Chapter of TRANSFORMING NEW ZEALAND. This is a draft. Comments welcome.
Keywords: Growth & Innovation; Globalisation & Trade;
The export sectors have a key role in the growth of a small open multi-sectoral economy. They can expand faster than the world economy as a whole, and drag the domestic economy along with them, accelerating its growth rate. However there are different sorts of exports, not all of which can be accelerated.
The Resource Based Commodity Export Sector
Historically New Zealand’s export growth has been dependent upon the growth of commodity exports based on sophisticated (technologically innovative) production processes which utilise resources. The most prominent commodity exports have been pastoral exports – wool, meat and dairy products – but in the last quarter of a century they have been joined by horticultural products, forest products, fish, and some energy and petrochemical related products. The diversification is welcome but this group, which makes up over 60 percent of merchandise exports (i.e. excluding service exports), suffers from two major weaknesses.
On the supply-side, commodity growth is usually constrained by some physical or biological limitation. Admittedly there are increasingly technologies which lift, for example, the rate of reproduction of sheep, but the availability of grass limits the amount of meat that can be produced. Meanwhile exports from petrochemicals from the Maui gas-field will phase out. The future jewel among the resource based is the so-called ‘wall of wood’, as the planted radiata pine forests double their production every 7(?) years through to 2025. But that is the result of plantings in the past. So the sustainable maximum rate cannot be changed for about 25 years when today’s plantings come on stream.
The Track of Commodity Prices: Is it Downward?
On the demand side, the prices of resource-based commodities tend to fluctuate. Because it is not possible to change world supply in the short run, any demand shift (say a fall-off because of a world recession) results in a fall in price (in contrast to manufacturing where they will hold their prices by cutting production). Perhaps one of the best ways of defining a commodity export is that the seller is a price-taker rather than a price-setter. Historically, this was sumarised by New Zealand’s fate being dependent on selling arrangements via auctions in Leeds (wool), and Smithfield (meat) and Tooley Street (dairy) in London. Producers get used to being a price-taker, although they’re grumpy when the price is at the lowest point in the cycle. The more ominous problem than the cyclical price fluctuations is whether there is a secular decline in their relative price (that is the price relative to a standard bundle of imports).
The belief there will be a long run fall in the price of commodities rests on the ease with which they can be produced so, the argument goes, there is a tendency for them to be oversupplied, depressing the market. The normal market adjustment – the falling prices force businesses out of the market – is undermined in by policies of domestic protection by – most importantly – the US and the EU, which has led to dumping (subsidised selling) their surplus in the remaining world markets and driving the price down. Unsubsidised producers, such as New Zealand, without recourse to the generous treasuries of the dumping nations, suffer too.
Meanwhile alternatives under-cut demand for wool (synthetic fibres), sheep and cattle meat (white meat) and butter (margarine) . However, this applies to only some commodities, and others which supply the synthetic alternatives (oil, fish and grain-fed animals, olive oil, canola and so on) presumably experience offsetting increases in prices. So there can be no generalisation of the general tendency for relative commodity prices to fall on this basis.
There is also the worry that in some key traditional markets of some New Zealand food commodities, consumpiton per capita is near saturation and may even fall because of perceived health consequences (particularly of animal fats). This would slowdown sales expansion, and depress prices. But there is also rapid growth of affluent populations in the Middle East, East Asia, Latin America and East-Central Europe, which are a long way from any saturation level, so we may be really talking about market switching.
A countervailing tendency is that some resources are being depleted to the point that their prices may rise. Candidates include oil and other minerals but also trees (as the tropical forests are cut down) and fish (as there seems to be world-wide over-fishing). The demand for some products – paper, fish and some horticultural products – is rising with affluence. So we need not assume that all commodity prices are inevitably falling relative to other prices.
While across all commodities (including many New Zealand exports) there is no evidence of a secular deterioration in the relative price, the empirical evidence is that the relative prices for New Zealand’s pastoral products seem to have been in decline in the post-war era. A major factor in the decline (in addition to the rise of synthetics) has been the dumping by US and the EU into third markets. New Zealand diplomacy has put an enormous effort into trying to reduce agricultural protection, but there has been stout resistance by the protected agricultural producers in more powerful countries, which have been lethargic and hypocritical in their responses. (In any case world agriculture is far more concerned with trading in grains than New Zealand’s products.)
