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Opinion: ANZ NZ's economics team look at key themes for 2013; Here's theme 2 - transitioning via differentiation and how NZ can cope

Posted in Opinion

Over the next five business days we are running a detailed review by ANZ NZ's economics team of six key themes for 2013. This is the second one. The first one is here »

By Cameron Bagrie*

Our key aim in writing this article is to alert our readers to some of the wider economic forces at work.

We want to highlight the inherent tensions that exist within the economic system, and to encourage readers to start thinking about the implications for their own businesses.

Ultimately, it is the average rate of growth over a number of years (and volatility around that growth) that matters, as opposed to what GDP growth will be in any single year.

The repercussions of the global financial crisis will continue to be felt for years.

Therefore, we would encourage our readers to think about the macro themes we outline below within a five-year time horizon.

THEME 2: TRANSITIONING VIA DIFFERENTIATION – four unheralded legs of the growth story

The upshot:
The New Zealand economy – like a host of others, continues to transition, facing a slow growth trajectory amidst a process of balance sheet repair and alterations in the mix to growth.

Beyond conventional price signals and drivers of growth across the New Zealand economy, four less-often cited factors will be critical in this transition: unlocking more growth from areas of advantage, including an abundance of natural resources; wrapping an innovation strategy around New Zealand’s unique points of comparative advantage; a functional political system; and society remaining receptive to change.

On top of this the microeconomic reform agenda needs to keep being progressed.

These are modern day differentiators that go beyond the conventional wisdom as to what drives growth, and growth is key for economic transitions to take place in an orderly fashion.

Five stages

For the past couple of years we’ve identified a five staged process for the New Zealand economy, and they still apply.

The first stage (A) was the “old normal”, where credit growth exceeded incomes by a factor of 2 or 3, traditional risk-return identities were ignored, growth became lopsided, imbalances ballooned, asset price bubbles materialised and artificial wealth drove spending. Ironically, the 1990s-2007 period was also referred to as the “Great Moderation” in recognition of a period of relative economic stability.

Stage B (over 2008-09) saw the inevitable initial purging that follows such excesses. The “Great Moderation” was nothing of the sort; spending beyond one’s means turned out to be unsustainable, surprise, surprise.

Stage C was the healing or recovery process that we saw in late 2009 and the first six months of 2010, helped by aggressive policy action and an inventory rebuild. “Healing” or “recovery” is probably a bit optimistic: it’s more like stabilisation following capitulation, and a recoil off lows.

The New Zealand (and global) economy entered stage D – which we call “transition”, around the middle of 2010. Normal pro-cyclical forces and drivers of the business cycle, such as consumer spending, failed to kick on and take the inventory rebuild into something of substance. That’s because there’s a debt “super cycle” and payback dynamic that is overwhelming the usual cyclical forces. This period is where the economy transitions on a number of levels, including altering the mix of growth  (rebalancing) and also paying penance for prior sins, i.e. lowering debt as a share of GDP across Western society.

This stage entails a period of stuttering and “grumpy” growth (D) as stylised below. You need to get enough growth during stage D to progress and remain master of your own destiny: a stagnant economy risks losing investor confidence and also creates social time-bombs down the track. However, the risk is that if you get too much growth, or things become easy, complacency sets in.

You can see this dynamic across some industries with the meat sector a prime example: strong lamb prices in late 2011 deflected attention away from inevitable consolidation and hard choices, which are now coming back onto the agenda.

In the final stage (E), trend growth rates (the slope) will be at least partly a reflection of the choices made in the transition stage. There is also a time limit on the transition stage determined by pending demographic pressure.

New Zealand’s demographics are altering. By 2020 there will be around 4 persons aged 15-64 for each person aged over 65, down from 5.9 in 1990. People are living longer.

It is blatantly obvious the current system is unaffordable. Changes will be required. The degree of change can be minimised by progress made in the transition stage (speed and quality) to unlock stronger growth potential during stage E.

The economy has been in the transition stage for a couple of years already and will remain so for a number of years to come. We are not talking booms to busts (we hope), but rather a period of sustained grumpy growth: there will be growth, but not at the pre-GFC rates we became accustomed to, and we’ll be working a lot harder to get it.

