Opinion: ANZ NZ's economics team look at key themes for 2013; Here's theme five - Asia; taking the story from the macro to the micro - it's all about execution

Over the next two business days we are continuing the detailed review by ANZ NZ's economics team of six key themes for 2013. The first one is here », the second one is here », the third one is here », and the fourth one is here »

By Cameron Bagrie*

Our key aim in writing this article is to alert our readers to some of the wider economic forces at work.

We want to highlight the inherent tensions that exist within the economic system, and to encourage readers to start thinking about the implications for their own businesses.

Ultimately, it is the average rate of growth over a number of years (and volatility around that growth) that matters, as opposed to what GDP growth will be in any single year.

The repercussions of the global financial crisis will continue to be felt for years.

Therefore, we would encourage our readers to think about the macro themes we outline below within a five-year time horizon.

THEME 5: ASIA ET AL: taking the story from the macro to the micro - it's all about execution

The upshot:
The opportunity Asia presents New Zealand is well documented. We put some natural caveats around aspects, but still strongly favour it as a secular theme.

Opportunity identification is a necessary, but far from sufficient, condition for real income gains to accrue.

It’s the speed of advance, along with the quality of execution at the microeconomic level which needs to be watched over the coming years.

We’ve seen some real, constructive shifts in aspects of the microeconomics over the past few years, and fully expect it to continue.

However, it needs to be front and centre to keep the mindset on execution.

Firstly, the macro

A lot has been penned in recent years about the macroeconomy and what needs to be done to reinvigorate it. It’s been customary to reference the untold opportunities that Asia and other emerging markets offer. Tapping into these opportunities has certainly been a key part of successive government’s strategies, with free-trade agreements at the heart of it.

We're already seeing evidence of the benefits with exports to China compounding at 18 percent per year since 2000. Great stuff, until you learn China's agriculture imports have been growing in excess of 20 percent.

This suggests we are undershooting the mark in an area of supposed strength, especially as we’ve also had the benefit of being the only country with a freetrade agreement with China (in place since 2008).

According to the World Bank and a number of other notable international organisations, the ASEAN trading block and other big players such as China and India, are well short of natural and renewable capital to meet their forecast insatiable lift in food demand.

Combine being short of renewable capital with the natural biological constraints in agriculture, under investment over the last 20+ years, urban creep and biofuel production swallowing productive land, water scarcity, a more volatile climate, and government intervention; these countries and others are going to be increasingly reliant on food imports.

The following table summarises the picture nicely. New Zealand is effectively “long” renewable capital, much of Asia is “short”, and we’ve either locked in, or are aggressively progressing free-trade agreements.

New Zealand ranks 8th out of 152 countries for natural capital and top of the list for ‘renewable’ natural capital according to the World Bank. Up to half of our assessed natural endowment is agriculture-focused on crop and pasture land. Furthermore, it is eight times greater than the global average on a per capita basis.

Combined with our locality, institutional knowledge in many primary industries, food safety reputation and increasing connectivity (via free-trade agreements with 29 percent of the global population and ongoing negotiations with another 28 percent) this positions us well to seize the untold riches in Asia vis-à-vis other food exporters.

Of course, for the story to unfold, the Asian growth story needs to hang together. Our Asian team are forecasting the continuation of a decent, though not spectacular, economic activity for the Asian region in 2013.

The simple reason is that Asia’s biggest trading partner region (Europe) will remain missing in action.

While China's GDP growth declined to a three-year low in the second half of 2012, growth momentum has since risen. Recent trade and production figures, retail sales and inventory data all point towards a further upturn over coming quarters. With more accommodative monetary policy in place and ongoing fiscal spending, it is expected China will achieve an annual GDP growth rate of 8.1 percent in 2013 a modest improvement on the 7.9 percent achieved in 2012.

However, it is the longer-term story that is more constructive.

Asia is becoming increasingly less reliant on trade with the West as internal demand and trade within the region grows. Millions of people are moving from low to middle-income status each year. Infrastructure and communication technology has increased mobility and productivity. Social policy reform, such as life insurance is being implemented to provide safety nets for families, the elderly and sick. This helps reduce the need for savings and lifts consumption. All these factors point toward increasing purchasing power and affluence, which leads to the likes of greater protein and fat consumption. Income levels vs.

