Brian Fallow: Covid's scarring will take years to heal

Treasury expects net migration to plunge from 86,000 people a year to just 5000. Photo / Peter Meecham

COMMENT:

The Treasury now expects the Covid-related scarring of the economy to be deeper and longer-lasting than it thought at the time of last May's Budget.

It has revised down its estimate of the economy's potential output in four years' time by nearly 3 per cent to reflect lower forecasts for labour supply, the capital stock and productivity.

In the pre-election economic and fiscal update (Prefu) released on Wednesday, it said more persistent scarring effects from alert levels 4 and 3 restrictions, extended border closures and a weaker world recovery would lead to a slower overall economic recovery, particularly in regions reliant on tourism spending.

The Budget forecasts had assumed the shock due to the pandemic, while persistent, would ultimately have limited impact on longer-term structural variables like the economy's potential output.

Potential output can be thought of as the maximum amount of goods and services that can be sustainably supplied in an economy without increasing inflation. It depends on the supply of labour and capital and on "multi-factor" productivity, which is how efficiently labour and capital are used.

The Treasury still expects the economy's supply-side capacity to grow over the next four years, but by about a quarter less than it thought even in the depths of the recession four months ago.

However it does not expect demand growth to outstrip that weaker growth on the supply side to the point that inflation becomes an issue. It sees consumer price inflation staying in the bottom half of the Reserve Bank's target band.

It points to two factors limiting labour supply, even after the border is reopened, which it does not expect to happen until the end of 2021.

One is an increase in the proportion of people of working age who are discouraged from participating in the labour market.

The other is a rise in "structural" unemployment as an increasing share of people find their skills are not those in demand. "This is likely to be the case for some tourism sector employees who may have firm- or industry-specific skills which may not be readily transferable elsewhere in the economy."

Capital accumulation is also expected to slow. Credit data show borrowing by businesses has fallen over recent months.

The Prefu expects it to take three years for business investment to recover to pre-Covid levels, about a year longer than the consensus among economic forecasters.

"On average we also expect lower productivity growth. Initially this reflects additional constraints and costs associated with providing goods and services in order to contain the virus. Shifts in demand may mean some capital assets, including physical, human and intangible capital, may be used less intensely than was the case before the pandemic."

This outlook, should it prove accurate, is all the more discouraging because the Reserve Bank in its monetary policy statement last month was already pointing to declining trend growth in the economy's potential output before the Covid shock hit.

Stronger headwinds from here will buffet an economy which was already losing momentum and well past the hump of the cycle.

The Reserve Bank estimated potential output grew just 1.8 per cent in the year ended March 2020, the weakest rate since 2011.

Growth in the labour force, which had been running around 1.5 per cent a year in 2016 and 2017, had already almost halved by March this year, while productivity growth had been trending down from 0.8 per cent in 2014 and 2015 to zero, even before the Covid shock.

Overall, and as expected, the Treasury's view of the near-term economic outlook is less negative than in the Budget, but the medium-term outlook is weaker.

The unemployment rate is now forecast to peak at 7.8 per cent in March 2022, which is both lower and later than the Budget's pick of 9.8 per cent in the current quarter.

But over the medium term the unemployment outlook has darkened. It is now forecast to still be 6.6 per cent by June 2023 and 5.3 per cent a year later, up from 5.2 and 4.8 per cent respectively at Budget time.

Looking forward, a key swing variable for both the supply and demand sides of the economy is what happens to net migration.

Unfortunately, the picture is especially murky, not just because of border restrictions introduced in mid-March but also, even before that, because of changes Statistics New Zealand has made in how it measures migrant flows, from using declarations on arrival and departure cards to tracking actual passports crossing the border.

For what it is worth, the Treasury expects the net migration gain to fall on an annual basis from 86,000 in March 2020 to just 5000 by June next year.

"While many New Zealanders and permanent residents have returned to the country in recent months, the departure of temporary visa holders is expected to broadly offset arrivals," it said.

"Extended border restrictions raise the risk of labour shortages, particularly in sectors such as accommodation and food services; agriculture, forestry and fishing; and construction."

Pre-Covid, people in New Zealand on temporary work visas accounted for about 6 per cent of the labour force.

The Prefu forecasts assume that as border restrictions ease from the September 2021 quarter, net migration flows will gradually rise to reach 35,000 by June 2024, the same end point the Budget forecast.

Weaker growth in potential GDP means the incoming Government, whoever that is, will have a smaller tax base than the May Budget numbers had foreshadowed.

The Treasury forecast for net core Crown debt by mid-2024 — this assumes no policy changes — is almost unchanged in dollar terms, $201.1 billion versus $200.8b in the Budget. That is up from $83b at June this year.

But when measured against the expected size of the economy, it has been revised up from 53.6 per cent of GDP to 55.3 per cent.

Either number would be the envy of most governments; it is NZ household debt that is the problem.

In any case, as Finance Minister Grant Robertson was quick to point out, lower interest rates (at least for the foreseeable future) mean that, even with the rise in debt, the taxpayer's interest bill is forecast to fall from $3.2b in the fiscal year just ended to $1.4b in 2021/22 and still be $2.4b two years later.