126 1,139 Christchurch central city rebuild (4) 1 (175) 1,241 1,126 Welfare support Southern Response support package (30) (30) (15) Other costs ,197 1,094 Core Crown Canterbury earthquake recovery costs 4,683 1,237 1, (175) 8,634 8,050 EQC (net of reinsurance proceeds) 7,757 (201) (164) (124) (1) - - 7,267 7,405 Other SOE and CEs (86) (26) Total Crown 12,354 1,010 1,583 1, (175) 16,526 15,950 Operating and capital expenses Operating expenditure (OBEGAL) 11, ,720 12,327 Capital expenditure , (175) 3,806 3,623 Total Crown 12,354 1,010 1,583 1, (175) 16,526 15,950 Total cash payments 3 8,002 2,740 3,007 1, (175) 16,044 15,477 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 include the timing of expenditure and escalating costs as well as the independent review of infrastructure costs shared by the Christchurch City Council and the Crown (refer to the Specific Fiscal Risks chapter). B.3 35

40 2015 BUDGET ECONOMIC AND FISCAL UPDATE Operating Balance Operating performance of the Crown continues to strengthen The OBEGAL deficit has reduced from $18.4 billion in 2010/11, to $2.9 billion in 2013/14 and is expected to be $0.7 billion in 2014/15. A surplus of $0.2 billion is now forecast in 2015/16 rising to $3.6 billion by 2018/19. It can be difficult to do international comparisons, as jurisdictions use different financial frameworks. However, looking at the fiscal balance 6 the IMF produces, to enable crosscountry comparisons, the New Zealand operating performance exceeds a number of other countries (Figure 2.7). Figure 2.8 shows the composition of OBEGAL from the different segments of the Government. The core Crown segment is forecast to have an OBEGAL deficit of $1.2 billion in 2014/15, breakeven in 2015/16, then continues to rise over the forecast period, largely reflecting growth in tax revenue outpacing growth in nominal spending. State-owned Enterprises (SOEs) are expected to continue to record operating surpluses throughout the forecast period. Figure 2.7 International comparisons of fiscal balance % of GDP Source: IMF Australia New Zealand United Kingdom United States Figure 2.8 Components of OBEGAL by segment $billions Year ending 30 June Core Crown Crown Entities SOEs OBEGAL (after inter-segment eliminations) Source: The Treasury The impact of Crown entities (CEs ) performance on OBEGAL results varies across the forecast period, largely reflecting changes in ACC results. In addition, Southern Response insurance expenses are expected to be $0.3 billion higher in 2014/15, adversely impacting that year. 6 Fiscal balance (sometimes referred to as net lending/borrowing) is defined as the net operating balance less the net acquisition of non financial assets such as property, plant and equipment. The inclusion of capital purchases and removal of impairments/write-offs are the major points of difference to OBEGAL. 36 B.3

41 FISCAL OUTLOOK As part of Budget 2015, the Government has signalled further reductions in the ACC levy rates of around $1.5 billion across the forecast period (largely in the last three years of the forecast). When combined with the consequential impact on investment revenue and insurance expenses, the fiscal impact on OBEGAL is expected to be on average $0.6 billion per year from 2016/17 (Table 2.7). An increase in expenses reflects the increased risk of meeting future claims with reduced revenue. Table 2.7 Impact of proposed ACC levy reduction Year ending 30 June $millions Total Decrease in levy revenue - (32) (372) (533) (547) (1,484) Foregone investment revenue - - (4) (28) (51) (83) Increase in insurance expenses Impact on OBEGAL - (44) (523) (632) (605) (1,804) Source: The Treasury...while investment returns lift the operating balance The total Crown operating balance, inclusive of gains and losses, is forecast to be a deficit in 2014/15 of $0.6 billion before returning to growing surpluses in each year of the forecast period (Figure 2.9). Figure 2.9 Components of operating balance $billions Investment returns in 2013/14 were higher than average, reflecting the strong performance of global equity markets. In 2014/15, the forecast gains on investments is $6.0 billion, primarily ACC and NZS Fund. The Year ending 30 June Source: The Treasury Gains and losses OBEGAL Operating balance forecast assumes investment income returns to a long-term rate of return, resulting in subdued growth going forward. These gains play a part in increasing the Government s financial assets and the Crown s net worth (discussed on page 43). While financial gains on investments are positive, the 2014/15 year is adversely impacted by losses of $6.6 billion, in relation to updated long-term liability valuations for ACC and the GSF, mainly owing to changes in economic factors (such as interest rates and inflation) impacting the valuations and reducing the operating balance surplus. The operating balance is sensitive to balance sheet movements. Refer to the total Crown balance sheet section later in this chapter. B.3 37

