Brian Fallow

The Economics Editor of the NZ Herald

Business in 2012: Fingers crossed as economy fumbles its way along

Over the next couple of years the economy will grow around 3 per cent a year, unemployment will fall, and inflation will be well-behaved.

That at least is the consensus among economic forecasters.

With any luck.

Fingers crossed.

As always, there are risks that things will not pan out that way, and this time they are, as economists like to say, "skewed to the downside".

Before considering the things to be wary of, it is worth noting that the forecast pick-up in growth would be off a pretty depressed base.

Economic activity in the September quarter, the most recent read we have, was no higher than it had been back in March 2008, at the start of the recession.

Top of the list of risks to the sanguine consensus view is that the economy will be walloped by another international shock.

The Europeans, and the Americans for that matter, are a long way from having got on top of their problems with government debt. Europe is heading into recession, if it is not already in one, but policies to boost growth are in short supply.

Instead, to judge by the most recent of many crisis summits, European leaders seem to think that the solution to the eurozone's weaker members' problems, caused by a one-size-fits-all monetary policy in good times, is to embed an austere one-size-fits-all fiscal policy in hard times.

The hope is this will restore confidence and bring bond yields down. The risk is that it proves counterproductive.

The issue is not government debt per se but the ratio of government debt to gross domestic product, reflecting the capacity to service the debt.

If austerity measures do too much damage to economic activity, the ratio may get worse, not better.

Why should we care?

The Asian crisis and US-centred global financial crisis made it very clear that if a major part of the global economy is in trouble then everyone feels the effects.

The three main channels through which Europe's travails could affect us are credit, trade, and confidence.

There have already been two major central bank interventions to restore liquidity in credit markets which European banks rely on for wholesale funding.

New Zealand's banks also rely on overseas wholesale markets for about a quarter of their funding. If they seize up again, as they did in 2008, we will feel the effects.

We can either be reassured that the European Central Bank and its peers have acted, or alarmed that they needed to, in the face of what amounts to a slow-motion bank run at the wholesale level.

Even if another financial crisis is averted, Europe is a big enough part of the global economy - the largest single market, after all - for a recession there to retard growth in both Asia and America.

Europe is as important a trading partner for the US as Australia is for New Zealand.

Indications are that the US housing and labour markets are improving, albeit from a very weak base.

But the federal Government continues to borrow an utterly unsustainable US40c in every dollar it spends, while the two major parties are poles apart on what is to be done about it, and a general election that might, just might, overcome the policy paralysis is still almost a year away.

AMP chief economist Bevan Graham expects "fragile debt-constrained growth" of around 2 per cent in the US in 2012.

In China, growth momentum is continuing to slow, he says, but only to a "soft landing" pace of 8.5 per cent.

"As with America, one of the key risks to China growth is a sharper-than-expected slowdown in Europe. If that eventuates, we would also expect to see further fiscal as well as monetary stimulus."

Reflecting these international uncertainties is a wide range of forecasts from economists about New Zealand's export outlook over the year ahead , ranging from 4 per cent growth to a 0.9 per cent contraction. And it was notable that the sharp decline in consumer confidence recorded in the Westpac McDermott Miller survey this month was led by consumers in rural New Zealand, the most sensitive to the international outlook.

On the home front, the two main risks are that the Government will overdo the fiscal adjustment it has in mind, and that the construction boom ahead will prove a very mixed blessing.

Behind phrases such as "getting the Crown's books back in order" and "returning to surplus within three years" lie plans for fiscal belt-tightening equivalent to around 2 per cent of GDP in each of the next two years.

That would make each of them tougher, by that measure, than any since the mid-1990s and probably since the Mother of All Budgets in the early 1990s.

Moves to rein in the growth in government debt are inevitable given the high level of debt the country (as distinct from the Government) has run up with the rest of the world and the fact that the external deficit is widening again quite fast.

Excluding the temporary effect of earthquake reinsurance claims, which until they are paid out are treated as an overseas asset, New Zealand's net international liabilities are $152 billion, or 76 per cent of GDP.

And the current account deficit, already 4.3 per cent of GDP, is forecast to continue to widen - potentially, economists warn, to a degree that will test the patience of the credit-rating agencies.

The question, however, is whether the economy is in robust enough health to withstand aggressive fiscal tightening.

Private consumption is being restrained by several factors:

* Weak population growth as the net flow of migrants has turned negative.

* Modest income growth, reflecting an unemployment rate which has been stuck around 6.5 per cent for two and a half years.

* An improvement, which needs to be enduring, in the household savings rate, and its flipside, a wariness of debt, reflected in the fact that aggregate household debt grew just 1 per cent in the past year.

The Reserve Bank expects uncertainty over how the European debt situation will play out to inject caution into businesses' hiring and investment decisions.

"Excluding the direct effects of the reconstruction in Canterbury, business investment is expected to remain weak throughout 2012," it said in its December monetary policy statement.

One of the arguments that the Government gives for running a tough fiscal policy is that, all else being equal, it will allow the bank to keep interest rates low for longer.

Offsetting that, though, is the inflationary risk posed by the rebuilding of Christchurch.

The Reserve Bank expects it to add about 1 per cent to economic growth through 2012 and 2013.

The timing of that boost may be delayed, however, by the most recent flurry of earthquakes, as insurers want evidence of seismic stability before they start insuring new buildings.

Rebuilding much of Christchurch is only part of the surge in demand the construction industry confronts.

Billions of dollars worth of repairs to leaky homes remain to be done, and then there is the task of upgrading the earthquake resilience of many commercial and public buildings.

In addition, there is the pent-up demand from a slump in residential construction over the past three years.

Overall construction activity in the September quarter was at its lowest since June 2002.

But that surge in demand faces a supply side which, as the recent Productivity Commission report makes plain, is not in good shape. With a handful of exceptions, the construction sector is a cottage industry, it says, with productivity that is low by international standards and not improving, and significant skill shortages, with the recent slump seeing tradesmen leave the industry or the country.

So it remains to be seen how much of the surge in demand will translate into jobs, profits and tax revenues, and how much into frustration, delay and inflation on a scale the Reserve Bank has to stamp on.

Reflecting on the outlook, the Bank of New Zealand's head of research, Stephen Toplis, says overseas developments will continue to be the bane of our lives, but the country has some things going for it.

Among them are a relatively solid fiscal position, a relatively sound banking system, political certainty, a floating exchange rate and the "right" exports to meet the demands of that part of the world which is growing most strongly.

"For these reasons, says Toplis, "we cling to our view that the New Zealand economy can continue to fumble its way along, albeit that the taskis becoming more difficult by theday."

- NZ Herald

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