What transition involves

Transition will involve a number of dynamics:

- A capped rate of growth, as a leveraging (borrowing) tailwind is replaced by a deleveraging headwind. The slope of D is less than A. For New Zealand we believe this trend rate is somewhere around 2 percent in terms of real GDP growth.

- A different mix to growth. It is untenable to imagine a debt-laden nation borrowing and spending its way out of a debt-induced jam. So spending sides of the economy need to underperform. However, this thematic is being tested with the requirement to rebuild New Zealand’s second-largest city and a less than ideal mix to monetary conditions across the economy (refer Theme 4).

- The re-mobilisation of resources, including labour and capital across sectors, as a spend centric model is replaced by a more balanced model for growth. Capital and labour does not respond instantaneously. It will be messy. Getting the basics right, such as a well functioning education system that responds to signals from the private sector will be key. This turns attention away from the macroeconomic picture and towards the microeconomic agenda. The length of the journey in D or period of grumpy growth can be shortened by getting resources shifting and responding in a timely manner. On some levels we can see price signals working (i.e. real wages falling in some industries) and economic incentives tilting behaviour. On others (i.e. an inflated NZD beyond local fundamentals), we’re not. Hence, it’s a journey fraught with frictions.

So what determines the rate of growth in the transition stage?

The weaker the balance sheet, the greater the deleveraging headwind holding back near-term growth. New Zealand is somewhat saddled here by sins of its past.

Flexibility across the economy in areas such as the labour market and having a floating currency all assist by allowing price signals and resources to adjust more readily.

On this front, New Zealand stands strong. Those with limited flexibility and poor price signals stand ready to repeat New Zealand’s experience of the 1980s – zero growth over six years, clearly a dire outcome. But even for those countries, the resulting performance will probably be better than the alternative of doing nothing.

Economists can probably point to 80-odd factors that determine growth. The problem is that it’s difficult to disentangle the causality, as many of the so-called growth-determinants (such as investment) are key components of GDP themselves.

We know that traditional dynamics such as population and productivity will of course be influential.

However, there is also a strong behavioural aspect that operates and drives an economy, particularly when you are witnessing a fundamental change in the DNA of society, and you need the confidence of investors.

Living standards are simply not what we had convinced ourselves they were, and we can either drop them immediately or wait (hope) and strive for income generating capacity to catch up. And while this goes on, we need to be cognisant of the economic environment: it’s all about maintaining confidence, credibility and showing competence as such changes are taking place.

Nothing is a problem until markets think it is a problem. As Ireland, Greece, Italy and other highly indebted countries will bear witness, problems can turn exponentially ugly in a very short space of time.

Key for a transitioning nation is the concept of differentiation and convincing investors that you’re on the right track.

Investors are eyeing the scene with confusion, and New Zealand is facing a marketing challenge of the utmost importance. There are the conventional insights that offer Asia up as delivering nirvana. There is a lot of upside here, though we believe New Zealand’s story is far deeper in terms of the factors we need to be eyeing.

Natural advantages

New Zealand needs to up the ante on unlocking our natural endowment riches. It is easier to transition if you have strategic areas of excellence, or areas of comparative advantage, and particularly if they are complementary to structural shifts around the globe.

This makes it possible to get debt to GDP down by lifting economic growth, a far preferable adjustment path to scrimping.

Structural reform agendas are easier to pursue if your endowment is high, because the economic payback is quicker via avenues such as unemployment (which matters in a political sense). It is far more difficult to implement reform if the perceived payback is slow (which is one reason reform tends to be a consequence of a big bang ex-post “accident” as opposed to being proactive).

New Zealand has a lot to point to here: water and land (alongside Mother Nature) clearly top the list, but energy, natural beauty (tourism), a huge economic exclusive zone, the brand NZ.Inc, food safety, minerals, and potentially oil also feature … the list goes on.

A host of these are complementary to structural changes around the globe, such as more consumption-centric growth in Asia and stronger demand for protein and fat.

NZ ranks 8th in the per capita natural resource wealth stakes globally, a few notches higher than Australia, who are often deemed the lucky country. The only countries ranking higher export huge amounts of oil.

And in terms of renewable natural capital (think land, timber, heritage assets, a large economic exclusive zone), New Zealand leads the world on a per capita basis.

Thinking about this in terms of the nations in Asia that we have free-trade agreements with – those very nations that are growing consumption at a fast clip and are “short” natural resources (refer table in the Theme 5 story) – and you can understand offshore investment interest in New Zealand agriculture as a secular theme.

