Agricultural production this year will be 1% lower than last year as a result of the exceptionally dry summer, with that legacy expected to be felt for some time yet.
But, according to economic and fiscal update documents released by Finance Minister Michael Cullen in this week's budget, record export dairy prices were still expected to more than offset the negative impact on national income caused by drought, lower consumer spending power and higher food prices.
The fiscal update and Dr Cullen's speech single out the dairy sector, an indication the economy was becoming more weighted towards dairy exports, a trend which would play a central role in what was predicted to be an export-led rebound from the current economic slowdown.
In the immediate future, export volumes would be hit by the high exchange rate, weak trading partner growth and the drought.
Export volumes in the year to March 2009 would fall nearly 1% compared to a year earlier, a significant turnaround from the 3% increase predicted by Treasury in its earlier half-year update.
"As dairy areas are particularly affected by drought, this fall will be driven by a fall in the volume of dairy exports," the latest update stated.
The latest fiscal update also predicted weaker world growth would impact on New Zealand commodity exports and prices, but this was yet to have any material effect Dairy prices were picked to peak in June this year then start to decline later this year in response to greater exports from the United States, Europe, Australia and South America.
Demand for protein from developing countries would maintain dairy prices and boost meat prices, helping the country's terms of trade.
While the dry summer has impacted heavily on dairy exports in particular, the update said the improving terms of trade led by dairying was reflected in the reduced current account deficit which, as a percentage of GDP, fell from 8.6% in the year to December 2006, to 7.9% a year later and was picked to be 6.7% in September 2008.
Economic growth was expected to show a more cyclical path due to the drought, slowing world economy and financial markets, and the housing market.
The update said GDP in the year to March 2008 was 3.1% and picked it to fall to 1.5% in the year to March 2009 and 2.3% to March 2010 before rebounding to 3.2% and 3% in the following two years.
That rebound in economic growth would be driven by exports - particularly from the primary sector, as agricultural production recovered from drought - as well as by growth in the dairy industry from converted sheep and beef farms.
That rebound would also be helped by greater economic growth among trading partners, expected to be about 3.6%, with export volumes expected to improve by 4% in the year to March 2010 and continue at a similar pace for the following two years, helped by an easing exchange rate.
