Cullen - Reality check needed on economy
27 February 2006
Hon Michael Cullen – Speech
Reality check needed on economy - speech to Chen Palmer & Partners business seminar
In deference to my host and to the recent Chinese New Year celebration, I thought I should entitle my address this afternoon, "Economic priorities in the Year of the Dog". One should bear in mind first of all that the connotations of the dog in Chinese astrology are quite different to some of those in Western culture, and they are generally good ones.
For the Chinese, dogs are trustworthy and ethical creatures, straightforward in their approach and good judges of character. So the Year of the Dog, coming as it does after the Year of the Rooster, the symbol of unguided energy and flashiness, is the year in which the Chinese prescribe a good dose of realism and a refocusing on what is important. To coin a phrase, I feel very comfortable with that.
It is a very apt message for New Zealand at the start of 2006. We have an economy that has come off the boil after an extended period of very strong growth. However, to talk, as some have, of falling into recession is both naïve and a little dangerous. It is naïve because it betrays an ignorance of economic history; and it is dangerous because if we are not careful we may talk ourselves into a recession that we don't need to have.
Hence, my first economic priority for the year is to encourage the business community and the community at large to take a reality check and to assess in a sober manner what is really happening with our economy before giving any credence to the panic merchants. One thing that the last six years ought to have taught us is that it is a foolhardy thing to predict the imminent demise of the New Zealand economy.
I am very fortunate to have allies in a number of respected business leaders and analysts who have spoken out against the trend in the business press towards an unquestioning pessimism. Ralph Waters, the CEO of Fletcher Building, has been urging the business community to maintain a sense of perspective as domestic demand falls back from levels that he has called "unmanageable". His fear, he says, is that "if enough people keep saying there is going to be a recession, it will be a self-fulfilling prophecy".
Instead, we should be very proud of an economy that will still be growing at around 1.6 percent per annum at the trough of the economic cycle. As I have reminded many audiences recently, GDP growth of that magnitude would have been welcomed with joyful celebration at any time in the 1990s
I think there are two common errors that people are falling into as they come to grips with the latest economic data:
· One is to make the mistake of using business confidence as an indicator of where the economy is heading longer term, when it is, at best, a confirmation of short term intentions.
· The other error is to mistake imbalances in the economy (such as the current stickiness in the exchange rate) for a fundamental macroeconomic weakness.
Jason Wong of First NZ Capital has expanded on both of these errors in a recent edition of New Zealand Strategy Weekly, and I would refer you to his piece for a more in depth analysis of the chance of recession based on current forecasts. He points out that business confidence is not a leading, but a coincident, indicator of economic activity. The surveys that gave rise to the current consternation merely confirm that businesses are expecting an immediate drop off in growth. They do not change the medium term expectation that growth will pick up again in 2007.
Indeed, as Jason Wong goes on to point out, business and consumer confidence surveys have been a very poor indicator of economic growth in the past. He reminds us that in the last five years, business confidence has averaged negative 16 percent, while GDP growth has been running ahead of trend at an average of 3.7 percent. And if we look at the five years prior to that, business confidence averaged a positive 12 percent while GDP growth averaged a decidedly ho-hum below-trend 2.8 percent.
The political insight that one might draw from this is that by and large the business community expected great things of National-led governments and yet were sadly disappointed by their actual performance. Conversely, while business has remained somewhat nervous about the current Labour-led government, the facts, as the figures show, are that the New Zealand economy has rarely had it so good.
I think the key message to be drawn from this is to look somewhere other than business confidence surveys for a reliable indicator of where the economy is headed. Indeed, what the consensus forecasts are starting to show is that the slowdown may not be as severe as in previous cycles. They suggest that while growth will slow, the trough of the cycle will not be as deep as it has been in the past. According to the Treasury, annual average real GDP growth is expected to trough at around 1.6 percent.
