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Implications for Policy

New Zealand is capital shallow — that is, has less capital per worker — compared to most OECD countries. Our rates of investment have recovered from lows in the early 1990s but the rate of business investment lags the OECD median.

Capital shallowness is likely to be the result of a combination of low MFP and an elevated cost of capital

An important conclusion is that capital shallowness can be thought of, at least partly, as a by-product of New Zealand's low MFP. That is, New Zealand seems to use labour and capital less efficiently than other countries, and thus presents fewer comparable opportunities for investment.

There may also be some distortions or impediments – particularly linked to low domestic savings and high external indebtedness – that are putting (or threaten to put) upward pressure on the cost of capital, driving New Zealand’s level of capital intensity below the level that would otherwise be justified by the economy’s fundamental (MFP) conditions.

Extensions to our basic model provided additional insights into what factors might influence investment and capital intensity. MFP growth arising in the traded goods sector may have a greater impact on raising capital intensity than in the non-traded goods sector. This result, from Grimes (2006), is worth exploring further to test its robustness as a basis for developing policy.

Agglomeration effects are also important. These affect the relative returns from investment in more economically concentrated areas over less concentrated areas. Spillovers from investment to MFP, particularly from FDI and ICT, may also increase the productivity benefits flowing from this type of investment.

What does this mean for policy?

Innovation, skills and creating an environment that support enterprise development will be critical to lifting MFP

One implication is that policies that support an increase in MFP (which directly increase labour productivity) are also likely to have an indirect effect of increasing incentives for investment. This would further boost labour productivity by adding to the stock of capital that workers have to work with. Innovation, skills and a business environment that is supportive of enterprise development will be the keys to producing more output from the given amounts of labour and capital inputs. These issues are discussed in more depth in the companion productivity driver papers.

A compelling explanation of why New Zealand faces a higher cost of capital is elusive but some policies that could help include

A second implication, arising from New Zealand’s elevated cost of capital, is to focus on impediments in the capital market that are giving rise to the interest rate premium New Zealand faces. While a compelling explanation for this interest rate premium is somewhat elusive, New Zealand’s high external indebtedness and extended exchange rate cycles are possible candidates.

…measures to boost national saving

Increased domestic saving should reduce New Zealand’s reliance on foreign savings. Treasury’s position on savings policy was released in 2007 and concluded that ‘in the light of the recent data, evidence and analysis mentioned above, on balance we think that further or stronger pro-saving action is now justified’.[25] This conclusion reflects a least-regrets approach in the light of data uncertainties, persistent macroeconomic imbalances and the possibility that individuals are basing saving decisions on long-run expectations that could turn out to be mistaken.

The Government has taken a number of measures such as KiwiSaver and tax changes for Portfolio Investment Entities that should support increased saving. Monitoring the effectiveness of these existing policies in terms of their impact on saving behaviour will help inform decisions around whether a further policy response is warranted.

…actions that reduce the volatility of the exchange rate cycle

Our exchange-rate cycle reflects a combination of local and international developments. Understanding what is driving exchange rate cycles and whether policy or other factors are exacerbating these movements are areas worth exploring further. These issues have been raised by submitters to the Finance and Expenditure Select Committee’s inquiry into future monetary policy framework.

…promoting financial market development

Other factors that might be creating an impediment to accessing capital are a shallow financial sector and general business uncertainty (for example, from the regulatory environment).

Stable macroeconomic policies, good tax and regulatory policies and an environment conducive to the identification of sound investment opportunities are paramount for the development of the financial system. However, other measures might also support financial system development. These include measures that are currently being implemented including enhancing the regulatory framework including disclosure of information to savers, stronger supervision of non-bank deposit takers and collective investment schemes and licensing of financial advisors. Other possible areas of focus include:

  • setting financial system development as an explicit goal and investigating whether there are further policy levers possible, beyond measures already taken in relation to export finance and venture capital;
  • gaining a better understanding of the relationship between local capital markets and aspects of firm performance including potential barriers to access for firms with intellectual property or highly specific assets that are unable to be used for collateral; and
  • removing barriers to the development of a strong domestic bond market.

Measures taken to boost national savings are also likely to contribute to enlarging and deepening financial markets, as has been experienced in other countries.

… and ensuring a stable and predictable regulatory and policy environment

Stability and predictability in the regulatory and general policy environment are also important to investors. Frequent and ad hoc changes in regulation should be avoided. A regulatory management system that ensures that both new and existing regulation are delivering net benefits to New Zealand is critical These issues are discussed more fully in the paper on enterprise.

The weight of evidence suggests that tax matters for investment but further work is required to identify the implications for New Zealand.

Agglomeration patterns are difficult to change but Auckland likely to play a key role

As this paper notes, agglomeration patterns may be difficult to alter. However, factors such as education, infrastructure and quality-of-life amenities are likely to be important. Auckland is likely to play a key role in generating agglomeration effects in New Zealand. Policies that facilitate its development into a world class city will assist. A focus on issues that affect productivity growth will be important.

Quality of investment matters — competition, efficient markets and in the case of public investment, cost benefit analysis, are the keys to quality

The final point worth making here is that the quality of investment matters. Simply ramping up investment expenditure will not mechanistically lead to higher productivity — investment projects must be productive. For private investment, competition and limiting distortions to markets will provide good signals to private investors about where their capital is most profitably invested. Well-functioning markets are critical. The situation is more difficult for public investment where other, non-economic, factors might affect investment decisions. Sound application of cost benefit analysis will ensure greater transparency of potential benefits and costs of public investment proposals and assist in raising the economic return from such investments.


  • [25]See Treasury Report T2007/654: A Synopsis of Theory, Evidence and Recent Treasury Analysis on Saving available on Treasury’s website at saving/synopsis/t2007-654v2.pdf, p. 4.
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