Address to Waikato Business Network Breakfast

Hon Michael Cullen

21 April 2004

Speech Notes

Address to Waikato Business Network Breakfast

Ferrybank Lounge, Grantham St, Hamilton

The seabed and foreshore issue has been commanding a great deal of my time and attention recently, so it is something of a relief to meet with a business audience and to discuss what is happening with my day job: that is, building a stronger economy and managing the government’s finances.

As everyone is aware, our economy is hitting a soft patch at the moment. We are experiencing the effect of a cyclical low in some of our major export commodity prices, combined with a very high exchange rate, driven primarily by weakness in the US economy.

If we take a step back, however, I think it is becomes apparent that our economy is a lot more resilient than many commentators had thought.

In the last two years the New Zealand economy performed exceptionally well, in the face of some considerable adversity.

If we look back to where we were at the start of last year, we were facing some adverse growing conditions for our primary producers and a weak global economy suffering from a slump in asset prices and confidence in the US. In addition the Iraq War was looming, with the potential to disrupt key industries like tourism and to further depress confidence amongst our major trading partners.

At that time most forecasters were expecting growth in the New Zealand economy to fall to around 2.5 percent in 2003, and then bounce back to over 3 percent in 2004.

Now that we are able to look back, we see that the expected slow down in the New Zealand economy did occur, although not exactly as predicted.

The Iraq War was mercifully short and its immediate impact on the world economy fairly modest, although the situation is by no means settled. The SARS outbreak was eventually contained and its impact on tourism and other export industries, though severe for a short while, has now been turned around.

Nevertheless, over the year to December 2003 the economy grew a total of 3.5 percent, which was considerably higher than the forecast 2.5 percent. There was a marked slowdown over the course of the year, however, with most of that GDP growth occurring in the first half of the year. Growth in the September quarter fell to 0.3 percent, with a slight rebound to 0.6 percent in the December quarter. The annual growth result is still considerably faster growth than in the United States, the UK, Europe, Japan or Australia. It is a very long time since we have been able to say that.

The domestic economy carried most of the momentum, and continues to do so. The GDP statistics for the December quarter confirm that consumer and business spending, labour income and investment in housing in particular, have grown strongly. Household expenditure remained buoyant in the December quarter, up 0.8 percent. Indeed the real gross national disposable income – which is a more sophisticated measure of spending power – increased 4.9 percent in the December 2003 year.

And New Zealanders are still in jobs in record numbers. The unemployment rate has fallen from a peak of 7.7 percent in 1998 to 4.6 percent in December 2003, in spite of rapid working-age population growth. It is also in spite of the Employment Relations Act, which commentators on the right predicted would stop economic growth in its tracks.

The big challenge ahead is in the export sector, and it is primarily with export returns rather than export volumes. Indeed export volumes increased by 1.3 percent over the last year, with a 5.2 percent rise in the December quarter showing a pleasing trend following declines in earlier quarters. There was a 7.8 percent rise in export of services in that quarter, and a 4.3 percent rise in exports of goods, with dairy exports the outstanding performer, up 24.6 percent.

It is export incomes that are being hit, although they remain high compared to the historical average. The rising exchange rate has already reduced nominal export earnings by 7.8 percent in the year to December, and there may be worse to come in the short term.

For example, merchandise trade data up to the end of December 2003 shows that the total value of meat, dairy, forestry and wool exports was $12.5 billion in the year ended December 2003, down 10.1 percent from the December 2002 year. A large fall in prices has offset a lift in volumes of meat, dairy and wool of around 5 percent. The price fall was mainly due to the appreciating New Zealand dollar.

Fonterra is now forecasting a payout to its dairy farmers of $3.50 per kilogram of milk solids for the year to 31 May 2005; down from $4.15 per kilogram in the current year. Assuming the forecast is accurate, that will be the lowest inflation-adjusted payout in 14 years. The effect across the sector will be a loss of around $750 million from the domestic economy as a result of the lower payout.

