Thursday, 28 May 2015

Another good seminar from LEANZ

Last night we had the latest Auckland seminar from the Law And Economics Association of New Zealand (LEANZ): Richard Meade's "Should Customer-owned Monopolies face Different Regulation than Investor-owned Firms?", based on his PhD work at the University of Toulouse. Richard, before his studies at Toulouse, had been at Victoria's Institute for the Study of Competition and Regulation (ISCR), and is now at AUT.

It was an interesting evening. I learned, for example, that New Zealand is by no means unusual in having a large number of consumer-owned electricity lines businesses, and indeed that the customer-owned or cooperative model is common internationally in other utility sectors as well, such as water and telecoms. The general motivations seem to be a consumer defence mechanism against the market power of a monopoly, and undertaking infrastructure investments in areas that would not be commercially viable for an investor-owned utility. Ideology likely plays some part in some places, but the widespread adoption of the consumer owned model is generally more down to commercial practicalities.

In New Zealand, 12 of the lines businesses have been exempted from the price-and-quality regulation they would otherwise have had, because the main incentive that customer owned lines businesses operate under (low prices for the customers) does a perfectly adequate job of keeping the monopolies to heel. Exemption from regulation is also reasonably common overseas, though not a given. Richard's theoretical work (and he kindly spared us the maths you'd expect from a Toulouse economics PhD) found, however, that in some cases a regulator can't rely completely on the consumer ownership to achieve regulatory objectives by itself, especially if an objective is to nudge the business towards an optimal price/quality combination: consumer ownership will generally deal to price. but may not hit the price/quality combo that consumers might want.

That's probably right: one thought I had was that governance of cooperatives tends to be a political process with elected boards (the bit of Part 4 of the Commerce Act that allows for exemption of consumer-owned lines businesses includes a requirement for elections by the consumers), and that can give rise to political pressures to keep prices down today even if it jeopardises needed future investment tomorrow. The longer term quality of the service may not get a good enough look in.

Richard's presentation on the challenges that regulators face in trying to hit cost efficiency and quality targets simultaneously was also interesting. The latest round of the Commerce Commission's default price/quality paths for the lines businesses includes an automatic mechanism whereby companies' allowed revenue gets a bonus or a deduction depending on whether they beat or miss certain quality targets. I gathered from Richard's presentation that this puts us up somewhere near the regulatory policy frontier when it comes to using CPI - X incentive regulation to steer towards desired quality outcomes as well, but also that the theory and practice of quality regulation is still very much in its infancy.

Another excellent evening: if you're not a member of LEANZ, you should think of joining up, as it depends, as a charity, on members' fees to keep these valuable seminars going, or supporting it in other ways, for example by giving a presentation yourself (and yes, yes I have, which I summarised here). LEANZ also depends on the generosity of a variety of businesses so thanks to Gary Hughes from Wilson Harle who did the introductions (Ed Willis from Webb Henderson would have but couldn't make it) and to Ross Patterson of Minter Ellison who provided the premises and the refreshments afterwards.

Friday, 22 May 2015

Where are the profits?

Yesterday I wrote up the big themes from the Budget (and a few of the minutiae), but didn't have time to write up one of the more interesting forecasts in the documentation (and you may well have a devil of a time finding it yourself, as it's in the 'Budget Economic and Fiscal Update 2015 Additional Information' document, which is the befu15-11of11.pdf file in all the bumph - you can find it here).

It's the forecast for profits - strictly speaking, net operating surplus, but same diff - for agriculture and for the rest of the economy over the next four years (years ending in March). I've extracted the numbers (from Table 3) and put in the percentage changes, and here they are.

Three thoughts, assuming the forecasts are mostly on the mark.

One, agriculture looks to be doing it tough over the next couple of years, and you can see why farming cropped up as a topic at the Reserve Bank's financial stability report last week.

Two, it's not much of a profit boom for the rest of the economy, either, is it? You'd think that in a economy of moderate wage growth, low interest rates, and ongoing economic growth averaging 2.8% a year, there'd be more of a profit gusher than this.

And three, our share market has risen to quite fancy levels on measures such as p/e ratios. Those expensive valuations may be explicable in a world where asset prices of all kinds have been inflated by globally cheap money, but shares priced as growth stocks don't make much sense if this is the profit outcome that's actually going to unfold.

