Good growth news for the next 18 months

Rising confidence levels and dodging a serious drought have placed the New Zealand economy in a better-than-expected state heading into 2016.  Although China is facing some struggles, we do not expect the worst-case scenarios for its economy to eventuate.  Nevertheless, worries about China’s prospects are affecting financial markets and will weigh on business decision making during 2016.  Services exports will continue to be a bright spot for the economy throughout the forecast period, but there are signs that an across-the-board downturn in building activity will drag New Zealand’s economic growth rate lower by 2018.  We forecast that GDP growth will recover from 2.4%pa in March 2016 to peak at 2.9% in the middle of next year.  The subsequent domestic slowdown sees growth ease to 1.8%pa by mid-2018, and possibly lower beyond our two-year forecast horizon.

Prospects for 2016 are being influenced by two countervailing forces.  Domestic economic indicators generally improved during the latter part of 2015, and suggest that the economy has entered 2016 with more momentum than we had anticipated in our November 2015 forecasts.  But concerns about the slowing Chinese economy and its effect on broader international economic conditions have raised some doubts about how long New Zealand’s momentum might be sustained.

Let’s turn our attention first to the domestic economy’s performance.  The most obvious point of difference with our previous set of forecasts is that our fears about a major drought hitting us due to the prevailing El Niño weather pattern have not been realised.  Conditions remained relatively dry throughout December, but some periods of significant rainfall at times during January have prevented soil moisture conditions deteriorating further across much of the country.  Although the lower North Island, Marlborough, and parts of Otago and Southland stand out as being appreciably drier than normal, there will be little direct effect on economic activity.

The timing of the rain in January, along with the preparedness of farmers for a potentially dry summer, mean that the agricultural sector’s performance will be better than we had expected.  Milk production in January was down 2.1% from January 2015, with total production for the season to date 2.7% lower than the same period in the 2014/15 season.  Dry weather may have had a small role to play in this drop, but low dairy prices will have been the main factor as further marginal increases in production would not have been worth the extra costs incurred by fertiliser, for example.

The rainfall was a welcome complement to the gradual improvement in both business and consumer confidence since August last year.  Sentiment levels have climbed back above their historic averages, suggesting that the more cautious approach to both business investment and household consumption spending will not be as pronounced during 2016.

Reinforcing a more upbeat view of the domestic economy has been the latest labour market data.  The unemployment rate had seemed curiously high since mid-2014, pushing up from 5.5% to 6.0% – a trend that jarred somewhat with the ongoing expansion of the net migration flow into New Zealand.  Although the lower unemployment rate of 5.3% recorded for the December 2015 quarter is unlikely to be maintained throughout 2016, it supports our view that labour market conditions in New Zealand remain balanced and, combined with strong population growth, will provide support for continued increases in spending.

We have revised up our forecast of growth in household consumption in the March 2017 year from 2.4% to 3.1%.  Part of this revision is due to net migration (and therefore population growth) being higher than previously forecast, but per-capita spending growth will also be boosted due to better labour market conditions and consumer confidence.  Nominal wage growth still looks pretty subdued, but a lack of consumer price inflation means that workers are still enjoying relatively good real wage increases.

One final factor that can’t be ignored in the consumer spending picture is the effect of lower fuel prices.  Petrol prices are at their lowest in over a year and (at the time of writing) just 2c/l away from a six-year low.  The slump in international oil prices to below US$30/bl has been unexpected, and the corresponding decline in petrol prices will boost the amount of money households have available for discretionary spending.

Graph 1.1

Although we’re happy about the direct effects of low fuel prices on household spending in New Zealand, the drop in international prices for oil and other commodities has raised serious doubts about the robustness of global growth.  Most of the blame for these global concerns has been laid at the feet of China.

Officially, China appears to be angling for GDP growth of 6.5% this year, down from the 7.0% target of 2015 and the 7.5% target of 2014.  Unofficially, things look more downbeat than that, with electricity generation currently growing at its slowest rate since late 2009, and rail freight traffic contracting at its fastest rate in at least a decade.