The slowing in growth reflects cyclical factors rather than a structural change to New Zealand's outlook and reflects the need for several imbalances in the economy to unwind following a sustained period of above trend growth. This will not be a painless process, as the news of job losses in some sectors confirms. However, the broader context shows a relatively benign outlook. A number of key features give our economy considerable resilience:
· First, we have a robust and flexible labour market. New Zealand's unemployment rate, at 3.6 percent, is the lowest in the OECD (for countries with a comparable measure). While unemployment is expected to rise over the next few years, by historical standards it is expected to remain below 5 percent. That compares with Australia's current unemployment rate of 5.3 percent.
· Second, the relatively tight labour market is expected to contribute to relatively strong wage growth, contributing to reasonable income growth for households. In addition the roll out of the Working for Families package will boost household incomes by providing targeted assistance to three hundred and fifty thousand families.
· Third, New Zealand households have experienced considerable wealth gains over recent years with strong house price growth a significant factor. While house price growth is expected to ease significantly, house prices are not expected to experience significant nominal price declines.
· Fourth, and very importantly, the growth outlook for our trading partners is good, with consensus forecasts expecting a return to growth of approximately 3.5 percent per annum, consistent with the medium-term trend. Buoyant global growth is likely to mean that while the prices received for a number of our exports (for example, meat and dairy) are likely to fall, they should remain relatively high by historical standards.
· Fifth and finally, the high exchange rate, which has been constraining export growth, is expected to ease over the next few years. This will assist with the competitiveness of our exporters, and should encourage a more balanced growth profile which is less reliant on domestic demand growth, and a reduction in the imbalances associated with a high current account deficit.
For these reasons, the smart money is on a return to strong growth over the medium term in line with our strong fundamentals. First NZ Capital conclude that the risk of recession is no more than 35 percent, and I would say that is a very cautious conclusion. As they point out, what would be needed to tip us into recession would be either a reversal of the current positive global growth trends or a weakening of our terms of trade. Neither of these looks likely in the immediate future.
The other argument advanced by my opponents is that, regardless of how well the New Zealand may come through the soft landing ahead, the real game is a kind of trans-Tasman 'keeping up with the Joneses'. Dr Brash lays great store in his calculation that New Zealand is on the wrong end of an 'income gap' that was 20 percent in 1999, is 33 percent now, and will be 40 percent in three years time. According to this analysis, New Zealand will simply be sucked dry of skilled workers.
There is no better illustration of how wrong-headed this kind of hand wringing is than the fact that the number of highly trained and experienced Australian executives moving to New Zealand has increased annually for the last six years. The trend has caused consternation in the pages of the Australian Financial Review, which reported recently that, "expatriate executives say it's easier to do business in New Zealand and tax imposts are lighter". Australian immigrants noted with pleasure that they do not have to pay capital gains tax or stamp duty, and the Review quoted Ralph Waters once more to the effect that his take home pay in New Zealand is demonstrably better than if he was doing a similar size job in Australia.
One suspects the two sides could trade anecdotes tit for tat. The important reality is that in an environment in which there is a very free flow of people across the Tasman the traffic in skilled people goes both ways. Each economy, and regions within those economies, has its own competitive advantages when it comes to attracting skilled workers.
This is the kind of reality check that is needed as we head into 2006. The Year of the Dog will bring a slowdown and an opportunity to reassess the longer term growth prospects. But it is essentially a friendly dog, the kind who is quite happy to eat plain food for a while and wait faithfully on the doorstep until we are ready to take him out for his next vigorous run.
Getting that message across, and countering the message of the doom-sayers, is my first economic priority. The second priority is to make progress on our over-riding economic need: to boost long term productivity in the New Zealand economy.
The last five years have shown us how well our economy can function, with our labour market in particular showing great strength and flexibility. However, the challenge for the next business cycle is to gain greater leverage for our efforts by working more productively. In short, we need to find out how we can stay stronger for longer.
There are many, many New Zealand businesses that are clearly focussed on this task. I am grateful for the leadership of many business people in refusing to be boxed into a pessimistic corner and showing how innovation and investment can create a lift in economic performance despite the ups and downs of the business cycle.
