Opinion: Fiscal surpluses dead and buried

By BNZ Markets Head of Research Stephen Toplis New Zealand's 15 year run of fiscal surpluses is at an end. And, not only will fiscal 2009 produce a shortfall in the Government's accounts but the red ink will, according to Treasury, climb to 3.0% of GDP by June 2011. Moreover, this is predicated on economic assumptions that already look horribly out of date suggesting that the eventual deficit is more likely to exceed 5.0% of GDP. That will leave us with the "worst" adjusted operating balance since 1985. By and large, the Government's written analysis looks credible but only when put in the context of when the analysis was performed. Treasury's economic forecasts were closed off on 20 November. Importantly, at that time the view was that New Zealand's trading partner growth for calendar 2009 would be around 1.2%. Since then the Consensus view has shifted down to 0.5% and, in reality, recent data from the United States and Asia already ensure that the truth will be even lower again. This raises serious question marks over Treasury's calendar 2009 New Zealand GDP growth expectation of 0.4%. In addition to this, we were surprised to see that Treasury is assuming that the New Zealand economy actually grew through the latter half of 2008. In contrast, we believe it contracted 0.5% in both Q3 and Q4. And last but not least, Treasury assumes that once growth returns to the New Zealand economy it will stay above trend for some time. We think this unlikely in what will be a changed environment bereft of substantial leverage opportunities and one in which households will be more prone to save than spend. In its December Economic and Fiscal Update, Treasury produces an alternative scenario in which it assumes trading partner growth of just 0.4%. This downside scenario sees the core operating balance peaking at 4.5% of GDP and the New Zealand economy staying in recession for much longer. We would suggest that it won't be long before Treasury officials publicly admit that the downside scenario has become the central scenario with an even nastier downside alternative a real possibility. As an aside, we also note that, under Treasury forecasts, the cash rate falls to 3.0% under its downside scenario as opposed to an implied 4.5% under the central scenario. Again, events appear to have overtaken the central scenario as it clearly does not include the 150 basis point cut in the cash rate instituted by the RBNZ on December 4. Even with the central forecasts as they stand, the Government is faced with raising a huge amount of cash over the next few years to fund both its investment programme and day to day operations. This year and last the net issuance of Government bonds was just under $2.0 billion per annum. Next year this rises to $3.4 billion and then to a staggering $10.0 billion-plus for the following three years. With bonds maturing in 2012 and 2013 the forecast gross issuance peaks at just under $16.0 billion. Of course, if our weaker outlook comes true then the eventual funding needs will be even greater. This raises the question as to how such a huge funding operation might affect the broader economy. In short, one can conclude that: interest rates will be higher than they otherwise would have been; and Government will crowd out the private sector. More generally, of course, questions are starting to be raised as to who will be willing to give the Government its requisite funding in an environment where authorities across the planet will be in heavy competition to fund their own fiscal excesses. Only time will tell but we are certain that at some point in the next year or two bond yields globally are going to back up savagely. Which the Federal Reserve in the United States delivers on its quantitative easing programme yields should probably fall further. But as soon as the liquidity is mopped up again the bond market sell off will be dramatic. Notwithstanding this, we are cautiously optimistic that New Zealand's relative position, both on a country and Government finance perspective, will leave us well placed. Of huge importance, in this regard, is the fact that we are starting this process with a Government which holds no net debt. Treasury's central scenario sees net debt rising to 20.7% of GDP by June 2013 or 25.6% of GDP under the downside scenario. That would only take us back to 1998 levels, which were hardly considered disastrous. Moreover, the net debt position would be around 10% of GDP less when the proceeds of the New Zealand Super Fund are taken into consideration. Perhaps the biggest question facing the Government, and New Zealand more generally, is how the rising deficit can be prevented from becoming structural and what are the Government's plans to eventually unwind the process. We are fully supportive of the Government running counter cyclical fiscal policy at this juncture. Moreover, it is great that the easing here is going straight into the hands of householders and businesses alike and/or being used for investment purposes which should, hopefully, add to future potential growth. This is quite different to many jurisdictions where fiscal expenditure is simply being used as a bail out package for industry, starting with the banks. Moreover, there is no suggestion from Government that the natural adjustment processes required in the housing market and to household balance sheets should not go ahead. Nor is there any suggestion that businesses operating on flawed models, such as the US auto industry, should be supported. This is refreshing by global comparison. Be that as it may, the fiscal situation must eventually be turned the other way. Clearly, at the moment this is work in progress and while the Government says it's going to get things under control it's not at all apparent as to how that might happen. Growing debt and deficits mean that fiscal policy must eventually turn contractionary. Businesses and householders alike should be under no illusion that this cannot happen without some eventual adjustment pain. * All of the research produced by the BNZ Markets team of economists is available here.