Potential Growth of Australia and New Zealand in the Aftermath of the Global Crisis
Author: Ms. Yan M Sun

Contributor Notes

Author’s E-Mail Address: YSun2@imf.org

Using a production function method, this paper assesses the impact of the global crisis on the potential growth of Australia and New Zealand. The two countries have not been hit hard by the global crisis, but have large net external liabilities. The paper finds that the main negative impact of the global crisis is likely to come through higher costs of capital, offset partly by a higher return to capital from strong demand for commodities by emerging Asia. It estimates medium-term potential growth of about 3 percent for Australia and 2. percent for New Zealand, higher than that of many other advanced economies.

Abstract

Using a production function method, this paper assesses the impact of the global crisis on the potential growth of Australia and New Zealand. The two countries have not been hit hard by the global crisis, but have large net external liabilities. The paper finds that the main negative impact of the global crisis is likely to come through higher costs of capital, offset partly by a higher return to capital from strong demand for commodities by emerging Asia. It estimates medium-term potential growth of about 3 percent for Australia and 2. percent for New Zealand, higher than that of many other advanced economies.

I. Introduction

This paper assesses the impact of the global financial crisis on potential growth of Australia and New Zealand over the medium term. It uses a simple production function framework to analyze key factors underlying potential growth in the last 25 years and explore possible developments in the next few years. The global crisis has not hit Australia and New Zealand as hard as many other advanced economies, although New Zealand’s economic performance has been less remarkable than Australia’s. Nevertheless, as Australia and New Zealand have long been “capital importing” countries, the global crisis could affect their potential growth through the cost and availability of capital and the productivity of capital.

This paper finds that the main negative impact of the global crisis is likely to come through higher costs of capital, offset partly by a higher return to capital from strong demand for commodities. Tighter financial conditions and higher cost of capital in the aftermath of the crisis may weigh on future investment and capital accumulation for Australia and New Zealand. At the same time, strong demand for commodities from emerging Asia, especially for Australia, could increase the return to capital and thereby support investment and capital accumulation. Given the limited increase in unemployment seen in both countries, labor participation and productivity are unlikely to be hurt significantly as a result of the crisis. However, demographic trends imply that growth in the working age population is set to slow modestly over time. On balance, this paper estimates potential growth of about 3 percent for Australia and 2⅓ percent for New Zealand over the medium term, higher than that of many other advanced economies, reflecting partly their strong linkages to fast-growing Asia.

II. Impact of the Crisis on Capital, Labor, and Productivity

The recent global financial crisis has sparked renewed interest in analyzing potential output. Given the “unobservable” nature of potential output, large uncertainties surround the estimate of output gap, the extent and sources of output losses, and future potential growth in the aftermath of a financial crisis. Nevertheless, having a clear understanding on these issues is essential for determining the timing and pace of exiting from the extraordinary policy support implemented in many economies. For example, an under-estimation of potential output loss in the face of large output falls may delay monetary tightening, fueling inflationary pressure. On the fiscal front, an optimistic medium- to long-term potential growth expectation may result in insufficient fiscal consolidation, jeopardizing debt sustainability.

In theory, the financial crisis could affect the level and growth of potential output through a number of channels.

  • Capital. Tighter financial conditions and higher risk premia could depress investment and capital accumulation, reducing potential growth during the transition period toward a lower equilibrium capital-output ratio. A higher capital cost would also cause the equilibrium capital-output ratio to fall, implying a permanently lower potential output.

  • Labor. The overall impact is not clear cut. A protracted and deep recession could reduce the potential labor force by discouraging labor participation and migration flows (European Commission, 2009). Possible hysteresis effects could also lead to an increase in the NAIRU (Blanchard and Summers, 1989). At the same time, economic hardship during a recession could encourage existing employees to work longer or secondary earners to join the workforce, or immigrate to countries with stronger job prospects. These positive impacts on labor input, however, may be temporary.

