Chapter of TRANSFORMING NEW ZEALAND. This is a draft. Comments welcome.
Keywords: Globalisation & Trade;
Michael Porter’s theory of competitive advantage emphasises that ‘firms, not nations, compete in international markets’ even though it recognises that nations have a role in fostering successful businesses (p.33). Thus the focus on exporting has to be on the businesses involved.
What determines a successful exporter? The list is long and includes the right product, advanced and advancing technologies, a capable work force, effective marketing and distribution, entrepreneurial initiative, good fortune … However, the single most important requirement is medium term profitability, for if the business is not getting enough revenue to pays for its inputs and its debt servicing, it will eventually go bankrupt.
This is a pretty obvious characteristic of a market economy, although curiously it plays little role in economic analyses, relegated to a mumble about factor returns, and rarely directly measured (because it is hard to do so for the rigorous economic concept). As a result, little consideration is given to what determines the profitability of an export business and, consequently, how economic policy can impact on its success or failure. The experience of the Fortex company illustrates the issue.
The Fortex Fiasco
The meat processor, Fortex, was formed in 1985 from three smaller firms, with a commitment to add value to 90 percent of the carcase, whereas most processors of the day were adding only 30 percent. It was a heroic vision, enthusiastically – if uncritically – endorsed in the business press, and for which the company received a number of prestigious awards. (Among the idealisations of it performance, was those by parliamentarians who justified the Employments Contract Act on the basis it would allow every business to have Fortex-like labour relations. After the company’s collapse it turned out that Fortex was a high cost producer compared to the other industry businesses. The parliamentarians did not revoke the statute on learning their arguments were wrong.)
Yet in February 1994, the receiver was called in. Apparently there were $90m of assets but $160m of liabilities. Some 1800 workers lost their jobs. Farmers, contractors creditors, and investors lost money.
It turned out that since 1988 the company had been entering loans as incomes in it accounts. This inflation of revenue disguised that it was often making losses when it reported profits. Even so, immediately after the collapse, Canterbury University accountant, Alan Robb, showed the pre-crash (but fraudulent accounts) reported cumulative operating cash flow (after interest and dividends) had sunk $40m between 1989 and 1993, which should have been an early warning to anyone who had cared to do the sums.
In 1996, the company’s managing director and its general manager were jailed for ten and a half years between them for misleading accounting. (There were no allegations of misappropriation of funds in their personal interests. This fraud was on a different planet to Enron’s.)
It is a sad story: for many individuals it involved heartbreak. The economic lesson is that Fortex’s enthusiasm for innovation and value-adding overrode the financial discipline of the market. The effect of the accounting deceptions was to understate the company deficit, keeping the company in business for longer than was financially justified. But, importantly, as Robb’s calculations showed, even had there been no financial deception, the company was doomed.
The fact is that Fortex could not make enough profit from the adding of to 90 plus percent of its carcasses. The conventional companies only processed what was profitable – 30 percent – and survived. Fortex in its vision and enthusiasm (and its advanced technology) was processing past that point of profitability. What could have made the processing more profitable for Fortex, or induced the other companies to do more value-adding? Since profits are (roughly) the difference between revenue and outlays, either the first is too low or the second too high.
Now Fortex did have higher costs than the industry average, although not enough to bankrupt the company as quickly as occurred. Its fundamental problem was that its revenue was too low. Most of its revenue came offshore, so we can trace how it happened.
Fortex was selling in foreign markets where, broadly, the foreign currency price was being set by the domestic producers in the export destination, who bought the carcases (possibly from another New Zealand meat processing company) and processed them locally. Fortex’s revenue, and hence for a particular cost structure the determinants of its profitability, was the foreign currency revenue converted into New Zealand dollars. If the exchange rate was low then the company received many New Zealand dollars, and there was a surplus over its costs. If the exchange rate was high, the company received fewer New Zealand dollars. In Fortex’s case they were insufficient to cover the costs the company was incurring.
As we shall see, Fortex embarked on its high value added strategy, when the exchange rate was high,. Hence its crash, despite fraudulent accounting to hide part of the deficit.
