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AS135 FILE COPY Vol. 1 Public Disclosure Authorized This report was prepared for use within the Bank and its affiliated organizations. They do not accept responsibility for its accuracy or completeness. The report may not be published nor may it be quoted as representing their views.

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT INTERNATIONAL DEVELOPMENT ASSOCIATION Public Disclosure Authorized

MEDIUM-TERM ECONOMIC POLICY

AND

DEVELOPMENT STRATEGY OF NEW ZEALAND

(in three volumes) Public Disclosure Authorized

VOLUME I

MAIN REPORT

April 24, 1968 Public Disclosure Authorized

Asia Department Prior to November 21, 1967

Currency Unit New Zealand Dollar (NZ$)

US$ 1 = NZ$ 0.719 US$ 1 million = NZ$ 719, 194 NZ$ 1 = US$ 1.39 NZ$ 1 million US$ 1,390,450

These rates are applied throughout this Report. On November 21, 1967, the new rate was established as follows:

Currency Unit New Zealand Dollar (NZ$)

US$ 1 = NZ$ 0. 892 NZ$ 1 = US$ 1.12

The New Zealand fiscal year starting April 1 and ending March 31 is used in.this Report unless otherwise stated. This report was prepared by a Mission which visited New Zealand in August 1967, consist- ing of' Messrs. David Kochav (Chief), Jack Baranson, Dieter Elz and Wolfgang Kaupisch. Miss Penny Davis prepared the regression analysis of imports and GDP, and helped with the statistical work. A preliminary draft was discussed by the Chief of the Mission with the New Zealand authorities, during a brief visit in December 1967. MEDIUM-TERM ECONOMIC POLICY AND DEVELOPMENT STRATEGY IN NEW ZEALAND

TABLE OF CONTEMTS

Page BAS'IC DATA MAP SUIvMARY AND CONCLUSIONS i

I. INTRODUCTION 1

II. THE IfIEDTATE PROBLEM 2

III. THE FUNDAMENTAL PROBLE. 6

IV. OUTLOOK FOR BALANCE OF PAflENTS 11

Basic Assumptions 11 Trade Projections 11 Invisibles 13 Financing of the Deficit 16 Measures to Improve Balance of Payments 17

V. STRATEGY OF INDUSTRIAL DEVELOPMENT 20

Present Characteristics 20 Reorientation of Industrial Policy 22 Automotive Industry 25 Iron and Steel Industry 28 Pulp and Paper Industry 32

VI. IMPORT RESTRICTIONS, PROTECTION TO DOMESTIC INDUSTRIES AND RESOIJRCE ALLOCATION 35

Effects of Import Restrictions 35 Protection for Infant Industries 36

VII. THE DEVELOPMENT OF TOURISM 41

Present Situation 41 Prospects for Expansion 41

VIII. INTERNATIEONAL TRADE RELATIONS 44

Relations with the United Kingdom 44 Relations with Other Countries 45

IX. INSTRUMENTS FOR ECONOMIC POLICY FORMULATION AND PLANNING 47

Present Weaknesses 47 Reorganization of Planning 17

ANNEX I - Projections of GDP and Imports in 1972/73 51

ANNEX II - The Criterion of Domestic Costs of Forcign Eachange 55 BASIC DATA

Area (two main islands only) 102,000 square miles

Population - March 1967 2.73 mJllion Estimated annual growth rate, 1961/66 1.8is%

Gross National Product - March 1966/67 NZ$3,937 million Per capita NZ$ 1,h442. Annual real growth rate: 1954/55-1 966/67 4.3% 1960/61-1966/67 B8% 1965/66-1966/67 4.5%

Sector Origin of GDP at Factor Cost - March 19g61/65 Agriculture, Forestry, Fishing 17% Manufacturing, Mining, Power 42% Construction 5% All Services 35%

Percentage of GDP at Current Prices March Year 1965/66 1960/61-1965/66

Private consumption 63 63 Public consumption 13 13 Gross investment 27 25 Gross domestic savings 22 22 Exports, f.o.b. 20 21 Imports, f.o.b. 19 19 Government taxation revenue 24 24

March Year Resource Gap 1965/66 1960/61-1965/66 As a percentage of gross investment 18 11

June 1967 Change Over Money and Credit (NZs mil.) June 1966 Total money supply 776 -4.0 Total bank lending 872 8.0%

Price Increases - 1960-1966 2.7% p.a. BASIC DATA (Cont'd.)

June Year

1966/67 Average Rate of Change External Trade (Nz$ million) 1961/62-1966/67 1965/66-1966/67 Exports, f.o.b. 725.5 4.5% - 5eO% of which: Wool (24%) 173.9 -3.5% -25.0% P,eat (28%) 204.7 709V 4.1% Dairy products (28%) 205.0 7.0% 4.9% Imports, c.d.v. 721.5 7.3% - 1.0%

Balance of Payments March 1966/67 (NZ$ million)

Exports, f.o.b. 781.9 Imports, f.o.b. -719. 4 Net invisibles -232.4 Balance on current account -169.9

International Reserve Position

As a percentage of imports, June 1966/67 25% IMF position, October 30, 1967 (US$ million) Quota 157 Drawings 144 of which: Compensatory drawings 29 Gross fund position 81. Credit tranche - standby 42 Credit tranche - other 39

June 30, 1967 External Public Debt (US$ million)

Total debt outstanding 675.8 Net of undisbursed 633.0 Debt service ratio, 1965-1966 (service payments as a percentage of goods and services) 5-6% NEW ZEALAND

NEW ZEALAND POPULATION 1966 .-. \< AWIangarci 2'1,S00 POPULATION OF MAJOR CENTERS SHOWN (CENSUS OF MARCH 22,1966)

AUCKLAND S48 '30

Hamilton 63,0. T uranga 31,60

Rotorua 33, 0

7.0 N- o '>-°O \ 2Cihon

'2~ -o>t,=/Nlir3,00 Plymnouti,,,.New 3 300 *

NN ~ ~ ~~ ~~~~~~~~~~~~~~~~~~~~~~~~~~~

- - r.137, 000

'Wanganui 38,23

Palmerston Norih4910

Mls te rt on 7 , D.13

Nelson 27,600 1

,RLL[NGTON F, Nll'l'T 282,50(

20t// t L, un . B,a0

SII'41TCSIIURCH247,200

Timaru 27,900

DUNEDIN 108,700

Invercargill

20 0 20 40 60 80 I(20

SCALE OF MILES

NOVEMBER1967 IBRD-21(,S SUMARY AND CONCLUSIONS

The Present Situation

1i During the last two years New Zealand has been undergoing a difficult period characterized by a large deficit on current account, which amounted to about NZ$135 million (US$189 million) in the year ending October 1967. 1/ The increased deficit is due mainly to a reduction in export earnings from wool, which forms some 25-30 percent of exports. The decline in wool prices has been in part the result of a general slowdown in demand in industrial countries, but the main cause seems to lie in a shift towards a greater use of synthetic fibres, particularly in carpet production for which New Zealand crossbred wool is specially suited.

2. The recent period of balance of payments difficulties was preceded by a boom, resulting from increased export earnings combined with expansionary fiscal and budgetary policies. This led to a sharp rise in imports, instead of reserves being set aside for rainy days. Following the large increase in the current account deficit, the Govern- ment took fiscal and budgetary measures to contain inflationary pressures and thereby to reduce imports. It also engaged in large-scale external borrowing, on both long and short terms.

3. Following the 14.3 percent devaluation of the British pound, Nlew Zealand went somewhat further and devalued her dollar by 19.45 percent. The effects of the recent devaluation on New Zealand's balance of payments cannot as yet be confidently assessed. It appears, however, to have strengthened her competitive position towards Australia and other countries which have not devalued, especially with respect to non-agricultural commodities.

The Basic Problem

4s. The present balance of payments difficulties reflect the basic weakness of New Zealand: she is a high-income country over- dependent on exports of a small number of primary commodities. These exports have generally done well in the past, in spite of cyclical fluctuations. But they are now facing prospects of a long-term price downturn, wool because of a replacement by synthetics, and dairy products because of a danger of losing the preferential market of the United Kingdom. This would occur if the United Kingdom as well as Denmark and Ireland join the EEC, since an extended EEC is likely to have large surpluses of butter.

1/ All New Zealand dollar figures throughout the report refer to pre- devaluation rates. - ii -

5. The Government has recognized the need for diversification and has encouraged industrial development in order to provide employment as wel:L as to replace imports. However, insufficient attention has been paid in the past to cost considerations. Sheltered by the quantitative restrictions on imports, which have been maintained since the 1930ts to safeguard the balance of payments, but which have in fact been serving also as a protectionist instrument, most industries operate at high costs and on a small scale. Thus, a large part of New Zealand's capital and labor resources is tied up in production of a wide range of goods, manufactured to supply the domestic market. While industry has been the largest sector in terms of employment, it has made an insufficient contribution to export earnings or to net import savings. The Prime Minister in his statement announcing devaluation, emphasized the need to introduce structural changes in order to improve the use of resources and to make industry more competitive. The devaluation could indeed be conducive to the introduction of measures to that effect.

Medium-Term Economic Policy and Development Strategy

6. Only if the industrial sector becomes internationally competitive can the dependence of the balance of payments on a few agricultural commodities be reduced. To accomplish this, manufacturing must selectively concentrate on those products which can be produced at competitive prices. In some branches this can be done by processing domestic primary products. In others it can be accomplished by taking advantage of the technological potential embodied in her highly educated population. Together with favorable climatic conditions, technology has played an important role in making New Zealand agriculture one of the most advanced in the world. On the other hand, because of the sheltering of industry from external competition, this potential has not been fully realized as a primary factor in industrial development.

7. The most important single measure which can help make New Zealand manufacturing internationally competitive is its gradual exposure to competition from imports. This requires a removal of quantitative import restrictions and a reliance on tariffs as the major instrument of protection for infant industries. Such tariff protection should be given only for a temporary period, and the rates should not exceed a maximum percentage level and should be gradually reduced.

8. Well-defined criteria should also be established by the Govern- ment for priorities of development in the major sectors in order to encourage those activities in which New Zealand has a comparative advantage. An appropriate indicator of the comparative advantage could be the domestic costs per unit of foreign exchange saved by import substitution or earned by exports. The introduction of incentives based on such criteria, as well - iii -

as the removal of quantitative import restrictions, would lead to the establishment of competitive industries in the future. The most difficult task, however, is to make existing industries more competitive. Such industries should eventually be subject to the same criteria, although they could be given a grace period for a gradual readjustment.

9. A detailed scheme needs to be prepared for such a shift from quantitative restrictions to tariff protection and for a restructuring of existing industries. A scheme of this type could best be prepared by special working parties of officials, who should suggest a quantitative framework for tariffs. Then the Government could consult with existing industries on the necessary adjustments to the new system. Furthermore, within the framework of the new system the Tariff and Development Board should be strengthened in order to be able to review a 'Large number of industries in a reasonably short period.

10. With respect to agricultural commodities, the most promising prospects at present are for meat exports, particularly for beef, the production of which should be further encouraged. in the long-run, wool prices are likely to be lower than in the pre-1966 period, which may tend to slow down expansion in the supply of lamb as well. Dairy products are likely to face increasing marketing difficulties, especially if Britain joins the EEC. In any case, efforts should continue to be made to establish permanent markets for dairy products in Japan and other Asian markets.

11. Regardless of the outcome of the present United Kingdom efforts to join the EEC, New Zealand should intensify her trade relations across the Tasman Sea and the Pacific Ocean. New initiatives on the highest political level in both New Zealand and Australia are now needed to overcome their protectionist policies, in order to make the New Zealand- Australia Free Trade Agreement an effective trade expansion instrument. The need for additional markets for agricultural commodities and for more efficient industrial development call for closer ties, in particular with Japan and the U.S.

12. New Zealand is presently lacling effective instruments for analysis and advice on long-term economic policy and development strategy. She should strengthen the existing planning unit in the Treasury and set up small units for sectoral planning in the other appropriate departments. One of the major weaknesses in New Zealand marketing has been in the projection of commodity trends. A trade analysis unit should be established to give the New Zealand Government and the marketing boards an instrument for systematic analysis of trends in export commodities and for advice on marketing and trade policy. - iv -

13. If recent trends continue, New Zealand is likely to face a continuous large deficit on current account, which by 1972/73 might require public borrowing of between NZ$100 to NZ$150 million a year. The major constraint on New Zealand's external borrowing is not likely to be her debt servicing capacity. Her debt service ratio at present is about 5 percent of exports of goods and services, and should remain comfortable in the future. Nevertheless, with the supply of external public capital so limited, a high-income country like New Zealand cannot expect to be permitted to borrow large amounts of capital during a lengthy period. A reorientation of the industrial policy and an improved marketing policy for agricultural commodities, geared more to changes in international demand, could gradually lead to a reduction in the deficit. In spite of her high standard of living, New Zealand would have a claim for external public borrowing to help finance an. effective diversification program. However, the decision to undertake and carry out such a program depends on the political will and determination of New Zealand herself. I. INTRODUCTION

1. This report has been written by an Economic Advisory Mission which visited New Zealaid in August 1967. The functions of this Mission, defined in the Terms of Reference, were as follows:

"1. ,..The major purpose of the Mission at the request of the New Zealand Government, is to be available for consultations on the long-term strategy for economic policy and development.

2. The Mission will pay special attention to policy and programs related to industrial development, which could hopefully lead to diversification of production and exports of New Zealand.

3. The Mission will discuss the implications for New Zealand of the possibility of Britain joining the EEC, especially with respect to production and marketing of New Zealand's agricultural commodities.

4. The Mission will also be available for discussions of other economic and financial implications on lNew Zealand related to the above matters. In particular the Mission will discuss with the appropriate representatives of the New Zealand Government the problem of obtaining the necessary inflow of long-term capital funds to finance development."

Following a later request by the New Zealand Government, the Mission also attempted to generally ascertain "whether expansion of tlhe tourist industry should be regarded as a useful avenue for development."

2. Thus, the Mission concentrated mainly on some major long-term economic problems facing New Zealand. The present report is designed to cover the Mission's major conclusions and suggestions, primarily for the use of the New Zealand Government. An assessment of the economic prospects of New Zealand for the Bank has been considered only as a secondary function. For that reason the Mission restricted the description of the state of the economy to the minimum, assuming it would be well known to many prospective readers of this report.

- 1- II. THE III-EDIATE PROBLEM

3. New Zealand is presently faced with serious economic difficulties, reflected most strongly in a large deficit on current account. In the years ending October 1966 and 1967, thle current account deficit 1/ amounted to NZ$82 million and NZ$136 million respectively (Table 1). A deiicit of that level is several times higher than in the three preceding years. Only in two years, 1959/60 and 1960/61, out of the last 15 has the deficit been of a similar magnitude.

4. The deficit on current account assumed worrying proportions as early as 1965/66, when exports were still increasing. The problem became more difficult in 1966/67, when export earnings declined. This decline was the result of a down-turn in wool prices toward the end of 1966 (Table 17, VoLume II), which was followed by a withholding of some wool supplies from international markets by New Zealand in expectation of an upturn in prices. On the other hand, the earnings of other major export commodities, butter, meat and cheese, continued to increase through 1966/67.