42 2015 BUDGET ECONOMIC AND FISCAL UPDATE Structural fiscal balance indicators and the fiscal impulse 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 these indicators can be found in the Additional Information section of the Budget Update, which is available on the Treasury website Table 2.8 Structural fiscal balance indicators Year ended 30 June % of GDP 2014 Actual OBEGAL (1.3) (0.3) Cyclically-adjusted balance (0.8) (0.2) Cyclically adjusted balance with terms-of-trade adjustment (3.2) (1.9) (1.7) (1.5) (1.4) (0.7) Fiscal impulse 7 (0.3) (0.4) 0.6 (0.9) (0.3) (0.7) Source: The Treasury Structural budget 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. It provides an estimate of what the budget balance would be without the effect of the automatic stabilisers, which are the tax revenue and unemployment-related expenses that fluctuate with the business cycle. The economy is currently estimated to be operating close to its potential level, so there are only small differences between the OBEGAL and the CAB. Both the OBEGAL and the CAB increase by 1.0% of GDP between 2014/15 and 2018/19. Therefore the increase in the forecast OBEGAL is indicative of structural improvements in the fiscal position. This is largely owing to gradual reductions in the level of government expenses as a percentage of GDP over time. A range of structural fiscal balance indicators can be calculated that are an extension of cyclically-adjusted balances, adjusting for a broader range of factors such as the effects of asset or commodity prices. An indicator of the structural budget balance relevant for New Zealand is one that incorporates a terms-of-trade adjustment. Such a measure gives an approximate indication of the OBEGAL 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 longterm historical averages. The medium and long-term outlook for New Zealand s terms of trade is underpinned by fast rising consumption in emerging market economies that is supporting demand for New Zealand s food exports. The Treasury s central forecast is for the terms of trade to remain elevated. Nevertheless, international and historical experience shows that terms-of-trade booms can reverse abruptly and so this is a risk to the outlook. The CAB with a terms-of-trade adjustment, using the 20-year average, suggests a weaker structural fiscal position than the CAB. Indeed, on this measure, a structural deficit persists across the forecast horizon. The trend is positive with a forecast improvement in this structural fiscal balance by 1.2% of GDP between 2014/15 and 2018/19. 7 The fiscal impulse measure shown is the core Crown fiscal impulse plus Crown entities excluding EQC and Southern Response payments. 38 B.3

43 FISCAL OUTLOOK Fiscal impulse The fiscal impulse is a measure of discretionary changes in the fiscal position, which can be expected to have an impact on aggregate demand in the economy. The change in the structural budget balance is a rough indicator of the fiscal impulse. The indicators above show an improving structural fiscal balance, implying a contractionary fiscal impulse. However, these indicators are based on adjustments to the Crown s operating balance. These are only very approximate measures of the contribution of fiscal policy to aggregate demand since the operating balance excludes some spending that contributes to aggregate demand (eg, purchases of physical assets) while including some items that do not feed directly into aggregate demand, such as KiwiSaver subsidies and goods with high import content (eg, much defence equipment). For these reasons, the Treasury calculates a fiscal impulse indicator that is a more precise guide to the contribution of discretionary fiscal policy on aggregate demand. The fiscal impulse indicator is calculated as the change in the cyclically-adjusted cash balance and excludes net interest payments, and makes a number of other specific adjustments. The fiscal impulse indicator shows that fiscal policy is expected to have a contractionary impact on demand in almost every year of the forecast horizon. Discretionary fiscal policy is expected to withdraw 0.3% of GDP from aggregate demand on average in each year over the five years to June However, the estimated fiscal impulse is positive in 2015/16. The positive fiscal impulse in 2015/16 is owing to: a fall in the tax receipts-to-gdp ratio in that year, partly as a result of the effect of lower inflation on tax receipts rather than any discretionary policy easing, and modest stimulus from higher capital spending, partly owing to Crown capital spending on the Canterbury rebuild that is expected to peak in 2015/16. These factors offset the negative contribution to the fiscal impulse in 2015/16 from operating expenditure that continues to fall as a share of GDP. The fiscal impulse is negative for the three years to 2018/19, which reflects ongoing operating spending restraint, some reduction in capital spending from its 2015/16 peak, and a small rise in the tax receipts-to-gdp ratio. There is much uncertainty about the precise magnitude and timing of the fiscal impulse and revisions between forecast rounds can be material. Perhaps the main conclusion that can be drawn is that continued fiscal consolidation can be expected over the next four years according to a range of indicators, although the pace of fiscal tightening is relatively moderate at less than 1% of GDP per year and may in fact be positive in the coming fiscal year. Fiscal tightening can be expected to provide some offset to other positive drivers of aggregate demand over the forecast period relating to private consumption, business and residential investment, and net exports. Fiscal consolidation is keeping interest and exchange rates lower than otherwise, which helps to facilitate this shift in the drivers of demand. B.3 39

