Phil O'Reilly: New Zealand’s silver bullet
New Zealand’s silver bullet
Address by Phil O’Reilly to Auckland Rotary, the Auckland Club, 28 November 2005
Last week the National Bank’s Business Outlook survey showed the lowest level of business confidence since the 1987 crash. The activity outlook indicator fell from 12% to zero. Inflation expectations are up to 3.4%. And around a quarter of the respondents expected profits to decline.
The trend had been picked in Business NZ’s monthly survey of manufacturing activity, the Performance of Manufacturing Index (PMI). Every month we interview several hundred manufacturing firms, and follow the trends across sub-indexes including production levels, level of new orders, and size of inventory. In any month, if the average of all the subindexes is more than 50, that shows manufacturing activity is expanding. If the average is less than 50, that shows manufacturing activity is declining. It’s an international convention – the US, the Eurozone, Japan and Australia each run their own PMI in the same way, so valid comparisons can be made across all countries.
The beauty of the PMI is that the manufacturing firms’ activity levels provide an early warning system of the strength of the economy. Seven months ago, in April, the PMI did a sudden dip down below 50 for the first time in two years, plunging to 47.9, its lowest level since the survey began in 2002. This was just the time of year when you would expect the PMI to be trending upwards, with the lower manufacturing levels from the summer holiday period giving way to higher levels, with new orders coming in for the new year.
Instead it showed, very graphically, a weakening in demand. Since then the PMI has dipped below 50 on three more occasions – in May, July and again last month, in October. So the decline in business confidence that we saw reported last week hasn’t been a complete surprise. Many of those manufacturers we survey are exporters, and they have been pummelled by the high kiwi dollar for more than a year, making their goods more expensive - and less competitive - on the world market.
Economists say we should try and export more and invest more in businesses that export, in the interests of the economy. We should put less of our wealth into the housing market, and we shouldn’t borrow so much against the rising value of property.
It can be hard to do that when the exchange rate is working against us, reducing the value of returns from exports, and when house values just keep going up. But the outcome is, of course, that the Reserve Bank will push up the official cash rate, and our interest rates will go up. On the back of the last hike a month ago, we may get another increase next week on 8 December.
The business community historically has a low tolerance for increasing interest rates and it usually argues strongly against them. Currently there is less support than usual for raising interest rates, for two reasons. First, because it will make us more attractive to overseas investors since they will earn more from their investment here, and that will lift the dollar further. And second, because it doesn’t seem to be working: higher interest rates are not succeeding in dampening down the housing market.
I wouldn’t want to be the Governor of the Reserve Bank. Dr Bollard has a harder job than usual – with rising inflation and a contracting economy. Those two phenomena are usually on opposite sides of the business cycle. It’s a conundrum because there’s a risk that using interest rates to fight inflation when the economy is shrinking will dry up demand and shrink it further.
What do you do? The Reserve Bank is obviously thinking of some kind of specific interventions aimed at the housing market. It announced a fortnight ago a project exploring housing-related interventions to try and manage rising inflation. The Reserve Bank and Treasury are to report back on the options at the end of January. These include imposing a ratio of loan to house value and other examples of intervention at the micro level.
Many in business remember the Muldoon years and do not want this level of intervention. Nor is there a large constituency for focusing so intently on the housing market. That’s not the only contributor to rising inflation.
Central and local government are big players in the inflation stakes. High spending by central government – student loan interest write-offs, the ‘working for families’ package, a big pool of state servants - is a big factor. So is spending by local government, funded by rates rising at more than double the rate of inflation over the last decade. Business would feel a lot more comfortable if government eased back on the spending. Government tightening its own belt would help dampen inflationary expectations.
A spate of interest rate rises and the prospect of more is a breeding ground for low business confidence. The last time we had ‘the lowest level of business confidence since the ’87 crash’ was in 2000, in what’s since been dubbed the ‘winter of discontent’. That was the period when the business community was absorbing the proposals for what was to become the Employment Relations Act - another indicator showing how government intervention can significantly affect business confidence.
This time round, low business confidence is very much tied to increasing interest rates. It’s the Reserve Bank’s response to inflation, now above the 3% band. But increasing interest rates only pushes the NZ dollar higher.
Why has the dollar been high for the last year or
so? Mostly because of the relative weakness of the
greenback - but it’s now being compounded by rising interest
A high exchange rate isn’t necessarily a bad thing. If you had a high dollar caused by high productivity in the New Zealand economy – that would be a different story. That is something our exporters could certainly live with.
This brings me back to those manufacturers that we survey every month. In my eyes, they are the heroes of the New Zealand economy. Against the odds, and in the face of declining profit margins, many are continuing their struggle to export.
They are doing, in my view, the two most important things possible for the health of our economy. First, they are engaging with and selling into world markets. And second, they are seeking to improve their productivity.
Exporting is crucial because we are a small market of 4 million people. Four million is the size of a suburb of one of the world’s big cities. It’s hard to get rich selling your products just to a suburb. You have a better chance selling into the biggest markets you can. Many manufacturers know that, and they’ve got their eyes trained on exporting to those big markets overseas.
Their job is harder than their overseas counterparts, because New Zealand is the most distant from the major markets of the world of all developed countries. Many of you here will have experience in exporting or trying to export to markets a long way away, and you will know how difficult and costly it can be.
