A rapidly worsening global economy will depress New Zealand's fledgling recovery and keep interest rates on hold until 2013, the New Zealand Institute of Economic Research says.

The institute's latest Quarterly Predictions slash the growth forecast for next year to 1.5 per cent, from 2.6 per cent in September.

NZIER has been at the gloomy end of the range of forecasters for some time.

It sees a rising risk of global recession, with its epicentre in Europe's sovereign debt crisis.


NZIER's principal economist, Shamubeel Eaqub, says that even in a "muddle-through" scenario - in which a political solution is found, the European Monetary Union does not break up and contagion to banks and other economies is avoided - the global growth outlook is much softer and New Zealand slows because of weaker exports and higher borrowing costs.

"The Government will be cutting spending and the Reserve Bank has little firepower left.

"Households will continue to pay down debt."

In a typical economic cycle, low interest rates encourage borrowing and investment, which kicks off the recovery.

This time, however, credit growth is very weak. This is needed after the borrowing binge of the 2002 to 2008 period, but until it picks up economic growth will remain subdued, Eaqub says.

He expects households to remain cautious and consumer spending to grind higher only gradually.

The institute puts a 25 per cent probability on another global crisis in which financial markets seize up and a worldwide recession ensues, with limited relief possible from monetary or fiscal stimului that have been largely exhausted.

Consensus forecasts for growth among New Zealand 's trading partners have been falling, the most recent being 3.3 per cent for 2012, down from 4.3 per cent six months ago.


"Slowing global growth will impact on non-rural exports the most, as food demand tends to be less affected. Manufacturing production and exports have already been hit particularly hard during the global financial crisis. Another recession will further hollow out the dwindling manufacturing sector."

Tourism will also suffer, Eaqub says.

So far exports have proven resilient, but the strength is narrow, he says.

"Four commodities to two countries drove half of the 11 per cent export growth in the year to October 2011: dairy, meat, forestry and oil to China and Australia."

The impact of the global financial crisis was buffered to a large extent by demand from those two markets, and slowing economic growth in both of them now is a risk to exports.

Meanwhile, continued stress in global financial markets poses a risk to both the availability and the cost of credit, Eaqub says.

New Zealand banks get about a quarter of their funding from overseas wholesale markets, the majority of it for short terms so that it needs to be rolled over frequently. Already the spread between mortgage rates and wholesale interest rates is widening.

"This indicates greater difficulty in raising funds by banks. This will flow through to a reduced supply of credit and rising costs of borrowing for risky projects."

A more downbeat economic outlook means tax revenue will be lower and it will be hard to return the operating balance to surplus within five years, let alone the three years the Government is targeting.

The institute expects residential investment to remain low until the Canterbury rebuilding adds momentum from late next year.