It’s not going away anytime soon. This is leading to various gestation issues in some camps over foreign ownership. It goes without saying that you need an appropriate regulatory framework to mitigate exploitation risks. New Zealand’s regime by global standards is stringent. The OECD ranks NZ as the 7th most restrictive of 55 developed economies in terms of foreign investment regimes.

Tensions

There are also tensions between some of these endowments. Unlocking them is not easy.

You wouldn’t want one area of strategic excellence such as mining to undermine another such as tourism, so sensible regulatory heads are required.

Moreover, having a large natural endowment does not guarantee success for a nation.

Indeed, it has historically tended to invite corruption and foreign exploitation. Just like successful businesses need something in their offering that is “different” (whether that be brand, relationships, or a better service proposition), the same applies for a nation.

New Zealand has this in spades, and it’s critical, for the more you pull an income-generating lever, the less pressure there is for austerity.

This makes issues such as the current debate over water rights (allocation, treaty, ownership) key to watch as somewhat of a flag bearer for New Zealand’s prospects.

We’ll turn very bearish if a key part of New Zealand’s flagged endowment riches gets bogged down and stymied by legal dysentery.

The same applies for the likes of our economic exclusive zone. New Zealand’s huge natural endowment or areas of comparative advantage will not deliver economic nirvana alone. It’s akin to a rugby team with deep in natural talent that doesn’t necessarily perform on the field, and there are some good local examples of that!

For riches to be unlocked, there are a host of issues that need to be addressed and fast tracked.

The right infrastructure needs to be in place, broadband functioning (think global connectivity), scientific method promoted, property rights defined, and the correct incentives to work and invest set in place etc. There seems to be enough happening here to keep offering hope, though it seems to be somewhat of a two-steps forward and one-step back process.

However, we also need to wrap an innovation strategy around our natural areas of comparative advantage.

New Zealand will not get rich shunting out volumes of agriculture produce like it’s been doing for the past 30 years.

To change and embrace such a strategy we suspect more thinking outside the “square” is required.

Consider the following examples:

- It rains here, so we have good access to water which can boost primary production if storage capability can be developed. This is key for areas such as Canterbury, Hawke’s Bay and Wairarapa. We should also be experts in regard to irrigation, water treatment, pumps, pipes and everything hydro.

- We pride ourselves on being clean and green so we should be leaders in green technology, renewable energy, insulation and eco-friendly homes.

- Our primary industries are world class so we should be exploiting these and diversifying away from farm-gate and production mantras to creating and marketing associated technologies, animal husbandry products, genetics, aquaculture, fisheries management and pest control.  We are a sports-mad nation punching above our weight on a population basis at the Olympics. This makes us a prime candidate as a nursery for training coaches and sports development.

- We’ve a city rebuild to contend with. God forbid another city suffers the same fate, although the odds are that one will. When that happens, New Zealand should be leading the pack and be the first port of call on building design and all engineering facets of rebuilding a city.

The crux here is to get people thinking beyond the obvious and into identifying and positioning a wider value-added proposition.

The political framework needs to be, and is, functional. New Zealanders tend to take their lack of corruption and well-functioning political system as a given. But it matters.

And while “democracy is the worst form of Government except all those other forms that have been tried from time to time” in that it rewards short-term thinking, we are encouraged by the consistency being shown across the entire political spectrum towards fiscal savings and responsibility.

Moreover, New Zealand has a political framework that is reasonably adaptive and receptive to change in a relative sense.

Of course, MMP has presented its own challenges. If you want evidence of political fragmentation and institutions that are conducive to gridlock, look no further than the US and Europe. Our system is not perfect, but it’s far better than most. Society needs to remain receptive to change.

The limits of leadership

An economy is a super-tanker: it takes time to turn.

Leadership can only take you so far – habits have to change on the ground.

Our economic performance, after all, reflects the decisions of 4+ million individuals, whether that’s their borrowing, spending, or voting decisions.

Japan’s lost decade epitomises a refusal to bite the bullet. It appears that the critical mass in New Zealand is now tilting towards necessary structural change.

Witness the continued uptake of KiwiSaver despite the smaller carrots now on offer; the focus on fiscal responsibility in the 2011 election; a refreshingly non-hysterical discussion of the possibility of raising the retirement age beyond the age of 65; and the savings debate turning more towards compulsion. Such signals don’t guarantee that society is willing to do the hard yards, but its reassuring that things are moving in the right direction.

