Graeme Wheeler: Improving New Zealand's economic growth
Speech by Mr Graeme Wheeler, Governor of the Reserve Bank of New Zealand, to the
Canterbury Employers' Chamber of Commerce, Christchurch, 1 February 2013.
* * *
I'm conscious of George Bernard Shaw's comment that "if all the economists were laid end to
end, they would never reach a conclusion". So I'll try and be more of a one-handed
economist in offering some thoughts on New Zealand's economic performance, ways in
which it might be improved, and our role in the Reserve Bank.
New Zealand's economic performance
Like other small, commodity-producing economies, our economic prospects depend greatly
on the growth in world trade and output. IMF data suggests that the global economy is
expanding at an annual rate of around three and a quarter percent - or just below its average
rate for the past three decades. But it doesn't feel like business as usual.
Over the past two decades, the global economy has changed dramatically. Asia is now the
world's largest economic region. Its GDP at market exchange rates is about 15 percent
higher than that of North America and 60 percent more than the euro area. China and East
Asia are the main growth poles in the global economy and emerging and developing
countries accounted for 80 percent of global growth last year. Among the advanced
economies, growth prospects in the US are improving (despite December quarter GDP) but
the recovery is the slowest for 70 years. Japan is going through another weak patch, and the
euro area is likely to be in a difficult recession until 2014, and then recover slowly. This, in
spite of US$15 trillion of additional spending by the world's governments in response to the
global financial crisis and over US$5 trillion of quantitative easing by the major central banks.
With official interest rates close to zero in the major advanced economies, investors continue
to search for higher yields in countries with stronger growth rates, favourable commodity
price outlooks, sound macroeconomic policies, and higher interest rates. As with Australia,
Canada, Sweden, Norway and some Asian and Latin American countries, the ensuing
exchange rate appreciation affects the growth of our import substitution and export sectors.
I'll return to this issue in greater depth when addressing the New Zealand Manufacturers and
Exporters Association later this month.
How have we fared relative to other advanced countries over the past two decades?
Since 1990 we've outperformed many OECD countries on inflation and unemployment. Our
inflation rate has been one and a quarter percent below the OECD median and our
unemployment rate half a percent lower. But our per capita income has lagged behind and
we've run large current account deficits. Real per capita GDP growth has been one and a
quarter percent, about half a percent below the median and our current account deficit has
averaged five percent of GDP - about the 6th largest relative to GDP in the OECD region.
There are two main ways in which our prosperity can improve over the longer run. The first is
if the world is willing to pay more for what we produce. The second is by raising our labour
productivity - that is by increasing the level of output per working hour. In the short term, we
can generate higher income if we increase labour force participation or work longer hours.
But we already have a higher proportion of our population in the labour force than nearly all
other OECD economies and we work longer hours than most people in the OECD.
The good news is that there's strong international demand for our commodity exports.
Despite falling over the past 15 months, our terms of trade, or the ratio of export prices to
import prices, remain 20 percent higher than the average for the 1990s. This improvement
partly reflects the expansion of the global middle income class over the past two decades,
led by China, and the rising demand for protein.
Our labour productivity story is much less impressive. Since 1990, our labour productivity has
grown at an annual rate of one percent, about one and three quarters percent below the
seven largest OECD economies. This is the main reason why our real per capita GDP is now
25 percent below the OECD median.
This is striking given the high international rankings for the quality of our institutions, control
of corruption, ease of doing business, and according to the World Bank, the highest per
capita endowment of renewable resources in the world.
So why is our per capita income so far below the OECD median? Partly it's due to our
geographic location and small economic size. Distance and economic size matter a lot even
in a more globalised world of trade, capital and knowledge flows, and increasing
interdependence. This also partly explains why our export range is concentrated over
relatively few products - with food and beverages accounting for almost half our exports. The
OECD and IMF believe size and distance, which limit economies of scale and market
opportunities, account for around three quarters of the gap in our per capita income
compared to the OECD average.
But this is not the whole story. Despite our high international rankings in key areas, the latest
World Economic Forum's Global Competitiveness Report ranks New Zealand's overall
competitiveness at 25th out of 142 countries. Besides market size, we perform poorly on our
macroeconomic environment, and especially on our budget deficit and low national savings.
But regulatory and performance-related factors also diminish our growth potential. Many of
the remedies to substantially improve our ranking lie in our own hands, and groups such as
the 2025 task force, the Savings Working Group, and the Productivity Commission,
emphasised reforms that can raise our living standards.
