Thursday, May 19, 2011

New Zealand 2011 Budget

Budget 2011 is presented in a domestic back-drop of a weaker than expected economy and a second and more devastating earthquake in Christchurch. This has followed previous Budgets where the National-led Government has had to cope with the economic and fiscal fall-out of the Global Financial Crisis, including costly commitments under the retail deposit guarantees. This Government must look back with some envy as the previous government reaped the benefits of a strong fiscal position on the back of strong, but what ultimately proved to be unsustainable, economic growth.

Many governments in developed countries have been grappling with the solution to large budget deficits and the need to consolidate their fiscal positions. At the same time they have had to balance that with supporting what have remained fragile economic recoveries. What has been making the situation challenging is that in many countries, budget deficits have a high structural component. That means governments cannot simply rely on an improving economic cycle to close up these large deficits and are having to cut spending and/or raise revenue to bring their finances back into order.

Our fiscal situation is not as bad as some. Government finances in the US, Japan and Europe are in far worse shape than ours. But the government’s fiscal position is only part of the story. Despite relatively low government debt, our external indebtedness is high by international standards. International rating agencies take the broader picture into consideration.

In 2009 we gave the Government high marks for turning around the trajectory of deteriorating fiscal ratios (operating balance and debt as percentages of GDP). In the 2010 Budget they achieved a significant and important reform of the tax system under still trying fiscal circumstances. However, we believe they have previously underestimated the structural nature of the deficit and the necessity to make long-term changes to high-cost policies if they were to achieve fiscal sustainability. Budget 2011 makes progress in that regard.

Fiscal Outlook

Expenditure restraint is a key feature of this Budget. Whilst there is $4b of new operating expenditure announced over the next 4 years, this has been achieved via $5.2b in reprioritised spending. Education and Health are the primary beneficiaries of that reprioritisation. The end result is that operating spending is $1.2b lower out to 2014/15. Previously the government had allowed itself $1.1 b per annum in new spending initiatives which would have increased spending by $4.4b over the same period. The net result is a $5.6 reduction in the borrowing requirement from operating expenditure. As a percentage of GDP, Core Crown expenses decline over the forecast period - the ratio falls from 36.4% of GDP in 2010/11 to 31.1% in 2014/15.

Revenue increases as a percentage of GDP over the period, reflecting the improvement in economic growth. The ratio rises from 28.5% of GDP in 2010/11 to 31% in 2014/15.

The operating balance (excluding gains and losses or OBEGAL) is forecast to be 8.7% of GDP in 2010/11. That’s up from the 5.5% forecast in the Half-Year Economic and Fiscal Update (HYEFU). The deterioration reflects the February 22nd Earthquake and weaker economic growth. OBEGAL then improves rapidly to be back in surplus (0.5% of GDP) by 2014/15. That is one year earlier than projected in HYEFU. The improvement reflects the combined effects of the one off nature of earthquake costs, improving economic growth (and therefore revenues) and the lower underlying track for expenditure.

Net debt is forecast to peak at 29.6% of GDP in 2014/15. The Government expects this to be back under its desired 20% of GDP by the early 2020s. An earthquake “Kiwi Bond” will be created to generate funds to help meet the Government’s share of the Christchurch rebuild. A long-dated inflation-indexed bond will also be introduced.

Underlying Economic Assumptions

Underlying economic growth assumptions are broadly in line with our own and therefore appear reasonable.

Annual average GDP growth is forecast to be 1.8% in the year to March 2012 (AXAGI 1.7%). The cycle peaks at 4.0% (4.1%) in March 2013 before declining to 2.7% (2.6%) in March 2014.

Expectations for the labour market, inflation and the current account deficit appear consistent with our own view. With regard to monetary policy, we expect monetary conditions will tighten more quickly than Treasury.

Key Policy Decisions

Changes to KiwiSaver, Working for Families and student loans were well flagged prior to the Budget.

The KiwiSaver member tax credit will be halved, effective from July 1 2011. From 1 April 2013 both the minimum employee contribution rate and the compulsory employer contribution rate will rise from 2% to 3%. However, from 1 April 2012, the tax-free status of employer contribution will end. Government will make $2.6b in fiscal savings.

Changes to Working for Families are designed to better target low income earners. Changes will be phased in over six years and are expected to be made in four steps. Despite the better targeting, the Government expects to save $448m over four years.

Changes to student loans restrict eligibility for some groups less likely to repay. These changes are expected to free up $277m in operating expenditure and $170m in capital expenditure.

The Government intends to extend the Air New Zealand mixed ownership model to Mighty River Power, Genesis Energy, Solid Energy and Meridian Energy. The Government also intends to reduce its shareholding in Air New Zealand. The Government intends to retain a majority shareholding in these enterprises. They expect to raise $5b - $7b which will reduce the borrowing requirement and fund around one-third of government investment over the next 5 years.

Infrastructure will receive a further $1.6b into broadband, rail and schools. This includes $500m of reprioritised capital spending.

The Government has established a $5.5b Canterbury Earthquake Recovery Fund to meet its costs of the earthquakes.


We have been critical that Government has been relying too heavily on the economic cycle to restore fiscal balance. In so doing they were ignoring the broader structural issues. Having now started to address long-term spending, Budget 2011 makes significant progress towards a more sustainable fiscal position.

The approach to funding new operational spending out of the reprioritisation of existing spending significantly changes the expenditure profile over the forecast horizon. Core Crown Expenses are now forecast to be lower than forecast in the HYEFU despite the additional costs the Government now faces as a result of the second earthquake and the weaker starting point for the economy.

This approach to spending combined with freeing up capital by extending the mixed ownership model to other state assets means over the forecast period, debt will be around $10b lower than would have otherwise been the case.

The phasing in of those policies over time strikes an appropriate balance between articulating a pathway to fiscal sustainability at the same time as supporting economic activity. Without the Christchurch rebuild, economic growth would remain subdued.

It is worth remembering that low growth now is not necessarily a bad thing. It reflects the good balance sheet repair work that is going on behind the scenes in household and businesses. That bodes well for a more sustained economic recovery.

In terms of support for economic growth, this Budget was more about the health of the broader macro-economic environment than micro-economic measures to support growth and innovation. Fiscal consolidation makes a considerable contribution to ensuring a stable low interest rate environment.

This budget does not change our expectations around monetary policy. As in many countries, fiscal restraint and improving fiscal balances will prove to be a significant drag on economic growth.

We estimate the “fiscal impulse” from this Budget to be -2% of GDP in 2012/13 and 2013/14. We haven’t seen a tightening in fiscal policy of this magnitude in any year over the last two decades, let alone two years in a row.

In that respect, fiscal policy will do a lot of the work that monetary policy might have otherwise had to do to keep inflation in check. We continue to expect the first tightening of 50bps in December this year, with the OCR rising to 4.5% by 3rd quarter of 2012.