Even so, one might detect – with caution, for it is really to soon to tell – that there has been some flattening out from the fall of the pastoral terms of trade following the Uruguay round of the 1990s, which may have curbed some of the worst excesses of world agricultural protection. Undoubtedly an ending of this protection would be the single biggest boost to the New Zealand economy via prices which represented the world’s production costs rather than the ability to subsidise. But it will not happen quickly, and it would be unwise to depend upon a price lift in the medium term.
Note that productivity gains may offset the falling relative prices. So the downward pressure on dairy prices has been offset by more efficient production. Moreover productivity gains which depress prices occur on the import side too. The spectacular example in recent years has been the falling price for computing.
In summary, New Zealand need not assume that its commodity exports will necessarily face falling relative prices, although some individual exports may, and most will be subject to higher price fluctuations than for other exports. The diversification of commodity exports and the growth of non-commodity ones, much less prone to these fluctuations, means the New Zealand economy as a whole is not as vulnerable to external price changes as it was a third of a century ago.
Why Commodity Exports Are Not Enough?
New Zealand cannot rely upon commodity exports in the way it did up to 1966. They do not generate enough foreign currency to sustain the economy at its current scale, while their contribution to accelerating economic growth is limited by physical and biological production constraints. So today around 40 percent of merchandise exports are not commodities. Add in service exports and today commodity exports generate less than a half of current external receipts – an enormous change from their excess of 90 percent of exports a third of a century ago.
The problem of the commodity producing sectors being unable to generate enough foreign currency was first identified in the 1930s. (Price volatility and expectations of a long run decline added to the concerns.) Some limitations were resolved by diversification from the dependence upon pastoral exports into other commodity exports, but this was insufficient so there evolved a couple of strategies which aimed to reduce the importance of the commodity based sector.
The first, and best known, was import substitution where New Zealand reduced its dependence upon imports by producing them at home, eking out the available foreign exchange and creating jobs. The substitution was stimulated by protection, either by tariffs which make the foreign product more expensive or import controls which prohibit imports altogether. Import controls have now been entirely abandoned and tariffs are for the most part very low or zero (the biggest exception if in textiles, clothing and footwear, where they are up to 15 percent). Thus the artificially protected import substituting sector is small, and probably will not expand greatly unless there is a massive – and unlikely – change in the world trading arrangements.
The second, and initially minuscule, response to the inability of the commodity export sector to earn sufficient foreign exchange was the development of a exports which were not commodities – but more characteristic of manufactures which are price-makers.
Part of the strategy was to use the commodities as a raw material for an ‘added value’ product. Instead of exporting wool, why not export woolen fashionware and carpets? Instead of carcases, why not meat packs to go direct into supermarkets and pharmaceuticals from the offal? Butter and cheeses, why not use the milk as a raw material for packaged dairy foods and pharmaceuticals? Instead of farm products, why not farm management services? Instead of wood, why not furniture? If wood why not aluminium based products? … Easier questioned than done, but there has been an increasing shift towards value added processing.
The strategy also involved exporting general manufactures, mainly but not exclusively to Australia, on the basis that New Zealand could produce them more cheaply than the destination market. That meant that costs would be low relative to productivity. Since the main variable cost was labour, the strategy meant keeping New Zealand wages low – ‘competitive’ in the jargon. New Zealand learned a lot about exporting of manufactures from the exercise, but ultimately it will fail, because other countries can undercut New Zealand wages and New Zealand workers will migrate overseas to where better wages are offered.
The practical fate of the world’s general manufactures may be that they will be dominated by exports from the Chinese economy, in line with the East Asian trend of undercutting high wage exporters who either abandon manufacturing altogether or move into specialist high quality manufactures. (The effect is being reinforced by China’s accession to the World Trade Organisation which means they face now lower tariffs and easier entry to New Zealand’s export and domestic markets than in the past, and by the Doha trading round which will lower tariffs generally and thus reduce the preference New Zealand has to its Australian market).
Is Protection and Alternative?
