Cullen speech to the Institute of Directors, AucklandFinance
Tuesday 10 December 2002Speech Notes
Embargoed until: 9.45pmAddress to Institute of Directors Auckland Branch Dinner
Thank you for your welcome, and may I also congratulate the recipients of the Distinguished Fellow Awards. It is true of business as of any other human endeavour that we stand on the shoulders of the giants, and that we often do not pay sufficient homage to those who have laboured to create what we now take for granted.
This is a useful stepping off point for what I want to say tonight about the challenges that are ahead of us in 2003; challenges that business leaders and political leaders must face head on.
It is said that the good is often the enemy of the best. The task of leadership involves sifting through a range of options, all of which have some appeal, make some people happy, and promise to impact positively on some indicator or other. Of course, these options often have hidden costs or add to future risks. Choosing the best option out of a range of arguably good ones is never an easy task.
It is here that a breadth of vision and a long-term perspective becomes essential. This is where we look to an experienced Board to provide leadership, and – in the context of economic management – this is the standard we must apply to political decision making on matters that affect the economy.
During my time as Minister of Finance I have been frequently accused of long-termism. I am happy to be found guilty of this.
As the year draws to a close, I would like to reflect on the implications of a long-term focus for economic policy, considering in turn the strategy for economic growth, long-term fiscal management, and the long-term deepening of our capital markets.
During this year our economy has managed to sidestep the worst effects of global turbulence post-September 11. The flow-through effects of high export prices and volumes have sustained an exceptionally strong level of economic activity in the first half of the year.
Indeed, the recent OECD report put the annualised growth rate for the period at more than 4.5 percent. This is the growth rate that, if sustained over a 5 to 10 year period, would more than likely return New Zealand to the top half of the OECD.
However, there are some potholes in the road ahead, and we will need to keep a firm grip on the steering wheel. Export prices have already declined, with dairy being particularly hard hit. The exchange rate provided a temporary cushion by staying below its long-run trend; but that effect is now diminishing. Consumption growth is projected to slow significantly in the current quarter.
Moreover, the cold spring weather in the South Island, and some localised catastrophic weather events in the Hawkes Bay and Nelson/Marlborough, suggest a lean year ahead for some parts of the primary sector. The benefits to the Auckland economy of the America’s Cup regatta will also come to an end early next year.
Meanwhile, we cannot expect any immediate help from the global economy, which faces the challenges of sluggish performance in the US and parts of Asia, and of course the uncertainty of the situation in Iraq and the threat of destabilisation by international terrorism.
Nevertheless, the rough patch in the road is likely to be relatively short. Forecasters are predicting that our export volumes will follow the global trade cycle and pick up towards the middle of 2003. GDP should also follow this pattern, slackening in the second half of 2002, and opening up some excess supply. This will set the scene for the re-establishment of robust, and non-inflationary, growth in mid to late 2003.
This is reflected in the latest National Bank Outlook which shows business confidence improving for a fourth consecutive month. The headline confidence figure is now up to 0.1 percent negative. I am convinced that before Christmas we can find the one more optimist we need to put us into plus territory.
I was especially encouraged by the all-important own activity index, where there has been an 8 point jump from last month to net 31 percent positive. The rebound is echoed in a strong increase in profit expectations over the same period, while other indicators – such as investment and employment – remain buoyant.
A robust medium term outlook is a helpful platform for working towards expanding our long term economic capacity. The Government’s growth strategy is aimed at that longer timeframe, and is about increasing our capacity for growth and innovation. We are still a small and geographically isolated nation attempting to box above its weight.
Therefore our vision has to involve achieving by intelligence, innovation and coordination what other economies achieve by virtue of their size, concentration and proximity to markets. This means:
vAttracting and keeping a highly skilled labour force;
vEarning a greater proportion of our income through our intellectual property;
vUsing high-speed internet technology to make our exporters ‘virtually’ present to their markets;
vFinding ways of overcoming the 'thinning' of our capital markets;
vStimulating an entrepreneurial ‘infrastructure’ connecting ideas and innovations with structures and processes that will grow them into successful businesses; and
vStreamlining our regulatory processes, without losing sight of their function.
Clearly this has to be a joint effort between business and government, both central and local. I believe that in the last three years we have won the intellectual debate on the question of the legitimate role of government in nurturing economic growth. Prudent fiscal management and monetary policy settings aimed at low inflation are necessary, but not sufficient, conditions for growth. I do not think there is any further argument to be had over whether Government also has a role in improving coordination amongst the productive sector and in making strategic investments in skills and public infrastructure. It does have a role to play, although how that is played out in detail is a matter for experimentation, debate and refinement.