5. In the three-year period between 1962/63 and 1965/66 merchandise imports increased by over NZ$200 million. In addition, net payments on invisibles, especially on investment income payments, travel and transportation, tended to increase at a fairly rapid rate (Table 20, Volume II). This steep increase in imports in that period was chiefly the result of a sharp rise in domestic demand, financed in part by the growth of export earnings and in part by an expansionary budgetary policy. National expenditures during this period increased at an annual rate of about 8 percent (Table 7, Volume II), twice the rate of long-term growth of GDP in real terms. Such a high rate of increase in domestic demand is an indication of excessive strain on resources. The sharp increase in imports was also associated wvith a steep rise in investments, which to some extent led to an expansion of production.

6. Developments in recent years basically followed a pattern typical and rather familiar in New Zealand. A considerable rise in export earnings since 1962/63 greatly increased the incomes of farmers and other factors related to export industries. At the same time, the Government maintained fiscal and budgetary policies which resulted in a rapid increase in public consumption and investments, as well as in private expenditures. The inflationary pressures were the result of a number of factors -- an expansion of social services, large-scale subsidies for investments in housing and consumption, and the desire to maintain a high level of employment, which in fact meant a continuous

1/ As defined in the data of overseas exchange transactions of the Reserve Bank, which differ from the customary definitions used in the balance of payments series, shown in Table 20, Volume II.

-2 - Table 1

NEI ZEALAND: OVERSEAS EXCHANGE TRANSACTIONS, 1962/63-1966/67 (NZ $ Millions)

F I S C A L Y E A R S Years Ending 1962/63 1963/64 196h/65 1965/66 1966/67 Oct. 1966 Oct. 1967

Current Account

Export Receipts 650.8 730.4 768.6 774.1 795.8 824.6 734.6 Import Payments 521.6 627.6 657.0 7h2.4 722.4 739.6 687.6

Trade Balance +129.2 +102.8 +111.6 + 31.7 + 73.h + 85.0 + 47.0

Invisibles (net) -114.8 -118.5 -136.0 -149.3 -180.1 -166.9 -182.7

Current Account BalancelV + 14.4 - 15.7 - 2h.h -117.6 -106.7 - 81.9 -135.7

Capital Account

Private and Local Bodies (net) + 12.3 + 7.3 + 5.0 - 2.3 - 1.2 - 0.7 + 4.7 Official (net) + 31.8 - 2.3 + 7.1 + 72.7 +113.0 + 96.8 +1h6.2

Capital Account Balance2/ + 44.1 + 5.0 + 12.1 + 70.h +111.8 + 96.1 +150.9

Surplus or deficiti/ + 58.5 - 10.8 - 12.3 - h7.2 + 5.1 + 1h.2 + 15.2

1/ Totals may not balance due to rounding.

Source: Reserve Bank of New Zealand and Department of Statistics, Economic and Financial Statistics, November 1967. situation of over-full employment. National expenditures, measured by GDE' growth at current prices, were allowed to grow at a rate almost identical with export earnings, as can be seen from Chart I. In fact, a regression analysis made by the Mission shows a "correlation coefficient" as high as 92 percent between export earnings and GDP in current prices. Thus, the Government did little to introduce anticyclical policies which could prevent excessive demand and in turn result in some accumulation of exchange reserves as a cushion against a fall in export earnings.

7. The mounting deficit on current account was financed by an increase in public borrowing from various sources, including short-term credits and drawings from the DIMF. As wool prices declined and the external financing difficulties increased, the Government was forced to taLte corrective measures, introduced in February and May 1967. Indirect taxes were raised, certain subsidies on agricultural commodities sold to local consumers were abolished, the growth of public sector expenditures were slowed down and credit ceilings reduced. These resulted in some unemployment (about 8,000 persons or less than one percent of the labor force), which had been unknown in New Zealand since the 1930's, and in a slowing down of GDP growth. Present indications tend to show a considerab:Le reduction in the level of imports and signs of a more positive attitude by labor and management toward the need to raise productivity.

8. In November 1967, following the devaluation of the pound sterling, the New Zealand dollar was devalued. With a change of 19.4 percent the New Zealand dollar has now been brought on par with the Australian dollar. The devaluation will certainly improve the competitive position of New Zealand's exports, especially in non-British markets, and is also expected to further ease the demand for imports. In a statement announcing the devaluation, the Prime Minister strongly emphasized the need to continue tight fiscal and monetary policies and to prevent increases in wages, so that the improvement in New Zealand's competitive position will not be eroded. It is of course too early to make any quantitative projection of the effects of devaluation. In the Mission's view, it is of paramount importance that the devaluation be followed by further measures designed to strengthen the structure of the lNew Zealand economy, as discussed in the following chapter. NEW ZEALAND: PERCENTAGE CHANGE OF GDP AND EXPORTS OVER PREVIOUS YEAR +20% 1 1 1 l 1 l iE+80%1 CURRENT PRICES l80%

+15% +60%

+10% +40%

+5% +20%

0 ~ ~0

, I 1----- ''t~~~~~I '-o EXPORTS (RIGHT SCALE ) -5% -20%

-10% I I___-40% 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 FISCAL YEARS ENDING MARCH 31

IBRD - 3561 . III. THE FUNDIlArENTAL PROBLEM

9. The Mission's basic contention is that New Zealand faces not merely a problem of how to cope successfully with the immediate difficulties described in the preceding chapter, but that the balance of payments situation is to a considerable extent a symptom of a fundamental and structural problem. The crlux of the fundamental problem is that the eccinomic well-being of' New 'ealand is still too narrowly dependent on a few export commodities. Among the high income countries, New Zealand has perhaps the highest concentration of exports, in terms of the small number of commodities as well as of export markets. Wool, meat and dairy products account for over 80 percent of exports, and the United Kingdom purchases about half of all New Zealand's exports. Because of this concentration export earnings have been subject to considerable fluctua- tion in the past. Presently, New Zealand seems to be facing a long-term decline in export earnings for these commodities, which may result in a large balance of payments deficit and thus endanger her growth and well- being.

10. A detailed discussion of the prospects of the major export commodities is contained in Volume III. In brief, prices of wool are not likely in the long-run to return to the pre-1966/67 level, because of the relative strength of competing synthetics. Dairy products, especially butter, could meet serious marketing problems, if and when Britain joins the Common Market. If past trends of industrial develop- merit continue, the prospects for a rapid increase of non-pastoral exports are far from encouraging.

11. The need to strengthen the base of the New Zealand economy by diversification of production has long been recognized by the Government, which actively encouraged industrial development. The main orientation of such development was not to diversiflication of exports, but to processing of a wide range of products for the small size domestic market with little regard to considerations of costs and comparative advantage. An evaluation of industrial development is discussed in some detail in Chapter V. How- ever, a few comments on the balance of payments effects are appropriate at this point.

12. If cyclical fluctuations in the volume of imports are dis- regarded, the ratio of imports to GDP has not shown a declining trend over the years. This can be seen in Chart II and in the results of a regression analysis made by the Mission and briefly described in Annex I. The trend of the ratio of imports to GDP, both at constant 1954/55 prices, has remained at a level of approximately 20.6 percent over the last 13 years.

13. The industrialization policy oriented mainly towards the protected home market has created employment opportunities and additional income, but has led to little net savings in imports or to growth in exports. With higher living standards and a larger import bill, New Zealand has remained

-6- NE'W ZEALAND: PERCENTAGE CHANGE OF GDP AND IMPORTS OVE£R PREVIOUS YEAR +10% - X E |+40% CONSTANT PRICES, 1955 =10IQD

-5% eX20% +

+15% , T 0 CURRENT PRICES

+1 _ ___- 0 0~~~~~~~~~~~~~~~~~~~00% \ G~~~DP

8F SCALEN Y NLEFT MAC 31

-5% + 20# 1954~~%195 15 97%5 99 160 16 92 16 94 16 1966

% %~~~~~~~~~~~~~~~~~~~~~~

IBRD- 3S62N - 8 - most vulnerable to changes in prices of a fewi export commodities. A considerable part of capital and labor resources are thus tied up in activities which have made an insufficient contribution to the removal of the balance of payments as a constraint on future growth. In this respect a good deal of industrial development in the past represents a misallocation of resources.

14. If New Zealand continues to develop on the same lines as in the past, she is likely to face serious balance of payments difficulties, which could then become a major constraint on the future growth of production and employment. Such a danger is strongly indicated by medium-term balance of payments projections prepared by the Treasury, which are discussed in some detail in Chapter IV. These projections, as revised by the Mission, show that the New Zealand Government might have to borrow from external sources between NZ$100 to NZ$150 million a yrear by 1972/73. A high-income country such as New Zealand cannot expect to borrow continuously such massive amounts of external capital.

15. If the long-term prospects for exports of her primary commodities are not encouraging, what options are then open to New Zealand? One possibility would be to sacrifice growth for balance of payments improvement. This could be done by pursuing deflationary policies for a lengthy period in order to reduce the level of imports. It has even been suggested to the lMlission that New Zealand might prefer to settle for lower growth rather than change her long prevailing social and economic attitudes. Wqhether all traditional social benefits could be maintained in a situation of very Slow growth and less than full employment is open to question. However, in the Mission's view, policies which would lead to very low growth rates for a lengthy period are not acceptable. The arguments against such a policy are based not only on the familiar grounds of the losses involved in economic well-being, but in the case of New Zealand, also on the nourishment of the prevailing feelings of remoteness from the mainstream of world progress, which may increase the country's brain drain. In fact, to maintain her traditional position as one of the more economically and socially advanced countries, New Zealand will have to grow at a rate not much slower than Australia and Western Europe, and in the Mission's view, at a rate not much less than 2 percent a year per capita. In brief, the objective of economic policy in New Zealand should be to encourage reasonable growth without upsetting the balance of payments.

16. The above comments should not be construed as a case against any contractory measures to help overcome the immediate difficulties. Indeed, any adjustment of the economy and reorientation in development policy could be carried out only in a disinflationary environment. How- ever, deflationary policy would be advisable only for a limited period, during which the economy could be readjusted toward a long-term development strategy. - 9 -

17. There is nothing wTrong in a high ratio of imports to CDP or in the constancy of that ratio per se. As a matter of fact, for a small country not richly endowed with natural resources, New Zealand is doing well to be participating so extensively in international trade and main- taining a high rate of exports and imports to GDP. However, to finance a growing volume of imports, exports must grow at a sufficiently rapid rate in order to avoid too 'Large a deficit. The limited number of both the present export commodities and the present export markets are not likely to continue to provide a sufficient level of earnings to finance an increasing import bill. Thus the real choice facing New Zealand is not between policies that pursue export expansion versus those favoring import substitution, but between economically efficient versus inefficient production. If production is carried out at competitive prices, it wil contribute towards a balance of payments improvement, either through export diversification or through net import savings. In that case, the balance of payments will not be a constraint to continued gro-wth of the economy.

18. New Zealand's present situation is similar to that which faced Norway, Denmark and Ireland in the past. These countries were also heELvily dependent on exports of agricultural commodities, but they managed to diversify their exports by building up competitive industries, and thereby reducing this dependence. Like New Zealand, all three countries have a small domestic marlcet and limited mineral resources which can be profitably processed for export. Nevertheless, they still introduced appropriate policies designed to encourage competitive industries. Denmark has liberalized trade by eliminating quantitative import restrictions and replacing them with relatively low tariffs, has supported increased industrial investment and productivity, and has expanded her markets by actively participating in EFTA. Norway too has consistently pursued a liberal trade policy by permitting only moderate tariff protection to domestic industries, has enlarged her market by joining EFTA, has encouraged foreign participation through cooperative agreements between enterprises, and has emphasized development of industries with a high labor skill content. Ireland has stimulated the inflow of foreign capital and know-how through grants and tax exemptions, has provided advisory services for industrial diversification, and has attempted to widen her markets as well as to liberalize trade through the Free Trade Agreement with Britair. and the gradual relaxa- tion of import restrictions.

19. On the whole, such conscientious efforts by Norway, Denmark and Ireland to reduce their dependence on agricultural exports have proven successful. From 1958 to 1965, the growth of industrial exports in all three countries greatly exceeded their agricultural exports. During this period the agricultural exports of all three countries grew at 6 percent per year while the industrial exports of Denmark, Ireland and Norway increased annually by 13 percent, 18.5 percent, and 12 percent respectively. This difference in the growth of industrial and agricultural exports is also reflected in the changes in each country's composition of - 10 -

exports. In 1958, 66 percent of Denmark's exports were agricultural commodities and 32 percent were industrial goods, but by 1965 only 55 percent were agricultural and 42 percent were industrial. The same was true in Ireland, where the percentage of agricultural exports had fallen from 74 in 1958 to 64 in 1965 and the percentage of industrial exports had risen from 14 to 26. Noryway too strengthened her export position with industrial exports, including minor exports of unwrought metals, 57 percent of the total in 1958 and 66 percent in 1965 and agricultural exports, including exports of fish and fish products, 37 percent of the total in 1958 and 28 percent in 1965.

20. New Zealand's industries have one major disadvantage compared to the above countries: she is located far from any large markets, and therefore has higher freight costs than the others. This disadvantage is often cited in New Zealand as a justification for establishing industries to serve the protected domestic market. The disadvantage of high freight costs must be duly recognized because it certainly affects the structure of industries. It favors export industries with relatively low freight costs, and gives a natural advantage to domestic industries producing bulky products with high freight costs by raising the c.i.f. price of competing imports. However, the disadvantage of high freight costs cannot be overcome by creating high-cost domestic industries, and cannot serve as a justification for undue protection of such industries.

21. The improvement in the use of New Zealand resources calls for a development strategy much more selective than in the past. It should direct capital and human resources only to those activities which could make a significant contribution to an increase of exports or to import substitution at competitive prices. Certain suggestions to that effect are made in Volume III and Chapter V of Volume I, which deal with agricultural and industrial development respectively. Basically, this strategy requires greater emphasis on industries oriented towards exports or tcowards import substitution at competitive prices, making use of New Zealand's technological potential. Industries producing mainly for the domestic market would have to be exposed to import competition, and their economic viability proven under market conditions. The latter would undoubtedly require a restructuring of several existing industries. The above principles should be expressed in clear criteria, based on priorities according to the costs of domestic resources per net earnings of foreign exchange or their net savings (see paragraph 65).

22. Such a reorientation is certainly not an easy task and it would require a trying period of adjustment. Perhaps the most difficult facet would be the necessary changes in existing industries, many of which, in the Mission's view, are high cost and economically inefficient. While the adjustment period may be painful, the Mission considers the above reorientation the only sound policy which, barring an unexpected sustained upturn in pastoral exports, could in the long-run attain both objectives of balance of payments improvement and economic growth. IV. OUTLOOK FOR BALA4CE OF PAYMENTS

Basic Assumptions

23. The balance of payments is the Achilles' heel of the New Zealand economy. If the balance of payments could be reasonably managed, perhaps most policy makers in New Zealand would be quite happy to carry on their past policies. It is, therefore, imperative to examine some basic trends which New Zealand is likely to face in the future. A focal point for such an examinattion will be projections prepared prior to devaluation by the Treasury for 1972/73 (Table 23, Volume II). At the present time, it is not clear whether these projections will have to be revised in terms of foreign exchange receipts and expenditures due to devaluation.