Three areas seem particularly important. The first, is to raise our level of saving and
investment, and improve the quality and productivity of our investment.
In 2007, the World Bank analysed the stylised characteristics of the 13 economies that had
grown at an average rate of seven percent per annum or more for a 25 year period since the
1950s. Eight of the countries were in Asia.1
We share many of the characteristics of these countries in terms of openness of the
economy, macroeconomic stability, and market based resource allocation. One key
difference however, is that all these countries had savings and investment ratios in excess of
25 percent of GDP and often over 30 percent.
Over the past three decades our net national savings rate averaged only three percent of
GDP - almost five percentage points below the OECD median. For the past 25 years, our
net household savings as a percentage of household disposable income averaged minus two
and a quarter percent - the lowest in the OECD (where data are available), and 10
percentage points below the OECD median.
Our desire for such high levels of consumption was met by borrowing the savings of
foreigners. As a consequence, our net foreign liability position is 73 percent of GDP, one of
the highest ratios in the OECD, and not much different from some countries that have been
at the centre of the financial crisis in the euro area. The build-up in external debt increases
our vulnerability to economic shocks and the high propensity of New Zealanders to borrow
means that higher interest rates than elsewhere are required to achieve similar inflation
outcomes.
Although, our national savings ratio is low, our investment rate over the past three decades
has been around the OECD average, and this is also true of business investment. But our
capital to labour ratio, or the amount of capital that labour works with, is low by OECD
standards. Second, much of our investment goes into housing rather than more
productivitypromoting investment, and in 2011, 70 percent of households' net wealth was in the form of
net equity in housing.
We need more investment, including foreign investment, that can bring benefits of job
creation, technology transfer and market opening. Today, about 75 percent of global trade is
undertaken by multinational corporations and about a third of trade is intra-firm trade.
However, instead of welcoming foreign investment, we have one of the more restrictive
frameworks among OECD countries. We should re-examine the factors, including tax and
regulation, that diminish and distort the incentives to both save and invest.
A second priority should be to return to fiscal surpluses and lower public sector
indebtedness. This will strengthen the economy's resilience and create more fiscal room for
responding to future economic shocks. The expansion in government spending has
historically been one of our main growth industries and our budget deficit relative to GDP,
after adjusting for the impact of the economic cycle on spending and revenue, was one of the
largest in the OECD in 2011. This is the main reason why the 2012 Global Competitiveness
Report ranked us 112th for our budget deficit. Important steps are being taken to reduce
government spending and this will be an on-going challenge as demographic change will
greatly expand government outlays unless there's significant policy change. For example, the
ratio of the over 65 age group to those of working age is projected to change from 1:5 to
almost half that in 25 years' time.
Increasing fiscal deficits mean that monetary policy has to be tighter and interest rates higher
than otherwise, and this adds to the exchange rate pressures on the export and import
substitution industries. This constrains output and employment in sectors facing international
competition - sectors where productivity growth potential is usually higher. Instead,
resources often find more attractive returns in the non-traded or sheltered sectors where,
although measured productivity is lower, producers face less international competition and
can raise prices more readily. This is one reason why it's critical to cut back ineffective
government spending, and ensure that our welfare spending is targeted better at those in
need.
Modern growth theory stresses the importance of the role of human capital, and the
knowledge and skills of the population. The quality of education is critical in creating
opportunities for growth and increasing real income. We need to improve the evenness of
our education outcomes. Globalisation and technology have widened the distribution of
income within most advanced economies, including New Zealand, over the past three
decades. In the mid-2000s we had greater income inequality than most OECD economies,
and this is unlikely to have changed. The bottom income deciles are populated by those with
lesser skills, and those who experience prolonged and recurrent spells of unemployment.
Addressing these groups would both promote productivity and reduce inequality.
Our education system is well regarded internationally. We rank 7th among 65 countries in the
OECD's Programme for International Student Assessment that tests high schoolers'
performance across reading, mathematics, and science. But, we have the greatest difference
in reading performance between students from different socio-economic backgrounds out of
all OECD countries, and the PISA scores for Maori and Pacific Island students are much
lower than the average for students of European descent. Over the past 15 years,
unemployment rates for Maori and Pacific Islanders have been three times that for the
European population.
