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Mallard: Economic transformation

2 June 2006

Hon Trevor Mallard: Economic transformation: the history and the future Key speech to Otago Chamber of Commerce, Dunedin

As you will be aware, the Labour-led government has made economic transformation one of its three top priorities for this term of office.

Economies need to grow. This is the only way that society collectively can generate the output needed to improve services and raise living standards for New Zealanders.

Our growth record over the past six years has been impressive, and we shouldn¡¦t sell ourselves short. Our gross domestic product grew by over 25 percent in the six years to March 2005, and it has grown further since then.

Put another way, 20 cents of every dollar that is generated from our economy comes out of the growth that has been achieved in only the last six years, compared with the 80 cents from investment and development over the entire span of the rest of our history.

On the one hand that is impressive, on the other it is quite scary - it illustrates the pace of change that technology and global expansion are requiring us to respond to.

Some of that growth accrued to foreign owners of businesses operating out of this economy. Of course we had a net turnaround in inward migration so there are more people that get a share of the increased product.

Despite that, real national income per capita - our average standard of living, or the income that accrues to people resident within our shores - adjusted for inflation and on a per head basis, rose by a tick under 19 percent.

We have been growing but we have also been changing. In the last six years, we have added over 300,000 new jobs.

One in seven workers are in jobs that were not available at the turn of the century, and that is a net figure. With some churn in the employment base, the transformation of the world of work has been more dramatic that even this gee whiz number suggests.

If there are criticisms about our recent growth record, they can be summarised under two broad headings.

Much of the recent growth was achieved by adding more inputs rather than by increasing productivity from each unit of labour or capital that we use. In itself that is not necessarily a bad thing. It means, for example, that we have reduced our unemployment rate to the lowest in the developed world. We are however close to our limits of progress in that area.

Secondly, our growth has not been accompanied by a significant increase in the degree of international connectedness.

International connectedness comes from a mix of increased exporting, and increased outward direct investment ¡V our firms establishing themselves offshore, or taking over foreign companies in their markets to establish a foothold there.

I will expand on why we need to increase productivity and increase our international connectedness in more detail in a minute. But the basic logic is that these are the vehicles we need to use if we are going to raise our living standards.

New Zealand does have special characteristics compared to other countries - our natural resource endowments are different, and we are a small country existing a long distance from key overseas markets.

Our opponents seem to prefer to talk up Australia but Labour has no intention of running down New Zealand and slagging off our economy purely on the basis of utterly false claims that Australian's pay less tax. They don't.

It is also worth remembering that a World Bank survey of 155 economies puts New Zealand at the very top in terms of ease of doing business.

We do still need to do more to raise our income levels. New Zealand's current situation has a lot to do with what happened in the late eighties and early nineties when the monetary authorities of the time maintained excessively tight settings.

This in turn pushed interest rates and the exchange rate up, devastated our tradeables sectors and orchestrated an incredible five-year stagnation during which economic growth averaged zero.

We stood still while they moved steadily ahead, and we have had to play catch up ever since.

It is with extreme irritation that I find that the same monetary authority of that time - Dr Brash - is now playing simplistic and populist politics by pretending that we can inflate our way back to trans-Tasman parity.

We can¡¦t. We have to earn our way back. That is where the focus has to go.

Let me come back to the issues of productivity and external expansion.

Productivity is a necessary condition for a sustained increase in national living standards.

Living standards can improve as we bring unemployed people, idle natural resources or underused capital back into production.

But when all of our resources are used, employment is at record levels and capital is running at close to capacity, we need to generate more from each unit of production to get the next income lift.

External expansion helps to raise productivity by a combination of getting beyond the limits of a small domestic market and spreading overheads across a larger sales volume, and by opening up high-value market opportunities.

The riddle is not so much why it doesn¡¦t happen overnight, but why it doesn¡¦t happen at all.

There is an increasing amount of research being done in the area of economic development by the World Bank, by academics around the world, and within our own Ministry of Economic Development.

It is leading to a lot of new thinking and I would be doing the findings an injustice if I was to pretend that I could summarise them in one speech. I will instead give you an outline of some of the strands of the new thinking.

