Over the next six business days we are running a detailed review by ANZ NZ's economics team of six key themes for 2013.
By Cameron Bagrie*
Our key aim in writing this article is to alert our readers to some of the wider economic forces at work.
We want to highlight the inherent tensions that exist within the economic system, and to encourage readers to start thinking about the implications for their own businesses.
Ultimately, it is the average rate of growth over a number of years (and volatility around that growth) that matters, as opposed to what GDP growth will be in any single year.
The repercussions of the global financial crisis will continue to be felt for years.
Therefore, we would encourage our readers to think about the macro themes we outline below within a five-year time horizon.
THEME 1: THE CIRCLE OF “[DIS]TRUST”
The Western world is facing Groundhog Day where we circle through a five-staged process: trepidation, response, upturn, “smugness”, tipping point, and back to trepidation, setting the spiral in motion.
Given weak debt fundamentals, breaking the spiral requires fiscal competency and credibility, and a mandate for economic reform. That’s a tall order to get a political mandate for.
Lacking these circuit breakers, we continue to morph through the various stages.
The cycle flags continued volatility, with financial market variables relevant to New Zealand (i.e. the NZD) oscillating as opposed to trending.
Interest rates will need to remain low.
There are five legs in the circle of “[dis]trust”.
-Trepidation – a focus on the fundamentals:
Western society needs to face up to the realities of a low growth trajectory in a world of ongoing deleveraging.
Basic maths tells us that fiscal positions are not sustainable in a host of nations including the USA and Japan, the largest and third-largest economies in the world. Growth models that include protectionism, labour market rigidity, massive social entitlements, and a huge role for the state are under the spotlight.
OECD countries are still borrowing faster than they’re growing; we’re seeing limited fundamental reform to lift growth capability across Western society (a necessary ingredient for fiscal sustainability); we have polarised political systems which lack a consensus; and large parts of society are still in the denial stage of the post-GFC grief cycle.
Central banks cut interest rates and crank up the monetary printing presses.
Systemic risks are contained. Green shoots appear. Markets breathe a sigh of relief and rally. Investors and businesses see opportunity.
Complacency appears. Lacking the market mechanisms to foster the required change, the pace of reform wanes and draws to a standstill. Populism prevails over leadership.
- Tipping point:
The rubber band again becomes taut. Fundamentals usurp sugar-pill economics. Green shoots turn brown and we swing once again to trepidation.
In the process, markets (and society) lurch from risk on to risk-off (somewhat simplistic terms in our view) and back again, navigating an environment of poor fundamentals – including massive global imbalances between the USA and Asia (the USA current account deficit soaks up around 3.5 percent of estimated global savings!), fiscal profligacy, significant monetary policy stimulus and liquidity, a lack of political awareness and consensus, and game theory that sees self-interest trump group interest.
Of course we are seeing improvement in a host of areas.
The provision of liquidity has helped calm financial markets. Equities are on an upward trajectory. Tail risks in Europe have diminished. We are seeing some semblances of political cohesion. The ECB’s proposed bond-buying scheme has seen a sharp tightening in peripheral bond spreads, the ESM bailout-fund has been given the green light, and plans for a regional banking supervisor in Europe will help plug the bank-sovereign loop. The financial plumbing is once again operational. We’re seeing wages adjust (decline) in Greece and Spain as unit labour costs between the periphery and core converge.
The outlook for the US economy has also improved as the housing market recovers. Corporates are awash with cash.
Financial conditions in Europe and the USA are flagging the potential for strong growth, though this is not occurring in some pockets of the Eurozone periphery.
Loose financial conditions would typically portend of a strong economic rebound, though we need to recognise that such measures lack key structural elements such as balance sheets that are currently a material restraint on growth.
Excess liquidity is being channelled into debt repayment (not investment), some speculative asset classes (i.e. Hong Kong property) and commodities. Lifts in the latter are an implicit tax on Western society!
Complacency (smugness) looks to be setting in with US “fiscal cliff” issues averted and the European debt crisis seemingly of little concern to investors. Politicians seem content kicking the fabled can down the road. Given an arm-chair ride by markets, necessity – a precursor to change – is lacking.
New Zealand experienced this cycle for more than a decade prior to 1984. By 1984, necessity was recognised – with crisis upon the economy.
Two nations to watch: Italy and the USA
Two nations are key to watch in 2013, namely Italy (more economic relevance than Spain in Europe) and the USA. To highlight the fiscal challenges, let’s look at the average primary balance that would be required to get net debt down to a “sustainable” position in ten years. For argument’s sake we define “sustainable” as the lower of 60 percent of GDP. And we look at different combinations of growth and real interest rates as both are important components of the fiscal sustainability story.
Italy faces an uphill battle. Italy has a primary surplus – a huge plus, but a very large stock of debt. The economy recorded an average growth rate of 1.7 percent in the decade prior to the GFC.
Even if they were to manage average growth of 2 percent over the next 10 years (which would out-do recent history, when they were busily borrowing) at real interest rates north of 3 percent, some pretty hefty primary surpluses are required. All this with a rapidly ageing population?