24.. Such projections are most often subject to serious misinter- pretations. Thus it is not superfluous to repeat some well-known comments on their nature and purpose. The purpose of these projections is definitely not to make predictions, since these are subject to extreme uncertainties. Errors may be especially big for such items as the current account deficit or public financing requirements, since these are only small residuals of much larger figures which cannot be forecast with any degree of accuracy. For instance, in the case of New Zealand an error of only 10 percent in export earnings, other things being equal, could result in a 100 percent error in the current account deficit. The figures discussed in these projections are merely quantitative indications of likely trends. The purpose of such projections is to locate those strategic factors which are likely to be of major importance in future development and which could be changed by policy measures. In brief, such a projection is not meant to be a "crystal gazing" exercise, but rather to serve as a basis for a discussion on policy measures.

25. The year 1972/73 has been chosen merely to indicate likely trends in the medium-term, disregarding cyclical ups and downs. Thus, no special significance should be attached to this particular year, which is just a point on a trend line.

26. The projections prepared by the Treasury for 1972/73 are generally based on an extrapolation of past trends. Only for a few lesser items, such as receipts from tourism, does the projection assume a significant departure from past policies. These projections specifically do not take into account changes in export receipts as a result of the possible entry of the United Kingdom into the Common Market.

Trade Projections

217. For most items, especially for invisibles, the Mission generally accepts the Treasury's projections. With respect to export estimates, the Mission suggests a lower projection for wool, but feels that the projections for other commodities are generally reasonable and consistent with

- 11 - - 12 - the basic assumptions. The prospects for agricultural exports, as seen by the hLission, are discussed in some detail in Volume III. With respect to non-pastoral exports, the Treasury projects a doubling of exports of forest products and a relatively minor increase in other exports. The Mission's projection for total exports amounts to NZ$965 million for 1972/73, some NZ$35 million less than the Treasury projection.

28. A critical factor is the level of imports. The Treasury has made four alternative projections, based on a 3 percent or 4 percent GDP growth rate andl a 21 percent or l9.5 percent ratio of imports to GDP (Table 26, Volume II). In the Missionts view, a GDP growth rate of 3 percent, or about 1 percent per capita, might be sustained for a year or two as a result of contractory policies. However, for a medium-term such as five years average growth of 1 percent per capita a year seems to the Mission too low to be accepted as a realistic target. The alternative of 4 percent overall GDP growth, which means a 2 percent per capita growth, is considered by the Mission to be reasonable as a basis for a medium-term balance of payments projection. This growth rate is slightly less -than the 4.2 percent average during the last 13-year period and considerab:Ly lower than the 6 percent average of the last three years.

29. To gain a better impression of the ratio of total imports to GDP (hereafter referred to as the "import ratio"), the Mission ran a regression on the 13-year period 1953/54-1965/66. The trend of the import ratio, calculated from 1954/55 prices of GDP and imports, appears to be approximately 20.6 percent. The figures seem to show a significant relationship between changes in GDP and imports at fixed prices, for which the "correlation coefficient" is 0.63. Although there have been some changes in relative prices of GDP and imports, they do not seem to have greatly affected the import ratio, since the "correlation coefficient" of GDP and imports both at current prices is 0.66, only slightly higher than the fixed price. Unfortunately a long-term series of imports classified by economic end-use is unavailable. Thus, the 'Mission has been unable to determine to what extent this stability of the ratio of total imports to GDP conceals a major change in import composition from consumer items to investment goods. Nevertheless, GDP growth in real terms seems to have been the major factor affecting imports (see Annex I).

30. Apart from the overall GDP growth rate, the future level of imports will probably also be affected by the composition of GDP, expecially by changes in investment composition. A proper forecast of import requirements would have to take into account such changes. It is hoped that such a forecast would be made by the New Zealand planning unit.

31. Because of the incomplete nature of the present import data, the Mission believes it prudent to assume a range for the ratio of imports to GDP for the next five years. As a preliminary and very rough estimate, 20.6 percent and 19.5 percent seem reasonable as the upper and lower limits - 13 - to this range of the future import ratio. The former has been extrapolated from the past trend by the Mission. It is somewhat lower than the Treasury's higher alternative of 21 percent, which is an average of the last five years, and the ratio of 22.6 percent, which prevailed in 1965/66. Nevertheless, when the present deflationary policy is also taken into consideration, the Mission feels 20.6 percent is reasonable as an estimate of the upper limit to the import ratio. The latter, 19.5 percent, is the lower alternative of the Treasury. In the Missionts view, such a ratio is reasonable as a lower limit to the range, because in two years, 1959/60 and 1962/63, out of the past 13, the ratio was lower than 19.5 percent. In both years the ratio was reduced by a combination of monetary and fiscal policies and a reduction in the issuance of import licenses. However, these policies were short-lived and after a brief period the import ratio rose. Thus, in the Mission's view, in order to maintain an import ratio of 19.5 percent for a lengthy period, either the present deflationary policies would have to be prolonged or there would have to be a major change in policies affecting industrial development. With this qualification, the IMlission feels that 19.5 percent is acceptable as a rough indication of the lower limit of the import ratio over the next five years.

32. International prices of New Zealandts imports are likely to rise somewhat and the Treasury assumed a 1 percent increase for the whole period, 1965/66-1972/73. This rate is tentatively accepted, although it is undoubtedly on the low side.

33. On the assumptions of a growth rate of GDP of 4 percent annually, a ratio of imports to GDP ranging between 19.5 percent and 20.6 percent, and a 1 percent increase in import prices, the Mission feels that New Zealand's import bill might range between NZ$840 to NZ$885 million by 1972/73. Combined with the projected exports, as revised by the Mission, this results in trade surplus of NZ$80 to NZ$125 million by 1972/73 (Table 2).

Invisibles

34. In contrast to a surplus on trade, New Zealand has consistently shown a large net deficit on invisibles. The Mission concurs with the Treasury's assumption that this situation is unlikely to change in the future, for the following reasons.

35. Transportation expenditures are estimated to increase at the growth rate of external trade, unless freight costs change. The expected expansion of trade, at fixed shipping costs, might increase net payments for transportation to some NZ$63 million by 1972/73, as based on the Treasury's assumptions concerning transportation projections and the Mission's revision of export and import projections (Table 27, Volume II). - 14 -

Table 2

Illustrative Balance of Payments Projection 1972/73

(NZ$ million)

1965/66 Actual 1972/73 Projectioni/

Exports Pastoral 670o1 845 Non-Pastoral 60.4 100 Re-exports 16.7 20

Total Exports 747.2 965 2/

Imports -718.8 -840 to -885 2/ Trade Balance 28.4 125 to 80

Net Invisibles Transport - 60.0 - 63 Travel - 27.5 - 40 Investment Income - 59.4 -123 Government Transactions - 17.7 - 32 Miscellaneous (including insurance) -28.4 - 45 Unilateral Transfers - 22.6 - 34

Total Net Invisibles -215.7 -337

Balance on Current Account -187.4 -212 to -257

Net Private Capital. 81.0 100

NIe-t Public Financing Requirements -106.4 -112 to -157

1/ The 1972/73 projection is expressed in NZ$ pre-devaluation in order to be compatible with the 1965/66 data.

2/ The export and import projections as revised by the Mission are rounded to the closest NZ$5 million. Imports are assumed to range between a ratio of imports to GDP of 19.5 percent to 20.6 percent.

Source: New Zealand Treasury Department. - 15 -

36. The Mission is aware of suggestions that payments on transportation could be reduced by building up shipping lines owned by New Zealand companies. However, in the Mission's view, investments in merchant ships for international +,rade are unlikely to be economical for New Zealand. There are two basic characteristics of large-scale shipping operations -- they are very capital intensive and employ mainly non-skilled labor. In both respects, New Zealand has little, if any, comparative advantage. She has very limited domestic capital that could be invested in ships, and would have to increase sharply her external borrowing to finance such an investment. Also, wages for New Zealand non-skilled labor are likely to be higher than on ships of many other maritime nations. Therefore, such shipping lines are most likely to be unprofitable, because any apparent balance of payments savings would probably be smaller than the balance of payments costs of the shipping facilities and capital servicing.

37. Net travel payments are expected by the Treasury to continue to rise, but at a rate slower than in the past. On the debit side, payments for overseas travel by New Zealanders are projected to grow from NZ$41 million in 1965/66 to NZ$70 million in 1972/73, which means a deceleration from the past rate of increase (Table 28, Volume II). Some slowdown might be achieved as a result of a slower rise in general income0

38. The treasury projection also estimates a large increase in tourism receipts from NZ$13.5 million in 1965/66 to NZ$30 million in 19-72/731/ The Mission's brief comments on the development of tourism are discussed in Chapter VII. The Mission considers the above increase to be feasible, but it will require a more concerted effort than presently envisaged, in both planning and executing the development program. Only on the assumption that such a program for tourism will be prepared ancl put into effect without delay can the Mission accept the Treasury's projection on tourist receipts.

39. 7nvestment income payments of the private sector are determined by the volume of private overseas investments in New Zealand and their rate of return, wuhile those of the public sector depend on the size of the public ext;ernal debt and its average interest rates. The Treasury's projection shows a steep increase on the debit side, doubling the net payments from 1965/66 to 1972/73 (Table 29, Volume II). Income of overseas companies operating in New Zealand might be expected to grow generally in line with overall economic activity, as ex-pressed by GDP in current prices. Since the expected containment of inflationary pressure will slow down GDP rise in current prices, the Mission considers the Treasury projection somewhat excessive, and suggests a slightly lower figure (Table 29, Volume II).

1/ Both figures are in balance of payments terms, which because of differences in definitions are considerably different from figures compiled by the New Zealand Tourist Department. - 16 -

40. The Treasury's projection of investment income payments on Government transactions assumes a steep increase in the external public debt and an average interest rate of 7 percent for additional new borrowing. In view of the prospects of a considerable increase in the current account deficit, these assumptions seem reasonable. Similarly, there is no basis to question the Treasury's projections on receipts on New Zealand's private and public investments, which offset a minor part of the payments to be made.

41. Other invisibles, such as Government transactions, miscellaneous (including insurance) and unilateral transfers, are projected by the Treasury to increase at about the same rate as in the past. The Mission sees no reason to depart from this forecast (Tables 30, 31, 32, Volume II).

Financing of the Deficit

42. The above items amount to a large increase in net payments on invisibles as well as a considerable increase in the current account deficit. A part of this increase can be expected to be financed by the growth of reinvested earnings of overseas companies, expressed in the balance of payments as a private capital inflow. But net public financing requirements still mighlt be expected to rise from the unusually high level of NZ$106 million in ]965/66 to an even higher level of between NZ$112 to NZ$157 million by 1972/73 (Table 2).

43. New Zealand has incurred considerable debts to the B.I.S., the Reserve Bank of Australia, and the I.M.F. in the past year or so and their repayment will impose a further burden on the balance of payments over the next few years. Moreover, the reserves are now low and there is a need to restore them to more comfortable levels. These considerations should be taken into account in assessing the size of both the balance of payments gap and the requiired finance in the coming years.

44. In the Mission's view, a gap of the above magnitude for any length of time greatly exceeds what New Zealand could expect to borrow. The question of the size of the net public financing gap for which New Zealand could realistically plan is a difficult one, and depends a good deal on expected developments in major international capital markets. It is almost impossible to foresee the degree of New Zealand's future accessibility to the New York or the London capital markets, since this depends to a large extent on such notorious uncertainties as the balance of payments situation of the United States and the United Kingdom. However, following some discussions with financial authorities in the United Kingdom in August 1267, the LMission feels that New Zealand could borrow in London and the European bond market NZ$30 to NZ$40 million a year, net of redemptions, as long as present - 17 - basic market conditions prevail. Since in the next few years the European bond market will probably expand at a fairly rapid pace, New Zealand might increase its net borrowing in the above markets to approximately NZ$50 million a year. Unless the U.S. balance of payments situation greatly improves, it seems questionable that New Zealand could expect to increase her borrowing in the New York market much above the level of her redemptions in that market.

45. The limiting factor on New Zealand's public borrowing in the next few years is not likely to be her creditworthiness. Fortunately, New Zealand has an excellent external debt record. The ratio of debt service payments to exports of goods and invisibles was about 5 percent in 1966, and even though this ratio is likely to increase due to the higher level of borrowing and the rise in average interest rates in coming years, it would still not be excessive. The primary limiting factor will probably be the de facto restrictions on exports of capital in major financial centers.

46. New Zealand could perhaps somewhat increase her external financing through suppliers credits, although this method would be suitable only for the purchase of equipment and capital goods. Even if a more vigorous search could make additional medium-term credit available, New Zealand should not compromise her wise long-standing policy of purchasing in the lowest priced market.

47. In conclusion, the Mission foresees the serious prospect of a large-scale financing gap for a rather lengthy period. It is worth stressing that the above balance of payments projection is not based on extremely pessimistic assumptions, since it considers none of the changes which may occur if the United Kingdom joins the Common Market without reasonable safeguards for New Zealand's butter exports, or if inflationary pressures resume in New Zealand. In the Mlission's view, the medium-term outlook for the balance of payments is a strong indication that the economy of New Zealand faces a structural problem, not merely a cyclical one.

Measures to Improve Balance of Payments

48. If the above outlook is basically accepted, the major question of future economic policy is: What can New Zealand do in order to achieve a basic improvement in her balance of payments, especially in trade?

49. First, a warning should be voiced against the illusion that a balance of payments deficit can be reduced by increasing administrative restrictions on imports or on invisibles, such as overseas travel expenditures. The past record indicates, in the Mission's view, that such restrictions have resulted in little net savings of foreign exchange. - 18 -

On the other hand, they have introduced serious distortions into the economy through the misallocation of resources in uneconomic domestic production. It may be feasible to save some foreign exchange for a year or two with restrictions, but in the long-run such savings would only be minor at best ancd would probably result in further distortions, leading to even more serious difficulties in the future.

50. Consequently, in the Mission's view, the medium- and long-term balance of payments policy should be geared to the following main objectives:

a) To increase non-pastoral exports at a considerably higher rate than implied in the Treasury projection.,

b) To produce import substitutes at competitive prices.

c) To increase the net inflow of private capital.

The measures required to attain the first two objectives have already been summarized in paragraph 21, are discussed in some detail in other parts of the report, and need not be repeated here.

51. New Zealand should make additional efforts to increase the inflow of private capital, especiaUly of direct investment, At present the flow of such investments consists mostly of reinvested earnings of existing overseas companies with a very small inflow of new private direct investments. There are many objective obstacles to an attempt to increase such investments, both domestic and external. These can be overcome only by an active policy of encouragement and offers of adequate incentives to overseas investments. It is not only the oalance of payments requirements which make such efforts to attr'act fo2eign private capital necessary, but the basic need to reconstruct ir,dustry as well. The technical ability and the marketing outlets,which appropriate overseas participation can offer, are essential factors in a reorientation toward export markets or in the exposure to competition with imports. Such participation would undoubtedly lead to an eventual increase of investment income payments, but the indirect benefits to the balance of payments of increased exports or of real import savings should not be neglected.