However, we’re also seeing evidence of old style behaviour and the belief that house prices only go up, though it is not flowing into the broader economy and measures such as consumer confidence.

There appears to be a lack of clear “consensus” in some sensitive areas (asset sales and water being two) which polarises the political arena and stymies progress.

Ultimately we believe such tensions will be overcome, but we’ll be tracking such debates with interest as fundamental flag bearers for New Zealand’s future prospects.

Microeconomic reform

We need to continue the process of microeconomic reform.

Microeconomic issues are often overlooked when assessing the macro economy, but as stated, the economy is the summation of its parts. It is crucial to get the right incentives in place.

New Zealand has already done a lot of the heavy lifting in terms of getting a system that is world class.

We rank at the upper end of the OECD in terms of literacy, attainment of secondary and tertiary education, transparency of our institutions, and law and order. Access to childcare has vastly improved, half of the population has now enrolled in KiwiSaver, and reform of the RMA has helped address infrastructure bottlenecks. However, we’ve got some clear challenges in key socio-economic groupings too.

Incremental improvements can still be made to overcome the tyranny of distance from markets.

Tax policy is a biggie here (we’d raise GST, bring in a capital gains tax and cut income tax rates further), as well as welfare policy design, the ease of starting a business, property rights, balancing public and private interests, and avoiding corruption and rent seeking behaviour (moulding one’s economic activity around maximising returns from distortionary policies, rather than true economic profit).

These factors do not deliver nirvana. Nothing does.

They also come with complications.

Investor confidence and belief in the wider New Zealand economic story is one factor inflating the currency beyond levels dictated by local fundamentals today.

In short, investors are banking on the story being delivered.

The challenge for New Zealand is to deliver in the face of an elevated currency.

Amongst the hurly burly of what to do about the currency (intervene, cut interest rates, capital controls) only one idea has any credence: an obsession with lifting competitiveness, and this will require give and take across all levels of the economy from central government, local government to businesses, and unions. At present, constituents from each of these groups appear to be in a round room looking for four corners.

In a world that is “transitioning”, differentiation through showing competency and maintaining confidence is key. Such differentiation allows you to remain in control of your own destiny (and adjustment).

The alternative is Greece.

-----------------------------------------------------------------------------------

*This report was written by the ANZ New Zealand economics team which consists of chief economist Cameron Bagrie, head of global markets research David Croy, senior economists Sharon Zollner and Mark Smith, economist Steve Edwards, strategist Carrick Lucas, and rural economist Con Williams. It is used with permission. Theme 3 will follow tomorrow.

We welcome your help to improve our coverage of this issue. Any examples or experiences to relate? Any links to other news, data or research to shed more light on this? Any insight or views on what might happen next or what should happen next? Any errors to correct?

We welcome your comments below. If you are not already registered, please register to comment in the box on the right or click on the "'Register" link at the bottom of the comments.

Remember we welcome robust, respectful and insightful debate. We don't welcome abusive or defamatory comments and will de-register those repeatedly making such comments. Our current Comment policy is here.

8 Comments

I'd be interested to see an

I'd be interested to see an analysis that takes into account the interests of New Zealand's citizens, rather than those of big business and megabanks.
There is nothing here about resource depletion, ever increasing oil prices, and climate change.
Who is going to want to live in, or visit, the wilderness produced by "unlocking riches"? Who wants a continuation of the failed neoliberal experiment?

How many ways are there to

How many ways are there to say higher revenue reduces your debt problem.
Is the problem high debt? or low Revenue?
Reading this you would think there is more a problem of low Revenue than high Debt.

Someone should tell John Key

Someone should tell John Key to read this ...... we need to exploit what we have got just like the Aussies do 

and once thats gone what do

and once thats gone what do our children exploit?
regards

Beyond conventional price

Beyond conventional price signals and drivers of growth across the New Zealand economy, four less-often cited factors will be critical in this transition: unlocking more growth from areas of advantage, including an abundance of natural resources; wrapping an innovation strategy around New Zealand’s unique points of comparative advantage; a functional political system; and society remaining receptive to change.
 
