Third draft of Chapter 5 of Transforminng New Zealand. Comments welcome. (Second Draft).
Keywords: Growth & Innovation;
As a general rule, but not exclusively, the sectors which can grow fast in New Zealand – faster than the rest of the economy – are exporting. Indeed world trade – exports and imports – grows about as twice as fast as the world economy (we mention below why this should be so). The export sectors have a key role in the growth of small open multi-sectoral economies, drag the domestic economy along with them, accelerating its growth rate, while largely funding the imports which also tend to grow faster than the rest of the economy. However not all exports 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 production processes which utilise resources. For almost a hundred years the most prominent commodity exports were 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 typically constrained by some physical or biological limitation, such as the growth of grass and the numbers of livestock to eat it. The jewel for the future is the so-called ‘wall of wood’, as the radiata pine forests double their production every 7 years through to 2025. But that is the result of past plantings. So the sustainable maximum rate cannot be changed much for about 25 years when today’s plantings, whose rate can be varied, come on stream.
On the demand side, the prices of resource-based commodities fluctuate more than manufactured exports. 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 ( manufactures will hold their prices and cut production). A way of defining a commodity export is that the seller is a price-taker rather than a price-setter. Historically, this was the fate of New Zealand’s export sold in auction markets. Producers may get used to being a price-taker, although they’re grumpy when their prices are at the bottom of the cycle. The more ominous problem whether those prices tend to decline in the long run (secularly rather than cyclically) relative to the price of (manufacturing) imports.
There are a range of reasons for believing commodity prices tend to fall relative to export prices. Many have been undercut by alternatives – wool (synthetic fibres), sheep and cattle meat (white meat including chicken and fish) and butter (margarine) – although the alternatives are also commodities. There is also the worry that in some key traditional markets of some New Zealand food commodities (such as animal fats), consumption is near saturation and may even fall because of perceived health consequences. 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, whose consumption is not yet near saturation levels. A countervailing tendency is that some resources – 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) – are being depleted to the point that their prices may rise. The demand for some products – paper, fish and horticultural products – is rising with affluence. We may conclude there is not universal law of declining relative prices for export commodities.
However the relative prices for New Zealand’s pastoral products declined in the post-war era. (We saw that in Chapter 2 in the story of the terms of trade.) A major factor in the decline (in addition to the rise of synthetics and changing market demand) has been intervention in the world agricultural markets. The US and the EU protect their domestic producers with high production prices and high consumer prices, which result in over-production. The surplus is usually ‘dumped’ into third markets, depressing their prices, with the price deficit for the protected producers made up by subsidies. Producers which do not get such subsidies – New Zealand’s are particularly clean in this respect – suffer lower returns. This seems to have been a major factor in depressing prices for meat and dairy products in the post war era.
In recent years, the world economic community has tried to reduce international agricultural protection. Even the protecting countries are getting tired of the costs to them of supporting inefficient farm producers: the subsidies frequently do not go to ‘deserving’ farmers but to large capitalist ones. The international trade negotiations of the early 1990s – the ‘Uruguay Round’ – curbed some of the worst excesses of world agricultural protection. It appears that there was a significant lift in the relative prices for some pastoral products as a result. The Doha Round which should (eventually) end all dumping of agricultural products is likely to result in further price gains, although New Zealand producers will still have restricted access to many affluent markets.
In summary, New Zealand need not assume that its commodity exports will necessarily face falling relative prices in the future, although most will continue to be subject to higher price fluctuations than for other exports. Moreover the diversification of exports means that 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
However, even with a boost in prices New Zealand cannot rely upon commodity exports in the way it did in the past. 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.
Once domestic import substitution, stimulated by protection, seemed to be a possible strategy to eke out the available foreign exchange and create jobs. However import controls have now been entirely abandoned and tariffs are for the most part very low or zero. 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.
It is impractical in the current world trading regime to return to the high levels of protection that once existed, so it is not proposed to rehearse that debate. New Zealand could, of course, break from the regime, but that would mean the losses of most of its commodities export markets, as its competitors fell over themselves. Free trade involves mutual obligations. (However that the drift is to ‘free trade’ does not justify New Zealand unilaterally abandoning its protective structure, as it has done in the past. Better to disarm in negotiations.)
Instead of import substitution, New Zealand has extended its exports with products which are not commodities. 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? Rather than ingots why not aluminium based products?
Another leg of the strategy has 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. While New Zealand learned a lot about exporting of manufactures, ultimately it will fail, because other countries can undercut New Zealand wages (or New Zealand workers will migrate overseas to where better wages are offered). The practical fate of the world’s general manufactures is likely to be dominated by exports from the Chinese economy which has an almost unlimited supply of cheap manufacturing labour. The entry of China into the World Trade Organisation means they face now lower tariffs and easier entry to New Zealand’s export and domestic markets than in the past, and the Doha trading round which will lower tariffs generally. New Zealand will find it increasingly hard to export general manufactures – even to Australia. If it wants to stay in the business of exporting additional to commodities, it will have to move into specialist high quality products the Chinese cannot produce.
Intra-Industry Trade
What would 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 Europeans buy Boeings and Americans buy Airbuses. 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 (quarter) shares – is explained by the traditional theory of ‘inter-industry trade’ based on comparative advantage, where different products are exchanged. Intra-industry trade is the rapidly growing sector of international sector, and a major factor why world trade expands faster than total production.
Intra-industry trade seems counter-intuitive – what is the point of buying a similar product from a different region? In part the answer is because the products are not exactly identical. Consumers may want to difference themselves by such distinctions. Product differentiation may assist consumer preferences for differentiation and fashion, but ultimately it may not matter much if general consumers have access only to, say, Volkswagen cars and not Renaults. (What is important is the consumer benefits from the competitive pressure each puts on the other.)