The key planks of our growth strategy remain the same:
1.Partnerships with business in the key areas of biotechnology, information and communications technology and creative industries, aimed at better coordination and the attraction of investment capital into those sectors;
2.A skills strategy based on a better focussed tertiary education system that is responsive to the skill requirements of New Zealand businesses;
3.A complementary immigration policy, aimed at attracting skilled migrants with the ability to fill the immediate and longer term skill gaps;
4.Investment in infrastructure – in particular in the area of roading – as one of the essential pillars of productivity growth;
5.Investment in those public services – health care, education, policing, environmental protection and others – which make New Zealand an attractive place for people with skills and ideas to live; and
6.Promoting free trade amongst our major trading partners.
2003 should see advances on all these fronts, all of them aimed at securing the conditions for long term sustainable growth.
Turning to the question of the government’s financial management, this year’s Budget announced a very important shift in our long term fiscal objectives. Sadly, the shift has not received the attention it deserves. Up until Budget 2002, fiscal objectives had focussed almost exclusively on the operating balance. We can, of course, run slightly larger or small surpluses, or even dip into the red from time to time without having any material impact on the financial health of the government.
What really matters is that when our debts fall due, we can refinance them. That is the real bottom line. It wasn’t an operating deficit that provoked the financial crises in Argentina, Poland, Mexico et al during the last twenty years. It was when they couldn’t refinance their debts that the bailiffs knocked on the door.
At one level, if the operating balance is positive, debt should not rise, so a focus on the operating balance might be sufficient. This is only true if we assess fiscal pressures over the short term. If we take a longer term view, we must acknowledge that – in strictly fiscal terms – the population structure will turn for the worse. The working age population will shrink relative to the retired population, a demographic shift that will be difficult to manage economically and socially unless we have reserves to draw upon and increases in the productivity of our workforce. Hence we must start to invest to anticipate and partially pre-fund that demographic transition.
In the longer term, we also need to spend on capital to keep our asset base robust, relevant and reliable. This is not only roads. It also means modernising schools and hospitals, re-equipping the defence forces, having sufficient electricity generating and transmission capacity to keep the lights on and so forth.
Operating revenue must cover operating expense on average, over the business cycle, but it also needs to make some contribution to meeting our capital spend and leave enough left over to partially pre-fund the demographic change.
It was this realisation that led us to make debt the primary focus of our long-term fiscal objectives. There is no rocket science here. It is a judgement call as to what level of debt is sustainable in the longer term. We have put a stake in the ground at around 30 percent of GDP on average, over the business cycle as a prudent long term goal.
We are committed to managing operating expenditure, Superannuation Fund transfers and our investment programme (whether funded by capital spending or borrowing) so that overall debt remains on track to meeting that long term 30 percent target.
That is a quantum leap away from the annual obsession with the operating balance. Managing for the longer term does, though, raises big issues when short term trends deviate from the long term goal. It is clear from the periodic reports on the Crown’s finances that revenue receipts are running well ahead of those forecast at the time of the May Budget. Under these conditions (and all other things being equal) debt would be lower than forecast. The exact extent of the revision to forecast will be revealed when the Budget Policy Statement is published on 19 December.
This raises the question of what a government that manages to the longer term should do when the numbers look a lot better than forecast. The answer is that it responds as any large and complex business would respond: with caution. Past experience suggests that a number of things can happen. Some of the revenue boost may turn out to be associated with timing: taxpayers paying early to avoid penalty interest. These early payments will reverse out in due course. Equally, some of the forecasts – especially in the outyears – may overstate emerging surpluses as a result of the technical assumptions that are used in making them. Some of the extra money may be a result of cyclical factors: at the end of a longish period of economic expansion the public finances are better than average. And some may reflect structural changes. It may just be possible that we are starting to see a lift in the trend rate of economic growth.
To be frank, at this point in time, we simply do not know what is driving the numbers. We do know that relatively small, but strategic, changes in underlying economic conditions – the exchange rate, commodity prices, trade flows, immigration etc – can have both large and rapid impacts on the revenue. Caution advises that we should keep some fiscal insurance in place during these times of intense global uncertainty. Caution also advises that, at this early stage, we should respond very carefully to any indication that the extra revenue may be of a more permanent or structural type. It is simply too early to move with confidence to a substantially higher spending track, because our experience is that these structural shifts in spending are very difficult to claw back if later evidence suggests that we need to.