If an unfavourable exchange rate signals against value-added exporting, and high interest rates signal against expanding, then a business must respect the signals. If it does not, eventually and inevitably the company will be bankrupted. The fraud at Fortex obscured and prolonged the dire state the company was in, rather than caused it. Value added exporting was not viable when the macroeconomic settings are hostile.
Exporting and the Exchange Rate
The illustration of an exporter like Fortex shows that its profitability was determined by the ratio of its production costs to the costs of its foreign competitors, measured in the same currency units. This is called the ‘real exchange’ rate in contrast to the ratio of the value of the two currencies, which is the ‘nominal exchange rate’. Most of the public discussion is about the nominal exchange rate, because it is easier to measure. However for the exporter or importer it is only part of the totality. (For instance when New Zealand switched to decimal currency in 1967, the nominal exchange rate changed but the real exchange rate remained the same.)
The formula of the definition is
The real exchange rate =
(the nominal exchange rate) X (the cost of production in New Zealand in NZ currency) /(the cost of production in the Export Market in local currency)
the nominal exchange rate =
(the value of the export market currency)/(the value of the NZ currency)
What the formula in the box says is that
The real exchange rate is HIGHER when
New Zealand production costs are HIGHER
Export market production costs are LOWER
The nominal exchange rate is HIGHER.
Under simple mathematical assumptions an increase (or an decrease) in the real exchange rate leads to a decrease (or an increase) in the exporter’s profitability. (The world is never as simple, but the model’s simplicity capture a powerful truth about the actual world.) Thus
Since when the real exchange rate is HIGHER,
The exporter’s profitability is LOWER, so
The exporter’s profitability is LOWER when
– New Zealand production costs are HIGHER
– Export market production costs are LOWER
– The nominal exchange rate is HIGHER.
The first two are obvious enough, but the third is crucial. Other things being equal the higher the exchange rate, the less profitable is exporting. As we saw with meat processing, a high exchange rate limits the ability of the industry to value add. That is equally true for other exporters not only in the value adding activities, but other exporting including commodity exporting. A high exchange rate eventually reduces the return to meat producing farmers (and dairy farmers, plantation owners, and so on).
Moreover profitability not only affects the cash flow of each business, but it affects the ability of a business to expand. Firms wont invest if there is no promise of cash flow to service their borrowings and provide a return for their own investment and some cover for the risk. Past cash flows are one of the sources of investment funds, either directly through retained earnings, or indirectly in that it provides external investors with evidence of the soundness of the enterprise.
Thus the real exchange rate, by being a major determinant of the profitability, is also a major determinant of the growth of the tradeable sector. The lower the real exchange rate, the faster the sector can grow. Since the growth of the tradeable sector is a major determinant of the overall growth rate in a small open economy, the real exchange rate is a major determinant of the growth rate of the economy.
How Low a Real Exchange Rate?
The logic of the previous section might suggest to have as low a real exchange rate as possible, since that will maximise the economic growth rate. The option is usually dismissed on the basis that competitive devaluations are self-defeating, as other countries will follow. But this reaction is not inevitable for a small economy such as New Zealand, since few economies would bother to follow it down – perhaps only some Pacific Islands. (We have yet another example of the uncritical adopting the US as the policy model, for competitive devaluations are a real policy reaction to it deliberately devaluing.)
However there is a practical reason why a country does not pursue an excessively low real exchange rate. (Fundamentally it is really about economic growth not necessarily being the same as public welfare.) Suppose the real exchange rate was cut by reducing wages. (Alternately the country might reduce its nominal exchange rate, which would increase the cost of imported goods, so the prices facing workers would go up. In effect their effective spending power (real wages) would be reduced, just as if they took a (nominal) wage cut.) That would reduce domestic production costs, and stimulate exporting because expanding production and selling overseas would be so profitable. Import competing businesses would also find it easier to survive against their overseas competitors.
In this scenario the workers would experience an immediate cut in their standard of living, with the prospect of a gain at some later stage as the economy grew faster. Whether they would be willing to accept this tradeoff depends upon the exact parameters (there is some discussion of them below) and their trust that the strategy would work, and whether they would be beneficiaries of it.