The issue of protection has been heatedly debated for over a hundred years. It is not proposed to rehearse that debate, because it is impractical in the current world trading regime to return to the high levels of protection that once existed. New Zealand could, of course, break from the regime, but that would mean the losses of most of its export markets. Competitors such as American and European pastoral farmers would fall over themselves excluding New Zealand from third markets, were it to return to a high protection regime.
Much of the protection debate is more notable for ideology and bad economics, than subtlety. Contradicting the so-called ‘free traders’, protection probably once made a useful contribution to the development of the New Zealand economy, when the export sector was almost solely pastoral industries (and were not particularly responsive to price changes) while an effect of the protection was to transfer the generous land rents from the farmers to the economy as a whole. Following the fall of the pastoral terms of trade in the late 1960s, and the subsequent diversification of the export sector, these arguments are not so telling, although it must be added that the diversification was in part a result of the import substituting industries becoming outward looking. Initially they tended to be in general manufacturing which has not got much future, but the experience has formed the basis for a more sophisticated manufacturing exporting. This contradicts the ‘pro-protection’ approach, so neither of the extremes is always correct.
Today there is not many import substituting industries left, other than those which are also exporting, in part because of the stripping out of protection. There are probably no big gains to rebuilding them. Of course, particular opportunities may arise. But any assistance needs to be on the same pragmatic criteria which applies to the promotion of export industries.
On the other hand, there is little merit – other than ideological purity – of unilaterally removing existing protection. We may want to as a part of our international negotiating position, but the abandoning of an industry simply because it does not fit our simplified account of the world, seems to be foolish. (We did so for car assembly in 1998, without any attention to the possibility that it could contribute to intra-industry trade in motor components). The little protection left is likely to be gradually phased out, but the aim needs to be to restructure the industry to compete against the rest of the world. The most prominent example is the clothing and textile industry which should be moving into high value fashionware including exporting.
What will a manufacturing sector not based on import substitution or the export of general manufacturing look like? Aside from those which come from the added value resource based sector, they will belong to a phenomenon known as ‘intra-industry trade’.
Intra-industry trade occurs where broadly the same product is traded between two different countries., as when Germans buy Renaults and the French buy Volkswagens. While it hardly existed fifty years ago, about a quarter of all international merchandise trade today is intra-industry trade. The remaining three-quarters – oil, other primary commodities, and general manufactures in roughly equal shares – is explained by the traditional theory of inter-industry trade based on comparative advantage, where different products are exchanged. (Ricardo instanced wine for cloth.) Intra-industry trade is the rapidly growing sector of international sector.
Intra-industry trade seems counter-intuitive – what is the point of buying a very similar product from a different region? In part the answer is because the products are not exactly identical – a child can readily distinguish a Renault from a Volkswagen. Consumers may want to difference themselves by such distinctions. Product differentiation is important, but in the end it may not matter much if general consumers have access only to, say, Renaults and not Volkswagens. (More important, as we shall see, the consumer benefits from the competitive pressure each puts on the other.)
Now the traditional theory predicts inter-industry trade (trade between unlikes) on the basis of comparative advantage. (Virtually every reasonable theory predicts trade based on absolute advantage – it is no surprise that countries with oil reserves export oil to those which do not have them.) But the theory does not predict intra-industry trade, Is there one which does? About twenty years ago, economists developed an account where the following characteristics were important.
– economies of scale in the production process;
– low costs of distance – transport costs, but also costs of storage, communication, control and so on (The costs have to be low so that producers from different regions could compete with each other without a serious cost handicaps and so reap economies of scale from the larger markets)
– product differentiation.
In summary this results in monopolistic competition in which businesses with similar but not identical products, compete in markets where they may, or may not, be the local producer.
An important curiosity, compared to the traditional economic theory, is that pattern of intra-industry trade is not predictable. No one has is surprised that those with oil reserves export oil, and economies with relatively more labour than capital export labour intensive products. However the theory of intra-industry trade says it may be an accident of history that the manufacturing plants are in one country and not another. Thus the theory does not predict that a firm like Nokia, the mobile telephone giant will develop in Finland. But it does predicts that such instances can arise. (The policy implication is that governments can probably not create ‘Nokias’ but they should ensure that if the accidents of history are favourable to one, they encourage rather than retard its growth.)
