Hon Dr Michael Cullen's Speech to Deutsche Bank
Hon Dr Michael Cullen's Speech to Deutsche Bank
24 March 2004 Speech Notes
Address to Deutsche Bank Investor Forum Maritime Museum, Auckland
Judging by the value placed on the New Zealand dollar by the global money markets in recent months, it is clear that one thing I do not have to do is to convince international investors that New Zealand is a good place to invest at the moment.
Of course, much of the current enthusiasm by investors is focused on the short-term and is part of a larger move to diversify away from a US economy which has performed indifferently and whose immediate prospects are hampered by the combination of a large current account deficit, a burgeoning budget deficit and a weak, though improving, labour market.
With an ambivalent outlook for the European and Japanese economies as well, the relatively strong New Zealand economy has made us an attractive option for many fund managers.
By and large, it must be seen as a positive development that the New Zealand economy is gaining prominence on international radar screens. However, as I have said on several occasions recently, in my view the level of exuberance shown by the international money managers has crossed the border into irrational territory. I now find myself in the strange position of being less optimistic about the New Zealand economy than the markets are.
So my task at the moment is to promote a somewhat more nuanced understanding of the New Zealand economy. As part of that I want to lay out today some key elements of the case for investment in the long-term capacity of the New Zealand economy, for it is here that I believe the best returns are to be had. I would also like to touch upon the recent minor adjustment to the monetary policy toolbox and the rationale for it, and finally to scope what I see as one of the more exciting developments, the progress towards a single economic market with Australia.
To begin, it needs to be said that the underlying logic for investing in New Zealand remains very strong:
We are a small open economy, with a large stock of accumulated foreign direct investment. We have one of the world’s more liberal foreign investment regimes, and my government plans to keep it that way. Increasing global connectedness is a key plank in our economic strategy.
Our Standard and Poors credit rating for local currency is AAA/Stable/A-1+ and our credit rating for foreign currency is AA+/Stable/A-1+.
Our macroeconomic policy is stable. The Fiscal Responsibility Act requires the Government to plan for the longer term when setting fiscal policy, and the Reserve Bank Act grants the Reserve Bank independence to pursue its goal of keeping the inflation rate between 1 per cent and 3 per cent, on average, over the medium term.
Government debt and spending, as a proportion of GDP, are low by OECD standards. Core government operating spending was 32.4 per cent of GDP in the 2002/03 fiscal year and is forecast to decline further to 30.8 per cent by the end of the current year. Sovereign-issued gross debt was 28 per cent in 2002/03, and is forecast to decline to 25.3 per cent in 2003/04. This is the lowest it has been since the mid 1970s. By sustaining prudent fiscal management during the last few years we have given ourselves a good deal of headroom to cope with unexpected downturns in economic activity.
Finally, despite some electoral posturing, New Zealand enjoys a good measure of political consensus around economic policy. Since the 1980s, governments have worked hard to ensure that core economic policies are internationally competitive, to offset the disadvantages of New Zealand’s small local market and distance from export markets. At first, that required major reform. More recently, the focus has switched to fine-tuning of policies, and the macroeconomic framework has not been subject to major change.
We are beginning to see our strong set of economic fundamentals bear fruit. A study of the OECD Quarterly National Accounts shows that New Zealand’s economy grew faster than the OECD average and faster than the United States’ economy over the ten years to September 2003. And despite a challenging global environment featuring SARS and the Iraq War, New Zealand’s GDP growth rate over the year ended September 2003 was 3.9 per cent. This was considerably faster than in the United States, the UK, Europe, Japan or Australia.
Of course, this is no grounds for complacency; and our aim, through a combination of private and public investment, is build a stronger platform for growth – a more skilled workforce, better quality infrastructure, more focused scientific research, a more mature capital market.
The main source of growth in recent months has been domestic demand. Consumer and business spending, labour income and investment in housing in particular, have grown strongly. Real gross domestic expenditure rose 6.0 percent over the year ended September. Immigration, relatively low interest rates, and rising house prices, have encouraged consumer spending.