52. The IhIission recommends that an expert with experience in attracting foreign private investment be appointed to look into existing incentives as well as disincentives for overseas private investments and to make detailed and specific recommendations for any additional incentives which seem to be required to attract such capital. J1 -

53. In the formulation and implementation of the above policies, there is admittedly an important time element. Even if serious efforts are made to formulate and introduce the required measures, only after a number of years would the effects be felt on the balance of payments. Thus, New Zealand is likely to undergo a period of adjustment, in which she may face additional balance of payments difficulties as well as social and political domestic pressures. In the Mission's view, if New Zealand would show a readiness to formulate and adopt such policies, geared to a basic improvement in her balance of payments, she would have a strong case for borrowing from public sources to help her bridge the adjustment period, as well as for development capital to help finance a genuine diversification program. V. STRATEGY OF IDDUSTRIAL DEVELOPNviENT

Present Characteristics

54. Manufacturing is the largest of the non-service sectors. It employs more workers and provides a larger part of GDP than agriculture. Moreover, the annual growth rate of manufacturing output, averaging in constant prices over 8 percent in the years 1958 to 1964, has been much faster than the 3.3 percent annual growth in agricultural output. About 20 percent of all manufacturing consists of direct processing of farn. products, another 14 percent consists of domestic forest products. The remainder is widely distributed among the other sectors, including textiles, building materials, metal industries and chemicals.

55. The major feature of lNew Zealand's industry is its orientation toward the domestic market. The main exceptions are the processing of butter, cheese and meat, technically classified as manufacturing, and the production of pulp and newsprint, all of which are largely exported. Apart from these products, industry provides only 1 percent of total exports, and only 4 percent of industrial production is being exported. The domestic market orientation of New Zealand industry is to a large extent the result of quantitative restrictions on imports. These have been maintained since the 1930's primarily for balance of payments reasons, but in fact they have acted as a shelter and bothouse for local industries. Under such protection, a wide variety of industries have been established, many operating on a small-scale and at high costs.

56. The Government has actively encouraged industrial development, regarding it as a major provider of employment and foreign exchange savings. The belief that domestic production, regardless of costs, saves foreign exchange has been and still is widespread. Few attempts have been made by the Government to identify those factors, such as advanced technology, in which New Zealand could have a comparative advantage, and then to search for methods which use these factors as a basis for industrial development.

57. Furthermore, neither the general labor situation nor the wage structure in New Zealand have helped to reduce production costs. Since there is such a great demand for labor in industry and since little premium is placed on efforts to gain skills or raise productivity, the wages for unskilled workers are relatively high in New Zealand. Thus those industries which have a large component of unskilled labor often produce at high cost.

58. By its very nature New Zealand's system of quantitative import restrictions, discussed in some detail in Chapter VI, makes it difficult to compare the costs of domestic industrial production with international standards. However, a number of studies show the following results for certain industrial branches: 1) ex-factory prices of final domestic

- 20 - - 21 -

products often exceed c.i.f. prices of imported goods by 50 percent or more; 2) in terms of value added, domestiic production costs sometimes exceed international costs by 100 percent or more; 3) wide variations of "excess costs" exist among industries and products.l/

59. The Mission waS not able to make detailed studies of specific industries and their cost; structures. But it did briefly review a number of industries through interviews and such cost data as were available. The automotive industry, the main characteristics of which are described in paragraphs 73 to 82 below, is one example of production of a wide variety of goods on a small scale and at high cost, Similar patterns can undoubtedly be found in other industries in New Zealand.

60. The steel plant presently being built, which is discussed briefly in paragraphs 83 to 91 below, illustrates a case of import substitution which, if spread over a wide range of products in small quantities in order to supply local requirements, could well raise costs. The alternative is to concentrate production on a larger scale partly on products which are domesticaLLy used in large quantities and partly on specialized products which could be exported.

61. Mforeover, the 'Latest official document, the Report of the Tariff and Development Board published in 1963, wihich discusses the Government's basic approach to industrial policy, concludes writh a list of 16 criteria so broad and general that they can hardly serve as adequate guidelines for industrial development.!/ In practice, there are very few industrial projects which could not qualify on one criterion or another.

62. In recent years, the Government has placed more emphasis on comparative costs as one of the major criteria for industrial development. Nevertheless, the continuation of quantitative import restrictions and Government encouragement of expansion in industries which are clearly noncompetitive indicate that there is still insufficient recognition of the factors which influence costs, and that the concept of import replacement, regardless of the costs, is still holding the upper hand in Government policy.

1/ P. Hampton, "The Degree of Protection Accorded by Import Licensing to New Zealand Manufacturing Industry", Publication No. 12 - 1965 - Agricultural Economics Research Unit, Lincoln College. See also P. Hamer, "Comparative Productivity Estimates in Six Selected New Zealand Industries During 1959/60", Australian and New Zealand Institute of Economic Research, 1965.

2/ Report to the Minister of Industries and Commerce on "Criteria for Industrial Development", New Zealand - Tariff and Development Board, June 1963. - 22 -

Reorientation of Industrial Policy

63. In the Mission's view, the time has come for a reorientation of New Zealand's industrial policy. Even if New Zealand were not faced with the prospects of balance of payments difficulties, such a revision would still be necessary in order to make better use of her capital and labor resources. The balance of payments outlook only makes such a reorientation more pressing and imperative.

64. Tne major guideline for industrial development should be concentration on those products which can be manufactured at competitive costs and which make use of those factors in which New Zealand has a comparative advantage. In some fields, this can be done by processing domestic primary products, especially in agriculture and forestry. Even in these fields processing should be done in forms which can be most profitably marketed abroad. This would require managers who are able to make the best use of domestic resources by applying know-how and dynamic marketing techniques. An example of an industry based on the use of domestic primary products in combination with an export-oriented management, is the pulp and paper industry, the characteristics of which are sutnmarized in paragraphs 92 to 95. In other fields, industry should be based on the use of advanced technology, which is potentially embodied in the generally high level of education in lNew Zealand. Since the wages of skilled labor in New Zealand are low relative to other indus- trialized countries, New Zealand has a potential advantage in those industries which are based primarily on advanced technology.

65. In order to secure an economically efficient use of resources, it is necessary for New Zealand to isolate those products in which she has a comparative advantage. In New Zealand comparative advantage cannot be expressed as the financial return on capital in different industrial activities, since there are several limitations on foreign exchange transactions and the exchange rate, even after devaluation, may still not be conducive to sufficient industrial export expansion. The comparative advantage of the New Zealand economy in various economic activities can be expressed by the criterion of domestic costs of foreign exchange saved bDy import substitution or earned by exports, on a net basis. This concept, which is briefly reviewed here, is discussed in some detail in Annex II -to this volume. It is as follows:

If by producing commodity a the economy can save or earn one unit of foreign exchange at a lower cost of New Zealand dollars than by producing commodity b, then more resources should be drawn into the production of commodity a. For example, if an imported vehicle costs US$2,000 c.i.f. and if the value added of such a vehicle assembled in New Zealand is 40 percent, then the direct cost of imports involved is US$1,200, while the net savings on imports amount to US$800. If the domestic costs of production are NZ$1,600, then each U.S, dollar of - 23 -

imports saved requires the use of domestic resources worth two New Zealand dollars. Thus if an alternative use can be found for such resources at which a net U.S. dollar earned in exports or saved by import replacement can be produced at a cost of NZ$1.5, then the economy would clearly gain by such a transfer of resources,

:Data on the domestic cost of foreign exchange saved or earned can help the Government rank the various products according to their comparative advantage. In order to make private firms act on the basis of this criterion of the amount of foreign exchange earned or saved rather than on the financial return to capital, the Government has not only to recognize the proper ranking of plants, but also to introduce incentives or disincentives accordingly. Such incentives can be given in the form of budgetary subsidies, or development loans at concessionary rates, or protective tariffs on imports. The same criterion should be applied not only to the manufacturing sector, but also to the other sectors which influence the balance of payments, particularly agriculture and tourism. 66. The most important measure for the reorientation of industrial development is the exposuire of domestic industries to import competition. Suggestions on ways to achieve this are discussed in some detail in Chapter VI.

67. The present projections of the Treasury indicate a small growth in industrial exports, apart from forest products, which are expected to increase frorn about NZ$13 million in 1965/66 to NZ$26 million in 1972/73 (Table 25, Volume II). This projected growth trend is totally inadequate. :If the present slow-down in the growth of domestic demand continues, manufacturers probably would tend to intensify efforts to increase exports. In addition, should exposure to import competition occur, several industries would be forced to raise their productivity. This process would undoubtedly help to increase industrial exports, especially if average costs are reduced by larger-scale production in existing plants. The recent devaluation too should increase the export capabilities of New Zealand industries, especially in those countries which have not devalued. In addition, the Government's decision to retain the special tax concessions for industrial exports forms a further incentive.

68. There is no reason why New Zealand should not use its human potential in industry to the same advantage that it has in farming. It is the concentration of agriculture on competition in international markets which encouraged the application of high level know-how and technical innovation, supported by excellent research institutions, which together with favorable climatic conditions have made New Zealand agriculture one of the most advanced in the world. If industry were exposed to international competition and if the Government would specifically encourage industries based on advanced technology, then the potential skills embodied in a well-educated population could gradually be realized in industry. Once the Govermnent gives increasing support to industrial development in technologically advanced fields, then universities, research institutes and technical schools would undoubtedly try to strengthen training facilities in these fields. The Government, within the limits of its financial support for higher learn- ing institutions, could then give priority to such facilities, if required. Furthermore, research expenditures within industrial plants could be given fiscal incentives by the Government, and particularly important cases could even be given direct financial support. Such efforts to develop science-based industries could help to reduce the "brain-drain" of engineers and managerial skill from New Zealand, which is due in part to the lack of attractive economic opportunities in the country.

69. The Mission also generally agrees with the attitude expressed in the report of the Taxation Commission with respect to the disincentives involved in the present high income tax rates for the medium range of income. A revision of the tax structure on the lines suggested by the Commission, which would reduce income tax rates in the medium income range and raise indirect taxes, could indeed be a much needed incentive to raising the level of skills and management in New Zealand industry.

70. The reorientation of industry will also require closer collabor- ation with international, firms. Attempts should be made to integrate the production of New Zealand firms with that of larger international firms either by subcontracting or other means. The Government should also not hesitate to encourage foreign financial participation in domestic industry, especially from those companies which can offer technical know- how and marketing outlets. In particular, efforts should be made to increase cooperation with industrial companies in Australia, Japan and the United States (see Chapter VIII).

71. The existing relationship between the Goverrment and industry should also be revised. The present system of in;port licensJ.ng necessarily involves Government interver.tion in the production of indivilc-al firms. In practice, the classic system of "past record," on wlhich an administrative licensing system is gern-rally based, favors old and established firms and penalizes new and dynamic ones. The 'licensing system should gradually be replaced by a general set of rules based on clear and well-known criteria for protection and for other incentives or disincenti';ves as discussed earlier and in the following chapter. The introduction of a new system would be facilitated by the establishment of an industrial planning unit of economists and engineers which couild be set up in the Department of Industries and Commerce. 72. A reorientation of industrial development is likely to require appropriate long-term financing facilities, not only to establish new industries, but also to help reconstruct existing ones. However, the Mission has not been able to obtain sufficient information in respect to the adequacy of supply of equity and loan capital for the legitimate requirements of industry. Nevertheless, the process of reviewing the strategy of industrial development should also include a review of the capital market's role in private industrial financing and the effective- ness of the small Development Finance Corporation and other institutions in the supplying of necessary equity and loan capital for industry.

Automotive Industryi/

73. New Zealand has one of the highest vehicle densities (average cars per person) in the world, in line with its high per capita income. As a percentage of factory production, the automotive industry in 1904/65 accounted for 4.3 percent of the value added and 1.9 percent of the labor force. Another 2 percent is probably engaged in automotive supplier industries. In the period 1951 to 1965, value added increased at an average annual rate of about 12 percent, while labor input has grown by 5.7 percent, due in part to increased mechanization and automation in production techniques and in part to an increase in the average number of employees per plant (Table 37, Volume II).

74. Vehicles are manufactured in New Zealand under a system of protection and import control, designed to save foreign exchange and encourage domestic assemply of vehicles and parts manufactured. The tariff schedule, shown in the following table, favors the import of vehicles in a knocked-down form (c.k.d. packs) and gives preferences to vehicles and parts of Commonwealth origin. In practice, the system of import licensing and foreign exchange controls provides absolute protection from imported vehicles (see paragraph 79 on "no-remittance" purchases). Each firm is awarded an exchange quota, based upon previous production performance, which strictly limits the number of vehicles that can be manufactured and sold.

Tariff Rates on Imports of Vehicles Commonwealth Most-Favored (Largely U.K. and Australia) Nation

c.k.d. packs 6h 45% Built-up vehicles 20 55%

1/ This section and the two following it contain a more detailed description of some specific industries which were referred to briefly in the previous discussion on the industrial sector. - 26 -

75. Prior to 1940, nearly two-thirds of the vehicles supplied to the New Zealand market were assembled locally and the rest were imported. The value added, composed mainly of labor and paint, was small. Subsequently, local industries began supplying tires, batteries, radiators and interior trim. Prior to 1961, it was assumed that the granting of a fixed amount of foreign exchange, based upon production volume in the previous period, was a sufficient incentive to increase domestic content, since the greater the usage of domestic components, the less the exchange cost per vehicle and the more vehicles or packs a firm could import. In effect, this scheme rewarded firms by allowing them percentage increases in total import allocations for increases in domestic procurement. Another bonus incentive scheme introduced in 1961 was designed to even further increase domestic content and encourage foreign exchange savings. Under this scheme, a firm assembling 3,000 c.k.d. packs, representing no more than 60 percent of total factory cost for the unit, would receive a 15 percent increase in its import licenses, or the equivalent of 450 additional c.k.d. packs. In practice, the scheme proved to be unrealistic, since it allowed no price increases and thereby failed to take into account the substantial increases in production costs associated with advances in domestic content.

76. In March 1965 a revised motor vehicles manufacturing scheme was issued covering local assembly of c.k.d. packs in batches of 300 to 600 units. In preparing the list of parts required to be produced domestically, account was taken of the foreign exchange costs of imported parts or the so-called "deletion allowance." The scheme also stipulated that the price structure of the retail product was not to exceed that of the imported built-up vehicles.l/ This was an unrealistic stipulation, in view of the increased cost of domestic production, as analyzed below. Manufacturing schemes had to be accompanied by full details on items deleted, deletion allowances by overseas suppliers, the cost of local product, and sources of local procurement. The paperwork alone connected with licensing ten firms manufacturing nearly 50 models has been a formidable task. One particular bone of contention between the Government and individual firms has been disagreement over what in fact constitutes "factory costs,"t which is difficult to define and even more difficult to administer.

77. By 1961, domestic content had reached an average of just over 30 percent. Under the bonus scheme, average domestic content increased to 40 percent by mid-1963 after such items as spark plugs, ignition coils and wiring systems had been added. Under the March 1965 incentive scheme, the Government requested that vehicle manufacturers add additional

1/ The regulation did not apply to manufacturing operations that had been previously authorized. - 27 -

"hang-on" items, such as driveshafts, wheels, and carburetors. These items are much more complicated from a technical standpoint and involve substantial incremental investment, especially for the volume and diversification of parts required. Domestic content reported by individual firms in 1967 ranged between a low of 32 percent and a high of 48 percent, averaging about 40 percent, the same as existed in 1963. In July 1967, in response to the worsening balance of payments position, the Ministry of Industries and Commerce issued a letter to the automotive industry calling for further increases of domestic content to 50 percent.