  • TFP. The overall impact is uncertain. Tighter credit supply and rising uncertainties could discourage firms from innovating and investing in R&D, and protracted unemployment could impair human capital. But removing obsolete capital and restructuring may improve efficiency and productivity.

Recent research suggests that financial crises could lead to lower potential growth in the near- to medium-term and large permanent output losses. Cerra and Saxena (2008) estimate a permanent output loss of 4–16 percent following financial crises in developed and less developed countries. European Commission (2009) finds that the recent global crisis will result in a drop of euro area potential growth by ¾ percent in the near-term and a permanent potential output loss of 5 percent. The IMF (2009) also finds that medium-term output losses following banking crises are substantial—close to 10 percent on average seven years after the crisis. Furceri and Mourougane (2009) find that past financial crises have, on average, lowered the level of potential GDP permanently by 1½–2½ percent, with some countries having potential output declining by as much as 4 percent.

A. Investment and Capital

Cost of Capital

A higher cost of capital may become a long-lasting legacy of the recent global crisis, weighing on future investment. On the supply side, tighter financial regulation and supervision—warranted for stability considerations—may well imply that financial intermediation will not return to the same high level as during the pre-crisis era. At the same time, rising public debt of major advanced economies will significantly raise the demand for credit. The crisis has also led to a general increase in risk awareness among investors, raising borrowing risk premia for many countries, including Australia and New Zealand.

  • By early May 2010, Australian bank CDS spreads and sovereign CDS spreads of Australia and New Zealand remained higher than pre-crisis levels (see text charts below). However, the increase in Australian bank CDS spreads to about 100 bps was smaller than that for large banks in the U.S., U.K., and Euro area. The widening of sovereign CDS spreads was muted for Australian and New Zealand, with no sign of contagion from the increasing spreads for some peripheral European countries.

  • New Zealand sovereign CDS spreads have remained slightly higher than Australia’s since 2009. New Zealand’s long-term government bond yields have also risen more than Australia’s relative to 2006–07, despite Australia’s higher policy rate. Higher external debt of New Zealand may be a factor behind its higher risk premium.

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Sources: ABS; Statistics New Zealand; and author’s calculation.

There is scope for central banks in Australia and New Zealand to adjust monetary policy to offset the changes in risk premia, although there are limits to this approach. This was evident during the global financial crisis. Despite the jump in spreads, borrowing costs fell as a result of significant and effective monetary easing, supported by a sound banking sector that weathered the global crisis well.

A simulation of the IMF’s GIMF model calibrated for New Zealand suggests that an increase of real domestic interest rates by 3 percentage points would lead to a permanent fall in the capital/output ratio of 12 percentage points (Box 1). The large jump in the cost of capital should be seen as a tail risk. The impact on the economy of such a large increase is significant, as it results in an almost 40 percent fall in investment after five years and 4½ percent drop in output relative to baseline over the medium term. The table below illustrates the impact of smaller falls in investment, by say 1, 5, or 10 percent that may result from smaller rises in the cost of capital or a lesser impact of the rise in cost of capital on investment. While the impact on potential output is smaller than in the GIMF simulation, the impact is still sizable.

New Zealand: Higher Cost of Capital and Lower Potential Growth

(In percent)

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Source: author’s calculation.

Higher Cost of Capital

The Fund’s Global Integrated Monetary Fiscal (GIMF) model, calibrated for New Zealand (see forthcoming IMF working paper by Werner Schule), has been used to estimate the impact of a permanent increase in the cost of capital in general equilibrium. The simulations assume a higher permanent sovereign risk premium that raises real interest rates by 3 percentage points and depreciates the NZ$ effective exchange rate (TWI) by 20 percent initially. The hike in real interest rates is much larger than observed recently and the experiment should be seen as stress test rather than forecast. The depreciation dies away as the economy adjusts.

Higher capital costs and lower sales expectations depress investment. As a result the Capital/GDP ratio falls permanently by 12 percentage points. Corporate net worth falls, but firms reduce borrowing by more as interest rates have risen. As a result, the corporate leverage ratio declines.