First, and contrary to the tenets of classical economic theory, countries that have done well in recent decades have not been the countries that have specialised in one field.

They are the countries that have diversified their production bases. This tends to confirm the government¡¦s interest in transformation rather than just doing more of the things we have been doing in the past.

The biggest problem with the free market experiments of the last quarter of the last century ¡V everywhere, and not just here - is that they failed to deliver ¡V in the jargon ¡V technological dynamism.

This is what sometimes goes under the banner of the knowledge economy, but even that phrase has its limitations. It is more a case of learning by doing, and diversifying from what we have been doing into something that spins out of it.

It's actually a process that has served New Zealand well in the past, and one that is particularly well suited to our national psyche.

We are a nation of ideas people and innovators, and we are probably not taking full advantage of this incredibly valuable national asset.

Secondly, it is now clear that productivity improvements drive economic growth, and that innovation drives productivity gains. But perhaps more importantly, innovation is a social or collective phenomenon.

There are always exceptions, but as a generalisation it is not some geek in a garage that produces the next big idea that reshapes the world.

Innovation is also cumulative. It is deeper and more continuous if it draws on our past knowledge and experiences.

This is quite an important message for a country like New Zealand. We sometimes get a bit despondent and think of ourselves as a perpetual incubator for the rest of the world.

We discover a new product or process - typically a process - because we are good developers. When it has gone through the proof-of-concept stage and is now established as a viable commercial proposition, an international company buys it out, and often relocates production closer to market or closer to cheaper sources of labour.

Of course that happens, but my point is that it doesn¡¦t always have to happen. The fact that innovation is collective and continuous means that innovative transformation is not automatically relocatable overseas.

Let me give you an example. About eighty years ago, a guy by the name of Bill Gallagher was annoyed that his horse always scratched itself on his car, so he devised a way to electrify the car so that the horse got some Pavlovian training.

That is the imagination. He then realised that he could use this device to control stock movement and started making electric fences. That is the innovation. His successors needed to expand and needed to penetrate export markets, but often they met different farming systems.

So they started selling animal management systems rather than electric fences. Animal management systems are useful beyond farming, so they adapted them for use in game ranches and reserves.

They can also control people movement, so Gallaghers moved into designing security systems around their electrification technology. This is diversification.

But electrification is only one element of security: a good security system needs to track and trace who entered what part of a premises and when. Hence access control systems became part of the portfolio.

The Gallagher Group sells a diversified range of products in 130 countries, and manufactures them in seven countries in the Americas, Europe, Asia and Africa. This is international connectedness.

But the bottom line is that the group is still centred in Hamilton. Now some of the explanation is loyalty, and deep down Bill junior is a good old Waikato boy at heart, and it¡¦s a family business so it's not exposed to foreign raiders.

But there is also a cold hard commercial logic underlying all of this. Deep in the core of this innovation-led expansion is the fact that diversification and growth are collective and cumulative. The strength of the process is the fact that it is grounded in the learnings that have built up over time from that Hamilton base.

The group is selling solutions that are developed out of its accumulated knowledge, not electric fences, and that is why it is difficult to simply relocate activity to a lower cost centre.

Just as important is the fact that because international competitiveness has been based on accumulated knowledge, it isn¡¦t that easy for rivals to copy the company, because constant innovation means that mimicry is not enough.

And, remarkably, this is precisely the sort of real life example that confirms what international research and theory are now discovering.

Now the bad news. Why is the story of the Gallagher Group so stark by its rarity? Why do we not have hundreds of Gallagher Groups dominating our corporate landscape?

I think we need more of an engagement between the business community and the government on this before we rush to conclusions about solutions, but to open things up I am going to focus on two processes that I think need more attention.

The first is where we start looking for engines of transformation.

We tend to think that it is the government that needs to take the initiative - develop the skills, fund the research, upgrade the infrastructure, negotiate trade access arrangements, support firms offshore and so on.

However, in practice it is firms that employ people, it is firms that hone their skills, it is firms that create new products, it is firms that sell goods on export markets.

The government can do everything to create the environment and to ensure an uninterrupted flow of inputs, but if the firms are not there doing the business, those initiatives go nowhere.