44 2015 BUDGET ECONOMIC AND FISCAL UPDATE Residual Cash Operating cash flows improve... Similar to the trend in OBEGAL, operating cash flows are expected to strengthen across the forecast period. Net operating cash flows are forecast to be about $1.0 billion in surplus for 2014/15, increasing across the remaining forecast period. The strength largely represents the growth in tax receipts outpacing operating payments. Over the forecast period, the Government is expected to generate cash flows from core Crown operations of $16.5 billion....but capital spending exceeds operating cash flows in the short term Net capital spending is forecast to exceed operating cash flows until 2018/19, while core Crown residual cash 8 returns to surplus in the 2018/19 year (Figure 2.10). Figure 2.10 Core Crown residual cash The Government is forecast to spend $24.0 billion (net of the Government Share Offer programme) on capital items, which include purchasing physical assets (eg, school buildings), advances (eg, student loans), providing capital to CEs and future new capital spending. The 2014/15 Source: The Treasury cash flows include capital receipts of $0.6 billion from the deferred settlement for Meridian Energy shares. Table 2.9 Capital expenditure activity 2014/15 to 2018/19 Year ending 30 June $billions Cumulative Purchase of physical assets (2.7) (3.0) (2.6) (1.9) (1.7) (11.9) Sale of physical assets Net purchase of physical assets (2.5) (2.9) (2.5) (1.8) (1.6) (11.3) Advances made (2.8) (2.8) (2.1) (2.3) (2.3) (12.3) Repayment of advances Net advances (0.7) (1.2) (0.5) (0.1) (0.2) (2.7) Purchase of investments (1.8) (2.1) (2.0) (1.6) (1.5) (9.0) Sale of investments Net investments (1.5) (2.1) (2.0) (1.6) (1.5) (8.7) Government Share Offer proceeds Top-down capital adjustment Future new capital spending - (0.3) (0.4) (0.7) (0.9) (2.3) Net capital spending (3.7) (6.2) (5.3) (4.1) (4.1) (23.4) Source: The Treasury 8 Net core Crown debt and residual cash indicators are measured on a core Crown basis. Residual cash includes both operating and capital activity. This differs from OBEGAL, which is measured at a total Crown level and includes operating activity only. 40 B.3

45 FISCAL OUTLOOK 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 35). Net investments largely represent capital injections to CEs, to expand their asset base, and are estimated to be $1.5 billion to $2.0 billion a year. The largest capital injections across the forecast period are to the New Zealand Transport Agency for state highways. Figure 2.11 capital activity for 2014/15 to 2018/19 by significant spending $billions Transport Canterbury rebuild Schools (excl Christchurch) Source: The Treasury Defence Student loans New capital spending Cumulative spend 2014/15 to 2018/19 Ultra fast broadband Figure 2.12 New capital spending (capital allowances) Other The unallocated new capital spending for Budget 2016 (totalling $0.5 billion) is forecast to be funded by the proceeds from the Government Share Offer programme (the Future Investment Fund) (Table 2.10). In addition, $190 million of KiwiRail funding is pre-committed against Budget 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 the spend. This profile is illustrated in Figure leading to a forecast cash shortfall of $6.9 billion Source: The Treasury Table 2.10 Future Investment Fund $billions Total fund Cash proceeds Allocated in Budget 2012 (0.533) Allocated in Budget 2013 (1.421) Allocated in Budget 2014 (1.050) Allocated in Budget 2015 (0.939) Future new capital spending Pre-committed Budget 2016 (0.190) To be allocated Source: The Treasury Over the entire forecast period a cash shortfall of $6.9 billion is expected. The cash shortfall is funded through additional borrowing and reductions in financial assets. B.3 41