The net effect of these internal and external trends is that growth will slow by mid-year as the effects of declining export incomes flow onto the domestic economy. By that time, currency hedges will have worn off, and exporters may cut back their domestic spending. A fall in the number of immigrants might also reduce economic growth.

Nevertheless there are some very positive signs starting to emerge. A full-blown recovery in the US is now looking more certain. Many of the indicators have been heading into healthy territory for some time, but the one that has lagged has been employment growth. That in turn has affected interest rates in the US, since it is an important focus for the Federal Reserve.

However, the latest employment figures are showing something of a turnaround, and this augurs well for consumer confidence. What is less certain is whether some progress can be made on the government deficit.

More importantly for New Zealand’s agricultural exports, world commodity prices are showing some very strong increases. The ANZ World Commodity Price Index, which measures New Zealand’s main export commodities in world prices, increased 1.5 percent in February to be 11.5 percent higher than a year ago, with only beef and lamb showing decreases in world prices. The index is now at its highest since April 1995,

So while the growth rate is expected to slow, it is forecast to “bottom out” at 2.8 percent over the next year or so.

And by 2005/06, thanks to a recovering global economy, and some exchange rate depreciation, which will revive export earnings, growth is predicted to return to an average of 3-3½ percent per annum.

Again, although job creation will ease with the slower rate of GDP growth, it will still be above zero, and the unemployment rate is expected to remain in the 4½ -5 percent range.

Whenever an economy comes off a period of unusually strong and sustained growth there is a danger in becoming obsessed with short term concerns and losing sight of the long term trends and opportunities.

This is a message that many New Zealand businesses understand. For example, over the course of 2003, while business confidence steadily dropped, actual investment by businesses in plant, machinery and equipment went up 11.6 percent. Of that increase, 3.7 percent was in the December quarter, when it was very clear that the high dollar would be hitting the export sector very hard.

Clearly, what is happening is that many businesses are taking the opportunity presented by the high dollar to purchase new machinery. But more broadly what this indicates is a perception of underlying strength in our economic fundamentals. That is why when surveys of business confidence show declining expectations of growth in the economy at large (as is currently the case), they often combine that with relatively high levels of confidence in businesses own activity. In other words, while business people are caught up in a general atmosphere of pessimism, many of them believe they themselves are well placed to ride it out.

Most importantly, government must not lose its nerve and alter fiscal or monetary settings. This is what happened the last time New Zealand had to endure a seriously overvalued dollar in early 1997. On that occasion, the effect was accentuated by the National-led government’s 1996 tax cuts which were more expansionary than had been expected. The only response available to the government was a fiscal contraction that proved to be pro-cyclical, and the result was a sharper contraction in economic activity and a larger jump in unemployment than ought to have been necessary.

This time around I believe the economic management regime we have in place, along with the long-term strategies for investing in New Zealand’s productive base, will stand us in good stead.

There are three elements of the government’s strategy I would like to touch upon:

- Improving the external conditions for trade and investment;

- Investment in long term capacity within the New Zealand economy, in particular around labour productivity and infrastructure; and

- Maintaining a steady macroeconomic ship.

A great deal has been done in the last couple of decades to free up trade and investment flows in New Zealand; but there is still a long way to do.

The most recent advance is the progress towards a free trade agreement with China.

Securing preferential access to China’s economy has the potential to deliver very significant gains to our exporters. China is the fastest growing major economy, currently growing at around 9.1 percent per annum. It is already our fourth largest trading partner taking $1.38 billion of goods and over $1 billion of services. New Zealand exports to China have more than doubled in the past six years.

Our agriculture sector in particular will benefit from an FTA with China. China’s middle class is now estimated to be more than 100 million people and growing. It is also an increasingly urbanised population, with a growing proportion of the Chinese people shifting into the cities, and therefore more accessible to imported consumer goods. This will fuel the demand for New Zealand dairy and agricultural products; but there are also very significant opportunities for our manufacturing sector and services sector, as the Chinese build new infrastructures and seek to acquire more sophisticated technologies.

The agreement to begin negotiations on an FTA will be formalised in June with the signing of a Trade and Economic Cooperation Framework.