How can the Reserve Bank best contribute to New Zealand's economic prospects?
There are two main ways.
The first is by delivering price stability and reducing the risk of inflation surprises. Price
stability, and expectations that future inflation will be both low and stable, contribute to
economic growth in several ways. They reduce uncertainty as to future inflation outcomes
and assist planning and long term contracting. They enable producers and consumers to
identify relative price shifts and allocate resources in response to shifts in demand. They
avoid the distortions created by the interaction of high rates of inflation and the tax system
that lead to higher effective rates of taxation. And they reduce the incentive for investors to
acquire non-productive assets, such as investment properties, as hedges against inflation.
Research by the IMF suggests that in industrialised countries the threshold level of inflation
above which inflation significantly slows economic growth is estimated at 1-3 percent.2
In considering inflation pressures the Reserve Bank closely examines recent developments
in the economy, and the outlook for competitiveness, demand, and output growth and
employment. In setting the official cash rate we aim to avoid excessive volatility in output
growth, interest rates and the exchange rate. We seek to respond to changing conditions but
avoid rushing into decisions that might need to be quickly reversed and in doing so create
uncertainty as to the Reserve Bank's objectives.
Four times a year we prepare two year ahead economic forecasts. But forecasting is far from
an exact science. Instead, there are conditional probabilities around each element in the
forecasts and our published numbers are our central expectations: that is, what we believe is
the most likely path of these variables. There are always many uncertainties, an important
one right now being the economic impact of reconstruction here in Christchurch. For
example, how much investment will take place and how quickly, how will insurance pay-outs
be used, how much employment is likely to be generated and where does it come from, and
what cost pressures and bottlenecks are associated with reconstruction and how is the
impact being reflected more broadly across the country?
The second area where we contribute to New Zealand's growth is by strengthening
prudential regulation and supervision to help create a more stable and efficient financial
system. A well-functioning financial system helps an economy grow by pooling and
mobilising savings, allocating funds to investment, providing liquidity, and redistributing risk.
The financial system needs regulation because in a limited liability framework the interests of
banks and bankers can differ widely from those of society at large. Bankers face incentives
to increase leverage and risk in the expectation of achieving higher returns. In doing so they
tend to under-price tail risk and often seek to build competitive advantage through complex
financial products and customised services. Their financial accounts can be opaque and
shareholders and creditors often lack the means to monitor bank balance sheets, or the
incentive to do so if they believe that the government will provide financial support to a failing
institution. As the global financial crisis demonstrated, interconnections among financial
institutions, and their sheer size, mean the failure of a financial institution can have massive
destructive effects on the economy and the welfare of citizens.
The Reserve Bank has several important initiatives underway to enhance the stability of our
financial system. Last month we increased the capital requirements for our banks and are
currently registering over 100 insurance companies and around 60 non-bank deposit takers.
We're working with banks to introduce an open bank resolution system by 30 June this year,
which will enable a distressed bank to continue operating, while placing the cost of the
bank's failure on the bank's shareholders and creditors, rather than taxpayers. And, later
next month, we will consult with financial institutions on a framework for the potential use of
macro-prudential instruments. These instruments, which include the counter cyclical capital
buffer, sectoral capital requirements, the core funding ratio, and quantitative restrictions on
high loan-to-value ratio lending, are designed to increase the resilience of the financial
system to shocks, and dampen the financial cycle when concerns increase about systemic
risk.
Conclusion
To a considerable extent our destiny largely lies in our own hands. We don't have the luxury
that many developing countries enjoy of relying on catch up technology to propel growth. We
operate much closer to the technological frontier, and if we are to attract new capital,
entrepreneurship and investment in innovation, our policies have to stand out internationally.
There's no simple generic formula for raising growth rates, but the more prosperous
countries and the economies that are growing rapidly all built strong linkages with the global
economy, and created an environment that fostered strong productivity growth, and high
rates of investment from domestic and foreign sources.
We've much to do in continuing to build our global linkages and addressing government
spending and regulatory issues that diminish productivity and competitiveness. But
addressing these will create valuable payoffs for our future given our major resource
endowments, our impressive agricultural and primary production engine, and the potential in
our education, tourism and other sectors.
In most situations the comments made almost a century ago by William Bryan, the 41st US
Secretary of State remain relevant: "Destiny is not a matter of chance; it is a matter of
choice".
BIS central bankers' speeches
BIS central bankers' speeches