It’s not just oil prices that are pointing towards the slowdown in Chinese demand growth.  The Reserve Bank of Australia’s index of bulk non-rural commodity prices is at its lowest level in 11 years.  The index has dropped 69% since its May 2011 peak and 30% over the last year alone.  Metal prices are also at their lowest since mid-2009 in the wake of the Global Financial Crisis, having plunged 20% since January 2015.

The problems posed by China are twofold.  Firstly, slower economic growth (of some unknown magnitude) will cap growth in demand for imports into China, having significant flow-on effects for economic activity in many other countries in the Asia/Pacific region.  China is the largest export market for Australia, Hong Kong, South Korea, and Taiwan, with all of these countries sending at least one quarter of their exports to China.  We have moderated our forecasts for economic growth in Australia and across Asia during 2016 and 2017.  New Zealand’s potential export growth will be affected by this softer economic performance, and our own direct exposure to Chinese demand – they take about 20% of our exports – should not be forgotten either.

Although a slowdown in Chinese economic growth is a near certainty, the second problem posed by China is a downside risk rather than something we have included in our central forecast.  Doubts have been raised about the robustness of China’s banking system for some time, and with slowing economic growth and a softening housing market, there is a chance that non-performing loans could balloon and place financial institutions under stress.  As a result, a financial sector meltdown in China is not out of the question.

Perhaps the most reassuring aspect of this scenario is that we would not expect China’s potential banking sector problems to have major repercussions for financial institutions throughout the developed economies.  There are much greater safeguards around the banking systems in the US and Europe than there were prior to the GFC.  Nevertheless, the associated risks are not zero – recent rises in credit default swap rates for Australasian banks to two-year highs point towards some nervousness in financial markets.  Concerns about the health of Europe’s financial system have also contributed to the upward trend in credit default swap rates internationally.

The real damage done by a Chinese credit crunch would be its negative effect on the country’s economic growth.  A Chinese economy growing at 6.0-6.5%pa is adequate, but if growth slipped below 4.0%pa due to constrained growth in household and business spending, the flow-on effects for global economic activity would be significant.  A lack of demand growth in China would be particularly pertinent given that America’s recovery is only progressing patchily, while the European and Japanese economy’s remain relatively fragile.

Graph 1.2

Although we have not included a Chinese meltdown in our forecasts, the fact that firms and households recognise that it poses a risk to growth prospects will still affect New Zealand’s economic performance this year.  The positive domestic factors outlined above will be partially offset by caution due to concerns about China.  In particular, decisions for businesses about investing in new plant and machinery will be carefully weighed up against the risk that demand could unexpectedly fall away.

Our November forecasts included a drought-induced decline of 3.1% in non-building investment over the year to March 2017.  We are now forecasting an expansion of 1.9% in non-building investment spending over the coming year.  This still-modest growth reflects the air of caution that businesses will maintain during this period.

In a relatively challenging export environment, one positive area of note is the services sector.  In particular, tourism and foreign education have contributed to spectacular growth in services exports since late 2014.  The volume of services exports for the year ended September 2015 was up 18% from the previous 12 months.  That growth rate is set to ease in coming quarters, but we still expect services exports to expand by an average of 8.6%pa over the three years to June 2018.

Tourism activity has been boosted by a range of factors.  There has been some improvement in economic conditions in the US and Europe, while falling fuel costs have helped bring down the price of flights.  The lower New Zealand dollar, compared with where it was in 2014, has also made New Zealand a more cost-effective destination for travellers. Airlines have responded to this increase in demand by adding to capacity on existing routes and opening up new ones, particularly between New Zealand and China.  Furthermore, tourism is one area where rebalancing in the Chinese economy has been successful, leading to a surge in Chinese visitor numbers.

We expect visitor arrival numbers to grow by a further 12% over the next two years.  About half of this forecast growth will come from increases in Australian and Chinese arrivals (up by 8.1% and 22% respectively).  Even so, growth in tourism is expected to be relatively broad-based as economic growth in developed countries gradually improves, while rising incomes across the developing Asian economies make international travel increasingly affordable for more people.

