Treasury Staff Insights: Rangitaki article by the Forecasting team
On 23 June the UK voted 52% to 48% in a referendum to leave the EU (“Brexit”). Although the referendum was regarded as binding, it will require parliamentary approval to activate Article 50 of the Lisbon Treaty which sets out the procedure for negotiating an exit from the Union. The exit process can take up to two years (or longer, with the agreement of all the parties). This special topic discusses the implications of the referendum vote for the New Zealand economy.
Vote led to widespread volatility…
The outcome of the referendum was not widely expected as polls (narrowly) and betting odds (strongly) pointed to a Remain vote. Because of this, it triggered widespread financial market volatility with the pound falling 12% the next day. It also led to political upheaval as PM David Cameron said that he would step down so that a new leader could take the exit negotiations forward. The referendum result also poses a risk to the internal unity of both the UK and EU, with Scotland and Northern Ireland voting to remain in the EU, and anti-EU political parties active in some other EU member countries.
…but economic impact on NZ is expected to be minimal at this stage
The referendum result has had – and will continue to have – widespread ramifications across political, financial and economic spheres for the UK, the EU and the world as a whole. There is not expected to be much impact on the New Zealand economy in the short term; in the medium and long term its impact may be negative, but that is also uncertain as it depends on how events unfold. At this stage, there is insufficient information and analysis to change the outlook for the NZ economy from the Budget Update.
Impact on UK economy expected to be negative…
The uncertainty created by the referendum outcome is expected to lead to lower growth in the UK in the short and medium term. Growth was already weakening prior to the vote because of the uncertainty it created; that uncertainty has now increased as it is not clear what future trade access and other regulatory arrangements will be. Firms are likely to continue to hold off on investment plans – or cancel them– and households may also become more cautious in their consumption decisions given the heightened uncertainty and the implications of the decision.
Financial market adjustments and volatility are also likely to have negative effects on economic activity, even though the Bank of England has stated that it is ready to provide additional liquidity to support financial institutions and that it will assess economic conditions and consider any additional policy responses in coming weeks. Nevertheless, the fall in the pound (it appears to have settled at about 8% down from its pre-Brexit level against the USD) will have an impact on incomes and purchasing power in the UK economy. Many forecasters consider that a mild recession is likely in the second half of 2016. Other economic impacts are also likely, including higher inflation as a result of the fall in the value of the pound which will further reduce real incomes.
Economic analysis prior to the referendum indicated that growth was likely to be lower once the UK exits the EU as a result of more restricted access to EU markets (around half of UK exports are to the EU), in addition to the direct impact on sectors such as the finance industry. HM Treasury, OECD and IMF had a range of estimates of the impact on growth between -1.5% to -6.0% over the next 2-3 years, depending on the severity of the shock and the nature of the market access to the rest of the EU under the new arrangements. An update to June Consensus Forecasts for the UK has marked growth down from 1.9% and 2.1% in 2016 and 2017 to 1.4% and 0.4% respectively.
…and for the EU and world economy
Economic growth in the EU is expected to be adversely affected by weaker demand from the UK and ongoing uncertainty, although not to the same extent as in the UK as exports to the UK represent only 3% of other-EU GDP. Estimates of the impact on growth vary, but range up to 0.5% points per year over the next 1-3 years. The updated Consensus Forecasts have reduced euro area economic growth in 2016 and 2017 from 1.6% in each year to 1.5% and 1.0% respectively.
The direct impact on economic growth elsewhere is generally considered to be small at this stage, apart from any impact via financial market adjustments or volatility; for example, the appreciation of the yen since the Brexit vote is likely to lead to slower growth and lower inflation in Japan. The stronger USD may also affect the US economy, but China, Asia and Australia are not expected to be directly affected at this stage, although there could be financial impacts in Asia.
Importance of the UK market to NZ…
Compared to the early 1970s when it joined the European Economic Community (as it was then), the UK is now a less important export market for New Zealand. In the year to March 2016, the UK ranked as our sixth largest export market (after Australia, China, Japan, the EU ex-UK, and the US), accounting for 3.3% of goods and 7.3% of services exports, amounting to 4.6% of goods and services combined. NZ’s major goods export to the UK is sheep meat (lamb), accounting for 36% of goods exports to the UK in 2015, followed by wine at 22%. The UK accounted for a fifth and a quarter respectively of NZ exports of those products in 2015, making them relatively dependent on the UK market.
The UK is also important for services exports, especially tourism (travel services). In the year to March 2016, there were 214,000 visitors from the UK, accounting for 7% of total arrivals and ranking fifth after Australia, China, the rest of Europe and the US. Long-term migration flows between NZ and UK are also important, with the UK accounting for 11% of total arrivals (124,000) in the year to March 2016; it is also an important destination for people leaving NZ longer-term, especially young people. Ten thousand people left for the UK in the year to March 2016 (17% of total departures). The UK is also a source of foreign direct investment (FDI) in NZ, accounting for 4% of the stock of FDI at the end of 2015.
…and of the rest of the EU
Given its greater size, the rest of the EU is a larger export market for NZ. It accounted for 8% of goods exports and 9% of services exports in the year to March 2016. NZ’s exports are more diversified than for the UK given the range of different markets, but lamb is also the major product (23% of goods exports in 2015), and fruit (especially kiwifruit), dairy products and wine are also important. The EU ex-UK accounted for more than a quarter of sheep meat exports in 2015, making the combined UK-EU market particularly important for that product.
Services exports to the EU ex-UK (particularly tourism) are also important, with 273,000 visitor arrivals in the year to March 2016, 8% of the total. Permanent and long-term arrivals from the rest of Europe in the same period were similar to the UK at 14,000 (11% of total arrivals), but it was less important as a destination for New Zealanders going overseas, with less than half the outflow to the UK, at around 5,000 in the past year.