78. A vehicle which would cost NZ$2,000 c.i.f. may cost about NZ$3,200 when produced domestically.l/ The 60 percent is however only the nominal excess cost. At domestic content of 40 percent, the net savings of imports are about NZ$800. If it costs NZ$2,000 in domestic resources to save NZ$800 worth of imports, the ratio of domestic to international costs in vehicle production is about 250 percent on a net basis.

79. Diseconomies of small-scale production are a basic source of high costs. The entire automotive industry in New Zealand assembled approximately 59,000 passenger cars and 13,000 trucks and other commercial vehicles in 1965/66 (Table 38, Volume II). Seven firms accounted for about 80 percent of vehicle assembly volume, or an average of 8,000 vehicles per firm, which is small-scale production by international standards (Table 39, Volume II). In all, there are at least 10 firms, operating 17 plants, turning out 40 to 50 different passenger car models (Table 40, Volume II). The proliferation of models and brands is aggravated by so-called "no-remittance" purchases. Under present Govern- ment regulations, purchasers with foreign exchange assets may place an order for the assembly and delivery of any model or make. One-third of General Motors sales in 1966/67 were in this category. Other countries, including Australia and South Africa, have recognized the constraints imposed by low volume markets and have adopted measures designed to limit the number of brands and models.

1/ The consumer pays considerably more than NZ$3,200 and in some cases he pays up to NZ$5,400. The extra NZ$2,200 is accounted for by a NZ$800 tax, plus as much as a NZ$1,400 premium on a new car without a purchase authorization or trade-in. "No- remittance" purchase authorizations are worth up to 45 percent above the c.k.d. value. - 28 -

80. At low production volumes, cost rise as a function of domestic content. This tendency is unmistakable in other non-industrial countries with national production volumes two and three times that of New Zealand. Judging by the experience of Argentina, where the domestic cost ratio is somewhat more favorable than that of New Zealand, the increase of domestic content from 40 percent to 50 percent may cost around 300 percent of the marginal savings of imports. Chart 3 shows what New Zealand may expect in terms of cost increases at successive stages of manufacture. 1/ The data used to plot the curves in Chart 3 is contained in Table 41, Vol. II, which was prepared as part of a draft study by the World Bank on the Automotive Industry in Developing Economies. These cost increases may be considered minimal since they are for production runs of 20,000 to 30,000, as compared to under 10,000 in New Zealand (Table 41, Vol. II). Total national production and average volume per firm is also relatively lower in New Zealand (Table 39, Vol. II).

81. In addition tc, small-scale production, there are other factors which have contributed to the high vehicle production costs in New Zealand. Turnover among workers has been high. Equipment is usually employed only at one shift, because of negative work rules and labor attitudes towards working overtime or on night-shifts. There are frequent changes in the value of import licenses issued for unassembled cars following balance of payments difficulties. All of these factors have tended to disrupt continuous levels of production and to raise costs.

82. The alternative to further import substitution is specialization in selective components and parts for export to manufacturing affiliates in nearby countries. Eventually, it may be feasible to reduce the number of models and brands assembled locally and to roll back domestic content to a level where the cost premium is well below 60 percent.

Iron and Steel Industry

83. About 10 percent of the iron and steel consumed in New Zealand in 1966 was produced domestically, largely by Pacific Steel Limited, and the remainder was imported from the United Kingdom, Australia and Japan. Presently, Pacific Steel supplies about 66,000 tons of merchant products, or close to h0 percent of the New Zealand market for this line of products. Pacific Steel's production is based on local scrap processed in an electric furnace and, at that level of market coverage, is quite competitive with imports, because only those sections are rolled which permit long and efficient production runs in the rolling mill. Import substitution is apparently achieved at costs competitive with c.i.f. prices for comparable imports.

1/ The chart and the text compares production costs for passenger cars in New Zealand with light trucks in Latin America. Cost structures in these two categories of vehicles are quite similar. - 29 - CHART 3

COST COMPARISONS AS A FUNCTION OF DOMESTIC CONTENT, LIGHT TRUCKS

280 - - -- l-_ l - , _

260 . _

240- - /

220-

0 v) ARGENTINA U).

200-1 z I- 180--0 LN C 0 X ~~~~NEW ZEALAND PROJECTED /* Nalion ConenIn19 JULY,1967

I 60E - ,R MEXICO -00

14 0 1 r-- _7

1- 0 0 - - _ _ _ 00_ de_ 6______1

0 10 20 30 40 50 60 70 80 90 100

Assembly IEasily Sourced Parts IEngine and Transmission I Sheet Metal

NATIONAL CONTENT (PER CENT)

* National Content in 1966. Econ. Dept., lBRD- 3607 - 30 -

84. Under the present steel expansion program, New Zealand plans to produce about 75 percent of the value of its required iron and steel demand by 1978. The actual and proposed levels of production are as follows:

(NZ $ million) Domestic Total Imports Production Production

1966 60 6 66

1978 22 68 90

Production by the New Zealand Steel Company, wqhose plant is presently under construction, is planned to expand in four stages with the production tonnage and range of products as follows:

Stage I Stage II Stage III Stage IV 1970 1975 1978 1983 Product (Tons) (Tons) (Tons) (Tons)

Billets 130,000 150,000 180,000 211,000 Hot-rolled strip - - 28,700 40,300 Cold-rolled strip - 60,600 111,000 141,900 Galvanized sheet 70,000 72,700 86,800 100,800 Welded pipe - 22,200 23,200 24,200 Tinplate _ - 13,300 16,700 Sections and rails - - - 70,000

Total 200,000 305,500 443,000 604,900

Source: Ministry of Industries and Corrmerce, Special Report.

According to a Government report, New Zealand will be saving about half of its foreign exchange requirements by 1971, as based on a c.i.f. sales value estimated at NZ $20.4 million. The domestic production program projects foreign exchange savings of NZ $40 million by 1978 and NZ $60 million by 1983 in Stage IV of the production plan.

85. New Zealand Steel made an agreement with the Government, assuring sales on the domestic market for as much as the company can supply in any agreed type of steel product. This assurance is subject "to the company selling its products into wholesalers' stores at New Zealand-wide prices not higher than the simple average of the prices of like products imported or importable from Australian and United Kingdom sources delivered to ports customarily serviced by overseas shipping increased by an allowance equal to the weighted average cost of delivering - 31 - steel into wholesalers' stores, excluding products imported or importable at dumped prices." 1/ The company has thus undertaken to sell at prices comparable to c.i.f. prices of imported steel, although the provision to exclude dumping is subject to interpretation. In some cases, dumping has been said to mean that export prices of a product are lower than its domestic prices, a situation which is quite possible in the future market for steel. In the Mission's view, such an interpretation should not be accepted ar.d "dumped" prices should be defined only as export prices prevailing during a temporary period (see para. 106).

86. During Stage I the production of billets by New Zealand Steel will be based on the reduction in a rotary kiln of iron sands to sponge iron and finishing in electric furnaces. The billets will be rolled into merchant products by Pacific Steel, in which New Zealand Steel has a 40 percent share. The galvanized sheet will be produced from imported cold-rolled steel strip. Eventually, New Zealand Steel hopes to produce both hot-rolled and cold-rolled steel strip itself. Alloys and heavy structural steel will continue to be imported.

87. Wtith the establishment of New Zealand Steel, billet availability from both Pacific Steel and New Zealand Steel will reach in 1970 about 200,000 tons a year for rolling into merchant products such as angles, tees, bars, rods, channels and gir,4ers. Assuming a scrap loss during rolling of 15 percent (under Pacific Steel's efficient operation it might well be less), 200,000 tons of billets correspond to 170,000 tons of finished products annually. Total deBand for finished products is projected to be 172,000 tons in 1970. 2/ The total domestic market in merchant products would thus have to be supplied, if steelmaking capacity at both plants is to be fully utilized. This would mean that a great variety of steel products would be domestically produced. In the absence of standardization (an important prerequisite for the establishment of an economic steel industry anywhere) there are hundreds of various shapes, sizes and specifications of intermediate products in use in New Zealand.3/ For many of these products only a few hundred tons per year are used. Rolling such small quantities involves a considerable increase in costs because of the doTrm time during roll changes. This demonstrates the danger inherent in import substitution achieved by production on a relatively small-scale, which necessarily involves a rise in production costs.

1/ New Zealand Steel Limited, Prospectus 1966.

2/ Ibid.

3/ A casual analysis of the sizes and shapes planned under the domestic production program reveals about 350 different varieties of merchant products. On many items, this would mean production runs of a few hours for a six months' supply of New Zealand's domestic market requirements. - 32 -

88. A detailed rolling program based on tlhe demand forecast prepared by New Zealand's steel consultants would show what profiles could profitably be produced in Pacific Steel's rolling mill. Tne Mission did not have the expertise to prepare such a rolling program. However, it could be reasonably assumed that such a program would involve concentration of production on a limited number of varieties made on a realtively large scale, if costs are to be kept within limits set by prices for comparable imports. Other varieties of steel products would have to be imported, rather than made locally.

89. Thus more billets may be produced than can be economically used in New Zealand, so either Pacific Steel or New Zealand Steel or both may have to curtail their billet production. The first alternative would greatly reduce, and perhaps eliminate, Pacific Steel's profitability, because production costs for its scrap-based billets are lower than those for New Zealand Steel's billets. The second alternative would increase the production costs of New Zealand Steel, while the third would spread the diseconomies inherent; in the present program over both companies. Therefore, increases in costs appear inevitable in all three cases, unless alternative uses are found for the surplus steel capacity.

90. One possible alternative use might be the production of special steel and steel alloys for which markets would have to be found mainly outside New Zealand. However, a great number of these products are commonly made in fairly small volumes in electric furnaces, generally from the type of steel New Zealand Steel would obtain from its sponge iron, if the technical and metallurgical results obtained in tests can be realized in commercial production. Such products might well be in a stronger competitive position than ordinary steel products, which could not compete against the output of large mills. Research and development have greater scope, relative to the scale of output in special steels than in ordinary steels. Access to overseas markets could perhaps be obtained by offering access for steel products which New Zealand should not make because of small, volume.

91. However, this approach involves a number of metallurgical and operational problems, in addition to marketing problems, that would have to be resolved. At this time it is by no means certain that they could be overcome at economic cost. It is, therefore, recommended that the time during which the plant is under construction should be used to study the overseas markets for special and alloy steels, and if these results are encouraging, then the metallurgical and operational problems could be investigated, after the plant has gone into operation.

Pulp and Paper Industry

92. The pulp and paper industry over the past 15 years, 1951 to 1965, has been increasing production at an average annual rate of about 24 percent. In 1965 production from this industry constituted about - 33 -

3.3 percent of gross domestic product. There are in all seven plants in New Zealand engaged in the manufacture of pulp, paper, and fibre board. Three large plants account for 80 percent of the total output, comprised largely of mechanical pulp, chemical pulp, newsprint, kraft paper and liner boards. About 30 percent of the newsprint and paper products manufactured in 1967 was exported. New Zealand now exports NZ$18 million in pulp and paper products.

93. The two largest New Zealand firms are Tasman Pulp and Paper Co. Ltd. and New Zealand Forest Products Ltd. The principal shareholders of Tasman Pulp and Paper Co. Ltd. are: Bowaters (U.K.)2/ Reeds (U.K.), Australian Newsprint Mills (Australia), Fletcher Industries (New Zealand)2/, and the general public, who hold about NZ$2 million of the NZ$21.4 million equity. Tasman has a reciprocal holding of NZ$4 million in Australian Newsprint Mqills, which produces newsprint in Tasmania, Australia, and whose main shareholders are the principal publishers and users of newsprint in Australia. Tasman is a major producer of mechanical pulp, chemical pulp and newsprint. It carries out its own logging operations and is a major producer of sawn timber. It exports about two-thirds of its newsprint production of 200,000 tons, about 90 percent (50,000 tons) of its market pulp, and about one-fifth of its sawn timber.

94. Tasman Paper has substantial export potential, since they have achieved an efficiency that is capable of competing in world markets. About 85 percent of its export sales is from newsprint and 10 percent from chemical pulp. The difficulty with newsprint is that production costs have been increasing and serious competition has arisen from Canadian, Scandinavian and Chilean competitors. It appears that at present there is a world over-supply of newsprint. Wages have doubled and capital investments increased by 25 percent in the period 1955 to 1967. Fuel and power costs run twice that of the Canadian producers. Another factor is that Australian publishers prefer to maintain several world suppliers, allocating no more than one-third of the market to New Zealand. Tasman recently announced its iintention of diversifying into kraft liner paper production with the introduction of a 100,000 ton machine to supply the Australian market. This has led to serious contention between Tasman and the major packaging paper manufacturer in Australia, Australian Paper Hills Ltd. (APM), which in turn has led to tensions between the two countries at the Government level. At the request of the Government consultations are proceeding between the two companies, Tasman and APN1, and these have been extended to include the possibility of New Zealand production of specialized pulps for the Australian market. The situation will have to be resolved at the Government level within the next few months (see paragrapbB133 and 13h).

1/ Bowaters have certain responsibilities for management control, including vetting of capital expansion proposals.

2/ A company in which the New Zealand Government owns about 20 percent. - 34 -

95. New Zealand Forest Products is at present mainly New Zealand owned, about 80 percent, with the equity spread over 55,000 shareholders, the largest holding being less than 1.5 percent of the total share capital. The company, who owns extensive forests, manufactures chemical and mechanical pulp as well as a wide range of fine paper, kraft liner paper and fibre board for the protected domestic market. It is also a major producer of sawn timber for the home and export markets and the largest exporter of logs to Japan. Furthermore, in converting operations it produces wall boards, sacks (e.g. for fertilizer and cement) and other finished packaging materials. In 1966/67 about one-fifth of the company's revenue was earned from export sales of logs, pulp, wall boards and paper. A major expansion program is under way primarily directed to meet the growth in the domestic packaging and fine paper fields, but there will be some capacity for export in thle early years of new production capacity. VI. D!IPORT RESTRICTIONS, PROTECTION TO DOiESTIC rT'DUSTRIES AND RESOURCE ALLOCATION

Effects of Import Restrictions

96. For a long time, New Zealand has maintained a system of quantitative restrictions on imports in order to safeguard the balance of payments. Some of these restrictions apply to certain raw materials, the allocation of which is used to direct industrial production, while other restrictions apply to processed goods, and this provides protection to domestic industrial products. An evaluation of the industrial policy is made in Chapter V; the present chapter concentrates only on the relationship between the methods of protection and industrial development.

97. In general, New Zealand has followed a policy of offering domestic industries protection against competition of imported goods which, in the Mission's view, has resulted in the allocation of scarce resources to industries of little net benefit to the balance of payments. Protectionism has been justified on the grounds of the need to provide full employment, to secure a high standard of living, to overcome the disadvantages of a small economy and paucity of raw materials, etc. Many of the arguments advanced for protectionism are fallacious, from the viewpoints of both economic reasoning and actual experience in New Zealand. A full discussion of the pros and cons for protectionism would be much wider than the scope of this report could permit, so the following comments will be limited.

