Cullen Speech: Canterbury Manufacturers’ Assn
Michael Cullen Speech: Canterbury Manufacturers’ Association Pre-Budget Luncheon
In a week’s time I will be presenting my fourth Budget. Once again, there will be no great surprises. Government Budgets are important milestones in the annual calendar of any economy. It is precisely because they are important that they should not be gimmicky or sensation-seeking. Everybody is now painfully aware that in the hyper-sensitive environment of current global stock and finance markets, the markets hate surprises. They tend to respond vigorously to even the mildest deviation of disclosure from expectation.
Budget 2003 was prepared against a backdrop of one of the strongest economic and fiscal settings that we have seen for a third of a century. It was also prepared against a backdrop of one of the most uncertain and unstable economic outlooks that we have seen for perhaps a quarter of a century. It was, to say the least, an interesting exercise.
As we face uncertain times, it is, of course better if we start from a position of strength.
The economy grew by 4.4 percent in 2002.
Employment was up 2.4 percent in the year, and that was not a rebound from a low base. Employment has grown for ten consecutive quarters.
Unemployment fell below five percent for the first time in fourteen years. It was not a result of people giving up on finding a job and leaving the labour market: our labour force participation rate – the proportion of the working age population in work or seeking work – is close to the highest it has ever been.
Inflation remains within the agreed target range, and in the first quarter of this year it actually declined slightly.
Living standards are rising with total wages and salaries paid outstripping inflation by three and four percent a year. This is not because of inflationary wage pressures, but more because more people are working, moving up into better paid jobs and being replaced by people coming off benefit. More people are working the hours of their choice rather than being locked into involuntary underemployment.
The current account deficit is around half the level it was three years ago.
All of this is reflected in a strong fiscal position, and I must add that the fiscal position is stronger still because this government has been disciplined and has resisted both calls and temptations to loosen the purse strings.
At the time of last year’s Budget, I was forecasting an operating surplus of around $2.3 billion. By the time we published the fiscal update in December, that had been pushed up a bit to $2.5 billion. Those of you who follow the monthly reports of Crown Financial Statements will have noticed that in the eight months to February this year, the operating balance was running a strong $900 million ahead of even the revised December figures. The statements for the period to 31 March are due out tomorrow.
The government uses accrual accounting methods and follows GAAP principles. This means that before the year end accounts are finalised we need to estimate what parts of the extra revenue will reverse out, what expenditures will come to book, how estimated liabilities for things like ACC and GSF have changed, what we expect from SOE profits and so on. The estimated impacts of all of these things are revealed in the Budget but I can indicate they are substantial..
It is here that I want to return to a theme from my first Budget. Back then, I was critical about the over-reliance on single figure evaluations of the strength of the government’s fiscal position. In particular, the raw operating balance figure could give a false impression of the state of the nation’s finances. Paticularly when revenue and expenses were roughly aligned – when the surpluses or deficits were small – valuation and accounting changes tended to swamp the final reported balance. These changes tend to reverse out over time as interest and exchange rates, and even stock markets, move through cycles, but in the meantime they can give a very false impression, not only of the fiscal stance, but also of the direction of change.
The valuation changes tend not to involve cash: in some cases they relate to liabilities that will crystallise decades ahead. They therefore do not impact on cash flows, bond tender programmes and government debt: all key variables of interest to finance markets.
That is why we introduced the OBERAC – the operating balance excluding revaluations and accounting changes. OBERAC was not intended to replace the operating balance as the primary fiscal indicator but to augment it. Look at both. Equally though, any balance is a snap-shot. We also need to consider trends, because if trends are adverse, a balance will not last. I have tried to develop a richer suite of fiscal indicators and remain ever hopeful that on the day, a scorecard approach will be taken in evaluating the annual financial report.
A rounded assessment of the finances means that analysts and commentators should look at the operating balance, the OBERAC, trends in expenses and revenues as a percent of GDP, levels of gross debt and trends in gross debt, levels of net debt and levels of net worth, as a package. It is much more important to take that whole of portfolio approach when there is volatility in global finance markets and uncertainties swirling around the global economy and around investment, tourism and trade.