The Service Sector
Historically the primary sectors were those that had to be located close to the resources they were based upon, while the service sectors had to be located close to the customers. Manufacturing was footloose with its location being determined by the tradeoff the minimum distances costs from its suppliers and markets, and the economies of scale a larger production runs (and industry clustering) could reap. As a result, the majority of economic discussions in international trade focuses on manufacturing (as has the above discussion on intra-industry trade did). Practically this propensity was reinforced by data bases being based on the tangible products which crossed the waterfronts, so that the service sector (the ‘invisibles’ in the balance of payments) tended to be ignored in economic analysis.
In fact some services are proving just as mobile as the manufacturing sector, insofar as they can be a provider some distance from consumers. Historically, freight insurance was supplied by centres far from the actual transport, so that a London company might provide insurance for shipping from Auckland to Vancouver. Financial services and transport were also treated as anomalies.
But other parts of the service sector are mobile too. If the service supplier cannot move then the customer may. This is how the tourist industry works. It also applies to education, with New Zealand earning over a billion dollars a year, from overseas students. It can apply to health treatment, when people travel to get better care in a foreign hospital.
Additionally, the telecommunications revolution has made the supply of information footloose. Call centres need not be in the same country, while New Zealanders read on the internet London and US newspapers before their hard-copy readers get up in the morning. Even more spectactularly – ignoring the precursor of the Sears and Roebuck catalogue – even parts of retailing need no longer be near their customers’ location. It is not unusual to purchase books, CDs and software, to participate in auctions, and make travel and accommodation reservations by the internet, all of which were once provided through main street shops. The ‘middleman’ has been cut out. Thus increasing parts of the service sector are joining the tradeable sector. (But not all. Dry cleaning is still a relatively local operation, but then so is fresh bread baking.) The analysis which applied to the merchandise export and import substitution sectors also applies to the tradeable service sector.
For every three dollars that New Zealand merchandise exports generate today, the service sector generates around another dollar: a quarter of current receipts of foreign exchange come from services.
Some Related Theories
Before describing the implications for growth strategy a couple of related theories need to be mentioned. One is that Australians, in particular, place some emphasis on the export of ‘elaborately transformed manufactures’ (ETMs). Some of these will be the result of adding value to commodities (e.g. turning aluminium billets into car hubs), and some will be true intra-industry exports. ETMs are easier to measure than Intra-Industry Trade, so it is a useful indicator of economic transformation. but the underlying notions are not so rich in insights.
A more elaborate theory is due to Michael Porter, most notably his The Competitive Advantage of Nations. This emphasises that factor endowment, the core of the traditional comparative advantage theory of inter-industry trade, no longer explains international trade between rich nations. Instead he focuses on ‘competitive advantage’ which might be thought of – in terms of the terminology of the previous chapter – the active seeking and implementing of new technologies which, Porter argues, are reinforced by a competitive economic environment.
Porter is not thought of highly by economists because his analysis is often rather vague. One might compare it to Alfred Marshall at his most lucid, but Marshall has formal models which he confined to footnotes: it is not evident that Porter has. If his approach deters economists it does attract business, with its propensity to seize fashionable ideas bereft of scientific content. (In New Zealand Porter’s reputation was sullied or enhanced – depending on the discipline – by the report Upgrading New Zealand’s Competitive Advantage. Illustrative of the weaknesses of the theory, is a diagram (on page 33) which purports to demonstrate why New Zealand has sustained international success in rugby. However the very same diagram applied to soccer would demonstrate that New Zealand was a top soccer nation too, suggesting as presented the diagram and the theory it illustrates are vacuous. There has been some recovery of Porter’s reputation among economists, following John Yeabsley’s Global Player?: Benchmarking New Zealand’s Competitive Upgrade.)
What I really like about Porter is his emphasis that ‘firms, not nations, compete in international markets’, and yet his recognition that nations have a role in fostering successful businesses. (p.33) A weakness, evident in the New Zealand study, is the tendency to think in terms of large economies which may sustain a number of rivalrous firms all exporting the same product. Thus the Nokia phenomenon, which is usually more relevant for New Zealand gets underplayed.