98. There is one particular argument for protectionism which seems to carry great respectability in New Zealand, even with several outstanding economists and officials. The argument is that as long as other countries, including some of the richest, pursue for their domestic agricultural products protectionist policies harmful to New Zealand, she should in turn protect her own domestic industries against their exports. This argument seems to be based on the assumptions that either New Zealand has had some real gains from her industrial protectionism, or at least her industrial protectionism has strengthened her bargaining power vis-a-vis other countries. The Mission considers these assumptions invalid. The protectionism practiced by other countries on agricultural production is indeed deplorable and New Zealand, which specializes in agricultural production, is one of the victims of such protectionism; nevertheless, it is New Zealand herself, and not her trade partners, who pays the price for tying up resources in inefficient industries.

99. Import restrictions are a hidden form of protection, which tend to result in a misallocation of resources. Naturally, the degree of protection they give varies by industry and product. Moreover, the effective degree of protection afforded each product is not usually known by the public and probably not even by the Government authorities. In the absence of a clear set of quantitative rules concerning the degree of protection to be given, decisions on the effective degree of protection end up being made by the Government in a round-about process, usually on - 36 - a case-to-case basis. No administration, even with the best of expertise and intentions, can expect to be a reasonable substitute for the price mechanism in the proper allocation of resources for investments and production. In addition, the administration of import restrictions on such a wide range of commodities places a heavy burden both on the Government and the private sector, and thereby greatly hinders their efficiency.

100. Often quantitative restrictions on imports may be undesir- able because of resource misallocation, but necessary on balance of payments ground. In the case of New Zealand, it is doubtful that import restrictions have resulted in net savings of foreign exchange on a considerable scale. It has been shown earlier that even with such restrictions, imports have soared in periods of increase in domestic demand. The experience in New Zealand is further evidence that import restrictions are not an effective substitute for fiscal, budgetary and income policies designed to prevent inflation in the domestic economy. If effective counter-cyclical policies are not into- duced in the future, no refuge can be found in import restrictions. On the other hand, when counter-cyclical policies become effective, import restrictions for balance of payments reasons will be superfluous.

Protection for Infant Industries

101. While the Mission feels that a continuation of import restrictions as a permanent feature of the New Zealand economy is harmful to her best interests, it does concede that a certain degree of temporary protection for "infant industries" is reasonable. The rationale of such protection is to give new industries a grace period in which to become established on a competitive and efficient basis. A protective system which is economically reasonable should be based on the following principles: a) Protection should be given only to legitimate infant industries which could be expected to become competitive in the foreseeable future; b) A ceiling on the maximum percentage rate of protection should be established;

c) Rates of protection could vary to a limited extent, as defined by well-established and clearly outlined economic criteria;

d) The rate of protection for each product would be set in advance to be periodically reduced;

e) The degree of protection given to each product should be made known to the public. - 37 -

In the Mission's view, a system of protection based on the above principles can be best aclieved by the removal of quantitative import restrictions and by reliance on tariffs to protect domestic infant industries

102. A discussion on tariffs or any other protective system is in many countries obscured by the question of the appropriateness of the rate of exchange. It ought to be empha3ized that the present discussion does not refer to a genezal surcharge e.r ta-f_ff on imports designed to correct a possible overvaluaticn of the e::-hange rate, but is concerned with tariffs designed to encourage propar industrial development, which may be desirable even when the exchange rate is in full equilibrium. Nor does the suggestion refer to tariffs and duties imposed for merely revenue reasons, and which have no direct protective effects on domestic production.

103. If the Government decides that quantitative import restrictions should be abolished and that tariffs should be the basic instrument for protection of newly established industries, then any industry which desires tariff protection would have to make a convincing case that during the initial protection period its costs could gradually be reduced to a competitive level. If the case is accepted, a tariff could be introduced on competing imports at a rate not exceeding a certain level at which imports would be freely permitted. The tariff would be set in advance for a certain number of years following the start of production, and it would be made known at the start that the rate would automatically be reduced every few years by a certain percentage.

104. Close attention must be paid to the effects of a protective system on resource allocation, and the structure of protection is of great importance in this respect. A distinction must be made between protection of the final good (nominal protection), protection of the materials and other items which are inputs for the production of the final good (input protection) and protection of the actual manufacturing activity, i.e. the services of labor, management and capital (profits) (effective protection). For the factors of production which are employed in an industry and which can choose to work elsewhere, it is not the nominal protection which counts in deciding whether an industry is attractive, but the amount of protection left after paying for material inputs. Thus it is the effective protection or the margin of protection provided to factors of production which is of major importance in the allocation of resources.

105. There seem to be reasons to apply an infant industry tariff in New Zealand to processed goods and to certain semi-processed goods, but not in most cases to raw materials and equipment which are not domestically produced. The effective protection of such a tariff - 38 -

should depend on the percentage of the value added of the product. An import tariff of 20 percent on the final product gives effective protection of 100 percent on a product with a value added of 20 percent. On the other hland, the same 20 percent tariff provides effective protection of only 40 percent for a product with a value added of 50 percent, and only 25 percent for another product with a value added of 80 percent. For that reason, tariff rates set on the final product have to take into account variations in the percentage of the value added of domestic products. If applied rigorously, such a system would require complicated calculations of the value added in each product, deducting the direct and indirect import component. To avoid these complex calculations, it would seem more desirable to classify the products by groups, for example, those with a value added of 30-40 percent, etc., and then to apply nominal tariff rates accordingly within the determined ranges.

106. Some special tariffs might have to be imposed as protection against "dumping." Such cases must be exceptional and quite limited in number. In general, the definition of "dumping" commonly used in New Zealand, as in several other countries, is too broad, and in fact refers to products which can be regularly imported at low prices. The appropriate test for "dumping" is whether the product can be imported at the so-called "dumped" price only for a temporary period. Consider- ations of whether certain products are exported at prices lower than domestic costs, average or other, are irrelevant. When products are exported for a lengthy period at prices said to be based on "marginal costs," there is no reason why New Zealand should not take advantage and buy these products at the lowest price possible.

:107. Under such a tariff system, the question would undoubtedly arise concerning the treatment of existing industries, which at present are subject to various levels of protection, with some levels equivalent to tariffs of several hundred percent of effective protection on their value added. Probably certain existing industries would have serious difficulties if exposed to import competition, even at the maximum level of tariffs for new industries. Solely on economic grounds, it could be argued that since the basic investments have already been made, such industries would continue to produce as long as prices were in excess of their variable costs, even if they were not profitable on the basis of total costs. However, on equity grounds such a treatment may be too harsh, especially since many of the existing industries have been established with the blessing and sometimes the active encouragement of the Government. It would, thus, seem justified to make special arrangements during a transitional period for existing industries by giving them higher levels of effective tariffs than new industries0 Yet, even for existing industries a ceiling on the maximum rate of effective tariffs should be established and should be subject to a gradual reduction. - 39 -

108. It would be useful if the Government would discuss with management and wvorkers representatives in various industries ways and means to make them more competitive. Within a system of import liberalization, this may lead to concentration of production in a smaller range of products made on a larger scale and at lower costs. In certain cases, amalgamation of small firms may be called for and retraining of workers may also be required. Whatever the arrangements to be made, it is important that these be within a set of basic criteria set by the Government.

109. It is difficult to say at this stage what changes in tariff rates will be required, if import restrictions are to be removed. The present maximum rate of tariffs is 32.5 percent, but this is the nominal rate which may often give a much higher effective tariff. For example, if the value added of a certain product is 50 percent and there are no duties on raw materials and other inputs, then a nominal tariff of 32.5 percent gives effective protection of 65 percent. However, for some products especially those with lower tariff rates, a rise in tariffs may be necessary.

110. To the extent that tariff rates will be raised, fears will undoubtedly be expressed that this would increase domestic prices. In most cases, such fears seem unfounded. If removal of import restrictions should result in increased imports of products now domestically produced, prices would tend to be reduced. For products not domestically produced, larger imports even if subject to higher tariffs would more likely mop up some of the semi-monopolistic profits of importers now granted import licenses, rather than raise prices. On the whole, price rises would not likely occur, if the Government makes it clear that the abolition of import restrictions is not a temporary measure. Another prerequisite for such a shift, as indeed for any other major policy changes, is the use of fiscal, budgetary and income measures to avoid inflationar, pressures.

111. A rise in tariffs would also require negotiations with GATT under Article XXVIII. However, if such a rise is proposed as a part of a scheme to remove quantitative restrictions, which would expectedly involve an expansion of international trade, there is no reason to foresee great difficulties in such negotiations.

112. A shift to a new system of protection would require a good deal of preparatory staff work, to determine appropriate levels of protective tariffs and to anticipate the effects of the proposed changes. It is doubtful that accurate estimates of the effects on each particular industry could be confidently made, but it might be possible to prepare a projection of the magnitude of the overall effects. The Mission recommends that a high-level committee of officials, backed by a team of economists and industrial experts, be appointed to prepare a detailed scheme for such a shift, preferably with alternatives. - ho -

113. The Tariff and Development Board seems to be presently capable of handling only a few cases a year and its procedures are slow. A large scale operation involved in the removal of import restrictions will certainly pose a very heavy pressure of urgent work on the Board, and the latter should be greatly strengthened in order to handle effectively such a situation. Its procedures should also be reviewed in order to assure expedient work.

L14. The successful introduction of a better protective system would require a strengthened external reserve position, for both economic and psychological reasons. In the Mission's view, a basic change in the protective system affecting the development strategy would be a strong claim for special borrowing operations from international and bilateral sources. VII. THE DEVEIOPIENT OF TOURISM

Present Situation

1L5. The Government requested a broad indication of the Mission's views on "whether expansion of the tourist industry should be regarded as a useful avenue for development." The first consideration should undoubtedly be an analysis of the volume and composition of the tourist traffic that could be expected. On the basis of such demand projections, some idea of the required investment and other expenditures could be obtained. There would then have to be a detailed examination of the economic justification for such expenditures. Such a justification would compare returns from allocating resources to tourism with those from alternative uses, taking into account all costs and benefits, particularly New Zealand's need for foreign exchange earnings and alternatives for obtaining such earnings.

:116. The Mission did not have the opportunity to make an investi- gation along the foregoing lines, nor do we feel that; the statistical data in New Zealand are in a form necessary for such an analysis. However, some broad inferences can be drawn from the available information.

:L17. The number of visitors to New Zealand, staying more than 24 hours, in the fiscal year ending March 1966, amounted to some 86,000 and their expenditures were estimated at NZ$19.8 million. In the following year the number of such visitors rose to about 94,600 and presumably their expenditures rose in a similar fashion.

118. It should be noted that, following accepted international practice, the Mission has excluded from the foregoing temporary migrant workers both from the number of visitors and their expenditures, although Hiew Zealand statistics include them as "tourists on working holidays." The M4ission finds the latter's inclusion in the New Zealand data a source of confusion with respect not only to the number of tourists, but also to the net exchange earnings of this sector. There are other temporary visitors earning remuneration in the country, who are not normally included in tourism statistics, which because of insufficient information we have been unable to exclude. It should also be noted that the expenditure figure does not include the receipts which the national airline, Air New Zealand, earns in bringing international visitors to the country.

Prospects for Expansion

119. The growth in the number of visitors to New Zealand remaining more than 24 hours has averaged about 17 percent annually since 1960, which is well above the world-wide average of 12 percent. The International Union of Official Travel Organizations (IUOTO) has noted a tendency for long-distance tourism to expand more rapidly than other types of tourism.l/ In the main, the New Zealand market is long-distance, since its major

1/ IUOTO, Economic Review of World Tourism, Geneva, 1967. - 42 - markets apart from Australia, are in the United States, the United Kingdom and other European countr-es. If the propensity to travel continues to grow in the future as rapidly as it has in recent years, and if air transport costs continue to decline as in the past, there is no reason why the number of visitors to New Zealand should not increase at least as fast as in the last six years or even faster.

120. Another major consideration is the amount of the net exchange gains to the economy from tourism. On this question, there are two sources which offer greatly varying results: 1) Estimates based on Reserve Bank data show for 1965/66 a net gain of NZ$5 million, about 36 percent of gross receipts, and 2) Tourist Department estimates, based on more indirect indications, show for the same year net foreign earnings of NZ$13.2 million, about 57 percent of gross receipts. An Officials Committee which reviewed both estimates reached somewhat inconclusive results, showing alternative ratios of 25-50 percent net foreign exchange earnings to gross receipts from tourism. In the M4ission's view, both calculations underestimate the share of net foreign exchange earnings, if used as an indication of the benefits of tourism development in the future.

121. As stated by the Officials Committee, estimates based on Rieserve Bank data show low figures on both gross and net receipts, because a good deal of tourists' foreign exchange seems to be transferred not through the official banking channels, but sold in the "free market" and used for imports or travel. This was due primarily t;o the overvaluation of the New Zealand dollar prior to the recent devaluation. Thus it is hoped that devaluation will remove this problem.

122. In the Mission's view, neither estimate presents a real picture of the tourism sector, because of the inclusion of tourists coming for a "working holiday." In the above estimates the outflow of funds saved by "workers on holiday" exceeds the inflow of funds transferred by them for their initial expenditures. The number of "holiday workers" coming to New Zealand is presumably affected less by factors related to the tourist trade, than by the labor situation in New Zealand relative to Australia. The fact that hotels and restaurants in New Zealand employ significant numbers of temporary foreign workers has been due to the shortage of workers in New Zealand, because of the reluctance of some New Zealanders to be employed in what they consider personal service. These factors might change in the future for reasons mentioned later.

123. Apart from their uncustomary definitions, both estimates have a very shaky statistical basis and should not be used as an indicator of the real benefits of the tourist sector. Therefore, the Government should make a more serious effort to arrive at a reasonable estimate of gross and net receipts from tourism. On the basis of estimates in other countries, it would appear that the share of value added to tourism should be in the range of perhaps 70-75 percent. - 43 -

124. The major criterion as to the priority of the tourist industry relative to other investments is not the share of net receipts, but the cost of domestic resources per net U.S. dollar earned (see paragraph 65). The Mission does not have necessary data to make calculations of this type for the tourist industry. In preparailon of an ixnwsstmenit program such estimates should be made, 1everethele,s, there seeris to be an a priori case for a certain priority to be given to inrestments in an industry which makes use of ra-bt.ral autractions, is not too capital intensive and has a relatively high value added.

125. A report prepared for Air New Zealand by the consul.ting firm Child and Waters Inc. of New York gave a fzairly cptimistic p.c-jection of the New Zealand touzi.st potential and incluced. a number of detailed .recommendations for imprcvements of t'ourist faci4lities, Further studies are now required to qumatify demand trends, not cnnly in numbers and in broad categories as shown in the official st.atist-cs, bu-t also in much greater detcil, such as t+he type of tourist expected., tne kind of accommoda- tion required and the range of ameni.-ies and activities need&d to help overcome the seasonal imbalance in tourist flows and offset the high cost of transport from all countries, excent Australia. In the course of these studies, a number of factors should be talken into accowit in forecasting: 1) the scope for cooperation with other tourist destinations in the South Pacific and for marketing arrangements with travel organizations in the countries of origin, 2) the extent to which inves-tment opportunities would be conducive to market arrangements, 3) the effect of reductions in air transport costs, 4) the possibilities of air charter operations, and 5) the incentives which the Government may wish to consider. This information would then provide the basis for an investment program which could and should be assessed in respect to the resources required, their relative scarcity and their costs and benefits.