46 2015 BUDGET ECONOMIC AND FISCAL UPDATE Net Core Crown Debt Net core Crown debt peaks as a share of GDP in 2014/15... Net core Crown debt as a share of nominal GDP is forecast to peak at 26.3% in 2015/16 (Figure 2.13) before reducing to 22.9% by 2018/19, consistent with the Government s longterm fiscal objectives of net core Crown debt at a level no higher than 20.0% of GDP by Figure 2.13 Net core Crown debt $billions % of GDP As residual cash returns to surplus, 0 nominal net core Crown debt begins to reduce in 2018/19, to stand at $65.5 billion. Source: The Treasury...while gross debt begins to decline after 2016/ Year ending 30 June Net core Crown debt % nominal GDP 5 0 Gross debt is expected to peak at $93.6 billion in 2016/17 after which forecast maturities are expected to exceed new debt being issued, so gross debt begins to decline. Gross debt is forecast to be $83.7 billion in 2018/19 which is equivalent to 29.3% of nominal GDP. The bond programme is expected to raise funds of $36.5 billion over the Year ending 30 June Gross Crown debt % nominal GDP forecast period, while $34.8 billion of existing debt will be repaid, providing Source: The Treasury net cash proceeds of $1.7 billion (Table 2.11). Any excess cash proceeds raised from the bond programme will be invested in financial assets and used to meet future debt maturities. The total bond programme is broadly in line with total repayment of market bonds over the forecast period. 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. Table 2.11 Net increase in government bonds Year ending 30 June $billions year Total Face value of government bonds issued (market) Cash proceeds from government bond issue Cash proceeds from issue of market bonds Repayment of market bonds (8.7) (1.8) - (11.3) (11.5) (33.3) Net proceeds from market bonds (0.5) (4.8) (5.1) 3.2 Repayment of non-market bonds (1.2) (0.3) (1.5) Net repayment of non-market bonds (1.2) (0.3) (1.5) Net cash proceeds from bond issuance (1.7 ) (4.8) (5.1) 1.7 Source: The Treasury Figure 2.14 Gross debt $billions % of GDP B.3

47 FISCAL OUTLOOK Total Crown Balance Sheet Operating balance surpluses result in a stronger balance sheet... Net worth attributable to the Crown is forecast to grow steadily in nominal terms across the forecast period largely owing to forecast operating balance surpluses. Beyond 2015, net worth attributable to the Crown is expected to grow by $18.1 billion to stand at $93.6 billion by 2018/19, increasing as a share of nominal GDP to reach 32.8% by 2018/19 (Figure 2.15)....with assets increasing by $40.2 billion over the forecast period... Figure 2.15 Net worth attributable to the Crown $billions Year ending 30 June Source: The Treasury Net worth attributable to the Crown %GDP % of GDP Total assets are forecast to grow by $40.2 billion over the forecast period to $296.3 billion in 2018/19, made up of additional investments in assets (both physical and financial) of $65.5 billion, partially offset by reductions (largely depreciation) of $25.3 billion. The largest asset growth over the forecast period is in the social assets portfolio which is expected to increase by $17.8 billion to be $149.4 billion in 2018/19 (Figure Figure 2.16 Total Crown assets 2.16) over the forecast period. This growth reflects increases in student loans and property, plant and equipment, (including Canterbury rebuild assets, school property, hospitals and increases in the social housing portfolio value). See page 50 for social housing assumptions. The financial asset portfolio is expected to increase by $12.9 billion to be $87.9 billion in 2018/19, reflecting the Treasury s New Zealand Source: The Treasury Debt Management Office (NZDMO) and Reserve Bank activities, and investment growth in the investment portfolios such as those managed by NZS Fund and ACC. The commercial asset portfolio is expected to increase by $9.5 billion over the forecast period to be $59.0 billion in 2018/19, with growth coming from SOEs investment in physical assets and growth in Kiwibank mortgages. B.3 43

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