The strategy will only work if the workers remain. Many New Zealanders – especially skilled ones – have the option of migrating to where wages are higher. Others might not bother to return from OE. Additionally, poorly paid workers tend to be sicker, have higher absenteeism, less incentive to work smart, and less incentive to upgrade their skills. The quality of the workforce would deteriorate, offsetting some of the gains from the lower real exchange rates. The danger then, is a low real exchange rate strategy could be self defeating, as it locks the economy into a low wage development path, perhaps dependent upon exporting general manufactures – in competition with East Asia.
There is also a practical limit to how low the real exchange rate can go, set by the capacity of the economy to produce. At full employment any reductions in the real exchange rate cannot lead to more exports, because there can be no additional production.
In summary there is a limit to reducing the real exchange rate to stimulate exports, set by the economy’s ability to produce, and by the capacity of the workforce and other factors to take an immediate cut in its remuneration.
Does the opposite of hiking the real exchange rate to a very high level make sense? This could be brought about by a higher nominal wages and a high nominal exchange rate. The workforce would now be better remunerated, but exporting and import competing firms would find their cash flow undermined. They would stop expanding and eventually lay off workers, so unemployment would rise.
This happened after 1985, when the exchange rate was at a high level as a part of the anti-inflation strategy (discussed below). The difficult situation facing most tradeable business was compounded by the removal of protection from imports and the withdrawal of subsidies. Exports slowed (part of the small expansion was various commodities – such as kiwifruit – coming into production following investment occurring before 1985); imports boomed; GDP stagnated; unemployment rose; and New Zealand per capita GDP fell fifteen percent behind the OECD average in less than a decade.
Now of course, as we saw with the Fortex example, there are some export businesses which survive at the higher exchange rate. Typically they are commodity producers with only a little value added processing, or general manufacturers to Australia where New Zealand wages make them competitive (and where CER still gives preferential access against alternative export sources). At some stage the tradeable sector will downsize to businesses which are viable at the particular exchange rate, and the economy will begin to expand again – as happened in about 1993 – probably at the same growth rate as the rest of the OECD.
Thus the economy behaved exactly as the analysis would predict.
Why did economists pursue what even at the time was obviously a growth inhibiting strategy. To understand this we need to understand how economic policy influences the exchange rate.
Monetary Policy and the Real Exchange Rate
By the late 1980s, there evolved the view that the Reserve Bank operational independence over monetary policy although the objectives of monetary policy were set generally in statute as ‘price stability’, and practically by the Minister of Finance as that the consumer price inflation should lie within a particular ‘band’. (The range shifted from 0 to 2 percent p.a. to 1 to 3 percent p.a. over the decade). The approach was justified by a mixture of wanting to minimise political meddling in monetary policy (a response to the style of Robert Muldoon), and a particular theory of the how monetary policy worked. Unfortunately the theory was based on a model of a closed economy for which economic growth was not a major preoccupation. Regrettably it has given little attention to monetary policy in an open economy.
It did work. Initially, in the 1980s, there was a rapid reduction in the rate of inflation (disinflation). Subsequently, in the 1990s, the New Zealand inflation rate stayed broadly within the bands throughout the period (although it must be said that the 1990s was a period of low inflation in the OECD). However it worked in a different way from what the theory of the closed economy said, and what the Reserve Bank said. The consequence was that economic growth has been inhibited.
The theory focusses on the inflation caused by shortages in the domestic economy. For instance, if workers are scarce, businesses are likely to pay higher wages to attract the workers they need. The bidding will push up wage costs, and that will feed into inflation. The Reserve Bank cannot investigate the pressure in every market, so it looks at the aggregate output gap in the economy and behaviour in some key sectors – the Auckland housing market is a favourite. If it thinks the gap is narrowing so the economy is ‘over-heating’, that is inflation inducing scarcities are beginning to happen, the Reserve Bank tries to restrain the economy by raising interest rates. The intention is that as borrowing gets more expensive, consumers will buy less, and businesses invest less, so there will be less expenditure in the economy, less production, less potential for shortages, and less inflationary pressures.
