The great correction

Recessions are obviously difficult times for both businessesand households, with uncertainty and pessimism dominating investment andspending decisions.   However, recessions do have some positive outcomes,rectifying imbalances in the economy and cleaning out inefficient or poorbusiness practices. The current recession, for example, has the potential torestore some balance to New Zealand’s external accounts and level ofindebtedness.

Economic imbalances
 88-9197-99Sep-09
 Pre-recessionPost-recessionPre-recessionPost-recessionPre-recessionPost-recession
Goods balance1.4%Jun-905.1%Jun-920.6%Jun-971.7%Sep-98-2.6%Mar-061.0%Sep-10
Services Balance-2.3%Dec-92-0.1%Mar-96-1.4%Sep-981.5%Jun-03-0.7%Mar-091.0%Dec-11
Invisibles balance-5.1%Mar-88-3.3%Mar-91-7.2%Sep-97-4.1%Jun-99-7.3%Jun-08-4.8%Dec-09
BOP-4.1%Jun-90-2.7%Jun-92-6.7%Jun-97-3.9%Jun-99-9.2%Jun-06-4.8%Jun-10
Private Investment (% of GDP)16.0%Dec-8913.0%Dec-9119.3%Sep-9616.9%Jun-9921.3%Jun-0815.2%Sep-10
Household consumption growth2.6%Jun-89-1.5%Mar-926.2%Mar-952.1%Jun-984.1%Dec-07-0.6%Jun-09
Household savings rate-0.4%Mar-911.7%Mar-92-5.8%Dec-98-2.1%Mar-00-13.5%Mar-07-4.2%Dec-11
Unemployment4.1%Mar-8711.2%Sep-916.1%Jun-967.9%Dec-983.5%Dec-076.9%Dec-10
Exchange Rate, TWI66.5Mar-8853.5Sep-9268.4Mar-9747.8Dec-0072.0Jun-0753.7Mar-09
Capacity Utilisation87.6%Dec-8983.7%Sep-9190.7%Mar-9786.9%Sep-9892.6%Mar-08No forecast
ANZ world commodity prices129.3Jun-89105.0Dec-90134.9Jun-95104.6Jun-99219.0Jun-08No forecast

A striking factor of this recession is the magnitude ofour current account deficit at its onset.   In June 2006, the deficit reached astaggering 9.2% of GDP, the worst since 1975.   The deficit is large byinternational standards, but we will see a correction in the current accountduring this recession.   There are two components that will drive thiscorrection – the return of a trade surplus and a reduction of dividend andinterest payments going offshore.

Import outlook worse than exports

A trade surplus should prevail by early 2010.   NewZealand’s exports are dominated by agricultural and food commodities, incontrast to exports from nations such as Japan, which are dominated bymanufactured products.   In the current recession, New Zealand has an advantagein the sense that non-luxury items dominate our exports, so volumes haven’ttaken as big a blow as those in many other economies. As the global recoverytakes hold, this fact also suggests that demand for our exports will increasebefore demand for manufactured goods, and consequently our terms of tradeshould improve as our export prices rebound – there is already evidence of thislift in prices occurring.

However, it is a bleak forecast for imports, rather thanan optimistic outlook for exports, that will be the primary driver of thecorrection in the trade balance.   Over the March 2009 quarter import volumesplummeted 15% from a year earlier.   And domestic demand looks set to stay lowwell into 2010.

Achieving a sustained correction in the trade balance isfar from plain sailing though.   The recent strength in the exchange rate makesan export-led recovery much more challenging.   Also, the export base wasarguably much broader back in the early 1990s recession than it is now.   Forexample, in 1990 dairy production made up 14% of total goods exports, comparedto 22% in 2008. New Zealand has a growing reliance on Fonterra’s performance –yet the latest forecast dairy payout is about 10% below the long-term average(after adjusting for inflation).

The other constraint tied in with having a high proportionof exports being agriculturally based is that there is limited capacity forgrowth.   Due to the stock cycle, the extent to which the agricultural sectorcan raise its volume of production is limited.

Not so invisible

Our net liabilities to the world have now ballooned to 98%of GDP.   The financial crisis has resulted in a much more conservative attitudetowards risk, and so greater attention will be paid to New Zealand’ssubstantial debt.   Investors will become more reluctant to fund our currentaccount deficit, and there will be growing pressure to start reducing ourforeign debt.   In the short term, the thinning of profit margins (reducing thedividends leaving our shores), as well as a lower interest rate bill, willresult in a large improvement in the balance of payments deficit.