With higher real interest rates, investment drops sharply below baseline and remains permanently lower. Real GDP drops about 4½ percent below baseline.

Investment Return

Demand for commodities from fast-growing emerging Asia, especially for Australia, is likely to raise the return on capital. Specifically,

  • Terms of trade gains. Australia enjoyed a substantial gain in its terms of trade— close to 70 percent—during 2000–08. While New Zealand’s terms of trade improvement was not as impressive as Australia’s, it was still sizable at 25 percent during this period. Despite a small correction in the terms of trade during the global crisis, IMF staff project the terms of trade to remain elevated for both countries, especially for Australia, where nominal GDP growth would benefit tremendously. Moreover, the large terms of trade gain in Australia and the capital intensive nature of the resource sector are factors explaining high investment relative to other countries. In a neo-classical model, higher terms of trade could offset diminishing return to capital input, boosting investment. Capital could also move to places such as Australia where higher returns are expected, dampening the negative impact of the crisis on Australia’s potential output.

  • Emerging Asia. Australia’s export destinations have shifted from slow-growing advanced economies to fast-growing emerging countries like China and India (see text charts and tables below). For New Zealand, the shift has not been as dramatic, but it has benefited indirectly from Australia being its largest trading partner, with close to a quarter of its exports going across the Tasman. Going forward, a further shift of exports to fast-growing emerging Asia would boost the two countries’ investment and growth prospects. To illustrate this point, a rough projection of the direction of exports suggests that by 2015 about a third of Australia’s exports would go to China, which is also expected to surpass the U.S. as New Zealand’s second largest export destination, only after Australia.2 This would raise Australia’s trade-weighted partner country growth to almost 6 percent and New Zealand’s to almost 5 percent, significantly above the growth rates implied by using current or historical weights.

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Sources: ABS; Statistics New Zealand; WEO; and author’s calculation.

Investment Prospects

IMF staff forecasts take account of the higher cost of capital and closer integration with Asia and expect stronger capital accumulation for Australia than New Zealand.

  • For New Zealand, investment fell sharply in 2009, but is projected to recover over the medium term. Growth in the capital stock would remain below pre-crisis levels (see text chart).

  • For Australia, investment barely fell in 2009, and average investment growth is expected to be slightly stronger over the medium term. As a result, growth in the capital stock is expected to be almost twice the level of New Zealand.3

  • The projected weaker capital growth for New Zealand reflects its much larger investment fall during the crisis and a slightly higher cost of capital and lower investment return going forward. New Zealand’s larger net foreign liabilities (about 90 percent of GDP) imply a higher risk premium and borrowing cost than Australia, whose net foreign liabilities stood at 60 percent of GDP in 2009. Moreover, Australia enjoys closer ties with emerging Asia and stronger terms of trade gains, boosting its investment returns.

UF7
Sources: ABS; Statistics New Zealand, and author’s calculation.

B. Labor

The limited increase in unemployment in Australia and New Zealand during the crisis suggests that trend labor supply is unlikely to be adversely affected by the crisis.

  • NAIRU. Australia’s unemployment rate peaked at below 6 percent while New Zealand’s peaked at 7.1 percent. The limited increase in unemployment suggests that hysteresis effects are unlikely to play out. Australia’s NAIRU is estimated to remain unchanged at 5 percent throughout the crisis (Figure 1). New Zealand’s NAIRU estimate increased only slightly during the crisis and is expected to return to 4½ percent by 2015.

    UF8

    Unemployment Rates

    (In percent)

    Citation: IMF Working Papers 2010, 127; 10.5089/9781455200863.001.A001

    Sources: Statistics New Zealand; World Economic Outlook.
    Figure 1.
    Figure 1.

    Australia and New Zealand: Labor and Productivity Growth

    Citation: IMF Working Papers 2010, 127; 10.5089/9781455200863.001.A001

    Sources: Statistics New Zealand; ABS; and author’ calculations.

