Friday, 25 July 2008

Tea Leaves and Belgian Dentists

Has the Reserve Bank Got it Right? Or, Should it Matter?

There has been a lot of debate recently over whether the Reserve Bank has done the “right thing” by starting to loosen monetary policy. We at Contra Celsum do not make it our business to prognosticate on near or immediate outcomes. It is far too difficult for mere, fallible humans to do credibly. It is even more difficult to benefit fiscally from such speculations. When a near term prediction is credible and widely believed it will be already priced in markets—so that, perversely, by the time conviction arrives, it is too late. The price horse has bolted, as it were.

When predictions of near term outcomes are uncertain, the risks are even greater. To invest or divest capital on the basis of such fantasies or speculations is folly indeed. Yet thankfully many do, which usually leads to the wonderful phenomenon of artificially and speculatively inflated or depressed capital markets—which, in turn, usually offers wonderful investing or divesting opportunities for a careful allocator of capital.

Whether the Reserve Bank was “right” in loosening monetary policy in New Zealand this week is a very difficult call. So prudence would suggest that we pass and consign it to the realm of speculation on a near term outcome.

What is more useful, however, is to consider some longer term economic fundamentals—factors which are usually overlooked in the frenzy of near term speculation, but which will inevitably “play out” in the longer term. Here, then, are some longer term fundamentals which we believe the sagacious need to keep in mind—in no particular order.

Economic growth occurs when capital and labour are both deployed to produce desirable goods and services of such quality and price to attract buyers. New Zealand is a small economy. It is an open economy. It can only sustain economic growth over the long term if it succeeds in producing goods and services which are more attractive in either quality or price, or both, than what other peoples and nations can produce. Thus, the key to economic growth is a competitive tradeable sector (that is, goods and services that are either exported or can be used efficiently to substitute imports, such as oil.)

New Zealand has few tradeable sectors which are sufficiently productive to cut the mustard in a global market. Agriculture is one (dairying in particular). Owing to the application of knowledge, research, and technology the productivity of the agriculture sector has steadily increased over the past thirty years, once the artificial subsidies of the Muldoon era had been removed.

The economic lifeblood of the nation is wedded to businesses that can trade effectively with the world, which means exporting to selling to domestic consumers who may also buy competitor imported goods on a cost-effective basis. There are two longer term critical impediments to doing this. Firstly, our labour productivity is falling. That is, less is being produced for every hour worked. Wages, however, are rising—therefore labour costs are going up, while productivity is going down. This means that in general New Zealand is economically terminal. Secondly, our cost of capital is high. This is due to its scarcity. We do not save enough: therefore, we rely on international savers to lend to, or take equity in, our businesses. They require a higher premium, a higher return, for investing in New Zealand because the risks are higher.

Given our higher costs of capital, and the falling productivity of our labour force, the longer term outlook for the New Zealand economy is not good. Things will have to change for the longer term outlook to become more positive—and change is likely to mean lower standards of living and some considerable economic pain.

Inflation is a hydra with many faces. Inflation is not caused by rising prices, per se. Inflation is caused by an increase in the supply of money. Prices can rise and fall due to imbalances of supply and demand. This is not inflationary. Thus, to the extent that prices have risen due to inadequate supplies of oil to meet increasing global demand, it reflects a non-inflationary market effect. It is highly unlikely that such market driven price increases will flow through to self-reinforcing general price and wage spirals without a commensurate increase in the supply of money (regardless of whether the increase comes from the actions of the Reserve Bank or from overseas investors.) Choke off the supply of money and an inflationary spiral is far less likely.

A small open economy will always be subject to occasional global economic shocks. It is not the shocks that are critical, for they are inevitable and unavoidable—it is the speed and efficiency with which the productive sector of the economy can adapt that is vital. The greatest impediment to a speedy adjustment is the government sector, both with its artificial propping up of the economy through distributive spending, and with its endlessly complex spaghetti of rules and regulations. New Zealand's government sector has grown substantially relative to the size of the economy over the past nine years. The ability of the economy to adjust to the current global credit crunch and oil shock has been commensurately weakened. This suggests that the pain will go on for longer. If the government introduces a carbon trading tax, it will go on for much longer.

A country that runs a large current account deficit can ordinarily expect that its currency will devalue over time. This, in turn, allows the tradeable sector to price itself more competitively. On the other hand, when an economy is competing effectively in the tradeable sector, over time one would expect that the currency would appreciate, forcing greater efficiencies—a virtuous circle.

New Zealand's currency has been propped up for a long time by our relatively high interest rates. Japanese housewives and Belgian dentists have lent money to New Zealand banks because the interest rates were so much higher than they could earn at home. This has made the New Zealand currency attractive. With such strong buying support, the dollar has remained high, creating a huge headwind for the tradeable sector.

Unfortunately, most of the investment in New Zealand by Japanese housewives and Belgian dentists has flowed through to the non tradeable sector—namely, housing. So, we have been subjected to a debt fueled lifestyle-consumption extravaganza. It has created a false sense of wealth. It has created a dual economy: one which has a productive, tradeable sector struggling in the face of significant impediments, and a consumption sector turbo-charging its appetites with easy credit. Government hand-outs have abetted the chimera of prosperity and given its speculation greater impetus.

This artificially propped up currency has to fall if the economy is to have any hope of righting itself. It would possibly be best if it were left to fall drastically and quickly. This would lessen the chances of creating a wage and price spiral as a result of gradually increasing import prices, due to a gradually falling currency. But fall it must—eventually.

In the light of the above, prudent investment of capital becomes a simple matter, although not easy. Firstly, there are businesses in New Zealand operating in the tradeable sector which have made a reasonable fist of growing their earnings, despite the huge headwinds of the past five years. As the currency falls, they are only going to do better.

Secondly, in tough economic times, the best companies get better still. They tend to increase market share as their competitors fade away. Consequently, it is a wonderful time to be a capital allocator, provided you can read a balance sheet and an earnings statement with a modicum of intelligence, and provided you have a reasonable dash of common sense, and your investing time frame is at least ten years. However, without those attributes, don't even think about it. Every time you get tempted to speculate (for that is what you will be doing) imagine Dirty Harry aiming his 44 magnum at your eyeballs, and growling, “I know what you are thinking, punk.”

Many of the things we have discussed will not play out tomorrow, or the next day, or the next year. Maybe not in the next five years. But, play out they will. The New Zealand economy is a huge leaky home. In the end, the rot will show through.

In the meantime, there is no better course as a capital allocator than to buy high quality assets at attractive prices, then take a ten year holiday.

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