Thursday, 21 May 2015

Budget 2015 - the big picture

So here we are again: another year, another Budget - this one's 'A plan that's working' - and another round of sausage rolls in the Treasury lockup for Budget analysts.

Generally there are only two big things you need to know about any Budget. Despite the vast publicity it's going to get, neither of them (as I've said before here) is the precise level of the fiscal surplus or deficit in any one year. It's almost completely irrelevant, except for scoring cheap political debating points. The things that really matter are: whether it's realistically grounded on a reasonable view of the economic outlook, and whether it makes long-term sustainable sense.

Are the economic forecasts underpinning the Budget realistic? I'm a bit in two minds about this. On the one hand, the GDP growth forecasts for the next four years look a bit high. They average 2.8%, and don't drop off a lot: there's 2.4% pencilled in for the March 2019 year, when you might have thought that somewhere along the way the rundown of the Canterbury rebuild would have led to a larger slowdown. On the other hand, the assumptions about net migration look too pessimistic. Net immigration was 55,800 in the year to this March, and is expected to be 56,600 in the year to June '16, but then is assumed to drop like a stone to 12,000 in the year to June '17. Migration flows can change quickly, that's true, but that quickly? So I'm not surprised that one of the two alternative economic scenarios that got modelled as part of the Budget included one where net immigration was modestly higher.

Net net, maybe there's a bit of overoptimism about the runoff of the earthquake rebuild, and a bit of a downbeat estimate of likely immigration, leaving us roughly where we should be, but I'm left with a slight feeling that the growth forecasts could a bit too high. They're certainly a bit higher than the most recent consensus forecasts gathered by the NZ Institute of Economic Research, and you can also find forecasters in the marketplace (notably the BNZ) who see a substantially earlier and sharper slowdown.

There's also one internal oddity, which is that the participation rate - the proportion of people in the workforce, either employed or looking for a job, and which normally rises as good times roll in - does nothing of the kind in these forecasts. It's at a high level now, certainly, but then it's expected to drop a bit over the coming year, and stay at that level thereafter. That makes little sense to me, although it has a politically handy side-benefit for the forecasts: a lower participation rate makes the unemployment rate go down faster than it would have otherwise.

Overall, let's give the forecasts a pass mark. What about the longer-term fiscal plan?

First, the obvious: crises apart, in normal times what you want to see is steady progress. One step after another doesn't make for catchy headlines, but in fiscal policy dull is just fine. And on that score the Budget does okay, if you compare 2015 with where we're expected to be in 2019, as shown in the table below. The size of the tax take as a share of the economy goes down a little, the size of spending goes down by a bit more, and there's a steady rise in the fiscal surplus and a corresponding reduction in the size of the public debt.

It's also worth saying not only is this steady progress towards a sustainable fiscal outcome, but it's also pretty good when you compare it with some of the usual suspects, as shown below.

So why just 'okay' as an overall assessment?

Two reasons. Here's the first one (in the graph below) which shows that the government is expecting a $2.5 billion hit to its finances from decisions it will make in the 2017 Budget. We don't know precisely what they'll be, but a large part is likely to be tax cuts for low to middle income households. I'm as happy to take a tax cut as the next person, but when you're still in the earlier stages of a fiscal rehabilitation, I'm not sure that (say) a $1.5 billion tax cut on top of (say) an increased spend of $1.0 billion makes complete sense.

Especially, and secondly, as we're not completely out of the woods when you look at the real underlying picture of the fiscal deficit. By that I mean what does the deficit look like when you strip out transient cyclical influences - the deficit will appear to shrink in a business upswing, as the government takes in more taxes, but it will widen again when times are tougher. Beneath the cyclical waterline, nothing's really changed.

Fortunately, you can make a rough (and I do mean rough) estimate of the 'real' deficit, shorn of the business cycle effects, and it's shown in the table below as the 'Cyclically-adjusted balance', as opposed to the headline fiscal deficit which includes the cyclical effects, the 'OBEGAL'.