There are some compelling reasons to believe that an FTA with China will be agreed relatively quickly. We have a very good relationship with China. China frequently recalls that New Zealand was the first developed country to sign off on terms for China’s accession to the WTO.

New Zealand’s small size, and the fact that we have relatively few areas where tariffs currently operate, offers China an opportunity to take its first steps on an FTA with an OECD economy that would involve a less complex negotiation than it would face with larger developed economy trading partners.

The agreement is also strategically important to New Zealand, in that it would provide us with some insurance against the possibility of a serious collapse in the WTO process. If the current WTO round fails to deliver, one scenario would be the creation of free trade blocks in the Americas, Europe and Asia. An established FTE with China would ensure we are not locked out, if this eventuates.

In the Trans-Tasman relationship, progress towards a single market stalled somewhat in the 1990s, with the missing ingredient being active sponsorship at the highest level. Since my government took office in 1999, making progress on the Trans Tasman relationship has been a particular priority.

In the last few years Peter Costello and I have developed a strong consensus on the benefits to be gained from greater economic integration and the need to clear away obstacles expeditiously. We are convinced that there is untapped value in a single market of some 25 million people. New Zealand businesses will benefit from greater opportunities to sell into the larger Australian market and a freer flow of investment within the trans-Tasman economy as compliance costs and other regulatory barriers are reduced.

We have agreed to meet annually to advance a formal agenda which encompasses business law, taxation and regulation of securities. Some significant steps forward have already been made, and there are more in preparation.

A single economic market across the Tasman is within our grasp and will deliver significant new opportunities for New Zealand businesses, both in terms of export earnings and in terms of investment in both directions.

The government is also active in investing in the long term capacity of the New Zealand economy. We have a particular problem with labour productivity. Indeed, this is the major factor that explains our relatively poor performance amongst OECD nations over the past two decades.

While our performance has been trending upwards since the mid-1990s, it remains at only 1.5 percent productivity growth on average per year over the last 4 years. We continue to lag behind other OECD countries with 2-3 percent productivity growth.

There are two parts to the problem. First, we have a lower level of capital investment per worker. This is something that New Zealand businesses need to address, as part of the process of reorienting our focus towards higher value goods and services, with a larger component of technological innovation.

But of course we need a workforce that is able to master that technology, rather than merely be servants to it. And that is where government starts to play a role, in partnership with industry. The fact is our workforce is on average less skilled than those of Australia, Western Europe, the US and Canada. In particular, we have a shortage of medium level skills.

In the past we have imported these from the UK and the Netherlands. More recently we have found it harder to attract such people in the numbers required. So while immigration will play a role, our education system has to be the major influence. We need to turn the workforce we have now into the workforce we need for the future.

That is what our tertiary education reforms are about. Looking back, the changes to tertiary education in the early 1990s represented a welcome move away from policies which tended to restrict access to higher learning and make it a middle class preserve. However, the belief that market forces would create a better quality system proved to be naïve, as many predicted at the time. Certainly rates of participation were increased; and higher participation amongst Maori and Pacific peoples was an important part of that. But along with an increase in quantity have come serious issues with unnecessary duplication and question marks over the outcomes for many students. Quantity did not necessarily bring quality in its wake.

Recently the Ministry of Education released figures which showed that only 40 percent of domestic students starting a qualification in 1998 had completed it after five years. Fifty-one percent of those who started a qualification in 1998 had left without completing it five years later, and nine percent were still studying towards it five years later. Even allowing for part-time study and legitimate reasons for abandoning study – such as gaining employment – this is a worrying statistic.

Certainly I would not dispute the fact that many young people in particular ‘find themselves’ in the course of tertiary study, and this can lead to a change in direction. However, in the recent past our system appears to have lost a significant number of people, who have drawn down an entitlement to EFTS funding and more than likely put themselves into debt, and now, it seems, have nothing to show for their efforts, or only ambiguous results.

In a country our size, we can’t afford to have large numbers of people effectively cooling their heels in the tertiary education system.

While we recognise the importance of a broad and liberal education for young New Zealanders, we believe that outcomes can be enhanced by more explicit links between education and industry.