We’d also like to issue a couple of caveats on the Asian opportunity.

These caveats come in the form of competition, imbalances, and the next leg of the growth curve for the likes of China. Our competitors are not standing still.

Take the US adding new whole milk powder manufacturing capability in an effort to export a larger proportion of their milk production and cash in on the lucrative Asian powder markets as one example.

Secondly, Asia is not immune to the challenges facing the US, Europe and Japan, to name a few. Economies are more interconnected today than ever through trade and communication technology. As we all know, the West still faces many challenges. Tough decisions are still to be made and we’re set for a drawn-out period of adjustment, making for a period of caution.

Thirdly, Asia must progress towards more economic growth coming from private consumption instead of being reliant on the traditional export and investment model, especially China. This type of change is a slow moving beast. It requires not only policy change, but also a change in behaviours. So we need to be eyeing how quickly China embraces reform at the microeconomic level.

Fourthly, as China and others move along the developing nation curve, movements in the business cycle will become more pronounced.

China’s largest challenge is making further moves up the income curve. The reality is that most countries who have attempted the move remain ensconced in a low-middle income snare.

In China, the combination of capitaldeepening investment, additions to the stock of capital and labour, and importation of technology via foreign direct investment are necessary, but not sufficient conditions for achieving high-income status. The shift requires a profound change in the social order where state dominance morphs into market influence – the key to leaps in total factor productivity. Productivity is a consequence of efficient resource allocation and sound microeconomic foundations.

Brace for some bumps along that transition for it involves market forces being unleashed. Certainly not in an unconstrained fashion: you need a regulatory framework. However, you do need to let resources respond to market-based signals for total factor productivity dividends to arrive.

Shifting tack

Rather than dwell on the big picture opportunities and risks, we’re shifting tack somewhat. In the agribusiness community we’ve lost track as to how many forums have, and still do, centre around the rather simplistic notion that population and incomes are growing and there is only so much land.

We constantly hear calls for driving efficiency and productivity. Companies such as Fonterra need more and more production to a) be relevant and maintain its global position and b) service rapidly-developing markets. Efficiency to lift volumes is a key strategic issue for sure. However, these types of calls are rapidly becoming a core element of being in business as opposed to growing a really good one.

For the primary industries the gap in the debate and analysis is around the end consumer and channels to market. Such analysis is critical to boost understanding, and ensure we target specific consumers, food categories, and the corresponding consumer channels offering the highest margins and least risk. This is all part of increasing market sophistication across Asia as the macroeconomic trends intertwine with local specifics such as food safety concerns and culture, which affects consumer trends, brand preferences, tastes and business practices.

Also while opportunity identification is a necessary, it is far from sufficient condition to reinvigorate the New Zealand economy.

The latter requires “walking the talk”, or the development of strategies to capture the identified opportunity and then successful execution of a chosen strategy.

In reality most of the major agribusiness industries, the tourism sector and others have already developed strategies around the Asian opportunity with some on to their second, third, or fourth iteration.

In fact, we believe this facet is under-appreciated: all the agri-industries have moved beyond identification and into execution (and we believe New Zealand is well ahead of Australia in this regard). The successful execution of these strategies is the next leg on which we’re looking for guidance and evidence.

The problem here is that benchmarking such progress typically doesn’t happen until you see it in the macroeconomic figures. We’re after earlier signals than that, which is why we’re eyeing all the small things at the microeconomic level.

So what are some of the examples and bellwethers in the microeconomic arena to watch? Examples include:

- Fonterra delivering on its new strategic path and taking the rural sector with it.

The latter requires more communication about the strategy itself as opposed to the opportunities: we know about the latter, we want to understand the strategy and see it in action.

It’s there, it just needs wider circulation, articulation and appreciation.

Several of the strategies are heavily focused on the Asian story, but each has a twist.

One example is growing its position in mobility through its Anlene bone health brand as well as other new products. This hooks into the likes of China’s large population, but also recognises Chinese people are ageing, with 1 in 3 expected to be of retirement age in 2050, compared with 1 in 9 currently.

Subject to management execution, the upside of delivering on this and other consumer business strategies would be significant for its earnings outlook.