The point I am making is that all of the indicators to date indicate that the strong position forecast at the time of Budget 2002 was not wishful thinking.
The net effect is that government debt is lower that forecast, and on last published figures gross debt had tipped below 30 percent of GDP and net debt to below 15 percent. To put this in perspective, both indicators were five percent of GDP higher at 30 June 1999: the balances I inherited if you like.
I have said that this overall picture is stronger and more balanced than it has been for nigh on a third of a century. We need to go back to the mid 1960s to find a better mix of indicators. Since that time, we have been on a roller-coaster. Growth has often been stimulated by tax cuts or tax concessions, so it has been accompanied by rising deficits and rising debt. Reigning in inflation was achieved alongside and because of a blow-out in unemployment. Falling unemployment was achieved by real income cuts. Conversely, real wage increases tended to be inflationary. We just never seemed to get all of the ducks in a row since the loss of preferred access to the British market and the oil shocks of the 1970s.
For now, that has changed, and the economic cycle is virtuous.
It hasn’t been all plain sailing. We have had to weather the rapid decline in the exchange rate in 2000, the winter of discontent over our partial re-regulation of aspects of the labour market, the dry spell and the electricity shortages of 2001, September 11, the persistent decline of global share values, the confidence jolts of the Enron and Worldcom scandals, problems in the world insurance industry, ongoing sluggishness in the consumer powerhouses of the northern hemisphere, a sharp reversal of dairy prices and the uncertainties that prevailed before the war in Iraq.
Navigating through those obstacles has required clear heads and calm nerves, and I think it is fair to say that doing it involved a collective responsibility and response – from government, from business, from the unions and from the community sector - not seen in New Zealand for a very long time.
There was a saying in the sixties that today is the first day in the rest of our lives. I think it was supposed to excuse all past excesses – especially yesterday’s! The thrust of the saying was that what matters is what happens next. In our current context, it would mean that all of our current performance counts for little as we face a future dominated by the longest global bear market in fifty years, weak investor confidence, uncertainty about the post-Iraq war reconstruction, pessimistic forecasts about returns to dairying, SARS, questions about the cost and supply of electricity, worries about the exchange rate, the effects of dry conditions in parts of the country and frosts in other parts, and I suppose everyone in the audience could add two or three items to that list.
It is the length of that list, and its complexity, that leads me to say that this is one of the most unpredictable environments that we have encountered since the stagflation and Third World debt crises of nearly twenty five years ago. I don’t think the past counts for nothing. It is very important to take comfort in the fact that we approach an uncertain future with significant policy headroom and a range of policy options. This is not simply fiscal headroom. The monetary authorities have room in which to move. Fiscally, there is scope to respond on both capital and operating fronts. If the economy does slow, we enter a slowdown with much more scope to absorb the labour market downside than we have had since the start of restructuring in the late 1980s. Corporate, farm and household balance sheets are in a reasonably healthy state – although as an aside, we need to keep a eye on growing credit card debt which has risen by over fifty percent in only the last three years. We did not have the tech stock or even stock market asset bubbles that other countries did in the 1990s, so there has not been quite the same degree of wealth loss to shake consumer sentiment. We have taken steps to expand trade opportunities, to plug some of the gaps in the venture capital market, to upgrade our training programmes, to align immigration policy more closely with skill needs and to rebuild the infrastructure: all factors that will make it easier for New Zealand firms to find their way in troubled times.
We can approach the immediate future with a lot more confidence than many other OECD countries.
It is important not to get too pessimistic, and even more important not to act precipitately. That is one clear lesson from our patient response to the post September 11 environment.
