SCENARIOS-How markets may react to tough New Zealand budget

WELLINGTON, May 27 - The New Zealand government will release its budget on Thursday amid an economy deep in recession and repeated warnings about a possible credit rating downgrade due to ballooning fiscal and current account deficits.

Following are some possible outcomes of the budget and how the might market react.

AS EXPECTED

ANZ-National Bank, Westpac Bank and Bank of New Zealand expect the budget to show the operating deficit will peak around NZ$10 billion, or 5 percent of GDP, in 2012 or 2013, before starting to decline.

They predict bond issuance will rise up to NZ$10 billion in the 2009/10 year, and to as much as NZ$20 billion by 2013. Gross debt is seen hitting around 40 percent of gross domestic product by 2012 from its current level around 19 percent, before levelling out.

A budget broadly matching these expectations would be seen as preserving Standard & Poor's current sovereign AA-plus credit rating with a negative outlook on New Zealand and may prompt a rally in the currency and bonds.

"Bond yields have risen over the last few days on concern over the possibility of a downgrade by S&P," said Westpac senior economist Donna Purdue.

"Some of that may unwind as the budget is delivered and if it does show pretty strong fiscal discipline."

A Fitch Ratings analyst said on Wednesday that a rise the operating deficit to 5 percent of gross domestic product over the next three to four years in itself will not trigger a credit downgrade.

Credit analyst Ai Ling Ngiam told Reuters that any rating change would require further assessment of public finances as well as the current account balance. [ID:nSP480879]

The benchmark two-year swap <NZDSM3NB2Y=> is trading around 3.55 percent, 20 basis points higher than after the central bank's last rate cut in April. The five-year swap rate <NZDSM3NB5Y=> has risen 42 basis points to 5.03 percent.

Any rise in the New Zealand dollar could be temporary, as the kiwi will likely be driven by broader market events and with the underlying risks still to the downside on concerns over the economy, the large current account deficit and expectations central bank rates will remain low for some time.

Front-end swap yields may fall also if fiscal policy is seen providing less of a stimulus to the economy, putting reliance on the central bank to keep its policy rates lower for longer.

WORSE THAN EXPECTED

Larger-than-expected operating deficits or bond issuance will likely lead to a steep sell-off in the currency and a jump in interest rate swap rates, as it would be seen as lifting the chances of a ratings downgrade -- a risk highlighted after S&P cut its outlook on Britain on concerns over rising debt levels.

"If the deficit comes in much larger than NZ$20 billion, you will probably see a sell-off in bonds, because that means there will a lot more future (debt) issuance," said Khoon Goh, senior markets economist at ANZ-National Bank.

The kiwi tumbled 5 percent immediately after S&P cut its outlook on New Zealand to negative from stable in January. [ID:nWEL368620}

New Zealand's 5-year credit default swaps <NZGV5YUSAR=MP> (CDS) -- insurance-like contracts that protect against defaults and restructuring -- will likely surge from current levels of around 91 basis points. They rose to as much as 240 basis points in mid-March tracking the global trend compared with pre-crisis level of around 20 basis points.

Over the longer term, foreign investors would likely cut their holdings of New Zealand government securities. The last time New Zealand's foreign currency rating was downgraded in 1998 foreign ownership of government bonds fell 10 percentage points.

BETTER THAN EXPECTED

If the budget forecasts smaller-than-expected deficits and debt levels over the coming years, it is likely to ease the risks of a downgrade but not enough to prompt a change to the country's negative outlook.

The kiwi is expected to rise, but interest rates would likely show little lasting reaction, given they would be anchored against expectations the Reserve Bank of New Zealand will keep its cash rate at or below the current 2.5 percent level until late next year to support the economy. For an associated FACTBOX on New Zealand's fiscal and economic position see [ID:nWEL461682]