What I can say with confidence is that we must avoid the temptation to spend the cyclical element of emerging surpluses. In the 1990s, fiscal policy was decidedly pro-cyclical. The government of the day tended to dissipate emerging fiscal surpluses through tax cuts. This gave a short term stimulus to activity, eventually requiring the Reserve Bank to apply the monetary brakes. When drought and the Asian crisis slowed the economy and the revenue flow, the response was to cut spending, thereby deepening the contraction.
In 2000, the new government made it clear that it was abandoning this approach. It declared an intention to look through the economic cycle and to allow the economic stabilisers to work. It is absolutely essential, both for the sake of sound fiscal management and for establishing credibility, that they be allowed to work on the upside, not only on the downside. In fact it is probably fortuitous that the first time we really let the economic stabilisers work, it is in good times rather than bad.
Fiscal cynics would say that everybody wants the fiscal stabilisers to work – but only during depressions! We want the best of both worlds: to go to the well in a drought, and also to draw off surplus water in the wet years. Fiscally, if we allow the balance to automatically contract when the economy does, to moderate the contraction, but do not bank the surpluses in an expansion, debt simply ratchets up. Banking fiscal windfalls will be a big test of the political will of this government.
We are also managing to the longer term with Crown financial assets. The government does have large financial portfolios in the Government Superannuation Fund and Natural Disaster Fund. Both are around the $3.5 billion mark. The New Zealand Superannuation Fund will have around $2 billion in it by the end of this financial year, rising by about that amount each year after that for some considerable time.
It is important that these funds are managed well, to maximise the returns we get from them, subject to the appropriate spread of risk. The overwhelming evidence of history is that a better return, with very limited risk, comes from a diversified fund, with a mix of bonds and equities, foreign and domestic. That is why we have made the decision to diversify the Crown financial portfolio, with the diversification overseen by experienced professionals, not politicians.
In such a fund, there will be good years and bad years, and different parts of the portfolio will experience different rates of return in any year. These funds are there for the long term. The NDF is there to cover some of the costs of a natural disaster. We don’t know when it will be needed. We do know that the GSF will be drawn down over many decades. We have actually passed a law stopping any withdrawals from the NZSF before 2020.
All of these funds are managed in terms of detailed statements of investment principles and policies, and they are reviewed annually. It is legitimate to question the judgement behind the principles and policies and the asset allocations that have been developed as a result. That is informed debate around long term objectives.
It is ludicrous to judge the financial performance of only parts of the portfolio of the funds, over periods as short as three months. And yet try as we may to lift discussion to a more rational plane, that is precisely where it is conducted in the political and popular media arenas.
If I could turn this around and look at some criticism that I hear from time to time, it is also important to take the longer term view of the impact of diversification of these funds on New Zealand capital markets. I hear suggestions that all, or a very large portion of these funds should be locked in to domestic securities.
I must stress that the primary purpose of diversification is to get the best return on our assets, consistent with a prudent management of risk. However, I have always thought that an inevitable and welcome by-product of diversification is that it will deepen our capital markets.
This will happen over time. It is the long term impact that we must focus on. There will be limits to the amount and pace of what our capital markets can absorb without creating an asset bubble. Each fund will make its own asset allocation decisions, and these will change over time as investment performance is reviewed. As an example, though, consider the GSF. It has set a long-term target of having 14 percent of its assets in New Zealand bonds and one eighth of its portfolio in New Zealand equities. That is over $400 million of new equity into our stock market. If the NZSF follows a similar asset allocation, new equity of around $250 million will be injected each year. So there will be a not inconsiderable deepening of our capital markets, but as always, we need to keep the focus on the longer term.
As John Maynard Keynes pointed out, “in the long-run we are all dead”. As with many of the great axioms of economics, Keynes’ statement is self-evidently true. However, it should not be taken as an encouragement to take a short term approach to encouraging economic growth or to managing public finances. Prior to our own long-run demise we of the baby-boom generation hope to enjoy a lengthy and comfortably Keynesian retirement. To achieve that we need to plan for the long term, both individually and collectively.
Moreover, although we will be gone in the long-run, our children will still be here. They will be living with the legacy of today’s economic leadership, and I would hope that that legacy would comprise a strong capital base and healthy skills-based industries. I would hope that their judgement will be that we served their long term interests in a distinguished manner.