The process of intra-industry competition can be important in economic growth. Consider the simplified of two countries each with a car production firm. (In practice the market is likely to have more than two companies, often from more than two countries.) If each only sells to itself the pressures on each to perform are primarily ones of engineering excellence, which will result in new technologies. But they are likely to be producer oriented, rather than consumer oriented.
But if the company is also exporting to the other market, each is under competitive pressure from its rivals, for there is no longer a secure home base. This requires them to seek out much more actively new technologies, and to be more customer focussed. No firm can afford for other businesses to get a significant lead on it: it is not unknown for a new model to be disassembled to the basic components by a rival in order to learn if there is a new technology involved.
Is there is something wrong with such competition. It can be destructive, it can be wasteful and, if the laws and the markets signals are poor quality, it can result in poor economic performance. Moreover, competition tends to drive down the price of inputs, notably labour, and it tends to be shortsighted. Nevertheless, competition is the best mechanism known for getting business to seek out and implement the new technologies which contribute economic growth.
Curiously, the place where technological enhancing competition is most likely to occur is where there is monopolistic competition, that is where a number of firms are offering differentiated but similar products, preferably with a minimum of barriers to entry. Economists are ambivalent about monopoly. On the other hand, as Joseph Schumpeter emphasised, monopolies can invest in new technologies and get a reasonable return, because they initially capture any benefit in their own profits. On the other hand, as John Hicks pointed out, a monopoly may take advantage of its lack of competitors to pursue the comfort of the quiet life, and fail to be technologically innovative.
If intra-industry trade is a particularly effective mechanism for technological innovation. What is New Zealand’s record?
New Zealand and Intra-industry Trade
In practice, most a couple of trading economies combine inter-industry trade with intra-industry trade. The relative balance depends on the balance between economic similarities and differences of the two countries. One would expect New Zealand, which is relatively rich in resources compared to its population to be involved in inter-industry trade more rather than intra-industry trade.
Even so, New Zealand is hardly involved in intra-industry trade at all. Only with Australia is there a relatively high degree of such trade. With every other country New Zealand’s trade is primarily inter-industry. This is summarised in the following table by New Zealand economists Sayeeda Bano. The measures intra-industry trade it uses results in most rich OECD have an index level of around 70 percent or more. The index of intra-industry between New Zealand and Australia was only 50 percent: with other economies it is even lower.
Moreover Bano shows that there has been little improvement over the previous decade. Indeed with some countries there has been a reduction, probably as a result of the reduction and elimination of protection. (The index falls for those Asian countries which have increased their clothing imports to New Zealand following the reduction of protection on clothing.) Not surprisingly, New Zealand EMTs (elaborately transformed manufactures) do not rise as a proportion of total exports to Australia, while Australian EMTs to New Zealand do.
It is easy to argue that New Zealand was a specialist economy, very different from the rest of the rich world, and so inter-industry trade is its natural mode of international intercourse. But the commodity trade which underpins this strategy is insufficient to provide the foreign exchange requirements for the country’s current population and affluence, and its growth is insufficient to accelerate the country’s growth rate. In any case, even the commodity producers do not neglect intra-industry trade, both in order to diversify and to seize profitable opportunities. When Fonterra strips out a chemical from milk and exports the resulting pharmaceutical it is participating in intra-industry trade. Any exchange revenue deficit is not going to be covered by general manufacturing exports because low wage countries will undercut New Zealand. It has little choice than to move into intra-industry trade as a means of generating the additional foreign exchange it needs, and adopting high productivity technologies to maintain and enhance a high income economy.
There are those who are deeply pessimistic about New Zealand’s ability to get into intra-industry trade, whether it be based on value adding to commodities or in other sectors. They see New Zealand’s future in commodity exports (plus – including – tourism) based on its natural resources. Insofar as they articulate a case for their view – one would hardly call it a vision – it is that New Zealand is too small to pursue an alternative or supplementary strategy.
The good news is that there are numerous advance technology export oriented firms and sectors in New Zealand. Most are small, but they are growing and with the right support they will make a considerable contribution to the New Zealand economy in the medium term, and also to New Zealand society as we shall see. Much of the rest of this book is how to promote them, although the contributions of the commodity export sector are not be forgotten, and the domestic non-tradable sector has a contribution too.