Kinley Salmon: Diversifying economy going awry

Shell is reconsidering its oil and gas exploration in New Zealand. Photo / NZME

Government’s push towards oil exploration a shortsighted strategy

'Shell weighs NZ exit as oil prices plunge.' New Zealand has been making headline news in the Financial Times, which noted this development was a setback to the "Government's vision of ramping up oil and gas exploration as a means of diversifying an economy ... " This phrase rather sticks in the throat of anyone with more than a passing interest in economic diversification.

There is no doubt New Zealand's economy needs to diversify. In 2013, 44 per cent of our goods exports were animal and animal products - the majority from the dairy sector. We are hugely reliant on primary products.

We simply don't produce enough of them (despite major unsustainable dairy intensification) to pay for what we importso New Zealand consistently runs a substantial current account deficit. In other words, we spend more than we save, which means we rely on financial inflows to cover the gap. Current account deficits aren't always bad, but they can quickly become unsustainable, leading to painful adjustments. This is a particular risk if the gap between imports and exports grows further and investors begin to lose interest in New Zealand as interest rates rise elsewhere.

Our heavy reliance on primary products also subjects New Zealand to major price volatility. The recent drop in the farmgate milk price from $8.40 to $4.70 in just 12 months, which took most farmers below their break-even point, was a $6.1 billion dollar hit, equivalent to 2.7 per cent of GDP.

Research by Ricardo Hausmann and his team at Harvard University shows that an economy's level of diversification is one of the best predictors of its long run economic growth rate. Their measure of diversification, the Economic Complexity Index, predicts growth with 10 times greater accuracy than the World Economic Forum's Global Competitiveness Index. Simply put, economies that learn to produce more complex high quality products do better in the long run.

New Zealand ranked 49th on the Economic Complexity Index in 2014, below countries such as Tunisia, the Philippines and Uruguay.

Hausmann's team predicts New Zealand's growth rate between now and 2023 will rank 97th out of 121 countries.

Second, without a doubt, the world is shifting to a lower carbon economy. Yet our top export sectors, including dairy, are highly emissions intensive. We are on the wrong side of one of the mega-trends affecting the world economy. We need to diversify, and fast.

Diversifying towards oil is not going to put us on the right side of the economic reality of climate change. Even Shell knows that. Despite substantial subsidies from the Government for exploration, the economics don't look good.

Worse still, oil is about the least strategic way possible to diversify the economy. Diversification is not a one-shot game - it is a continual process of expanding the array of products an economy produces. It therefore matters whether the initial steps in diversification make further diversification easier or harder.

Some products better enable future diversification than others because learning how to produce these products generates the skills, regulations, inputs and technology needed for many other related products. Just look at the development and subsequent diversification of the New Zealand film and media industry.

But other products, simply by their nature, do not generate as many skills or inputs that can easily be used for further diversification.

Of course depending on what a country produces today, some products are easier to begin to produce than others. The Centre for International Development at Harvard has mapped products to show for any given country which products it could feasibly begin to produce and which products will best enable further diversification.

And oil? Well it is about as unstrategic a product as possible. By building the capability to produce oil, we do not give ourselves any strategic advantage to diversify further. Instead, we risk getting stuck into yet another product with huge price volatility, record low prices today, and high emissions. Sound familiar?

If the Government is going to support diversification (which it has been doing for oil) the smart, strategic approach is to support products and sectors that are low in emissions and which best enable further diversification.

Shell is having a rethink. It is high time the Government did the same.

• Kinley Salmon is an economist. He is a graduate of the Harvard Kennedy School and has worked for McKinsey and Company and the World Bank on questions of economic development and diversification. The views expressed here are his own.