I want to stress that the future we face is uncertain, rather than uniformly negative. By way of example, a post war reconstruction may well see commodity prices rise and petrol prices fall as Iraq pumps more oil and buys the items it needs for reconstruction. Equally, continued instability could have the opposite effect. The world economy could remain subdued, or it could finally get some traction now that there is more certainty about Iraq. SARS may slow Asian tourism here, but other tourists may divert from Asian destinations to New Zealand ones.
These uncertainties mean two things. Firstly, we have to accept that there is going to be less confidence about the forecasts that we make in the Budget than would be ideal. Secondly, regardless of the overall performance of the economy, there is likely to be much more variation in growth between sectors, industries and regions. The average will mask quite major internal differences.
What I do say is that this in not the time for stunts. With all of the jockeying for position that is going on on the political right, the public is being bombarded with suggestions about how to spend our fiscal surpluses.
I want to make three points in return.
The first is that there is still quite a lot of momentum in the economy. At the time of the March Monetary Policy Statement the Reserve Bank noted that a strong currency and a stronger domestic economy were pulling inflation in opposite directions. Two months later it noted that the international influences were starting to slow things down, but that the domestic economy was still relatively robust. On balance it felt that a quarter percent interest rate cut was justified. If I try and stimulate that relatively strong domestic economy further through fiscal means, there is a real risk that all I do is complicate and frustrate any interest rate easing that might be in the pipeline.
Secondly, by holding the line fiscally, we have lowered debt servicing costs. In the 1999 financial year, financing costs were around seven percent of government spending. In the last financial year they were 5.6 percent. The difference amounts to hundreds of millions of dollars. That sort of money can make a real difference with core income support programmes and I am not going to sacrifice that level of fiscal discretion lightly.
Finally, I must keep repeating that the fiscal surplus is a small difference between two very large numbers. Surpluses can disappear as quickly as they emerge; a fact that both the American and British governments have confronted in recent years. If revenues are just one percent less than forecast, and expenses just one percent more than forecast, the surplus is $820 million less.
We are keeping a close watch on the numbers. If it is clear that there is a stronger underlying, or structural, surplus than we need to meet our long term fiscal objectives, then we will adjust fiscal settings. As I have said, and repeat given the uncertainties of the near term, we are not in a position to make the judgement or the adjustments this year.
In the meantime we will keep a watching brief and will continue to let the fiscal stabilisers work. There is a clear difference between this government’s fiscal style and that of the 1990s. In the 1990s, governments were too quick to cut spending when things deteriorated, and too quick to dish out tax cuts when the position improved. That made the downturns worse and the upswings overheat.
I am going to change the subject now and talk about electricity, because even if I don’t you will ask me about it as soon as I sit down.
I am not making excuses and I am not trying to shift the blame or to avoid responsibility for what is an important part of our economic and social infrastructure. I do, though, want to put on record some of the basic facts and harsh realities of our options when it comes to power.
Electricity is an unusual commodity. Demand for power fluctuates; each day, between the seasons and over time. But we cannot store or stockpile electricity to meet those fluctuations in demand. That, in a nutshell, is the challenge for energy policy.
In the past, we have tended to err on the side of caution. We built generating capacity in case it was needed, and we built all sorts of power stations capable of being driven with a variety of fuels in case one fuel stock was in short supply. As an example, Marsden B was built at enormous expense and it never generated an ohm in anger.
Of course we paid for this: the cost of maintaining a high level of reserve capacity and of expensive feedstock fed into the average price that electricity users paid. For better or for worse – there is no point in trying to rewrite history – a decision was made to try and balance the supply/price trade-off. Restructuring of the industry sought to give consumers some price relief – cheaper power – but it did necessarily mean a reduction of some reserve capacity. Be clear on this: those who want cheap and abundant power are dreaming. Abundance comes at some cost.
Internationally, this has been an extraordinarily difficult balancing act to perform. I get quite irritated when I hear uninformed commentators talking about our electricity supply arrangements as Third World. The sorts of problems we have are very much first world problems. Problems with large price spikes, power outages, generator bankruptcies and so on have been associated with attempts to walk the price/supply tightrope in California in 2001, in the US East Coast and in the Mid West between 1998 and 2000, and in Scandinavia, Spain, the United Kingdom and Australia around the turn of the century.