It is my commitment and that of my government to provide comparable leadership at a macro level. In the Year of the Dog there are a number of items that are high on my agenda as part of the economic transformation that we want to see. Indeed, several of them have been on my agenda for quite some time.
What I want to do now is give you a heads up on progress with a number of these, specifically:
· infrastructure and the regulation of network industries;
· the trans-Tasman relationship and the Single Economic Market;
· savings; and
· business tax.
To begin with infrastructure, it is very clear to me that this is an important element in our productivity challenge. Infrastructure that is not world class will dull our competitive edge.
The challenge my government has confronted has been two fold. First, we faced the need for major infrastructure upgrades which should have been initiated during the 1990s, but were not. These are five to ten year projects requiring complex consents processes, advanced engineering and long term financing. As we know, any loss of momentum in this kind of game is very hard to recover from.
My belief is that, six years on, we have got the most important programmes of infrastructure investment back on track. Our annual public spend on transport capital assets is up something in the region of 90 percent this year on the 1999 level and 100 per cent next year.
There are difficulties, of course, and the recent announcements by Transit New Zealand of a forecast shortfall in long-term roading revenues illustrates how careful we need to be to ensure contingencies within our plans. You will recall that, due to a combination of reduced petrol consumption, higher roading construction costs, and growth in the Government's contribution to public transport, Transit's draft ten-year forecast opened a funding gap of $684 million.
This news merely reinforces the value of developing long term plans and forecasts. For a ten-year programme worth around $12 billion, a $684 million forecast shortfall is no reason to panic. But it is a reason to examine alternative scenarios now so that we are not caught on the back foot later on. Accordingly, we have set up a ministerial advisory group to examine costs and revenues in the roading sector and consider ways of moderating the cost increases. This includes taking a look at whether Transit is over-designing roads and whether its tendering processes are adequate and provide incentives for finding better value for money alternatives.
On the funding side, it is an opportunity to look more closely at options such as infrastructure bonds. This far out, I am very confident that we can maintain our commitment to the roading plan and to the businesses and communities who are depending upon it.
The second aspect of the infrastructure challenge is regulation. I believe there is a risk, in the aftermath of major reforms such as occurred in the 1990s, that we allow our thinking to become a little calcified as we wait for our carefully-designed regimes to deliver the intended benefits.
I have no great enthusiasm for further reform, so long as competitive pressures are indeed giving a good deal to New Zealand consumers, and so long as there is a healthy amount of new investment going on. The problem is that in some areas these results are not yet forthcoming, and consumers have a right to be agitated.
We must not lose sight of what we intended competition would achieve; restraint on prices and a stable basis for investment. If there is not a clear path towards this goal we risk getting the worst of all possible worlds: a public revolt insisting on micro-regulation and a poorly performing market mechanism.
There is a particular imperative for the telecommunications regime to deliver better results. The information superhighway is becoming a basic infrastructure for business. Broadband is a critical enabler of productivity, growth, and economic transformation, and in the view of my government our connection speed offerings and standard upload speed are on average still too slow.
We are one of the few countries where restrictive data caps have been the norm. Our superhighway seems to function with several lanes permanently closed, with inexplicably high tolls and with flashing lights warning users to reduce speed.
The government will be addressing the policy, legislative, and regulatory settings as a matter of urgency, with a view to creating an environment which encourages investment through enabling adequate rates of return, but ensures stronger and more effective competition than in the past.
The way forward on the trans-Tasman relationship and the Single Economic Market is much more straightforward. Increasingly we can begin to see New Zealand as part of a unified Australasian domestic economy. Moreover, we have some distinct competitive advantages from the point of view of investors;
· we have solid GDP growth driven by a very diversified export sector and a strong domestic economy;
· we have a government that has a strong balance sheet and a tight fiscal policy. Crown debt has been steadily sinking as a percentage of GDP to a point where it will soon cease to feature as a significant factor in assessing sovereign risk;
· and we come out on top of the World Bank's regular survey on the ease of doing business. This reflects lower regulatory imposts on business, a flexible workplace environment, and a relatively simple tax system. These are all areas in which the Australian states face some challenges. Workplace reform, for example, looks set to be a cause of some instability in the medium term.
