Westpac Economic Commentary
An analysis comparing the Bank’s earlier predictions with the Treasury Update
Auckland, September 13, 2023
On the surface, the government’s books contain no huge surprises.
But scratching beneath the surface reveals medium-term and long-term challenges that future governments of all shades will need to grapple with.
As expected, the Pre-Election Economic and Fiscal Update (PREFU) showed some deterioration in the government’s books since Budget 2023 and a delayed return to surplus.
The Treasury now forecasts that the operating balance (OBEGAL) will return to surplus one year later (i.e. in 2026-2027) than previously. Over the forecast period (2022-2023 to 2026-2027), the cumulative OBEGAL is around $12.7 billion lower than forecast at the Budget, close to our estimate of a $15 billion deterioration.
Upside risks to spending
The Treasury’s revenue projections were downgraded by less than we had expected, but spending was upgraded relative to our expectations and Budget 2023 estimates.
Looking ahead, we see upside risks to spending and downside risks to revenue that, in the absence of mitigating action, point to downside risks to the operating balance and upside risks to government borrowing compared to the picture depicted in the PREFU.
The Treasury’s economic forecasts appear optimistic. There has been surprisingly little change in the PREFU forecasts, finalised in early August, compared to those in Budget 2023. And so, as was the case with the Budget, we think that the Treasury’s forecasts for economic growth, and both the tax take and projected return to surplus, are on the optimistic side.
Looking first at overall economic activity, the Treasury’s forecasts for economic growth are stronger than our own. However, the Treasury is also assuming that interest rates will fall faster than we expect and that inflation will remain contained. On both of those fronts, we are much more circumspect than the Treasury.
As we have seen in other countries, inflation in New Zealand has been ‘sticky,’ with core inflation lingering at high levels well after the start of the interest rate hiking cycle.
Lingering inflationary pressures
Against that backdrop, central banks face having to keep interest rates higher for longer.
The related pressure on borrowing costs signals downside risk for both private spending and economic growth compared to the Treasury’s forecasts (but upside risk to the government’s financing costs). The forecasts take an optimistic view on the rebalancing path the economy is to take and suggest rebalancing can occur without further policy action from the RBNZ.
Digging into the details of the Treasury’s forecasts there are also some key assumptions that warrant closer scrutiny. Most important is the Treasury’s assumption for government consumption spending – i.e., the provision of public services.
The Treasury continues to assume that the aggregate amount of services provided by the government will essentially remain unchanged over the coming years.
However, with the population rising at a rapid pace, the Treasury acknowledges that would mean that the government ends up spending less on public services on a per-capita basis.
That is despite the growing demand for all manner of public services including health care, education, and aged care services. In addition, the Treasury has made a large upward revision to its forecast for net migration, meaning that the pressure on spending levels, including infrastructure, is likely to be even more pronounced than previously assumed.
Static imports level
Another notable assumption in the Treasury’s forecasts is that slowing economic growth will result in imports remaining flat for the next two years. That in turn flows through to an improvement in New Zealand’s trade balance.
That seems like quite an abrupt change, especially given the rapid rise in the population.
While we are also forecasting an easing in import demand as growth cools, we still think that import levels will continue to rise over the coming year even with a weaker economic growth profile. That also means a more gradual improvement in the current account in our forecasts.
Lastly, the Treasury’s forecasts assume only a muted outlook for house prices.
The Treasury is assuming that house prices only grow by around 1% to 2% per annum over the next couple of years. That is despite the projected easing in interest rates and a pickup in population growth. In contrast, with the housing market having already found a base in recent months, we expect that house prices are on course to rise by close to 8% next year.
Impending fiscal challenges
Fiscal challenges lie ahead. In our minds, what happened before the PREFU hinted at what lies ahead on the fiscal front. Recall that, on 28 August, the government announced circa $3.4 billion in operating expenditure cuts and savings. This belt-tightening, and $0.7 billion of additional revenue from increased fuel taxes announced since the Budget, was important in ensuring that the PREFU shows OBEGAL a return to surplus at the end of the forecast period.
In the coming years, it is possible that additional fiscal policy measures will be necessary to meet the operating surplus target. Since we see downside risks to the Treasury’s economic growth forecasts, we also see downside risks to forecasted government revenue and upside risks to government expenditure. The combination of these risks indicates to us that under current policy settings and prevailing trends, reaching an operating surplus by 2026-2027 may be challenging.
Treasury, too, sees challenges ahead.
In the PREFU the Treasury writes: “Based on past analysis, the remaining Budget operating allowances should be broadly sufficient to meet remaining critical cost pressures not already funded, however, significant trade-offs will be required. There could also be additional demand (e.g., population changes) that could add extra pressure to future Budget allowances.”
As a result, and regardless of who is in power after the 14 October election, the government will face tough fiscal choices. Unless it is prepared to run higher operating deficits and higher levels of debt, risking reactions from both the rating agencies and a monetary policy response from the RBNZ, any new Budget spending decisions will likely require cuts to spending elsewhere or new sources of revenue.
The Borrowing Programme
Bigger deficits mean a larger borrowing programme. As expected, the deterioration in the underlying fiscal position has had implications for the government’s borrowing programme.
New Zealand Debt Management (NZDM) has advised that the NZGB programme for the 2023-2024 fiscal year has been revised up to $36 billion – an increase of $2 billion from the programme announced back in May in Budget 2023. This is a relatively modest adjustment considering that the cumulative OBEGAL deficit in 2022-2023 and 2023-2024 is $6.9 billion larger than projected in the Budget. Helping to explain the difference, the government’s residual operating cash deficit is just $3.3 billion larger than forecast in the Budget, while the government’s closing cash balance in 2023-2024 is about $1.9 billion lower than forecast in the Budget.
Looking across the whole forecast period, the Treasury now projects total NZGB issuance of $129 billion in the four years to 2026-2027, up $9 billion from Budget 2023 (still less than the $12.7 billion cumulative deterioration in the OBEGAL balance over the period).
Allowing for maturities and repurchases of bonds from the RBNZ (associated with the wind-down of the LSAP programme), net NZGB issuance is expected to increase by just over $49 billion over the four-year period, lifting outstanding issuance to about $202 billion by the end of 2026-2027.
In the media release accompanying the announcement, NZDM noted that, subject to market conditions, it expects to launch two new nominal NZGB lines, via syndication, before the end of the fiscal year. The maturities of these bond lines will be 15 May 2035 and 15 May 2054.
As in the Budget forecast, gross issuance into inflation-indexed bonds (IIB) is expected to be less than $1 billion in 2023-2024. The composition of short-term borrowings will include a minimum of US$1 billion of ECP and $2 billion of T-Bills.
The above analysis appeared on the Westpac website on September 12, 2023.
