Economy: The Downside Of 2006

Fasten your seatbelt. Return your seat to the upright position.

After three years at a cruising altitude of 4 per cent growth, the economy began its descent in 2005.

The consensus among economic forecasters is that 2006's landing will be a relatively smooth touchdown, with annual growth slowing to somewhere between 1 and 2 per cent.

But dropping with an undercarriage-buckling thud to a recession is a possibility, especially if some international shock hits.

"In any case," says ASB Bank's chief economist, Anthony Byett, "it's going to be a tough year, whether it's a recession or not. Some people are already hurting, in the forest industry, fishing and horticulture, for example, and more will hurt next year.

"That it is a soft landing is no comfort at all to those folk."

The economy has been flying on one engine, household spending, while the other, the export sector, struggled with an exchange rate stuck around the US70c mark for most of the year.

High world prices for the major pastoral export commodities provided some offset to the strong dollar, but lately they have started to slip.

The household spending which has propelled the economy of late has been based on strong growth in incomes as a tight labour market delivered more jobs and higher wages.

Spending has been further boosted by the wealth effect from a buoyant housing market as homeowners borrow against the rising value of their properties.

The net effect has been "dis-saving" by the household sector as whole, as it spent $1.14 for every $1 of income.

A key uncertainty for 2006 is how people will respond if the housing market cools as expected.

As higher interest rates bite, growth in house prices tapers off and the job market weakens, consumer spending can be expected to decelerate.

Based on what happened in Australia and Britain when their housing booms ended, the Reserve Bank is expecting the annual rate of growth in household spending to drop sharply from about 5 per cent to zero.

If it does, it will be despite a stimulatory fiscal policy, boosting incomes though the expansion of the Working for Families package and making student loans interest-free.

The most recent Westpac McDermott Miller consumer confidence survey recorded its steepest drop for five years - especially sobering since the labour and housing markets are still strong.

Business confidence is also in the pits.

Profits are squeezed by higher labour and energy costs. And for firms which export or have to compete with imports, the exchange rate has turned from a headwind into a howling gale.

ANZ National Bank's leading index, based on firms' expectations of their own activity and investment and hiring intentions in the bank's monthly sentiment survey, is the weakest it has been since the 1998 recession.

Most of the conditions associated with the last two recessions, in 1991 and 1998, are in place again: a high currency, tight monetary policy, an unsustainable current account deficit, overvalued housing market and inflation at problematic levels, the bank says.

These by themselves did not instigate the recessions that followed but they left the economy vulnerable to the shocks that followed - global recession and the mother of all budgets in 1991, drought and the Asian crisis seven years later.

Over the past year business spending has been almost as important as household consumption in driving economic activity.

"We are seeing significant investment," says Deutsche Bank chief economist Darren Gibbs. "The rate of addition to the capital stock is as great if not greater than anything we have seen in the past 20 years."

But Gibbs said looking ahead the dollar was probably going to fall, so the cost of imported plant and machinery would rise and firms would have less profit to play with. He expects the rate of business investment to decline.

A big and sustained increase in rates of business investment compared with recent decades is essential if the gap in productivity and incomes between New Zealanders and their peers across the Tasman and in the wider OECD is to narrow.

The Treasury says labour productivity made little contribution to economic growth in 2005.

The recent increase in employment and fall in unemployment are likely to have attracted an increasing number of inexperienced and lower-skilled people into the workforce, diluting average productivity. But as those people become more experienced, and given the surge in capital expenditure by businesses, it should lead to higher productivity down the track.

A HARD LANDING?

* Annual economic growth to slow to 1 to 2 per cent.

* Recession remains a possibility, especially if an international shock hits.

* Growth in house prices to slow.

* Annual household spending growth to drop from 5 per cent to zero.

* Business investment to decline, but remain high.