As most of you will be aware, I have just returned from my regular meeting with Peter Costello where we concluded a number of important new elements in the trans-Tasman harmonisation process;
· for securities offerings, we signed a treaty to mutually recognise documents issued in each other's jurisdictions. This will reduce barriers to cross border securities offerings and benefit issuers and investors in Australia and New Zealand;
· in business law we signed a Memorandum of Understanding which details a new 5 year work programme that will reduce compliance costs for companies, and improve coordination between Australian and New Zealand financial regulation;
· regarding accounting standards, we have cross appointments between the relevant Australian and New Zealand bodies, and a work programme designed to consider convergence between the different standards applying in each country;
· we have also agreed to amend the Trade Practices Act and Commerce Act respectively to allow the ACCC and our own Commerce Commission to exchange information gathered in the course of investigating competition and consumer protection matters.
All of these initiatives move us closer to a seamless trans-Tasman business environment.
This week marks an important milestone with the introduction of the KiwiSaver legislation. It may seem at first that this legislation, which provides for a standard state-assisted workplace savings scheme, has little to do with boosting New Zealand's productivity. In fact, it does link to productivity in two important ways.
First, one of effects of the scheme will be to boost the level of domestic savings. These savings will be invested by funds managers who will be required to follow general standards of prudential management. It is highly likely that this will mean holding some portion of those funds in New Zealand, and over time this should mean an increase in the pool of investment capital looking for worthwhile investments in this country. That in turn should decrease our need to borrow off-shore, with all of the additional costs that brings.
Second, it is clear from what studies have been done that a workforce with a higher savings rate and a greater general awareness of the need for financial planning and wealth management is a more productive workforce. When people have a stake in the future, they tend to put more effort into making that future a brighter one.
In this sense, KiwiSaver is designed to foster an important mindshift within the New Zealand workforce.
Regarding business tax, we have sought to provide a stable environment for planning purposes and to remain vigilant for opportunities to reshape the tax system to encourage investment and promote productivity. The review that is underway recognises that we have a business tax system that avoids many of the complexities that afflict other systems, and to some extent compensates for this by having a higher headline rate.
What Peter Dunne and I have commissioned is more of a ground up re-think of what arrangements provide the right incentives for innovation and investment, without opening the door too wide for the tax planning industry. We will, of course, be looking closely at the Australian reforms and considering what measures may be logical in light of changes there.
You can expect a discussion document on the subject to be issued mid-year, and we are aiming at having any changes in place for the 2008 tax year.
A word finally on this year's Budget. It should be no surprise that restraint will be a watchword for Budget 2006. One does not establish a careful fiscal stance over six years and then give it away. The fact remains that current fiscal settings leave little room for a loosening, either on expenditure or revenue, without inviting a monetary policy response.
As the Reserve Bank has noted, the government's Working for Families programme, which will continue to be rolled out this year, will provide some additional strength to the domestic economy at a time when demand might otherwise flag. The situation remains finely balanced, and I have no intention in upsetting it.
In particular, I will be taking a very clear line on state sector wages and salaries. The truth is that the government has made some significant investments in the state sector in the past few years. These have been predicated on the notion that we were building capacity and that there would be a productivity dividend in due course. State sector CEOs need to be aware we expect that dividend to emerge starting from this year, and that one of the implications of that will be careful management of labour costs.
To sum up, in the Year of the Dog I think it will be important for both business and government to focus on how to preserve through a period of slowdown the considerable momentum for positive change that has built up in New Zealand over the past six years. We are mid-way through the crucial process of shifting the balance in our economy away from commodity production towards goods and services that can command a premium on world markets and are less prone to cyclical swings in prices and demand. As for the government, I certainly have the sense that we are gaining important traction on key issues such as tertiary education reform, infrastructure investment and trade access, but that we cannot afford to let those efforts flag.