Brian Fallow: Pastoral nightmare

A foot-and-mouth outbreak belongs in the "worst nightmare" category for New Zealand's pastorally-based economy.

In 2003, the Reserve Bank and Treasury reported to the Cabinet in broad outline what they expected the economic impacts of a hypothetical limited outbreak of foot-and-mouth would be. Unsurprisingly, it makes unpleasant reading.

The scenario they considered was an outbreak that initially occurred among pigs and then spread to sheep and cattle. It was contained in the North Island, allowing trade from the South Island to resume earlier.

Some other assumptions were made. One was that the impact on dairy exports was limited, with a ban by trading partners lasting just six weeks. But the ban on sheepmeat and beef exports to markets free of foot-and-mouth was assumed to last up to a year.

The impact would be to cut New Zealand's total exports, in volume terms, 8 per cent in the first year.

The outbreak is assumed to mean a long-lasting reduction in export prices, reflecting the loss of the premium New Zealand lamb and beef have in some markets. The researchers assume that prices begin to return to what they would otherwise have been after 18 months, but don't fully recover for four years.

The combined effect of lower export volumes and lower prices would be to cut export receipts by $5.5 billion, or 12 per cent, by the end of the second year.

The magnitude of the hit the exchange rate would take can only be guessed at. The researchers assume a drop of about 20 per cent in the first quarter and that the exchange rate takes 2 1/2 years to fully shake off the effects.

Business confidence would tumble, reducing investment. That is assumed to result in a permanent decline in the economy's capital stock and its long-term potential output. That is, we never entirely make up the investment and resulting output that would be lost.

Having poured these assumptions into the Reserve Bank's mathematical model of the economy and cranked the handle, what comes out?

The cumulative loss of economic output would be $6 billion in the first year, rising to $10 billion by the end of the second year.

Put another way, nominal gross domestic product would be 5 per cent smaller at the end of year one and 8 per cent smaller at the end of year two than it would otherwise be.

A partial offset is that inflation would also be lower, by about 1.5 percentage points, so the impact on real GDP is less, "only" $3.5 billion lower after two years.

The model predicts the loss of 15,000 to 20,000 jobs and that unemployment would remain higher than it would otherwise be for about two years.

But economists say this may be an underestimate: "If farms and employers in related industries expect a longer-lasting decline in output than the one currently assumed, then the number of lay-offs would be significantly higher."

The flipside of blighted growth and lower inflation is lower interest rates. The model predicts the Reserve Bank would cut its official cash rate by 2 or 2.5 percentage points in each of the first two quarters after the initial outbreak, then gradually tighten after that.

As a result, 90-day interest rates would bottom out at 1 or 2 per cent.

Longer-term interest rates would be pushed up by an increase, of perhaps 50 basis points, in the risk premium international investors would require to invest in New Zealand assets. But that effect would be more than counterbalanced by the effects of the Reserve Bank's rate cuts so that real longer-term rates would decline by about 50 basis points.

Firms would delay or cancel investments, which would drop 20 per cent in the short term, recovering only partly to be 6 per cent lower than otherwise two years on from the outbreak.

The reduction in investment would shorten the economy's stride for a relatively long time. All of this would have a significant impact on the Government's accounts.

The officials assume a one-off expenditure of about $200 million upfront to cover compensation provisions under the Biosecurity Act and some sort of relief programme for the rural sector.

But that is just for starters. Government tax revenue is expected to decline about 1.1 per cent of GDP (that would be $1.5 billion if it happened today) in the first year and take four years to recover.

Spending would increase 1.5 per cent of GDP, reflecting higher unemployment benefit costs and a higher interest bill.

The double whammy of lower revenue and higher expenditure is that the Government's operating balance would be down about 2 per cent of GDP for as far ahead as they care to look.

This has a cumulative effect on the ability to reduce Government debt.

The authors of the report emphasise that such an exercise is fraught with uncertainties, not only about how the outbreak would be contained but about trading partners' reactions.

Nor does the modelling capture any fallout from the impact on an outbreak on the financial sector.

But separate work by the Reserve Bank gives some comfort as far as the impact on the banks is concerned.

As part of an exercise in "stress-testing" the banking system, the Reserve looked at the potential impact of a variety of shocks, including a foot-and-mouth outbreak that was short-lived and well-contained.

Meat producers would experience severe income losses under this scenario, but only for a year or so.

Because new farm loans are generally limited to about 60 or 65 per cent of the value of the farm and livestock, and given the loss of income short term, debt-servicing costs were likely to remain manageable, it concluded.

Banks' profits would take a hit, falling a cumulative 18 per cent on average after three years.

But it is an ill wind that blows no one any good. The banks also noted that the fall in the exchange rate would boost the unaffected tradeable sectors, softening the impact of the loss of farming income on the wider community.