As an example, if half of its current sales mix can be migrated from the low margin (3 percent EBIT) and low return ingredient biased operations to the higher margin (>11 percent EBIT) consumer-branded dairy product businesses in Asia/AME and LATAM it could deliver up to NZ$400mn (40 percent) in additional EBIT.

This will not happen overnight, but Fonterra’s product and earnings mix are worth watching with such strategies now centre stage.

The successful launch of TAF is another key peg in the ground which shows Fonterra are making progress.

- Rationalisation and consolidation within the meat industry so the food and beverage sector can overcome its “one big pony with a long tail” look.

We liked the spirit of the redmeat sector strategy report released in March 2011, but question whether it went far enough and progress on some of the initiatives nearly two years on seems slow.

The sheep flock is declining, the ROE on sheep farming is poor, there is excess capacity across the processing sector, collectively meat processors suffered record losses last year, and our major markets in Europe are depressed.

If farmers are having “good” times, processors are experiencing “poor” times and vice versa. Put simply, the economics for sheep farming do not stack up.

To be fair, it’s been a struggle for some time.

We simply seem to be closer to an inflection point where a tipping point drives necessary changes.

Muddling through is not a strategy. More scale is required to help fill in the missing middle in New Zealand’s food and beverage companies.

- If you think the meat industry is dysfunctional, the wool industry is worse and in need of rationalisation and consolidation.

While there have been some notable new initiatives floated to promote rationalisation, new thinking and investment in product development and marketing, by-andlarge none are yet to get fully off the ground with critical mass.

Support from farmers has been poor as past failures have coloured thinking, leading to a reluctance to commit and invest.

If the economics of sheep farming are to improve then dramatic structural change is first required beyond the farm-gate in the wool industry.

For this to occur, farmers need to invest and pin their colours to one mast.

- The composition of boards and governance in the agri-space must keep evolving.

More cultural diversity, marketing expertise, outside thinking and input from the younger generation are crucial.

- Consolidation, or collaboration within smaller niche sectors to deliver to the scale requirements of Asia and others.

Small/medium-sized enterprises trying to access export markets usually don’t have sufficient scale to service the market and face significant sunk costs accessing and developing new markets. They also face a market failure situation where the benefits of individual investment often accrues to others, hence firms under-invest, or tend to free-ride off others.

We are starting to see consolidation in the wine sector where groups of wineries are collaborating to supply larger clients, such as a particular supermarket or hotel chain, as it is impossible to meet volume requirements by themselves.

The New Zealand Hops grower-owned co-operative is another example of collaboration between growers in a small niche sector to access a lucrative export market. They supply 50 percent of their unique aroma and bittering varieties to the US craft beer market.

Scale is required as a craft brewer in the US is a lot bigger than in New Zealand.

- Signs that farmers are moving up the performance curve, with the focus on profit and less on capital gain.

Most farmers think they are in the top 20 percent of performers: the reality is that 80 percent aren’t. Just over half of all profits in the meat and fibre sector accrue to the top 20 percent of farmers.

Rural financiers are increasingly focused on debt servicing ability/cashflow and less so on security, which is helping to drive a mindset change from capital gain to profit. Regulatory changes on farm borrowing are also assisting here.

A host of other good stuff has been going on over the past few years to help support the move up the performance curve and change the mindset, and often it’s in the form of small forums exchanging information and techniques.

Large organisations – Fonterra, the fertilizer co-operatives, meat companies, PGG Wrightsons, etc are showing “skin in the game”, co-ordinating with national groups (Beef + Lamb NZ) and central government to actively sponsor and lead performance forums. These forums now attract more than a 100 as opposed to less than 50 attendees with farmers often travelling long distances to attend.

This momentum has been startling to watch over the past three years, and needs to continue.

On every New Zealander’s “bucket list” should be Mystery Creek and the National Fieldays in June: you will come away with a different notion of farming, such has been the structural evolution across the industry.

- Evidence we’re starting to understand the end-consumer and channels to markets more and more.

Some good progress is taking place in this space also. Businesses are employing local experts to help understand and overcome communication and cultural issues. They are boarding planes and attending trade shows to see and talk to customers.

However, this needs to step up a gear.

A good example is New Zealand wine growers and New Zealand Trade and Enterprise who are working together with wineries to educate Asian markets about wine. Wine appreciation courses are often oversubscribed by a factor of three in China.