Now, can somebody translate this advertising speak so we can all have a better idea what ANZ is up to in the real world with nearly ~NZD 820 billion of derivatives on it's books - see page 25/26 of the latest disclosure statement. Note this latest outrage is down from positions close to NZD 1 trillion last year - and are we not just the size of a medium town in Europe - with less than 1.5 million people commited to real export related work? Can they pay for any fallout from one or more failed counterparties to these trades? Doubtful.
 
Which brings us to the exploding derivative scandal witnessed in Italy over recent days., courtesy of Zero Hedge 
 
It was about a week ago when Bloomberg reported that the world's oldest bank, Sienna's Banca Monte dei Paschi (BMPS) had masked a massive (for its size) loss courtesy of a Deutsche Bank-facilitated derivative transaction dubbed "Project Santoini." The trade, which led to a $2 billion loan from Deutsche Bank in December 2008, helped Monte Paschi mitigate a €367 loss from an older derivative contract with Deutsche Bank. As part of the arrangement, the Italian lender made a losing bet on the value of the country’s government bonds: one wonders if DB made BMPS buy some of its Italian holdings because, as is well-known, it was about this time that the German bank was getting uber bearish on all the periphery (for more on the details of the derivative read here).
 
Today it's deja vu again, as the news keeps on coming, this time from Reuters, which reported that BMPS could face total losses as much as $1 billion on prior derivatives trades which have only recently been discovered. The shares promptly plunged, and BMPS was halted for trading minutes before the Italian market closed:
 
Sure enough not even 24 hours later, Mario Monti, speaking in Davos, said something that immedately confirmed just what is at issue here:

  • ITALY'S MONTI SAYS NO OVERSIGHT FAILURE ON PASCHI

Translation, it was not the Bank of Italy's fault, and that of its then-head, Mario Drahi (sic), that it failed in supervising the iconic Sienna bank. Because, you see, it is all the evil management's fault. The same "management" whose Chairman just happened to be head of the entire Italian banking lobby. Until yesterday.
And another, less politically correct translation: a (super) Goldman brother is helping another (super) Goldman brother out before the reporters figure out just what happened.
 

Stephen, Well done. What do

Stephen,
Well done. What do you think are the likely/possible ramifications for ANZ? And for NZ Inc?

Good that the ANZ has

Good that the ANZ has published their views.
A few questions arise:
 
Flexibility across the economy in areas such as the labour market and having a floating currency all assist by allowing price signals and resources to adjust more readily. On this front, New Zealand stands strong.
And yet all the price signals for the last 20 years; and in particular the last four, with a ridiculously high NZD, and relatively low interest rates, encourage importing, overseas travel,  more debt and house trading. They have lifted non trading costs, such as government, central and local, electricity and gas, by 50% in USD terms in 4 years. They kneecap exporting and import substitution. So something is not working.
Nothing is a problem until markets think it is a problem. As Ireland, Greece, Italy and other highly indebted countries will bear witness, problems can turn exponentially ugly in a very short space of time.
Good economists will advise that problems exist well in advance. The countries noted had real problems, not just a lack of confidence. Without scaring the horses, I would contend that NZ does as well. In particluar a massive and persistent current account deficit.
 
The challenge for New Zealand is to deliver in the face of an elevated currency.Amongst the hurly burly of what to do about the currency (intervene, cut interest rates, capital controls) only one idea has any credence: an obsession with lifting competitiveness, and this will require give and take across all levels of the economy from central government, local government to businesses, and unions. At present, constituents from each of these groups appear to be in a round room looking for four corners.
At least they note the fundamental problem with an elevated currency. They make no argument at all against intervention (using for example the main proposal publicly on the table- sufficient printing rather than foreign borrowing to pay for some government deficit/expenditure.) Finding the four corners using their analogy will never happen. (and even if we did, the current system would merely flood us with even more foreign money). So why not fix the fundamental problem? Given they have not made such a case, one suspects the reason is that fixing the problem would not be in ANZ's interest. The rest of the paper is very good. But no addressing of the fundamental problem makes it all moot.
 

  Despite the need to

 

Despite the need to radically reform the banking sector there are still 

several UK banks with respective balance sheets greater than the sum total 

of the UK economy, that is, £1,300,000,000,000 (King 2010).

 

http://www.gowerpublishing.com/pdf/SamplePages/Third-Sector-Performance-CH1.pdf