Short-term interest rates have remained low compared to the historical average, although higher than global rates. With the strong domestic demand growth New Zealand has experienced the Reserve Bank has not reduced interest rates by as much as central banks in other countries. Indeed, recently the Reserve Bank actually increased the official short-term interest rate by 25 points, to ensure that the inflation rate remains stable and low over the medium term.
Steady economic growth has brought jobs. The unemployment rate has fallen from a peak of 7.7 per cent in 1998 to 4.6 per cent in December 2003, in spite of rapid working-age population growth. It is also in spite of the restoration of worker’s rights through the Employment Relations Act, which commentators on the right predicted would stop economic growth in its tracks. I am glad to say that those commentators were proved wrong; and I am predicting a similar fate for the recent hand-wringing over the government’s moves towards bring our annual leave provisions into line with standard practice throughout the OECD and other minor changes to the employment laws.
Our major challenge is in the export sector. While export volumes have increased steadily over the last year, and export incomes remain high compared to the historical average, we are heading for turbulence. The rising exchange rate has already reduced nominal export earnings by 6.4 per cent over the year to September, and there is probably worse to come in the short term.
The ANZ World Commodity Price Index, which measures New Zealand’s main export commodities in world prices, increased 1.5 per cent in February to be 11.5 per cent higher than a year ago, with only beef and lamb showing decreases in world prices. The index is now at its highest since April 1995,
However, once those prices are measured in New Zealand dollar terms the situation is reversed. The February increase in world prices was more than offset by the increase in the dollar’s value. Indeed the New Zealand dollar commodity price index fell 1 per cent in February to be at its lowest level since July 1999, and 7 percent below its level in February 2003.
For example, merchandise trade data up to the end of December 2003 shows that the total value of meat, dairy, forestry and wool exports was $12.5 billion in the year ended December 2003, down 10.1 per cent from the December 2002 year. A large fall in prices has offset a lift in volumes of meat, dairy and wool of around 5 per cent. The price fall was mainly due to the appreciating New Zealand dollar.
And looking ahead, Fonterra, which accounts for a large percentage of New Zealand’s export earnings, is now forecasting a payout to its dairy farmers of $3.50 per kilogram of milk solids for the year to 31 May 2005; down from $4.15 per kilogram in the current year.
Assuming the forecast is accurate, that will be the lowest inflation-adjusted payout in 14 years. For the average farmer producing 90,000 kilograms of milk solids a year, total income will fall nearly $60,000. The effect across the sector will be a loss of around $750 million from the domestic economy as a result of the lower payout.
So we have a domestic economy which has built up momentum and is expected to continue growing strongly over the short term; but it is harnessed to an export sector which is experiencing a sharp tug on the reins from the high dollar.
What this suggests is that beyond the immediate future, growth will slow temporarily as the effects of declining export incomes flow onto the domestic economy by mid-2004. By that time, currency hedges will have worn off, and exporters may cut back their domestic spending. A fall in the number of immigrants might also reduce economic growth.
It is important to note that despite this the growth rate is not expected to slow much. It is forecast to “bottom out” at 2.8 per cent over the next year or so. By 2005/06, growth is predicted to return to an average of 3-3½ per cent per annum, thanks to a recovering global economy, and some assumed exchange rate depreciation, which will revive export earnings. These forecasts are from the December Economic Update and that since this time the downside risks around growth further out (especially in 2005/06) have increased, with the exchange rate at a higher level than expected and immigration slowing a little quicker.
Along with the slower rate of GDP growth, the rate of job creation will ease. Nevertheless, employment growth will still be above zero, and the unemployment rate is expected to remain in the 4½ -5 per cent range.
In light of the short term difficulties, it is no surprise to me that last month’s National Bank survey showed a slide in general business confidence from net 16 per cent negative to net 28 per cent since December, in line with concerns about the exchange rate. However, businesses remained optimistic when it comes to their own activity (which is a better indicator of future economic activity).