An interesting point to note here is that with our netliabilities being so high, one might expect a much greater correction of theinvisibles balance than in prior recessions.   However, the make-up of the invisiblesbalance means that we do not expect it to improve by as much as it didfollowing the Asian crisis in the late 1990s.   In 1997, 36% of gross debt wasmade up of equity investment, but now it is only 19% of the debt.   The returnon debt (ie interest rates) is likely to be much less variable than returns onequity, and with equity now making up a much smaller proportion of totalliabilities, the scope for investment payments heading offshore to ease is muchreduced.

Bursting the investment bubble

New Zealand’s large current account deficit is symptomaticof economic activity that is being excessively driven by domestic demand.  Although households have attracted a lot of attention for the strength ofconsumption spending growth over much of this decade, spending on gross fixedcapital formation (ie spending on investment goods such as buildings,machinery, etc) has arguably been at higher and less sustainable levels.

The credit crisis and massive loss of confidence werealways going to have a significant negative effect on business investment.  With business profitability also being squeezed, investment spending issuffering and will continue to contract over the next 12 months. As apercentage of GDP, we expect private investment to ease by a total of sixpercentage points between 2008 and 2010.   This reduction is twice as much asthe one that occurred in either the 1990 recession or the Asian crisis of thelate 1990s.

The overstretched economy

Even with private investment running at over 20% of GDP inMarch 2008, the New Zealand economy was showing signs of being overstretched.  The capacity utilisation rate, as measured in the NZIER’s Quarterly Survey ofBusiness Opinion, was as high as 92.6%.   The unemployment rate had also fallento 3.5%, its lowest level since the early 1980s.

With activity in the manufacturing and building sectorsfalling away, capacity utilisation dipped to a 17-year low of 86.3% earlierthis year.   The unemployment rate has also risen, but had only reached 5% byMarch this year – 15 months into the recession. Unemployment will continue torise over the next year, reaching a peak of 6.9% in December 2010.   Incomparison to the early 1990s (when unemployment reached 11.2% at its peak),the labour market is showing greater signs of resilience.   The restructuringtaking place in the economy during the current recession is much less dramaticand widespread than it was during the late 1980s and early 1990s, so the numberof job losses will be smaller.   Firms are also trying to hold on to theirworkers as much as possible given the extreme tightness of the labour marketand difficulties in getting new staff over the last few years.

What savings?

New Zealand’s household savings rate had deteriorated to-13.5% of nominal disposable income by early 2007.   This figure was an all-timelow, but households’ high debt levels and lack of savings are being exposed, tosome extent, by the current recession.

It has been a common characteristic of previous recessionsfor the household savings rate to deteriorate during the early days of therecession before it improves.   This lag is due to the initial dominating effectof increased unemployment and, thus, the loss of income faced by households.  We expect this lagged effect to apply in the current recession as well, withsome deterioration in the household savings rate over 2009 as unemploymentcontinues to rise.   But over 2010 and 2011, as the labour market stabilises andthen starts to recover, there will be a long-overdue improvement in the householdsavings rate.   We forecast that the household savings rate will reach -4.2% bythe end of 2011, an improvement of nine percentage points. This improvement farsurpasses the 3.5 percentage point lift in the savings rate in the late 1990s,and highlights how bad the household savings rate had become leading into therecession, and the massive scope for improvement that existed.

Recessions have the ability to highlight imbalances in anyeconomy. For New Zealand, with several facets of our economy being pushed totheir outer limits earlier this decade, this recession was destined to provokelarge corrections in the economy. The massive current account deficit, horrifichousehold saving rate, and an overstretched labour market are all undergoingsome form of correction.

Given the persistently high exchange rate and relativelynarrow export base, questions remain about whether some of the correctionstaking place in the economy will be large enough.   With the starting point formany of these variables much more off-balance than heading into previousrecessions, the corrections need to be that much greater as well.   As noted inour recent forecasts, we have our doubts about whether the New Zealandeconomy’s problems will be adequately addressed over the next 12 months.   Onthat basis, our forecasts highlight the chance of New Zealand’screditworthiness being downgraded by international investors within the nextfive years.   The negative credit watch announced this week by Fitch Ratingsshows that we are not the only ones concerned about New Zealand’s imbalances.

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