For example, we have placed a high priority on industry training, and adopted a target of getting 150,000 New Zealanders learning on the job by the end of 2005. As a result the number of workers participating in industry training jumped by nearly 20,000 last year to a new record high.

Total numbers in industry training during 2003 reached just under 127,000 trainees, a 19 percent increase on the number participating during 2002, and a 56 percent increase over the number in late 1999. The number of employers involved in the industry training programme also increased substantially, with around 29,000 firms now on board (up from around 25,000 in 2002).

On the basis of these results, our target should be achieved.

At a more general level, the reforms require tertiary education providers to develop detailed charters and profiles that demonstrate, among other things, that they are actively working with their local business communities seeking ways of collaborating that are mutually beneficial and generate positive spinoffs for students. Many institutions have been doing this for many years, but the reforms encourage a more consistent and disciplined approach to integrating the work of a tertiary institution with the needs and priorities of the businesses and communities around them.

We are starting to see some very innovative partnerships between tertiary institutions and business. Some are focussed on research and development, and on providing a stronger commercial edge to research programmes. Others involve local governments as partners and are focussed on building stronger clusters of businesses in areas which have been relatively depressed in the past.

The other crucial area in which government is investing is improving our infrastructure, the collection of structures and systems that underpin our quality of life and our ability to do business.

I would like to say that we are making good progress on all fronts. However, there are some fairly intractable problems which require sustained effort over a long period. The truth is we underinvested in infrastructure in the 1990s, and turning that around is no easy task.

First of all, it can be fiendishly expensive. Secondly, even when finances have been secured, it is important to undertake careful planning to ensure that our proposed solutions are both technically sound and socially responsible. (In this regard, we should not rush to pass judgement on the RMA. What finally led to the abandonment of the Aqua Project, for example, was a series of geotechnical reports which demonstrated that the project was likely to be uneconomical. We should be thankful that we did not rush ahead with the investment, as some have suggested.) And thirdly, there are very real constraints to construction timetables, such that, even with all other obstacles cleared away, we are talking in terms of decades rather than years.

However, there is progress to report. One example that will affect the Waikato is the recent confirmation of a $1.62 billion investment in Auckland's transport system. For too long, confused and inefficient lines of responsibility have inhibited Auckland's transport development and the establishment of a single 'business-like' transport organisation for the Auckland region. The package delivers an unparalleled, long-term investment by central government, and a clear, fair solution.

This is part of a larger transport package addressing both Auckland’s problems and also some of the other key transport bottlenecks elsewhere in the country.

It should be the watershed event that Auckland needs. Providing regional and territorial authorities in Auckland continue to meet their responsibilities for transport funding, Aucklanders will finally see the steady development of a world class, well integrated transport system.

Finally, underpinning our efforts to support long term growth in the New Zealand economy is a stable fiscal and monetary policy. It is easy to forget this, and easy for governments to undermine their good work in other areas by unsustainable spending or equally by unsustainable tax cuts.

We currently enjoy a Standard and Poors credit rating for local currency of AAA/Stable/A-1+. That reflects, among other things, the Fiscal Responsibility Act which requires the government to plan for the longer term when setting fiscal policy, and the fact that government debt and spending, as a proportion of GDP, are low by OECD standards.

Indeed core government operating spending was 32.4 percent of GDP in the 2002/03 fiscal year and is forecast to decline further to 30.8 percent by the end of the current year. Sovereign-issued gross debt was 28.0 percent in 2002/03, and is forecast to decline to 25.3 percent in 2003/04. This is the lowest it has been since the mid 1970s.

These gains are hard won and should not be frittered away. National risked doing this with their 1996 tax cuts which weakened the government’s finances at a time when the dollar was overvalued and export earnings under severe pressure. This time round we have made sure that we have sufficient headroom to provide ourselves with options in the upcoming budget.

So, in spite of the downturn in our export sector, I believe that we are more robust now than we were in the 1990s. We have the conditions in this country to return to strong growth and to sustain that growth into the long term.

Thank you.

ENDS