The second thing that many of our exporters are focusing hard on is productivity. This is what I call New Zealand’s silver bullet. Here’s what American columnist Paul Krugman says:
“Productivity isn’t everything, but in the long run it is almost everything. A country’s ability to improve its standard of living over time depends almost entirely on its ability to raise its output per worker.”
High productivity is crucial because if your productivity is low, you won’t be internationally competitive and you will find it harder still to compete in those large markets.
Business has a responsibility to increase productivity levels, because productive businesses create a productive economy. Advocacy groups like Business NZ have a responsibility to advocate for all possible changes that would help us move towards a more productive economy. And Government has a role to play. The Government has been strongly promoting productivity improvement for more than a year. Business NZ is very supportive of that. We would like to see the Government go further and take tangible steps towards making changes in policy settings that would help businesses become more productive – for example by reducing the tax burden or the number of compliance costs.
Business NZ’s recent work on productivity has turned up a few misapprehensions. It’s sometimes said that productivity is the same thing as production; that it’s the sum total of what we as an enterprise or a nation produce.
But productivity is not production – it is output divided by input, a ratio to measure how well a business (or an individual or a country) converts inputs into products and services. The inputs are resources, like capital, labour and materials. You can get more productivity by increasing your output with the same amount of inputs, or achieving the same amount of output with fewer resources.
Why does it matter? Productivity is important because it underpins economic growth. It determines real incomes by determining the amount of goods and services - and hence the standard of living - that we can purchase and enjoy. Productivity growth is win-win for business, employees and consumers because it brings higher growth, more employment, higher wages, higher living standards, lower inflation and improved international competitiveness.
International competitiveness is where productivity hits home. If resources can be used more efficiently offshore, then they will be. More productive countries get rich at the expense of less productive countries. Maintaining productivity is therefore crucial for keeping investment and industry in New Zealand.
Developed countries with high productivity growth – like Ireland, Korea, or the US - generally have higher growth and lower unemployment. Developed countries with relatively low productivity growth – like Germany, France or Italy - have relatively low growth and higher unemployment.
Capital and labour are highly mobile internationally. That means both businesses and government have to be on their toes to keep improving productivity. You have to have competition to spur businesses to improve their productivity. And government has to make sure that taxes and compliance costs are not heavier here than in other countries because that makes it harder both to improve productivity and to compete.
Lets look at some of the inputs. Skills are crucial for levering productivity. Much of our productivity is on the back of our national education system that delivers the baseline competence of our workers. There’s no shortage of people knocking our education system, but I continue to have faith in it. Despite the enormous upheaval of the new qualification system, it is continuing to improve. The decision to go back to a ranking system for the scholarship exams was an appropriate one. The NCEA has the ability to grow into something that serves both academic and vocational studies – unlike other countries where there is an artificial ‘divide’. And the standards-based system is already working very effectively in industry training. More funding for industry training would increase its effectiveness further.
But there’s no doubt that our bank of skills is under pressure. The skills shortage is the number one issue for business according to surveys that we have run this year. So we have to have an immigration policy that lets in the right number of skilled immigrants. And we have to demand more from our education system.
Last week’s announcement by the Government of more investment in literacy and numeracy in the workplace was loudly cheered by Business NZ. The critical skills of numeracy and literacy need to be widely dispersed throughout the population, not just in patches. We need depth in our skills base, just as we have depth in rugby. It’s all the more important because with a population of 4 million there are so few of us.
Think of it as a room full of people. Let’s say most of the people in the room can calculate well enough to get by, and can read and write well enough to follow instructions and operate machinery correctly and safely. Among that number of people with those skills, you would expect to find at least a couple who were really outstanding – geniuses, entrepreneurs, high skilled individuals capable of good productivity.
The problem is that in other countries, the ‘room’ is very big, with lots of people in it, with lots of skills. New Zealand is only a small room. So we can’t afford to have only a couple of people in it with good skills – that wouldn’t give the critical mass of skills to throw up our geniuses and entrepreneurs.
This little room we’re in – let’s say it represents New Zealand businesses. What has to be in that small room to make sure that those businesses improve their productivity?
The first thing I’d say is: relationships. Inside that room there should be people talking to each other, swapping ideas and experiences, learning from each other, deciding to work together in certain ways to take on outside markets. Business clusters – like the sophisticated exporting clusters in Europe - grow out of such relationships.
As we noted before, the room also has to contain a high level of skills.
It also has to contain a sound financial system that gives good access to capital for development. That financial capital lets us buy physical capital – conveyer belts and tractors and computers – things that can leverage up our productivity.
I said before that I had faith in our ability to get more out of our education system. I also have faith in our ability to grow business clusters, to invest in our businesses, and to do all the other things that are needed to improve our levels of productivity.
They are all important because it’s a challenging world out there. Other countries are higher up the productivity ladder than we are. The average rate of productivity increase per year in developed countries is 1.9%. Australia’s rate of increase is 1.9%. Ours is 1.4% - that’s a big difference.
We can improve our productivity. We’ve improved business capital investment levels from $15 billion a year in the 1990s, to around $25 billion a year now – and we can do better still. We can continue to make improvements to our education system. We can seek improvements in our regulatory regime so our companies aren’t so hampered by high tax and compliance costs. And we can keep our eye on the ball by continuing to focus on productivity as a key indicator for future success.