Employment and investment intentions are robust, consistent with the economy growing at near full potential. And anticipated export volumes have remained reasonably upbeat at a net 20 per cent, which was the level they fluctuated around for most of last year.
How then should we negotiate the road ahead? There have been two other occasions in the last twenty years when New Zealand had to endure a seriously overvalued dollar on any fair estimate of its value. Those were in late 1985 and early 1997. On the first occasion, the dollar had not long been floated and was experiencing some volatility while it found its level. On the second occasion the effect of the rising dollar was accentuated by the 1996 tax cuts which were more expansionary than had been expected. In response the then National government had to undertake a fiscal contraction that proved to be pro-cyclical, and the result was a sharper contraction in economic activity and a larger jump in unemployment than ought to have been necessary.
I am confident that the New Zealand economy will come through this period of difficulty in better shape. This is because of stronger economic fundamentals and a more flexible and diverse economy; but also in some part because of a more active stance by government. While the lesson of the last two decades has been that governments can at best take the edge off of adverse global conditions, we believe that that small gain is nevertheless worth having. It can be just what is needed to keep businesses above the threshold, keep communities feeling confident above the future, and keep skilled workers from looking to other labour markets.
This time around our stance will be seen in a much more active labour market policy than was adopted by our predecessors, including more effective case management of the unemployed and better support for retraining. A skilled and motivated workforce is one of our most important assets, and we do not intend to let a short term weakening of the labour market compromise that asset.
You will also see a more pragmatic approach to business assistance which will be evidenced further in this year’s budget with increased support for exporters. This is on top of ongoing measures to simplify taxation, reduce compliance costs and negotiate better market access for our export products.
Indeed, this year’s budget will be somewhat more stimulatory than its predecessors. As the Governor of the Reserve Bank noted in the recent Monetary Policy Statement, the government’s announced intention to edge up real expenditure growth rates over the three years from 2005 will – serendipitously – act as a stabiliser for the economy. I would stress nevertheless that the level of stimulation will still be modest enough to ensure we do not stray from the straight and narrow path of fiscal prudence. Certainly, our prudence during the period of growth in the last three years – our refusal to fritter away surpluses on unsustainable tax cuts or unsustainable spending promises – has meant we now have sufficient fiscal headroom to allow us to respond to any slowdown without engaging in pro-cyclical fiscal contraction. This was the mistake that the National government made in the late 1990s, and we have no intention of repeating it.
We are also moving cautiously towards a more active role in ameliorating the more wayward swings in the value of the New Zealand dollar.
The New Zealand dollar underwent a protracted decline between 1997 and 2000, and therefore a significant appreciation against the currencies of our major trading partners was inevitable given the stronger than average performance of our economy. Nevertheless the trade-weighted exchange rate has appreciated by 11.2 per cent since the start of 2003 and is currently around 42.6 per cent higher than its 2000 low. Overall the TWI is currently around 11.2 percent higher than its post-float average.
The government believes this is out of step with the strength of the New Zealand economy relative to our major trading partners, especially Australia, and given the rising current account deficit.
While they are important signalling and stabilising mechanisms, exchange rates do appear, at times, to be driven by speculative excesses and herd behaviour and to depart from relevant economic fundamentals. It is difficult to be absolutely sure when this is the case; but where such behaviours can be identified it appears possible (and sensible) to try to change that behaviour.
On balance the international experience suggests that “excessive” exchange rate swings are costly. Our major concern at the moment is that a continued high dollar may discourage investment in future capacity in the export sector. We do not want a situation where our ability to take advantage of a future global upturn and a lower dollar has been compromised. The Reserve Bank has advised that they considered it prudent to raise the level of foreign reserves held in order to be prepared to respond to the need to provide liquidity in the event the foreign exchange market became disorderly. Its level of reserves has not changed since 1990. At the same time the Bank has been considering the merits of foreign exchange intervention goals in addition to the current objective of restoring foreign exchange market functionality.