126. One of the key questions that should be examined is the supply of labor in the hotel industry. As mentioned earlier, there is considerable use of temporary migrant labor from abroad and the latterts export of part of their season's earnings represents a dr.ain on New Zcaland's foreign exchange. However, recent lessening in demand for labor already seems to have increased the supply of New Zealanders willing to work in tourist industries. The Government shoLld also encou:trage professional training programs for hotel and restaurant staff. This would not only raise standards of service, but would also provide the professional and social status required to attract good workers.

1.27. To surmarize, the Mission sees a reasonable case for an expansion of the tourist industry. However, a dstailed investrmient program showing the costs and benefits in quantitative terms needs to be prepared without delay. VIIIo INTERNATIONAL TRADE RELATIONS

128. The Mission's views on prospects for agricultural commodities and on the appropriate strategy for industrial development have a number of implications for New Zealand's international trade relations.

Relations with the United Kingdom

129. New Zealand's most important trading partner is the United Kingdom. For more than half a century New Zealand's economy has been developed as a complement to the British economy to the benefit of both. The trade agreement between New Zealand and the United Kingdom which has been recently extended to 1972 is of vital importance, since the United Kingdom is a market for 90 percent of New Zealand's butter and lamb exports and for 80 percent of her cheese exports (Table 16, Volume II). New Zealand, in turn, accords preferential treatment at considerable margins to a wide range of British industrial products. The preferential tariffs accorded to British exports are generally a worthwhile quid pro qun. However, the present margins of preference should not be sacrosanct. If such preferences have detrimental effects on the development of certain industries which can become more efficient by cooperating with non-British industries, Nlew Zealand should negotiate for a reduction of the margins.

130. New Zealand is justifiably concerned about her access to the British market, if the United Kingdom should join the European Economic Community (EEC). The United Kingdom has already announced that it would accept the Rome Treaty and the Common Agricultural Policy (CAP) of the EEC. For all practical purposes, CAP reserves the domestic markets for local producers of most agricultural commodities, except beef. There is already a surplus of butter in the EEC and if the present expansion in output continues, the surplus is likely to grow. The probable entry of 'Denmark and Ireland along with the United Kingdom would naturally aggravate this problem of a surplus. If New Zealand were to be cut off from her present access to the British market, she would have little prospect of selling in other markets the same quantities of commodities, especially butter, which she now sells in the United Kingdom.

131. Although the leaders of the British Government have stated a readiness to accept the CAP, they have also emphasized on several occasions the need to make certain special arrangements for New Zealand's exports. Understandably they have not publicly specified the nature of such arrangements. The EEC Secretariat also has recognized the special problem of New Zealand. In informal talks with the Mission in August 1967, members of the Secretariat appeared to consider that a transition period in which New Zealand could adjust her production and marketing to a gradual reduction of sales in the British market might be advisable. Because of their concern over the prospects of an enlarged butter surplus with an expanded EEC, some Secretariat members would favor such an arrangement within the context of an international dairy agreement. At this time there is no basis for an evaluation of the prospects for such an international agreement and its implications for New Zealand. In any case in the lMission's view, if the United Kingdom joins the EEC even with a special arrangement for New Zealand's dairy products, New Zealand's earnings from dairy exports in the United Kingdom would gradually be reduced.

Relations with Other Countries

132. Regardless of the future relations of the United Kingdom with the EEC and of New Zealand with both, New Zealand should make special efforts to intensify its economic and trade relations across the Tasman Sea and the Pacific Ocean. The Government has placed increased emphasis in these areas, but, in the Mission's view, an even mnore concentrated effort is required, both to increase prospects of marketing her agricultural commodities and to help New Zealand raise the efficiency of her industrial sector.

133. In particular, the Mission attaches great importance to a closer relationship between New Zealand and Australia. The New Zealand- Australia Free Trade Agreement (NAFTA), which came into effect on January 1, 1966, provides for a gradual reduction of duties on commodities which account for about 5O percent of the present trade between the two countries and for regular consultations with the intention of extend- ing its application to more commodities. In practice, the list of commodities covered in NIAFTA has been limited because of strong protectionist interests in both countries, to which the Governments of Australia and New Zealand succumbed alike. Even this restricted scope of NAFTA is now threatened by disagreement over planned sales of New Zealand craft paper to Australia by the Tasman Pulp and Paper Company. This company, which already exports newsprint on a large scale to Australia, can realize its comparative cost advantage, based on raw materials, advanced technology and farsighted management, only if it is allowed to supply this type of paper up to 100 percent of the projected increase in the Australian demand. An Australian counter- proposal, enabling New Zealand to participate in the market expansion of a number of paper products, would not permit concentration of production in just one line which is the necessary condition for cost reduction.

134. The attitudes toward NAFTA of both Governments during the short period of its existence do not augur well. If present trends continue, NAFTA is likely to be overcome by protectionist interests and policies in both countries, and it will then be of little conse- quence to the development policies of either New Zealand or Australia. In the Mission's view, new initiatives are now called for at the highest levels of political leadership in both countries to give a new impetus to NAFTA. The final aim should be closer cooperation in the future development of both countries, which will enable sufficient specialization of each in their respective fields of comparative advantage. Closer economic cooperation will benefit both countries: freer access to a relatively close and natural market can help New Zealand overcome - 46 - some of the handicaps of its small-size market; and since New Zealand is the largest single market for Australian manufactured exports, the freer trade becomes, the more New Zealand is likely to purchase from Australia.

135. Japan with a rapidly increasing demand for agricultural commodities, especially for meat, is a very promising trading partner. The highly successful introduction of New Zealand mutton is a good example of a dynamic marketing effort. Of no less importance for the future is the potential cooperation in the field of manufacturing, particularly in science-based industries. The Mission hopes that the New Zealand Government will continue to pay increasingly more attention to close cooperation with Japan.

136. A number of other countries in East Asia have been increasing their income levels at a rapid rate and are also likely to become importers of dairy products. New Zealand should strengthen hier economic relations with those countries and should closely follow developments through trade commissioners and representatives.

137. In the Mission's view, there is a wide scope for increasing trade relations between New Zealand and both the United States and Canada. Progress has already been made by New Zealand in exporting agricultural commodities, such as beef and lamb. However, much more has to be done to process lamb in forms which can be marketed at higher price levels in both countries. A better adjustment to demand trends in the American market requires closer cooperation with progressive marketing firms in the United States. New Zealand's efforts to penetrate the United States market seem to be very cautious, because of the fear of protectionist restrictions, such as the recent imposition of quotas for dairy products and proposals for quotas on meat imports. It would indeed be deplorable if New Zealand, which is attempting to strengthen her overall relations with the United States, is further harmed by additional restrictions on her export commodities.

138. The strengthening of international trade relations as suggested above must be based on more effective trade and marketing analysis in New Zealand (see paragraph 149), as well as on expanded trade representation in other countries. IX. INSTRUMENTS FOR ECONOMIC FOLICY FORMULATION AND PLANNING

Present lWleaknesses

139. New Zealand is faced with serious and complex long-term economic problems, which have to be expertly and systematically analyzed prior to the formulation of policy suggestions. Indeed, such an analysis is a prerequisite for a real understanding of the basic economic problems by both the civil service and the political leadership. It is hard to imagine an ordinary process of policy formulation in a modern economy without a series of discussions based on well-prepared and well-presented documents, contain- ing forecasts, assumptions on external factors, and policy recommendations preferably with alternatives. Wjhether this process is called "planning", indicative or otherwise, is of secondary importance as long as it serves as a proper guide in the fields of general economic policy and development.

140. The need for creating an indicative planning unit in New Zealand was recognized and discussed in some detail by the present Government in the "Economic Review" presented to Parliament in June L966. In General, the Mission concurs with the attitudes expressed in this Review, although it overemphasized the role of projections of public sector expenditures and underemphasized the need for overall guidance of the economy and the formulation of development strategy. Previous to the report, in 1965 a plan- ing unit had been established in the Treasury, under the direction of a division chief in charge of external economic policy affairs.

14L. The Mission encountered some scepticism with respect to the difficulty of forecasting future trends for New Zealand's export commodities and the danger of basing policy suggestions on such uncertain forecasts. The Mission concedes that such projections are subject to considerable error, especially when short-term fluctuations are considered. How- ever, in the Mission's view, the vulnerability of New Zealand to external commodity fluctuations requires a more concerted effort to improve projection techniques and to work out policy suggestions on ways to make the domestic economy less vulnerable to unexpected fluctuations. Like a boat, an economy which is subject to rough and unexpected winds needs particularly good steering instruments. Even a continuation of past methods is a major policy decision which requires continuous scrutiny.

Reorganization of Planning

142. In the Mission's view, the Government should take steps to strengthen its machinery for medium-term economic policy and planning. This machinery should provide a systematic analysis of the problems facing New Zealand's economy in the medium and long term, and advise the Government on overall economic policy, especially development strategy. One of the unit's first tasks should be the recommendation of specific measures for the improvement of the balance of payments and

- 47 - of resource allocation. Whether the above functions can best be performed by the preparation of a medium-term indicative plan, or whether a different and more flexible policy framework would be more suitable, is the for Government to determine, It is actually the availability and continuous use of professional economic advice, rather than a formal plan, which is the essence of effective planning.

143. This strengthening of planning does not necessarily have to increase the Government's role in economic affairs. In fact, an improvement of analysis and policy formulation should result in more reliance on general policies and guidelines, rather than the present practice of detailed licensing which necessarily involves Government intervention in the investments and production decisions of individual firms.

144. There are in New Zealand political differences of opinion as to the type of planning suitable for the country. Such differences are legitimate and natural, and are found in most countries. Nevertheless, in view of the economic difficulties facing New Zealand, the Mission believes that a strengthening of the tools for economic advice and planning would have wide public support. Economic planning should become a regular feature of public administration, regardless of the party in power, and it should be established on a statutory basis, preferably approved by Parliament. However, at the present time the Mission favors a pragmatic approach; any machinery which would enable the work to be started without too much delay is acceptable. Then after a few years' experience, the planning unit could be set on a statutory basis.

145. Such machinery for policy advice and planning requires the combination of a central. unit and sectorial ones. The central unit should be close to the principal department in charge of economic policy formulation, which at the present is the Treasury. It should be headed by a high-level official, with the rank of no less than an Assistant Secretary, who would devote his full-time attention to the planning function and would have direct access to Cabinet Members and Committees. The staff of the unit could be relatively small, perhaps eight to ten persons, but it should be strictly professional. This small staff could easily draw on wider resources by allocating specialized studies to research institutes and universities.

1h6. The division of responsibilities between the planning unit and the other divisions in the Treasury dealing with budgetary estimates, fiscal policy, current economic analysis, and other aspects of economic policy is important. The Mission supports the view expressed by senior officials that the Treasury should be reorganized along the lines of a central Ministry which is responsible for the management of a modern economy. This subject is presently being discussed by a special committee, which, in the Mission's view, should also define the relationship of the planning unit to the other Treasury sections at the same time. For instance, the planning unit should annually prepare a tentative framework of the use of national resources in familiar national accounts terms, as background for the preparation of the Government budget proposal, which - 49 -

would be the major function of a budgetary division. The planning unit should cooperate closely with other government units dealing with current economic problems, but it should not be detracted from its primary long- term functions.

147. The work of this central planning unit could also be easily coordinated with that of the Monetary and Economic Council, especially in the area of fiscal and monetary problems. The work of this Council, in the Mission's opinion, has made important contributions to the understanding of New Zealand t s economic problems and policy formulation, and should be further encouraged.

148. A crucial aspect of policy and development planning is the analysis of major international trade and marketing trends, which is presently weak and needs urgently to be strengthened. The Mission favors the establishment of a central unit for trade analysis, which would specialize in demand projections of major agricultural commodities, but which would also be able to project demand for other products, including industrial ones, of potential interest to New Zealand. Such a unit could be placed either in the Treasury, in order to maintain close contact with the units responsible for balance of payments analysis, or in the Depart- ment of Industries and Commerce, which is dealing with external trade policy.

149. The trade analysis unit should have a permanent and profEmssional staff. Its responsibilities should be well defined and include ;;he analysis of long- and short-term prospects for the major export coomodi- ties and the presentation of periodic and special reports to the Govern- ment and to the marketing boards. The marketing boards could be invited to appoint representatives to an advisory commi-.tee, which s-hould also include economisits expc,ienced in techniquies of market analysis. In addit,ion, each i, rketi:g board should employ an econo,ist G serve as a liaison officer wit'-. tne -;;Lde analysis unit. When apprcp:-iate ,he marketing boards might second staff to the unit provided this is done for a sufficient length of time. The trade analysis unit should cooperate closely with the economic research unit in the Department of Agriculture, which is rnainly responsible for the analysis of production trends.

150. All maior Denartments dealing with economic development, such as Industr:es ar:2 Comi->;rce, Agriculture, Transport, Hou1sing, Labor and Tou'`.L,m s uld have a wi:it f'or economic advice and plarnning. In fact, the Depar r,l'sants of Industries and Commerce and Transport urgently rneed to establish such economic advisory and planning units, siwo'e both are faced with pressing complex development problems. In most c.:ses such units could be small, enploying scrintimes 7no more than one o,; two '-:ono- mists. Th.1e could bs gCuid:; profecsion-1.1y by +he central. --,it, -fLthough froii Jthe teint of view of ac';ninistrc ion and general policy 'hey s,:2'uld Je part of thetr oun Depa,tments. These sectorial planning units could also delegate studies to economists not in Government service. - 50 -

151. Staffing of the planning unit may present difficulties, but, in the Mission's view, these could be overcome with strong support from the senior civil service. The first and most important step is to recruit the chief of the central planning unit, either from the senior staff of the civil service or from among leading economists outside Government service. If a proper candidate cannot be recruited on the basis of the regular Government salary scale, which is much too low for senior civil servants, a special contract as a consultant might be used to attract an appropriate candidate. Once the central and sectorial planning units are given reasonable stature and influence, other economists could more easily be attracted. In general, the Mission believes that as economic advice and planning play a more important role in public policy formulation, the Government should be able to hire economists graduating from the universities and possibly even to attract some New Zealand economists who at present are too easily tempted to go abroad. This seems to be a case of demand creating its own supply.

152. Close consultation and cooperation with various economic groups, such as producers, marketing organizations, trade umions, etc., are essential parts of the planning process. The experience of close cooperation between Government and farm groups in the Agricultural Development Confer- ence is encouraging, and similar arrangements should be sought in the future. At the same time, the respective roles of the Government and such groups should be clearly recognized. Since the Government is the representative of the community as a whole and of the long-term interests of the country, while the producers and marketing groups represent special though legitimate interests, it is the Government wihich has to take responsibility for economic policy and which should in all cases set the framework and the basic guidelines for the developnment strategy. ANNEX I Page 51

PROJECTTCF.OTS OF GDP AND IIMPORTS FOR 1972/73

1. Basic Assumptions. Based on past performance and relationships, the Treasury estimated four alternative levels of GDP and imports in constant prices by combining the different estimated values of each variable. It was assumed that GDP would either grow at 3.0 percent or 4.0 percent per annum on a linear basis and that the import component of this projected GDP would either be 19.5 percent or 21.0 percent in 1972/73. Ranging from the highest level to the lowest level of total imports which could result, the four alternatives were:

(1) GDP growth of 4%, import component of 21.0% (2) GDP growth of 3%, import component of 21.0% (3) GD? growth of 4%, import component of 19.5% (4) GDP growth of 3%, import component of 19.5%

2. Regression Equations. In order to determine which of these four altermatives was likely to occur in 1972/73, six basic equations were set, up. Twfo equations were used to estimate GDP level and growth. Two equations -using this computed GD? trend were run to estimate the expected import component. Twiso equationsGDith the GD? level and growth projected by the Treasury were also computed to estimate the expected import component. All of these equations were compared with the four alternative assumptions of the Treasury.