The maths are not pretty.
The numbers for the US are not as ugly in terms of the primary surplus needed, but require an overhaul of fiscal policy.
The USA has a lower debt profile than Italy, but has a large primary deficit and it is the rapid change (lifts) in debt from year to year that is worrying. At growth of say 2 percent, the government needs to run a roughly balanced budget to return net debt to a more sustainable level over the next decade.
But a caveat – this analysis gives the average primary budget balance required over the next ten years. The US primary deficit was 7 percent of GDP in 2012.
This is a very slow ship to turn and flipping this into a primary surplus is a huge lurch in policy settings. In practice, achieving primary balance over the next 10 years will require some very large surpluses in the second half of the decade.
If, for example, we use the OECD forecast of net US debt of 86.5 percent of GDP in 2012, and not unrealistically assume the US will take until 2017 to stop adding to its net debt, they would need a whopping primary surplus 3.8 percent of GDP the following five years to hit the 60 percent net debt target by 2022. That’s a massive change in fiscal policy settings.
Breaking the spiral
Do we foresee a circuit breaker in 2013 that breaks the spiral? There are candidates, but they face challenges.
strong growth (which seems unlikely given deleveraging requirements, a lack of reform and lags between reform and growth anyway);
a consensus across Western society for change and reform (think of turkeys voting for an early Christmas);
political consensus both at the intra-country level and across nations within the likes of Europe and between the USA and China (game theory tells us otherwise).
Debt relief / write-offs for peripheral Europe to reset the clock look inevitable but are a low-odds bet at the current point in time.
Inflation surprises could be one of the few variables to assist countries in deflating their debt by stealth, though Japan has been trying this for decades: deleveraging is deflationary as opposed to inflationary. And so we’re left with the monetary printing presses pumping up asset values in the hope that we’ll generate sufficient growth to magically erode the debt burden.
Why it matters for New Zealand
For New Zealand, the circle of “[dis]trust” is relevant on a number of levels.
First, we’re the two-bit player at the international roulette table. If global markets are set to swing and oscillate through the circle of [dis]trust over 2013 then New Zealand will be caught in the rip. This means global nuances will dominate local ones once again, so we’re set for another year of volatility. We expect the NZD to remain elevated relative to nations of fair value and oscillate from being extremely expensive to expensive (think 0.76- 0.86 cents) depending on the stage in the [dis]trust cycle.
Second, New Zealand’s fundamentals remain weak in some areas and the potential for contagion risks from offshore will need to be managed. New Zealand’s national balance sheet remains structurally impaired though it has improved markedly over the past three years. Net external debt has fallen from 85 to 71 percent of GDP. The household savings rate has improved from -3.3 percent of disposable income in 2009 to a zero balance in 2012 (and from -8 percent in 2003). That’s progress from dreadful to bad. Households have deleveraged somewhat, though are showing signs of pre-2007 behaviour. Household debt to income has fallen from a peak of 154 percent in mid-2008 to 143 percent in September last year.
The fiscal position has deteriorated markedly, though with net debt still below 30 percent of GDP (the OECD average is 65 percent) it’s still world class.
Weak fundamentals up the ante on defining, articulating and generating sufficient buy-in (i.e. a consensus) to execute a growth agenda. New Zealand needs to be squeaky clean, which ties in to Theme 2, transitioning via differentiation.
Third, New Zealand is managing to break the spiral at the local level, which mitigates the contagion risks. This is happening on a number of levels and we need to see more of the same.
There is more fiscal leadership than populism; the polar opposite to what’s happening in other nations.
The banking sector remains strong, with substantial new prudential oversight mechanisms also introduced over the past three years.
Reform is occurring, despite some angst in certain areas (i.e. asset sales). Society still looks modestly receptive to change and is broadly buying into the government’s strategy of reform and more efficient use of public services. It’s not universal, but policymaking never is. The main opposing political party is promoting a capital gains tax and raising the retirement age, so the reform agenda is not the sole domain of the incumbents. Neither the mainstream political parties will admit it but there is some pretty strong commonality in key policy areas. The past year has seen initiatives in welfare, local government, state-owned assets ownership, and continued implementation of earlier tax policy initiatives. These are not game-changers, but the combination adds more steel to the economy’s backbone.
- Economic growth prospects are being supported by the Christchurch rebuild, boosting construction and employment at a time when the government is tightening its own belt as it plans to return to surplus. Having a city rebuild ahead is somewhat fortuitous for the New Zealand economy. It’s growth in the bag, and if there is one variable to eye over the coming year, it’s growth: debt positions can quickly turn pear shape when growth is absent.
*This report was written by the ANZ New Zealand economics team which consists of chief economist Cameron Bagrie, head of global markets research David Croy, senior economists Sharon Zollner and Mark Smith, economist Steve Edwards, strategist Carrick Lucas, and rural economist Con Williams. It is used with permission. Theme 2 will follow tomorrow.