You'll see that the cyclically-adjusted balance comes in two flavours. One is plain, and one is sprinkled with a 'terms-of-trade' adjustment. The plain one is fine: the headline deficit and the 'real' deficit are pretty much the same. The one with sprinklings, however, makes the (arguably reasonable) assumption that we've been living in unusually good times when it comes to the prices we get for our commodity exports, and that we oughtn't count on them being around indefinitely. On that basis - and it might be over-cautious, but equally it might be just the sort of prudence you ought to steer by - we don't get back to surplus at all. It's deficits all the way. So again you get to the same point, that it looks a bit premature to be giving the deficit a $2.5 billion boost as early as 2017.

In sum, all pretty sensible, perhaps a bit optimistic on how things will actually pan out, but generally going in the right direction.

I won't go into many of the minutiae - you drown in press releases at Budget time, all the way down to ones publicising $2.1 million initiatives - but four caught my eye.

The end of the $1,000 starter subsidy for KiwiSaver. It came as a big surprise, but when I'd settled down, I thought - makes sense. There are 2.8 million of us who have two neurons to rub together and have already said yes please to a free gift of $1,000. If you haven't done it by now, why should the taxpayer bother with you?

That $52 million fund to help build housing on surplus government land in Auckland - fine idea, but a spit in the wind in terms of impact. It's not entirely clear how it's going to work - I asked one of the helpful Treasury people, and it seems as if the $52 million will be to buy the land from its current owners for housing development, with the precise development model yet to be determined - but if so it's not going to go very far. At a very, very conservative estimate of $100K per section, that will get 520 houses going, over a period of years. Well meant, but half of five eighths of the proverbial.

Funding for only 2 more charter schools - sorry, partnership schools. People have mixed views on them, but whatever your views, you'd want to see more policy experimentation going on than this. Particularly when one of Bill English's key priorities (rightly) is getting more value for each public dollar spent, and you'll never know if you are, if you stick to the same monolithic 'one size fits all' model that has typified much of health and education spending.

And finally that $25 million funding for 'Regional Research Institutes'. We don't know exactly where they'll be, and we don't know exactly what they'll do. But if I had to pick between them finding a cure for cancer or becoming boondoggle sops to "the regions are dying", my money would be on the boondoggle.

Wednesday, 20 May 2015

How's the other property market doing?

The latest global commercial property survey from the Royal Institution of Chartered Surveyors in the UK came out recently, and it said some interesting things about our commercial property market - the market that gets trampled in the reef fish rush to cover the residential property market. You can download the latest, March, report for yourself from the RICS site (head for the 'Knowledge' section), though there's a (free) registration process to get at it.

Here's the most dramatic result.

When you combine the demand from tenants with the demand from investors, we have the strongest commercial property market in the world right now. It's become fashionable to mock our 'rock star' status, and it's true we're probably past the peak growth rate of the current business cycle, but every now and then it's worth noting that by international standards we're still doing pretty well. For example - and I'm not knocking Australia, we need its economy to be a strong export market for us - you can clearly see what the current sub-par rate of growth in Oz has been doing to tenant demand there.

Another reaction might be that we're doing rather too well for financial stability comfort, especially as overexuberant commercial property markets tend to be near the front of the queue in financial crises. Here's another RICS chart.

It doesn't look to me that rent and capital gains expectations in our property market have got out of hand. They're fairly strong, but we're in the middle of the better performing pack, rather than at an extreme. That said, as the RICS commentary noted, "more respondents in the majority of markets now believe that commercial property in their locality can be categorised as either expensive or very expensive rather than cheap", a consequence of the global hunt for residual pockets of yield in a world of ultra-low interest rates on bank deposits and bonds.

An alternative way of getting to the same conclusion, that our commercial property market is on the expensive side but not at silly levels, is to compare the dividend yield on our listed property securities to those overseas. The yield on the FTSE EPRA/NAREIT Global Real Estate Index (which you can find here) is currently 3.27%: our yields haven't fallen so low. A representative selection: Kiwi Property 5.25%, Precinct Properties 5.92%, Property For Industry 5.77%.

I really like these RICS reports (I know, I've said it before). We don't have a lot of other info on what can be one of the more important moving parts in the cycle: they fill a real gap:

Monday, 11 May 2015

Unfinished work - and what it's costing us

There's been some discussion on Twitter and elsewhere about whether enough has been done under the current or previous governments to achieve 'transformational' change - something big enough to make a real difference to New Zealand's potential rate of growth and future standard of living.

