Rebalancing: fact or fiction?
The existence of household caution, strong export growth, and fundamentally different credit conditions have convinced many analysts that the New Zealand economy is undergoing a step change. This change is termed rebalancing. We continue to believe that fundamental rebalancing has not occurred – although there are some areas of the economy where changes will be permanent.
What’s in a name?
The word "rebalancing" has been thrown around with almost reckless abandon since the financial crisis in late 2008. However, it isn’t exactly clear what people mean when they claim the economy is rebalancing. Rebalancing may encompass one or more of the following three elements of change in the economy.
- Cyclical change: when the economy sits at a certain point in its general cycle, agents within the economy behave in a different way.
- External structural change (exogenous shocks): when factors that influence the domestic economy, but are not part of it, change (eg the terms of trade, world interest rates).
- Internal structural change: when the behaviour and/or preferences of agents in the economy change independently of either cyclical or external factors.
When we discuss rebalancing, we are specifically talking about the third category internal structural change. This type of change is not captured by conventional economic models because they are predicated on these unobservable internal structural factors remaining the same.
Such a separation may seem pedantic, but when it comes to discussing where the economy will go, this separation is essential – differing views on rebalancing are largely responsible for the current difference in forecasts between analysts.
The specific type of rebalancing that is discussed by analysts involves a sustained shift in activity from consumption and towards net exports. As a result, we can analyse the rebalancing story by looking at ratios of consumption to GDP.
Arguments for and against rebalancing
The rebalancing story
At first glance the argument for rebalancing seems compelling. Growth in retail sales, and consumption more generally, has been anaemic (with annual real consumption volumes only growing by 0.7%pabetween June 2007 and June 2010). Meanwhile we have seen net exports climb markedly (with the real deficit shrinking by $2.4bn in the past year).
To illustrate the changing nature of consumption, the Reserve Bank publishes a graph that shows the ratio of consumption volumes to the volume of economic activity (real consumption GDP/real total GDP). We will look at similar statistics below.
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During the boom times of 2006/07, household consumption’s share of GDP rose towards the record highs of the early1990s (see Graph 8.1). Taking into account that the consumption share of GDP is usually elevated during a recession (as households and firms prefer to cut back on investment rather than consumption) this suggests that the volume of consumption was unusually high.
Furthermore, the fact that consumption’s share of GDP did not rise during the recession suggests that households may have responded more sharply to the change in conditions then they have in prior recessions.
Including residential investment into the story, on the basis that it is a form of household investment, makes the change in household behaviour during this recession even more stark compared to the early 1990’s and the during the Asian Crisis (see Graph 8.2) – with this measure of household spending falling significantly during the 2008/09 recession.
So there are two factors that suggest a permanent change in household behaviour could be on the cards.
- Real household consumption has been well above its historic trend,
- Households have responded differently to this crisis then they did during the previous two recessions.
But if we dig a little deeper, parts of this story change dramatically.
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Graph 8.3 looks at the ratio of nominal consumption to nominal GDP. This compares how much was spent on consumption to how much was spent in the economy in total. The main difference with the real ratio in Graph 8.1 is that the nominal ratio includes changes in the relative price of things – a factor that real variables miss.
With productivity increases in the developing world (namely China) driving down the price of manufactured goods, and New Zealand’s terms of trade climbing, the relative price of consumption has declined. As a result, even though New Zealanders have been buying more consumption goods, the cost of doing so has been fairly modest.
Overall, the ratio in Graph 8.3 implies that spending on consumption goods was never excessive.
However, during the recent crisis, household consumption’s share of nominal GDP did not rise to the same degree that it has in previous recessions. As a result, it is true that households have responded differently this time around right? Well, not necessarily.
Looking at real consumption (to capture the change in the volume of activity), activity during this recession fell 2.6%from its peak (between December 2007 and March 2009), compared with a 2.6%decline in the early 1990s (June 1990 to September 1992). So the level of consumption fell just as sharply – but the relative price of consumption grew a lot weaker during the recent recession than it did in the early 1990s.
Effectively, households over the last two years have responded just as rapidly as they did in the early 1990s in the face of falling real house prices, slowing income growth, and rising unemployment.
With uncertainty about their income and labour market status appearing to be the main driver of household behaviour at present, we would expect consumption to pick up during a cyclical recovery –rather than staying structurally depressed.
When residential investment is included (Graph 8.4), nominal spending does appear to have been relatively elevated for a long period. With the number of houses in New Zealand not significantly out of line with underlying demand, this ratio suggests that either the cost of building houses has risen excessively, or that households have been building higher-quality houses than they could really afford. In truth, it is likely to have been a combination of both of these factors.
It isn’t really surprising that households have shifted to spending a greater amount on housing, given the availability of credit and the sharp appreciation of house prices through the middle of the 2000s. Borrowing to build appears to have been a contributor to our current debt position.
With these factors reversing, and the tax treatment of housing having been made less attractive, we would expect any shift in household behaviour to be focused on the level of residential investment in the future – not consumption more generally. As a result, the shift in behaviour is more likely to be sector-specific – not a complete rebalancing of households’ preference for consumption more generally.
But the external factors matter
So, if the world returns to normal it is our view that the behaviour of the New Zealand economy throughout its cycle would also return to normal. However, this outcome is not what we are forecasting.
There have been fundamental "exogenous shocks" to the global economy that we do not expect to disappear in the foreseeable future. For example, these shocks include:
- the credit crisis and its impact on credit markets
- the price of our commodity exports
- what New Zealand pays for manufactured goods imports?
- changes to the type of product being demanded from overseas – due to changes in where New Zealand sells
- tax and policy changes.
All five of these central factors appear to have changed fundamentally over recent years.
The introduction of new regulations in credit markets, combined with significant consolidation in the industry (both domestically and overseas) implies that credit conditions will remain tighter than they were in the mid-2000s.
Rising demand from China, the introduction of biofuel regulations, and changes to the protectionist policies in overseas markets will all lead to structurally higher export prices going forward. With demand for manufactured goods weak, we expect New Zealand to experience a persistent increase in its terms of trade.
Finally, changes to the taxation of property and a switch from income tax to a higher GST will have an impact on where people put their money, and when they decide to consume income.
These external factors will have large, long-term, effects – some of them negative, some of them positive. However, given that these "exogenous shocks" have been observed before we can use our models to discuss what their impact will be.
Rebalancing has been used as a central reason why analysts are saying this time is different – and why many people are forecasting a weak economy for a long time even while forecasting strong terms of trade and a recovering global economy. However, as discussed above, we do not believe the core rebalancing story holds up to scrutiny.
Importantly, household consumption has not been wildly out of line with historical norms, and it isn’t clear that the current response by households is outside the realms of a typical cyclical response to falling real house prices and rising unemployment.
As a result, outside of a negative “external shock" (eg a significant fall in the terms of trade) we cannot see consumption growth remaining anaemic over the next three years – contrary to the views of the Reserve Bank and many other analysts.
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