Smallness, remoteness clip Kiwi wings

By BRIAN FALLOW

New Zealand's small size and remoteness from large affluent markets have had a profound negative effect on its economic performance.

The reforms of the 1980s, though necessary, have not proved sufficient to pull New Zealand back from the relegation end of the league table of rich nations.

"That may be," says Treasury economist Dr David Skilling, "because they did not address the fundamental cause of New Zealand's long-term economic performance: the combination of size and distance which has profoundly affected New Zealand's industrial structure and human capital composition,"

These views, set out on the Treasury's website, are propositions for debate, and are preliminary hypotheses to be empirically tested, Dr Skilling says. They are not concluded views.

Still less are they an excuse for fatalism and inertia by policy makers.

Nevertheless, he mounts a plausible case that the combination of smallness and remoteness hampers growth by making it much harder for New Zealand firms to achieve the scale or the specialisation needed to be at the top in their fields internationally.

The indicators of economic underperformance are familiar and stretch back decades.

Real per capita incomes have grown more slowly than in other developed countries since the 1950s. Over the past 30 years they have grown only around 1 per cent a year, less than half Australia's rate or the median for OECD countries.

Productivity growth is low, household savings rates are low and current account deficits persist.

Can it be a coincidence that New Zealand also stands out among developed countries in having such a high proportion of small businesses?

Only 4 per cent of firms employ more than 19 staff and only 2 per cent employ more than 50.

In the manufacturing sector 90 per cent of firms employ fewer than 20 (compared with an OECD average of 70 per cent) and only 0.3 per cent employ more than 500 people.

This is not an automatic consequence of a small population. Scandinavian countries with domestic markets not much bigger than New Zealand's have much higher concentrations of large firms.

Exporting and research and development spending are concentrated in relatively few companies.

Last year, 151 firms, 0.06 per cent of the total, generated 78 per cent of export earnings.

The top 70 firms accounted for two-thirds of private sector R&D spending, which is only about half of what the state spends and is paltry by international standards.

A study by the Ministry of Commerce suggests small firms find it difficult to grow.

Only 6 per cent of the firms which in 1995 had up to five employees had more in 1999. And those which had more than five employees in 1995 were more likely to have shrunk than expanded four years later.

Not too much can be concluded from such snapshots as, for one thing, 1995 was cyclically a good year.

But such numbers do support Dr Skilling's thesis that New Zealand firms face strong barriers to expansion because of a small domestic market and the big fixed costs, and risks, associated with exporting.

"This structure creates an incentive for firms to diversify rather than specialise as specialisation is risky for firms in small, distant markets."

It hinders the development of clusters of firms in the same industry which can provide the dense upstream and downstream linkages and the specialised inputs that help firms grow by concentrating on specialised high-value products.

The obvious objection to this argument is that New Zealand was even smaller and just as far away 50 years ago when it ranked among the richest countries in the world per capita.

But Dr Skilling says the fact that growth among developed Northern Hemisphere countries has so far outstripped New Zealand's shows that technological progress has been strongest in manufacturing and latterly in IT-rich service industries, rather than the primary sector.

Unfortunately the primary sector, where high productivity growth has been achieved, is only 9 per cent of the economy.

"Although New Zealand has a strong comparative advantage in primary products, the effects of size and location have made it very difficult for New Zealand firms to establish sustainable competitive advantage in the manufacturing and service sectors where most of the technological progress has occurred."

One of the main ways the absence of deep local and nearby markets hampers growth, Dr Skilling argues, is by reducing the opportunities and incentives for people to acquire specialised skills.

Since the 1970s, progress has been driven by the marriage of skilled labour and technology.

Capital equipment is increasingly complementary to skilled labour, rather than something which displaced it as in earlier industrial revolutions.

"It may be necessary to have very specialised knowledge to identify and incorporate the technological advances that occur elsewhere."

B Y SOME measures, New Zealand's investment in human capital - years of schooling, tertiary participation rates and so on - is about average for a developed country.

But the size of the Kiwi diaspora testifies not only to the size of the income gap that decades of underperformance has opened up between New Zealand and other countries, but to the fact that for many occupations there is little work available here.

Dr Skilling cites international evidence that higher population densities are associated with higher productivity, attributed to greater specialisation in the division of labour, and better matching of employers and employees.

In thin labour markets, by contrast, people have less incentive to invest in more specialised skills, leading to a low-wage, low-productivity economy.

This is a recipe for continued decline in New Zealand's relative standard of living.

Dr Skilling emphasises, however, that although size and location are influential factors they do not wholly determine outcomes.

Clearly some New Zealand firms have defied the odds.

But economic policy has to be founded on a clear, New Zealand-specific understanding of what factors drive firms' growth and of the dynamics of successful entry into the export arena.

"I think policy settings have been given undue emphasis as an explanation for New Zealand's poor economic performance because they led to highly visible distortions in decision making."

The economic reforms of the 1980s, Dr Skilling says, addressed the effects of earlier unsuccessful attempts to counter the fundamental drawbacks of smallness and remoteness, not the underlying problem.

"The reforms removed a set of policy interventions that were generating large deadweight losses, but did not address the structural problems caused by the size and location of the New Zealand economy."

It does not follow that policy interventions are necessarily futile, however.

"For example, if scale and linkages are important, then a focus on some parts of the economy may allow performance to improve."

That sounds suspiciously like a call to pick winners. Surely not.

Dr Skilling says the Treasury has a lot more research to do before any policy conclusions can be offered.