Traditional international theory predicts trade between unlikes (inter-industry trade) on the basis of comparative advantage in which each country specialises in what it is most productive at. (Additionally there is 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. About twenty years ago, economists developed one 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 and so reap economies of scale from the larger markets)
– product differentiation.
The outcome is intra-industry trade. (Intra-industry trade is not so surprising if one thinks of intra-regional trade in a single country. Virtually the same product will be produced in different regions and supplied nationally.)
Intra-industry competition is important in economic growth. Consider of two countries each with a car making firm. If each only sells in its own market there will be little pressure to perform (except self imposed engineering excellence). But if the company is also exporting to the second market, each is under competitive pressure from its rivals, and there is no longer a secure home base. This requires them to be more customer focussed. Neither firm can afford another business to get a significant lead on it: a new model from one firm will be disassembled to the basic components by a rival in order to learn how it was made and how much it cost.
Tthe 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. Economists are ambivalent about monopoly. 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. But 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. The monopolistic competition associated with intra-industry trade means a quite life is not an option, but technological innovation has to be.
An important theoretical curiosity is that, compared to the traditional economic theory, the pattern of intra-industry trade is not easily 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 intra-industry trade theory predicts that a firm like Nokia, the mobile telephone giant, will arise, but it cannot predict it will develop in Finland. There is a strong element of luck as to just where it will. The implication is that a ‘Nokia’ could, and by luck will, arise in New Zealand (especially as the cost of distance falls). While governments can probably not create such ‘Nokias’ they should ensure that when the accidents of history are favourable, 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 did the above discussion on intra-industry trade). The service sector (the ‘invisibles’ in the balance of payments) tended to be ignored in economic analysis of international trade.
Increasingly, however, some services are proving just as mobile as the manufacturing sector, for they can be provided some distance from consumers, especially via cheap telecommunications.
Who a couple of decades ago would have envisaged virtual retailing such as amazon.com? In America 14 percent by value of books are sold on-line, as are 5 to 10 percent of music, event tickets, leisure travel, videos, clothing and computer hardware and software. Less visible is business processes services. For example, an Indian based in Bangalore (India is always the example) may enter the data embodied in an emailed image of a form filled out in the US into an electronic file which is emailed back to the US. Or he may decide whether a US applicant is creditworthy (because of the time zone differences, this reduces the decision period by two days). Or he may develop some software rather than have it done in America. Between business and consumer services is outsourcing, which also may occur offshore.
Other parts of the service sector are mobile too, where the customer is moved to the service. That 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.
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.
Today, for every three dollars that New Zealand merchandise exports generates, the service sector generates around another dollar: a quarter of current receipts of foreign exchange come from services. Services can be part of the rising intra-industry trade too.
New Zealand and Intra-industry Trade
In practice, any pair of trading economies combine inter-industry trade with intra-industry trade. The relative balance depends on the degree of economic similarity and difference between 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.
But New Zealand is hardly involved in intra-industry trade at all, other than with Australia. With every other country New Zealand’s trade is primarily inter-industry. One study found that most rich OECD have an intra-industry merchandise trade index level of around 70 percent or more. The index for New Zealand with Australia was only 50 percent: with other economies it is even lower.
Moreover 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.) New Zealand elaborately transformed manufactures (another measure of export sophistication) do not even rise as a proportion of total exports to Australia, while Australian ETMs to New Zealand do.
It could be argued that New Zealand is 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 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. 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 and tourism, based on its natural resources, since – they argue – New Zealand is too small to pursue anything else. The good news is that many numerous advance technology export oriented firms largely ignore them. When Fonterra strips out a chemical from milk and exports the resulting pharmaceutical it is participating in intra-industry trade. It is not only commodity trade will not provide the foreign exchange requirements for the country’s current and future population and affluence. Moreover New Zealanders want a life style which cannot be supported by a commodity based economy. New Zealanders may want to develop software, create pharmaceuticals or make films. They can do so in New Zealand if we can sell software to America, drugs to Europe and films to Hollywood as well as import them from there.
What drives intra-industry trade? We have that seen economies of scale and low costs otrf distance are important, but they are not enough to generate monopolistic competition. The term for these other factors is ‘Competitive Advantage’. Since intra-industry trade will be vital in New Zealand’s future, we turn to that notion, observing that the same policies to promote it will also enhance the contributions of the commodity export sector and the domestic non-tradable sector.
The notion of competitive advantage is developed in Michael Porter’s book The Competitive Advantage of Nations, a work undervalued by economists who complain his analysis is vague. Perhaps in popularising he has obscured his relationship to economic analysis. The book emphasises that factor endowment, that which drives of the traditional comparative advantage theory of inter-industry trade, no longer explains international trade between rich nations. The new trade is based upon ‘competitive advantage’ – the active seeking and implementing of new technologies, which is also the foundation of intra-industry trade. Indeed Porter’s term ‘competitive advantage’ may be used interchangeably with ‘intra-industry trade’ without a lot of adaption. I really like Porter’s emphasis that ‘firms, not nations, compete in international markets’, and yet his recognition that nations have a role in fostering successful businesses.
(Porter’s reputation in New Zealand has been damaged by the report Upgrading New Zealand’s Competitive Advantage. Illustrative of its weakness is a diagram which purports to demonstrate why New Zealand has sustained international success in rugby. However the very same diagram applied to soccer or cricket or tiddlywinks would demonstrate that New Zealand was a top nation in those sports too. But see John Yeabsley’s Global Player?: Benchmarking New Zealand’s Competitive Upgrade for an attempt to recover the value of the analysis. Moreover Porter tends to focus on large economies which may sustain a number of rivalrous firms all exporting the same product. The Nokia phenomenon, which may be more relevant to New Zealand, tends to get underplayed)
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.