The UK and EU are also important sources of imports for New Zealand, with motor vehicles the major item (20% of goods imports from the UK and 12% from the rest of the EU). In the year to March 2016, the EU-28 (i.e. including the UK) was the largest market for goods imports with an 18% share, ahead of Australia (17%) and China (16%).
Short-term impact on the NZ economy likely to be limited…
The impact of the UK’s decision to leave the EU on the NZ economy is likely to be limited in the short term. The main transmission channel for any immediate effect is financial markets; ongoing volatility is likely to lead to the postponement of trade, investment and consumption decisions in the UK. For example, the fall in the pound against the NZ dollar may make it more difficult to secure export contracts in the UK. The extent of that effect – and whether it is just a change of timing – will depend on how long the volatility continues.
In addition, while major developed economy bond rates have fallen (on expectations of more accommodative near-term monetary policy and a switch from risk assets to bonds), risk premiums and spreads to other bonds have increased. NZ bond rates have also fallen, but funding costs for NZ banks could increase. Local banks are understood to be well funded at present, so this is unlikely to have an immediate impact.
Ongoing uncertainty about the outlook would also affect business and consumer confidence, leading to reduced economic activity. Falls in asset values, particularly equities, may also curtail firms’ and households’ spending plans. These effects appear minimal at this stage; a timely measure of consumer confidence in Australia dipped only slightly this week from prior to the referendum.
…medium-term impacts likely negative but less certain…
The impact of the UK’s withdrawal from the EU on New Zealand in the medium term is less certain as it depends on how a number of factors develop. Lower economic growth in the UK in the second half of 2016 and in 2017, especially if combined with a weaker pound, would adversely affect demand for NZ products and services. The same would apply to the rest of the EU, although to a lesser extent as its growth is not expected to be affected as much and the euro has not fallen as far. There could also be effects via third markets; for example, if a lower pound makes UK exports more competitive relative to NZ exports in those markets.
The impact of the weaker pound on NZ imports from the UK is uncertain: it may lead to increased imports from that market and/or lower import costs and so lower inflation.
Services exports to the UK are likely to be affected in the medium term, given lower income growth and a weaker bilateral exchange rate (GBP/NZD), two of the main drivers of tourism demand given its discretionary nature. Economic activity arising from the 2017 Lions Tour of New Zealand may be affected by these developments with lower spending and/or fewer visitors.
Slower growth in the UK and a weaker currency may increase New Zealand’s net migration inflow. Some New Zealanders may return from the UK, especially if it enters a recession in the second half of 2016, and fewer young people are likely to go there to seek work, especially in the finance industry if it is directly affected by Brexit. Whether more British people migrate to New Zealand is uncertain. UK foreign direct investment is likely to be adversely affected by weaker growth and a lower pound.
…as are longer-term impacts…
What impact recent developments have on the NZ economy in the long term is difficult to estimate as it depends on future trade arrangements and other regulatory settings. In particular, the EU and UK will have to negotiate new trading arrangements with each other, and New Zealand and other countries will have to negotiate new trading arrangements with both of them. This could lead to a period of uncertainty extending beyond the two-year Brexit negotiating period. There may be other long-term impacts as well, for example access for New Zealanders to the UK and EU labour markets.
Weaker demand from that part of the world for some of New Zealand’s key export products might mean lower export prices and terms of trade in the long term and weaker demand for services exports (tourism). However, the long-term effects depend largely on what access arrangements are agreed and what the future growth path is in those economies. There may also be positive opportunities in this regard.
Global risks also increased
The main impact on the global economy is an increase in uncertainty at a time of already heightened risk. Brexit was one of the risks identified in the Budget Update, along with China’s slowdown and transition from investment to consumption, slowing growth generally in developing economies and an ongoing slow recovery in developed economies, and geopolitical risks especially in the Middle East.
The risks are further exacerbated at present by low growth in the world economy and the lack of both monetary and fiscal policy room, with policy rates near or below zero and government debt high in major developed economies. However, at this stage it is considered unlikely that Brexit would lead to a global financial crisis. On the other hand, the recent developments highlight a trend towards protectionist policies which would be negative for world trade and economic growth.
Impact on NZ uncertain at this stage…
Overall, the impact of the UK’s exit from the EU on the New Zealand economy is uncertain at this stage, but is not considered likely to be significant, at least in the short term. If financial market volatility continues, it may have a temporary adverse effect on trade and investment. Medium-term impacts will depend on how quickly the current uncertainty and volatility is resolved; if it continues for a period of time, it could have some negative impact through financial and confidence channels (e.g. a lower value of the pound leading to weaker services exports to the UK).
Longer-term impacts will depend largely on what sort of relationship the UK negotiates with the rest of the EU and with its other trading partners, including New Zealand. If New Zealand access to either the UK or EU for key products (e.g. lamb) is restricted, demand for those products will be affected, although other markets may offset some of that loss. However, there may also be some positive opportunities from new arrangements.
…but NZ is in a relatively strong position to withstand any shock
If a crisis did develop, the New Zealand economy is in a relatively strong position to withstand an economic shock. Economic growth in the year to March 2016 was 2.4%; the banking sector is well capitalised, particularly as a result of the policy changes introduced by the RBNZ following the global financial crisis; the exchange rate would adjust first in response to any external shock; the OCR is at 2.25% with room to be reduced further; the fiscal position is broadly balanced and net core Crown debt is relatively low at around 25% of GDP. However, any shock could still have a material impact on the New Zealand economy.
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Treasury Staff Insights: Rangitaki
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