  • Labor participation. The relatively shallow recession is also unlikely to have discouraged labor participation significantly. The labor participation rate has broadly held up during the crisis and is expected to continue trending up, albeit at a slightly slower pace. Reflecting a flexible labor market, the trend decline in average working hours, which other advanced economies such as Canada and the U.S. also experienced, is expected to continue in the medium term.

  • Working age population. Australia’s population growth has been trending upwards in recent years. The jump in net migration in Australia and New Zealand in 2009 boosted the growth of working age population and may have in part reflected the relatively strong economic performance of these countries. However, this trend is not expected to continue for New Zealand, with a stronger recovery in Australian labor market likely attracting workers across the Tasman. Additionally, an aging society will reduce the growth of working age population over the medium term.

UF9

Working age population growth

(In percent)

Citation: IMF Working Papers 2010, 127; 10.5089/9781455200863.001.A001

Sources: ABS; Statistics New Zealand; and author’s calculation.

C. Productivity

One likely channel for the global crisis to reduce productivity growth in Australia and New Zealand is through higher cost of capital. Estevao and Severo (2010) show that increases in the cost of funds have a significant negative impact on TFP growth, through the channel of poor allocation of factors across firms reducing the productivity of entire industries. Although Australia and New Zealand did not experience a domestic financial crisis, their large external liabilities expose them to higher borrowing costs in the global market. The impairment of human capital, another important factor underpinning productivity, is minimal due to the limited increase in unemployment in both countries.

D. Projections for Potential Growth

Looking ahead, Australia’s potential growth is projected at about 3 percent and New Zealand’s 2⅓ percent in the medium term (Tables 1 and 2). The projections should be seen as illustrative given the uncertainties about the impact of the crisis, especially the extent of change in the cost of capital and its impact on investment. Key elements underpinning the potential growth projections for Australia and New Zealand are compared in Table 3. Given inherent difficulties in estimating productivity, trend TFP growth is assumed to remain broadly constant in the coming years. This assumption takes account of the result that trend TFP growth for both countries is found to have stabilized around 0.4 percent during the last five years (Figure 1).

Australia and New Zealand: Contribution to Potential Growth in 2015

(In percent)

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Sources: author’s calculation.
Table 1.

New Zealand: Path for Potential Output Growth Components

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Sources: Statistics New Zealand, and author’s estimates.

Output-labor elasticity assumed to be 0.6 and output-capital elasticity assumed to be 0.4.

Table 2.

Australia: Path for Potential Output Growth Components

article image
Sources: ABS, and author’s estimates.

Output-labor elasticity assumed to be 0.6 and output-capital elasticity assumed to be 0.4.

Table 3.

Elements of Australia and New Zealand Potential Growth Projections

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Source: author’s estimates.

The difference in the potential growth estimates for Australia and New Zealand (0.8 percentage point) is similar to pre-crisis levels during 2005–2008, and can be explained largely by differences in capital stock growth. New Zealand experienced a much sharper investment fall in 2009 than Australia. Looking ahead, an expected rise in the cost of capital as a result of the global crisis is expected to weigh on New Zealand’s investment and capital accumulation, adding to the pressure on potential growth from an aging population. For Australia, investment is expected to be less affected by a higher cost of capital, thanks to stronger demand for resources and larger terms of trade gains.

Among major advanced countries, Australia’s growth potential over the medium term clearly stands out as the best. This in part reflects Australia’s strong linkages to fast-growing Asian economies (see text charts below). For a similar reason, New Zealand’s growth potential is projected to be slightly higher than that of many other advanced countries. However, at this pace, New Zealand is unlikely to narrow the sizable income gap with Australia.

UF10
Sources: WEO; and author’s calculation.
Potential Growth of Australia and New Zealand in the Aftermath of the Global Crisis
Author: Ms. Yan M Sun