If we are going to see a transformation, we need firms with the scale to carry both the risks and the costs of innovation and development, and firms with sufficient scale to capture the benefits of that innovation and refresh it before rivals come and mimic the innovation and dilute returns.

But they are just too thin on the ground in New Zealand. Our large firms tend to be producer co-ops or state-owned enterprises, our mid-sized firms tend to be subsidiaries of multi-national parents, and our New Zealand firms tend to be owner-operated micro enterprises.

They are fine in themselves, and they have and they will continue to serve us well. However, if there is to be a stronger push to transform the economy, we will need domestic firms of scale to take us along that path.

What I am trying to convey today is that the government is not resting on its laurels. We are determined to lift the game, but we are very aware that to do this "business as usual" is not acceptable, and we will not do it on our own.

We are in this together, and I stress that it is working out the best way forward, not simply the implementation of the transformation agenda that requires this dialogue.

For its part, though, the government cannot take the view that it is exempt from the imperatives of economic transformation. The fact is that we own a substantial number of the firms of scale in our economy.

State Owned Enterprises will be a key part of our work to transform the New Zealand economy.

What I am announcing today is that from now on, State Owned Enterprises will be encouraged to expand into new areas of business that are linked to what they already do.

To do so they will have to meet strict conditions, and their new business must have good spinoffs - for communities but also potentially for private firms.

New Zealanders have agreed that we should keep state assets in public hands. But that does not mean that they should not be put to work for us.

They are big commercial operations and that's why they're perfectly placed to play a key role in helping to change New Zealand into an innovative, high-wage and high-value economy.

I realise that there are risks with allowing SOEs to diversify, and the government is not about to play fast and loose with taxpayer assets. I also want to make it absolutely clear that the government has no intention of dictating what diversification options SOEs might consider exploring. That is for the business planning process.

It will come as no surprise to you that my advisers warn of widening the scope of business of SOEs given that they operate under very weak capital market constraints and they are not under constant threat of acquisition.

Despite that, and partly to ensure that they remain vibrant and partly to extract some wider public benefit from the considerable knowledge, motivation and energy that resides within the SOE portfolio, I have signalled to SOE board chairs that shareholders are prepared to consider proposals from them to broaden their scope of business and to extend the time horizon over which they seek to capture a return on investments.

This is not a blank cheque or invitation to indulge in flights of fancy. We will only consider approving diversification paths if four criteria are met:

„h Diversification must be based on an effective use of existing core competencies. It must be into adjacent technologies, products and markets. This lowers the risks and increases the chances of effective renewal.

„h New activities should have a demonstrated potential to enhance the competitive competencies of other firms and industries. We are looking to deepen our mastery of processes that have multi-firm applicability and wider third party benefits. This means, there must be wider spillover benefits.

„h Other than in very rare circumstances, the diversification should be able to be financed off the existing balance sheet of the SOE. This is not an invitation to seek fresh equity injections.

„h Finally, any revised scope of business must be accompanied by robust evaluation processes using explicit performance indicators, leading to a clear exit route for ventures that are not going anywhere.

I don¡¦t anticipate that this will be a quick exercise. Reflecting on the longer-term development path for these companies, in the context of their statutory obligations, is something that is likely to take time. It is also vital that it does not distract them from their core and ongoing business.

Having said that, I will not rule out favourable consideration of opportunistic investments that come up outside the planning cycle.

For our part, we will be prepared to review the financial constraints that SOEs operate under in order to make approved diversification strategies viable. I am talking here about flexibility around dividend policies and gearing.

My theme today is based on the presumption that if we stagnate we decay. That is true for every company in New Zealand and for the New Zealand economy as a whole. SOEs are no exception.

A number of initiatives were announced in the Budget, and it is clear that this is an action-oriented government with an investment agenda.

I¡¦m not going to repeat what you have already heard on that score.

I do want to stress, though, that the Budget is a start, but it is certainly not the end of the action during this term of government.

The message is: get engaged in constructing the development agenda for the country, own it, and commit to its implementation. The government has the capacity to apply resources but I stress again - it's firms that do the business.

ENDS

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