In addition, foreign student numbers have also boosted services exports.  Arrivals on student visas have surged 77% over the last two years to almost 28,000pa.  Over half the growth has come from increased numbers of Indian students, with China and the Philippines together contributing 29% of the increase.

The foreign education sector finally appears to have shaken off the bad reputation it got in the early part of last decade when students were often taken for granted as a cash cow and little attention was paid to the quality of the service provided.  The catalyst for the growth was a change at the end of 2013 to restrictions about how much work foreign students could do while studying here.  The fact that Indian students were not a major part of the market in the early part of last decade means that our reputation in India will not have been sullied by the poor practices that prevailed at the time.

With the New Zealand dollar predicted to hold at about 70 on a TWI basis over the next couple of years, we expect tourism, foreign education, and other services exports to remain relatively competitive on the international stage.  We forecast the services component of the balance of payments to expand to a surplus of 2.3% of GDP by mid-2018, its most positive in 14 years, and a result that will mitigate the weaker merchandise trade balance and prevent the current account deficit from blowing out to more than 4.5% of GDP.

Graph 1.3

The Auckland housing market is one of the most difficult facets of the economy to judge at the moment.  It is clear that the current build rate of 9,251 for the 2015 calendar year is not sufficient to keep up with demand, let alone starting to shrink the undersupply – net international migration of 38,300 into the region during the year suggests demand for an additional 12,800 homes.

At the same time, house prices in Auckland are now equal to 12.3 years’ worth of personal income, and rental yields are now 30-70 basis points below their previous record lows reached in 2007.  Housing affordability measures and income returns on residential property in Auckland look unequivocally horrible.

The wind has been taken out of the Auckland housing market, at least temporarily, by the tighter loan-to-value restrictions on investors and the new bright-line test for capital gains.  But with the city’s housing undersupply still expanding, we see a real possibility that the market’s current slowdown could prove to be as short-lived as the one in 2014 following the initial introduction of LVR restrictions by the Reserve Bank.

Graph 1.4

Our forecasts see nationwide house price inflation slowing from 15% to 5.1%pa by September this year, with house price growth holding at a similar rate through until September 2017.  This forecast represents a deliberately conservative view on future house price growth in Auckland given how bad rental returns and housing affordability measures are in the region.  Further strong growth in residential consent numbers in Auckland, combined with slowing population growth, will also help the supply of new housing finally start to get ahead of underlying demand in the region.

Although production GDP growth is set to accelerate from 2.4%pa in March 2016 to 2.9%pa by mid-2017, this trend will mask more difficult times ahead for the domestic economy.  Construction activity has been a significant factor in the New Zealand economy’s growth over recent years, initially due to residential rebuilding and repair work in Canterbury, with non-residential activity in Christchurch and construction of new dwellings in Auckland subsequently driving growth.

Residential rebuilding work in Canterbury has already peaked.  Our modelling suggests that, by late 2017 or 2018, non-residential rebuilding work will also have maxed out.  Auckland currently has a sizable pipeline of non-residential work on the way, but it is questionable whether activity will hold up at the same level beyond a two-year horizon.  Finally, we expect residential consent numbers to peak at almost 14,700pa in June next year, easing as the city’s population growth slows and the undersupply of housing becomes less acute.

In an ideal world, the expected growth in construction activity over the next 12-18 months would take place over a longer period of time, leading to a steadier stream of work for firms in the sector and reducing the magnitude of the humps and hollows through the industry’s cycle.  However, history shows that this more measured outcome hardly ever occurs.  We have tried to take a relatively conservative view of the downturn in construction activity during 2018, but even so, our forecasts show growth in private investment spending turning negative during that year, and overall GDP growth slowing to 1.8%pa by mid-2018.

Weaker construction activity will have flow-on effects for other industries such as manufacturing, leading to a general feeling of sluggishness across the economy as domestic spending growth eases to its slowest rate in eight years.  This “investment hangover” could last for a couple of years, and firms’ are unlikely to have much appetite for new investment spending or hiring throughout 2018 and 2019.

Graph 1.5