A. GDP - GDP in constant prices was computed as a function of time, once on a linear basis and once on a semi-log basis. Using thie relationship between GD? and time determined by the regression coefficients, GD? was then forecasted to the period 1972/73. The equations and their correlation coefficients were as follows:

Where: 1. GDPk =(f)T T or time = 1 in 1953/54

GDPk = 1616.92 + 97.78 (T) k = constant prices

R = .972 R2- correlation coefficient corrected for degrees of freedom

2. LogGDPk = (f)T

LogGDP = 3.23 + .018 (T)

R2 = .990 ALl WEX I Page 52

The growth rates of these computed GDP trends as compared with those forecasted at 3.0 percent and 4.0 percent by the Treasury were as follows:

------Growth Rates ------1953/54-72/73 1953/54-65/66 1965/66-72/73

1. GDP (linear trend) 4.0% 4.4% 3.1% 2. GDP (semi-log trend) 4.3% 4.3% 4.3% 3. GDP (Treasury 3% forecast) 4.0% 4.2% 3.0% 4. GDP (Treasury 4% forecast) 4.4% 4.2% 4.0%

In comparing these GDP growth rates, the following factors should be taken into account. First, the growth rates of the Treasury's alternatives were based on the actual level of GDP in 1953/54-65/66, and only the rates in the 1965/66-72/73 period were projected. Thus, 4.2 percent was the actual growth rate for the historical period. Second, the growth rates of the other two alternatives were based on computed GDP trends and forecasts from these trends. Consequently, as rates from computed trends, they depend upon the type of equation used.

Since a semi-log equation produces an overall constant rate of growth, a 4.3 percent compound rate existed in all periods, actual and projected. This 4.3 percent rate wras almost identical with that of the historical period, as illustrated by a very high correlation of .990. But if major export prices were to fall substantially in the forecasted period, then growth of 4.3 percent could not be maintained. On the other hand, a linear equation gives an overall decreasing rate of growth, because a constant amount is added to a higher base in the projection period. Thus, the simple rate of 4.4 percent for 1953/54-65/66 was higher than the actual rate for that period, while the simple rate of 3.1 percent for the projected period was much lower than that which actually should be expected. In fact, in only three years out of the thirteen-year historical period from 1953/54-65/66 did the growth rate ever fall to 3.1 percent or lower. Therefore, a rate of 3.1 percent probably could not be maintained constantly throughout the forecasted period, except under very heavy social and political strains.

Thus, on the basis of past trends as supported by these equations, the GDP alternative which best seemed to estimate the future growth rate was the Treasury's alternative of 4.0 percent. This rate was somewhat lower than the compound estimate and higher than the simple estimate, neither of which could be expected to be maintained continuously. In addition, the growlth rate of this alternative for the overall period, 1953/54-72/73, was 4.4 percent; a rate which was very close to that of 4.3 percent in the semi-log equation. Because the correlation of the semi-log equation was so high, a rate of 4.3 percent or 4.4 percent for the overall period 1953/54-72/73 would probably be close to thatrate which could be expected, barring major economic disturbances. ANNEX I Page 53

B. Import Ratio - Imports in constant prices were now computed as a function of the above computed GDP trends and the GDP alternatives projected by the Treasury. Using the relationship between GDP and imports determined by the regressions, imports were forecasted to the period 1972/73. The four equations, their correlation coefficients, and the import ratios each equation produced were as follows:

1. GDP trend computed on a linear basis: Where: 1Ak = (f)GDPk M = imports

Mk = 90.41 + .178 (GDPk) k = constant prices -2 -2 R .631 R = correlation coefficient corrected for degrees import ratio = 20.4% of freedom

2. GDP trend computed on a semi-log basis:

U'k 2Ik (f(fGD Pk

Mk = 78.23 + .184(GDPk)

R2= .662

import ratio = 20.4%

3. New Zealand GDP projection at 3.0%:

Mk = (f)GDPk3

½sk = 66-53 F .189(GDPk3 ) -2 R = .738

import ratio = 20.7%

4. New Zealand GDP projection at 4.0%:

Mk = (f)GDPk4 Mk = 66.53 + *189(GDPk4) R2 = .738

import ratio = 20.6% ANMEX I Page 51

In all of the four equations the ratio of total imports to GDP was approximately the same, 20.6 percent. However, since data is not available in order to determine to what extent this stability of the import ratio conceals a shift in import composition, the knowledge of which is important in more accurately estimating the future level of total imports, the Mission preferred to assurme a range for the ratio of total imports to GDP in 1972/73 (see para. 31). AIESEX II Page 55

TIHE CRITERION OF DO1EST-C COSTS OF FORETGIGN EXCHAIGE

L. In a private enterprise system, resource allocation is done mostly on the basis of the expected financial or private returns on capital. Theso criteria are customarily expressed by well-known techniques, such as t;he expected rate of return on capital, or the discotnted value of future returns or other variations of a cost-benefit analysis. However, in many cases private returns on capital differ from the social returns, either because of non-financial benefits associated with the particular project or because of indirect taxes or duties which represent costs for the private firm, but which from the social viewpoint are merely transfer payments and do not represent real costs to the economy. Because of such differences the Government often has to intervene in resource allocation, using criteria which represent social rather than private returns on capital.

2. If foreign trade, the exchange rate and international capital movements were free from Government regulation and thus able to be freely set by the forces of demand and supply, then the social rate of return, ELs expressed in domestic currency, would also express the rate of return in terms of international prices. However, there are very few countries where foreign exchange transactions as well as exchange rates are completely free from regulation. Even in such countries there may be a difference between the present "eequilibrium" exchange rate and the long-term one, if future changes, which the Government may anticipate, but the private sector may not, are considered. Almost all countries tend to protect the level of activity and employment in their domestic economies from fluctuations in international trade and finance. In such cases the allocation of resources according to the rate of return in domestic currency does not necessarily correspond to the optimal resource allocation consistent with balance of payments goals.

3. This discrepancy may not be particularly important in those countries wiith a relatively small foreign trade sector or in those in a strong balance of payments position. But in countries which have a relatively large external trade sector and/or a balance of payments deficit, which could adversely affect activities in the domestic economic market, such a discrepancy may be of great importance and may require some corrective measures to assure domestic resource allocation consistent with the balance of payments requirements. This is indeed the case in New Zealand. There- fore, a criterion is needed to help identify those activities in which the domestic economy has a comparative advantage, and such activities should be expanded in order to make the best use of domestic resources. Such a criterion can serve as a major guideline for Governmen-t incentives to improve resource allocation.

4. An apyropriate criterion is the costs of the domestic economy per unit of foreign exchange saved by import substitution or earned by exports, on a net basis. If by producing commodity a the economy can save or earn one unit of foreign exchange at a lower cost of New Zealand dollars than by producing commodity b, then more resources should be drawn into the production of commodity a. TFor the sake of brevity the U.S. dollar shall ANNEX II Page 56

hereafter be used to represent all foreign currencies.) The domestic costs per net U.S. dollar saved or earned is actually the exchange rate implicit in the production of the various domestic products.

5. It is the net savings on imports or the net earnings of exports, rather than the gross, which represent the balance of payments effects. To the extent that the domestic product requires imported inputs such as raw materials or machinery, such inputs are a drain on the balance of payments, rather than a gain. Therefore, only the net savings of imports or export earnings should be taken into account.

6. In a modern and diversified economy, there are various stages of processing of a final product,in some of which the domestic economy may or may not have a comparative advantage depending on its particular endow- ment of resources. For example, Australia may have an advantage in the breeding of sheep for wool, but not in the production of wool clothing. She then benefits by exporting raw wool and importing wool clothes. On the other hand, the United Kingdom may have an advantage in processing wool, rather than in breeding sheep for raw wool. Moreover, even in the production of certain types of wool clothing, one country may have a comparative advantage over another. The more diversified an economy becomes, the more significant are its advantages or disadvantages in different stages of production. Thus the costs of a particular processing stage or economic activity have to be evaluated rather than the comparative costs of the final product or even the value added of the product.

7. Moreover, there may be a considerable difference in the comparative advantage involved in the various stages of processing of the same product. The automotive industry clearly indicates such a phenomenon. In vehicle production the domestic costs per U.S. dollar of imports saved may be considerably lower in the first 20 percent of domestic content than in the next 20 percent. Thus in the evaluation of an investment project or production program, each of the stages of production should be evaluated separately. This is similar to procedures followed in the financial analysis of investment projects, in which different stages of investment and production are assessed separately.

8. In many cases domestic plants are required to use domestic inputs rather than imported ones. If imports are free from licenses or tariffs, the plant itself could decide whether to use domestic or imported materials, choosing the least expensive input for comparable quality. In actual practice, domestic production of raw materials or semi-processed goods is frequently protected either by tariffs or by quantitative restrictions in imports. In such cases, a plant, which is forced to use domestic inputs priced higher than international ones, may show a relatively high domestic cost for its final product. This may even happen to products in which an economy has a comparative advantage in a particular processing stage. To avoid such pitfalls, each processing stage has to be evaluated on its own merits. This could be done by calculating the value of inputs purchased domestically at domestic prices at their import prices, or similarly at the domestic cost, less the effects of the tariffs. ANNEX II Page 57

9. This calculation can be applied to inputs which can be physically imported, but such a treatment cannot be used for inputs which for natural reasons cannot be imported and therefore whose imported price is meaningless. Such inputs are henceforth referred to in accordance with the practice in international trade literature as "nontradables," As a matter of fact even nontradable inputs could be separated according to their import content as opposed to their domestic content. Their import content could then be calculated, as other imported inputs, at their import cost. However, this separation requires somewhat complicated calculations, which in many cases may not significantly affect the domestic costs. A simplified method, as suggested by Corden, would be to treat nontradable inputs as part of the domestic cost of the plant, rather than as an importable input.l/

10. Ihe calculation of the domestic cost per net U.S. dollar saved or earned can be shown by the following hypothetical example. Suppose a car is domestically produced at the following costs: Symbol

p Price of a Ful:Ly Imported Car US$2,000 a Components Imported by the Plant c.i.f. (Engines and similar parts) US$ 800

b Purchases from Other Firms of Tradables, at import prices (Tires, Glass, Steel, etc.) US$ 80

c Depreciation, at import prices US$ 70 d Purchases from Other Firms of Non- tradables (Power, Water, etc.) NZ$ 100 e V'alue Added by the Plant (Wages, Interest and Profits) NZ$1,600

1/ W.M. Corden,"The Structure of a Tariff System and the Effective Protective Rate '"The Journal of Political Economy, June 1966, pp. 226-227. AiDThEX II Page 56

The net savings of the national economy in the domestic produlction of the car is the difference between the full price of the imported car, p, and the import costs of the importable inputs, a + b + c, or US$2,000 - US$ (800 + 70 + 80) = US$1,050. The domestic costs are d + e, or NZ$(1,600 + 100) = NZ$1,700. The domestic cost per each U.S. dollar saved is

NZ$1,700 = NZ$1.62

Illustrated symbolically the domestic cost per net U.S. dollar saved is

NZ$(d + e) US$ p -(a+b+c)

In this way data on domestic production costs and net savings of imports, or net export earnings, of various products could deternine those products in which the economy has a comparative advantage, as expressed by a lower domestic cost per net U.S. dollar saved. If the domestic cost per U.S. dollar saved in another activity, such as in tractor production for the domestic market, or in the production of paper for export or in tourism, is lower than in car production, then the national economy would gain by drawing more resources into the latter activities and contracting the former.

11. When the domestic cost criterion is used to evaluate export commodities, the marginal or additional export earnings have to be calculated rather than the average earnings, as would be done in an evaluation of the financial returns on capital. This has important implications for some of New Zealand's agricultural commodities, which face an inelastic demand. Similarly, when the extension of a plant is considered, the marginal domestic cost, rather than average, has to be taken into account.

1L2. Data on the domestic cost per U.S. dollar saved or earned can help rank the various plants according to their comparative advantage. In order to make private firms act on this criterion, rather than on their financial returns, the Government has not only to recognize the proper ranking of plants, but also to offer sufficient incentives on this basis. Such incentives can be given in a number of forms, such as budgetary subsidies or development loans at concessionary rates, or protective tariffs on imports. As long as such incentives are based on criteria expressing "real" values, in this case the long-term value of foreign exchange, they are corrective rather than distortive.

13. What is the relationship between the domestic costs per U.S. dollar saved and the pro-tective tariff as discussed in Chapter VI? From the point of view of the calculation technique, the domestic cost per U.S. dollar saved and the protective tariff percentage are identical, if both are calculated on the same processing stage. This can be showm in the following way. A1N2MC II Page 59

The above symbols irith the sign of (') represent the costs of production of the imported car, if fully produced abroad:

p = a' + b' + c' + d' + e' (all in US$)

If importable inputs used in the domestically produced car are calculated at import costs, disregarding transportation costs, then:

IJS$(a + b + c) = US$(a' + b' + c')

The effective tariff would be given to protect the domestic value added as opposed to the foreign value added content of the product, and could be expressed as: NZ$ (d + e) US$ (d' + e'

Since p -(a + b + c) = d + e (all in US$) then NZ$ (d + e) = NZ$ (d + e) S$ p -US$(a + b + c) US$ (d' + el)

The domestic cost ratio and the protective tariff rate for the value added are then identical, and both express the ranking of various plants according to their comparative advantage. Obviously a plant which requires a lower effective tariff indicates a relative comparative advantage. The major justification for tariff protection suggested in this report is based on the expectation that after a certain period plants will reduce costs, and in that way will improve their comparative advantage ranking.

14. The domestic cost criterion thus ranks the various plants according to the implicit exchange rate of their product. An interesting question then arises: What is the relationship of this criterion with the official exchange rate? As can be seen in the above example, the domestic cost ratio is independent of the official exchange rate. Yet it can serve as an important guide as to what exchange rate would be consistent aith various targets of export expansion or import substitution. Suppose the data shows that even follow-ing me ures taken to reduce costs such as concentration of production or a,nalgasiation of firms, the domestic costs in most industrial plamnts would exceed say NZ$1.4 per U.S. dollar, while the official exchange rate is NZ$1.12 per U.S. dollar. This woulcd be an indication that the official exchange rate is not conducive to sufficient expansion of industrial exports. Therefore, the data on the domestic cost ratio can be helpful in suggesting the exchange rate most conducive to a desired level of export expansion.

15. To the extent that the Goven-ment gives proper financial incentives, either by subsidies, tariffs or development loarns to encourage the Expansion of plants with lower domestic costs per U.S. dollar earned, the ANNEX II Page 60

private financial returns on capital will indeed correspond to the social returns, consistent with the balance of payments requirements. In that case, the Government would not have to interfere with resource allocation as set by the market beyond the use of the above incentives. The role of the domestic cost criterion could then be a guide to the Government in grouping plants according to their rank, and such a ranking could in turn serve as a basis for tariffs or subsidies. This would be the most reasonable approach, since the Government could then limit its direction of economic activities to the minimum corrective policies, and let the private sector allocate resources in accordance with the financial rate of return.