The government’s view is that there may be some merit in having a greater capacity for foreign exchange rate intervention, similar to that of the other central banks, including the Reserve Bank of Australia’s. Such a capacity would allow room for an intervention policy that aims to dampen the extreme peaks and troughs of an exchange rate cycle, i.e. the three to five year swings from peak to trough in the exchange rate.
The best way to structure this capacity, to maximize its effectiveness and manage risks, is currently being worked through.
Any intervention impacts are unlikely to be large; maybe a few cents at the peaks and troughs of the cycle, or alternatively helping the cycle to turn a little earlier than otherwise would happen. The nature of the exchange rate cycle would be little changed. The floating exchange rate will remain a key component of New Zealand macroeconomic policy framework, and it will continue to play a role as a key price signal for firms and consumers and as a means for smoothing out shocks in the economy. Exporters will still need to factor in the probability of large exchange rate movements and manage their foreign exchange risks.
There are risks to such an approach and it is important that any revised policy seek to minimise these risks. One important way this can be done is by ensuring that the Reserve Bank Governor can operate this policy independently of day-to day political pressures, that is by keeping a focus on the medium-term.
It is also important that the inflation objective remain foremost in the Governor’s considerations. Indeed any revised policy on intervention is unlikely to alter the Policy Targets Agreement. It is merely another tool to help the Governor achieve those targets in the least cost manner. It is consistent with the requirement in the Policy Targets Agreement for the Bank to seek to avoid unnecessary instability in the exchange rate.
It also needs to be said is that an amended intervention policy would be merely one part of a broader response to the problem of exchange rate volatility. Whatever action might be signalled or taken needs to be seen in the context of, for example, the business support policies in the budget and ongoing work to improve business competitiveness.
An important factor in the long term health of New Zealand’s economy is the degree of economic integration with Australia. I have for the past few years been working with the Australian Treasurer Peter Costello to develop a single economic market by co-ordinating business regulations between Australia and New Zealand. While this initiative has received only modest amounts of coverage in the media, it will in fact have a major impact upon the shape of the New Zealand economy in the future. New Zealand businesses will benefit from greater opportunities to sell into the larger Australian market and a freer flow of investment within the trans-Tasman economy as compliance costs and other regulatory barriers are reduced.
We are focusing at the moment on a number of key areas:
We are considering a proposal for mutual recognition and harmonisation in prudential regulation of our banking systems. This will reduce the transactions costs for the banks, and create greater certainty and protection for consumers.
We have recently established an Advisory Group on Accounting Standards whose task is to propose a single set of accounting standards to operate across the Tasman to streamline business for companies which are doing business on both sides of the Tasman. The ultimate aim is to permit such companies to keep only one set accounts which serve in both jurisdictions.
In May of this year we will be releasing a discussion document on mutual recognition of securities offerings. The discussion document will propose a model under which an issuer, having complied with the substantive requirements of one jurisdiction’s fundraising laws, will be able to extend an offer of securities to the other jurisdiction with only minimal further requirements. Correspondingly, in the event that an issuer breaches the law, the regime will make it easier for investors to pursue statutory remedies in both jurisdictions.
We are also working on coordinating trans-Tasman competition policy. The work programme has three tiers. The immediate issues involve a set of questions that can be worked on now without legislative reform. The medium term issues are questions that generally require legislative reform in at least one of the countries to advance. Long-term issues are a third tier and we have commissioned an in-depth study and agreed that all options should be left on the table, including the options of joint laws and joint competition agencies. The purpose of the study is to provide a strong basis for the work on developing options to progress. We are currently working with our Australian counterparts on terms of reference for the study.
New Zealanders are often heard to lament the fact that people in other parts of the world lump us in with Australia, to the point of regarding us as one country. While that might be an affront to national pride, it is not in fact a wrongheaded perception. Like many other observers, I believe there is untapped value in our combined economies, both as a single market of some 25 million people and as a population of seasoned exporters positioned close to the Asian continent. It is the job of investors and business people to release that value; but it is the task of governments to smooth their path. This, I hope, will be substantially achieved in the next five years.