This ‘circuit’ is entirely characterised by domestic activity, as if the economy is closed to the rest of the world. However there is also an external circuit, and a faster acting one in a floating exchange rate regime such as New Zealand’s. As interest rates rise, investing in the New Zealand dollars becomes more attractive to foreigners. The effect of foreign investors being attracted to invest into high returning New Zealand financial securities, is that the nominal exchange rate rises.
(Many readers will skip thorough this paragraph but the circuit works this way. Convert foreign currencies into New Zealand currencies, involves finding someone who wants to transact in the opposite direction, converting New Zealand dollars into the foreign currency. Usually New Zealanders obtain foreign currency by finding an exporter who want to transfer their export receipts into the home currency to pay for their domestic inputs and investors. With investors also offering to sell, the price of the transaction will be depressed from the perspective of the foreign currency suppliers, and so the nominal exchange rate will rise.)
That is great as an anti-inflationary mechanism because the higher nominal exchange rate reduces the price level as measured by the consumer price index. Over 40 percent of the basket of consumption goods which makes up the regimen of the Consumer Price Index are imports. So a hike in the nominal exchange rate, reduces the price of imports which feeds through into lower consumer prices. The Reserve Bank would deny that it consciously hikes the nominal exchange rate. It says, rightly, that it does not set the exchange rate, as it would for a fixed exchange rate. But undoubtedly its interest rate settings influence the exchange rate. Of all the policy instruments available to the government, the Reserve Bank’s interest rate settings have the greatest short term influence. Moreover the circuit works far faster on the price level than the domestic circuit through inhibiting expenditure. Whatever the Bank says, it is a beneficiary of a high nominal exchange rate, and there has to be a tendency in its policy to favour policies which influence that outcome.
Unfortunately a rise in the nominal exchange rate raises the real exchange rate. (Follow the equations in the previous section.) So the faster, more certain, and more effective anti-inflationary mechanism at the Reserve Bank’s disposal reduces the profitability of the tradeable sector, and thereby the growth rate of the economy.
The Reserve Bank does not seem to have any specific view of the growth rate of the New Zealand economy. The model it adopted to underpin its operational settings was of a closed static economy. (It is perhaps a miracle that there has been any growth at all.) However there is an implicit growth rate it calculates the output gap of the economy, which amounts to an average of the growth rate in the recent past (which, note, has been inhibited by the Reserve Bank’s high exchange rate outcomes).
Clearly then, accelerating the economic growth rate requires the Reserve Bank to use a more sophisticated theory in implementing its monetary operations. However it cannot do it by itself. Fiscal policy also has a role.
Fiscal Policy and the Real Exchange Rate
For much of the late 1980s and the 1990s aggregate fiscal policy, the use of net government spending to contribute to the management of aggregate demand in the economy was considered irrelevant. Instead the government was expected to run a budget surplus to reduce government debt, and when that was low enough to mechanistically ‘balance the books’ with neither a deficit nor a surplus. In recent years, the fiscal policy stance has swung back to the more orthodox view of it having a role in aggregate demand management. In particular if there is a major depression, the government account will be allowed to go into deficit. One of the reasons for running a budget surplus at the moment is to reduce government debt, so the depression deficit is easier to manage, just as a family builds up a nest egg for a rainy day.
However this section is concerned with the different, although not unrelated, issue of aggregate fiscal policy as a part of a growth strategy and, consequentially, the need to coordinate it with monetary policy. The microeconomics of fiscal policy, individual government taxes and spending, is the topic of a later chapter. This one is concerned only with the aggregate impact, summarised by the size of the budget deficit or surplus.
There is a widely helped view which argues that the fiscal stance should be as expansionary as possible, with a large fiscal deficit. This would result in the unemployed resources (such as labour) being used for production, and give business the incentive and confidence to invest and expand. Such ‘expansionism’ comes from a simple reading of Keynes’ theory, and may be very appropriate in a severe depression. However the standard model used to justify it involves a closed economy – or a semi-closed one like the US where the external sector is a relatively small part of the economy, and yet there are strong feedbacks from its importing, through the other economies that are stimulated, to importing. Aggregate fiscal policy in a small open economy such as New Zealand has to be thought about in a quite different way.