As it happens, the OECD  has got something useful to add to this debate, both on the issue of whether enough is being done, and on what the transformational changes might be. Its Going for Growth series has been coming out every other year since 2005, and is squarely aimed at identifying priority policies that would raise countries' rates of economic growth. You'd have thought that it would have received a ready hearing in New Zealand, where relatively slow growth over long periods of time is our number one economic issue, but strangely enough the amount of media attention it gets is generally minimal - this year's version also came and went (in February) with little local coverage.

One thing the latest version says (press release, summary etc here and the whole thing online here) is that appetite for transformational change has waned across the developed economies: it's not just us. After a burst of 'we've got to do something' fervour during and immediately after the GFC, "The pace of structural reform has been slowing in the majority of advanced countries across the OECD over the last two years" (p16). And that means that large, 'transformational' potential gains in GDP are being left on the table. As the OECD calculates it

The OECD's also done a country-by-country calculation of how much GDP would increase if its proposed reforms were put in place: here's the result (extracted from Figure 4.5 on p120) of the 'moderately ambitious' one (the OECD also had one scenario that was less ambitious and one that was more ambitious again). We'd actually gain more than the average OECD country if we got on with it.

What sort of reforms does the OECD have in mind we should carry out?

Before showing the full list, it's worth pointing out that the OECD puts its policies into two boxes - the 'labour utilisation' box holds the policies designed to get people into work (eg liberalising labour market regulation), and the 'labour productivity' box holds the ones designed to boost how much people can do when they are employed. In our case, the focus is almost completely on the 'labour productivity' box, as this graph (extracted from Figure 1.5 on p29) shows. It explains how much of each country's income level, relative to the average level of income in the top half of the OECD, is down to labour use and how much down to to labour productivity. In our case, it's entirely down to labour productivity: we're actually better than many other countries at getting people into work, but we lag when it comes to what they produce when they're employed.

So here's the full set of proposed policies.

It's a balanced list. Yes, there are things there that won't appeal to the lefter-wing end of the world (such as privatisations). But equally there is a strong emphasis on fixing socially inequitable outcomes in education and health. Because of the mix, it's probably unlikely that any one government is going to be able to pick them all off: at best we might get one government doing one subset, and the next government doing the rest (and hopefully not unpicking the first lot).

Hopefully we can work our way through them one way or another: as long as they're left undone, we're some 8% poorer than we need be.

Wednesday, 6 May 2015

Overgenerous protection?

I'd never heard of the Express Scripts prescription-price index before I read 'Much ado about something', an article on generic drugs companies in the latest issue of the Economist (it may be available here but it may be paywalled, I can't easily tell as I've got a subscription). The article said that "whereas the average price for branded medications in America has risen by 127% over the past seven years, the average for generics is down by 63% over that period".

I was rather intrigued by this from a competition perspective, so I went to the source. Express Scripts is a US listed company that provides various pharmacy processing and management services, and it has a website, 'The Lab', where it publishes a range of interesting analysis and research. One of its publications is its Drug Trend Report, and on p57 you'll find this graph of the prescription-price index, which measures the prices of the most commonly prescribed drugs in both their branded and generic versions (it's also on p6 of the Executive Summary pdf).

It's hazardous drawing conclusions from one country, and one country with a rather dysfunctional health system at that, but these patterns do lead you to wonder whether patent protection hasn't been overdone. Yes, of course, the costs of developing safe new drugs are high and rising, and patents should enable drugmakers to recover their costs and earn an appropriately risk-adjusted rate of return on their outlays. And yes, you'd have to do the heavy lifting of comparing actual and fair WACCs to be make a fully informed call (and even then there'd be judgement calls involved). But price divergences of this order at a minimum make you wonder whether the length or scope of protection haven't been overdone. Overgenerous protection  would also help explain the squalid trade of branded producers bribing potential generic competitors not to produce (as I wrote about here, here and here).

I'm hesitant even to mention the Trans Pacific Partnership - every anti-trade nutter in the country will be reaching for their tin-foil helmet - and I'm going to reserve final judgement on the thing till I see all of it as a package. But if, as has been widely speculated, one of the elements is extended life for intellectual property protection, then it's probably a step in the wrong direction.