I say these are first world problems because it is typically a period of sustained economic growth that puts pressure on the demand for electricity, and an expansion of generating capacity involves long lead times. Reserve margins are quickly squeezed.
Our own experience with deregulation has special features. Competition was introduced at a time when demand for electricity was moderate, generating capacity substantial and fuel cheap and abundant. We had built the dams and the power stations, Maui had been discovered and developed and we had a national transmission grid. I have heard one industry expert describe our cost structures then as being comparable to a nuclear power network without the costs of decommissioning. Those conditions probably never existed anywhere else in the world and will never come again.
But because they existed, the early years of competition were dominated by large price falls, particularly for industrial users. The market we developed was based on a blend of fixed contracts and a wholesale or “spot” market. Buyers and sellers could choose which part of the market to operate in, and take the risks and costs associated with each.
In the early years, there was more surplus supply than there was demand, so prices on the spot market were very low compared to those obtainable on fixed contract. The industrial uses tended to take their chances there: low prices were the order of the day.
Now understandably the generators tried to avoid this low price part of the market, so they went after retail consumers to more closely match available capacity with committed sales. Volumes traded in the spot market reduced.
At the same time, demand for electricity was growing: a combination of more manufacturing production, more tourists, an immigration turnaround, more people living in more houses, dairy conversions and so on all boosted demand. In recent years demand has been growing at roughly twice the long term trend rate.
To complicate the picture, a reassessment of the Maui reserves indicated that this large fuel source would be depleted sooner than expected. And then the rain stopped falling. The rest, as they say, is history.
Looking at this picture, we can detect three phases. In the short term – this year - our power supply is heavily dependent on the levels of water in the hydro lakes. There is simply not enough time to build other power stations that run on other fuels. If it doesn’t rain enough, and we do not save power, there will simply not be enough supply into the national grid, period. Power will have to be rationed. There is no way around this, and so the government is working hard on explaining why and how people have to save power. The fact that they save money at the same time should not be understated.
In the mid term – say the next three or four years – extra stations can be built. The willingness of generators to build them will depend on their assessment of whether they will be able to sell the extra power at a price that will cover their costs. It is always risky building reserve plant. If there is a lot of rain, and the hydro stations operate close to capacity, the new plant will not be competitive.
There is a balancing act required around risk, reward, incentives and the possibility of underwriting returns on new capacity. The government is working with the industry in setting up a market governance arrangement that is fair to all. Decreeing that stations will be built, or imposing pricing restrictions on the returns that new stations may generate are unlikely to be helpful. But a more active role within the governance structures to ensure a greater reserve margin of capacity is under active consideration.
In the longer term – moving ahead over the next five plus years – we want to evolve a regime that is both reliable and efficient. That sort of regime will put a lot of emphasis on renewable sources of energy and on energy efficiency. The government can incentivise some of that with Kyoto credits and the like, but the fact is that renewable energy is relatively expensive. The message is that we need to evolve a mature attitude to the use of electricity.
There is no point in wishing the retention of prices that do not cover the cost of new generating capacity. The cost will be covered; if not by users then by taxpayers. There is no point in users gambling on the spot market if they are not prepared to accept that sometimes gamblers lose. I expect that we will see much more interaction between generators and industrial users about the structure of their contracts, and about the effective management of electricity use during volatile periods of supply.
There are no hard answers yet, because we are still working through complex issues with a broad range of interested parties. We will not turn our backs on the problem and abandon electricity users to the wonders of pure market solutions. In the mean time, we face this winter with the stock of options that we have, and they cannot be added to.
I talked earlier about how we had shown a collective responsibility to economic adversity. I am confident that we can face the short term power crisis and the longer term power supply challenges with the same collective maturity.
So turn down the lights, tune in to Thursday’s Budget, but be prepared for the expected.