Practically, the problem is that an expansionist stance blows out through the sucking in of imports for production and consumption, and the inability to be able to obtain the foreign exchange for paying them. (The complications of using quantitative import controls to prevent the blow-out, need not detain us, except to note that while they may restrain consumption of imports, producers also need imported inputs, so at best the controls slow down, rather than prevent, the foreign exchange blow-out. Note that expansionist policies are more likely to generate inflation. That is true for closed economy expansionism too, although there are differences in the precise inflationary mechanisms.)
If the government is running a budget deficit it is absorbing national savings, if it is running a surplus it is contributing to national savings. Those savings are used for investment. In a closed economy national savings exactly equals national investment, an identity which has a crucial role in the Keynesian theory of a closed economy. However an open economy, may borrow or invest outside, to make up the difference between national savings and investment. New Zealand is usually a net borrower, that is the economy wants to invest more than the savings which are available. The foreign borrowing appears as a deficit in the nation’s current account, which is not the same thing as a deficit in the government’s accounts. (We make the distinction by calling the current account of the nation which includes the actions of private entities such as businesses and households, the ‘external’ account, and the current account of the government as the ‘internal’ account.)
Suppose the government increases its (i.e. the internal) deficit by reducing taxes. (The effect of increasing its spending gives broadly the same outcome.) With more cash in hand, because their after-tax income is higher, individuals will increase their spending, some of it being outlays on imports, so there will be an increase in the external deficit too. The increase will not be the same, because individuals will not spend all the extra income they receive from the tax cut and the subsequent increase in economic activity, but they will save some. Even so there is a direct connection between the internal and external deficits.
What does a larger external deficit mean? That means more borrowing from foreigners, which drives up the nominal exchange rate, just as we described in the previous section. Thus the higher internal deficit not only does nothing to contribute to export expansion, but it inhibits it. By doing so it inhibits economic growth in the long run.
Practically, New Zealand has a private sector which does not save sufficiently to fund all its investments, and which does not save a lot out of any additional income. Compared to what New Zealanders want, private savings are too low on average and on the margin. The New Zealand government has to offset that deficiency by being a high saver itself. Thus it needs to run a budget (i.e. internal) surplus in normal circumstances.
That is a very painful decision. There are understandable political demands to spend any surplus on urgent issues of concern to the public (health, education, the environment, culture and leisure) or to increase individual’s spending power with tax cuts or increases social benefits. In the short run that generates a surge in economic production and a general feeling of prosperity. But soon the economy experiences undue inflationary pressures and, if it is an open one, the import suck which begins to compromise the balance of payments or drive up the exchange rate.
At this point, the Reserve Bank will step in, and boost interest rates to ease the inflationary pressures., further raising the exchange rate, inhibiting exporting and undermining the growth potential of the economy. One implication is that monetary and fiscal policy need to be coordinated, rather than operated independently. (In the past, the Governor has been more willing to talk of about social security and education than about aggregate fiscal policy.)
A second implication is that an internal surplus means interest rates can be lower (all other things equal). An internal deficit involves the government unloading its debt (government stock) into the financial markets. The more there is the more investors will demand a higher interest rate to take on the additional stock to their portfolio. However in a small open economy such as New Zealand this effect seems smaller than the impact on the exchange rate.
Of course the government should manage its fiscal stance to maximise the utilisation of productive capacity. What we learn here is it has to trade off its ability to stimulate domestic demand against inhibiting exporting via the pressure on the exchange rate, and hence slowing down the prospect of economic growth in the long run. In my view it should aim for an exchange rate which maximises the growth of high productivity exports (values added and intra-industry-trade type products). Identifying the right macro-economic settings is not easy, but it gives the prospects of a high quality sustainable economic performance.
The remainder of this book assume that the macro-economic settings are to maximise this growth rate. But can we tweak the rate by better microeconomic settings?