Drinking wine in China is different to drinking wine anywhere else. The Chinese traditionally pour wine into small glasses and drink it quickly. However, the younger generation is learning to think differently to the older generation. So while they currently enjoy/use wine in a different way the younger generation are out exploring the world, learning about food and wine and developing their tastes.

Education, such as wine appreciation courses, helps them learn to taste and appreciate the wine, or the food and wine pairing.

- Identifying wealth and opportunities is one thing, but to be successful New Zealand will also need to identify markets that offer facets that are complementary to the basket of goods we can provide, such as refrigeration and distribution functionality.

As an example, for China, we have derived a proxy variable using seven indicators with equal weighting to rank the main regions for market attractiveness of New Zealand food and beverage exports. The most attractive regions are on the East Coast seaboard with Shanghai, Tianjin and Beijing ranking as the top three.

These regions are densely populated, have more purchasing power, spend more on New Zealand oriented food products, and have a robust cool chain and distribution network.

To put these three regions in perspective, they have a combined population of 57.3 million, just over two and half times the size of our largest trading partner Australia.

- Resolving farm succession is a key challenge for many sectors that face demographic challenges.

Farm succession is unique to each individual situation and market conditions will be relevant (i.e. land prices), but there is still a strong desire in the agri space to pass on the business to family.

In fact a whopping 61 percent of farmers see this as their succession plan, compared with just 18 percent of nonagribusiness owners. Farmers look a little more advanced than non-agribusiness in that over 50 percent are developing a plan, or already have one in place.

The successful execution of these plans will ultimately determine the future direction of sectors.

- Increasing the pool of talent with appropriate degrees and skill-sets aligned with business’ needs.

This involves encouraging more high school students into degrees related to science, engineering, business, agriculture, finance, marketing and information technology, and fewer into the arts.

It also involves retaining them in New Zealand once they’re trained.

Closer collaboration, such as the Agri One Ltd joint venture between Lincoln and Massey University, to offer short courses/professional development opportunities aimed at specific areas is another example of innovation in the education sector that helps upskill existing professionals.

- Boosting research and develop expenditure and the commercialisation of this investment.

In the agri space it has been estimated that research and development investment has led to an estimated 17 percent rate of return, providing a compelling case for more. Certainly, with New Zealand research and development investment languishing around 1.3 percent of GDP, compared with the OECD average of 2.0-2.5 percent, there is a good case for more.

There are many examples here, such as the development of different varieties of kiwifruit (despite present Psa challenges). Introduction of the Gold variety has tripled the value a grower earns from a hectare of land compared with the traditional Hayward Green variety.

The Primary Growth Partnership promises to deliver more, but businesses need to put their hands into their pockets more often going forward and look for collaboration opportunities.

- Greater palatability from the rural sector towards environment issues and how a pure/clean/green image can be monetised.

There is some momentum growing with more on and off farm investment going into this area.

The dairy industry has recently come up with a successor to the “Clean Stream Accord” called the “Sustainable Dairying: Water Accord”. It centres around a step change in the management of risks to waterways from dairying through effluent, waterway and nitrogen management. Annual audits are included, along with support mechanisms for education, training and facilitation of best practice for all three aspects of water management.

New Zealand’s clean and green image is a source of strategic leverage and future market premium.

- Steps aimed at encouraging Asian tourists to stay longer and experience New Zealand in different ways i.e. choosing to study in New Zealand.

The total number of tourists visiting from Asia (excluding Japan) has more than doubled since 2000 with Chinese visitors leading the charge to become New Zealand’s second largest source of tourists. While the length of stay is less for Asian tourists compared with their Anglo-Saxon counterparts, their average expenditure per trip is higher.

Therefore, attracting them to stay longer will be key, but other add-ons such as encouraging them, or other family members to come back to study just as important.

Collaboration between the likes of the tourism and education sector is important to seize such opportunities.

The strategic game-plans of Auckland International Airport and Air New Zealand are flag-bearers for the wider tourism industry also: their strategic visions need to be articulated and supported widely. The successful execution of these strategies will bring huge positive externalities to the wider economy and the tourism industry in particular.

Once again we’re after evidence the industry is changing and understanding the end consumer. Are we seeing a massive change across tourism hot-spots such as Queenstown?

Not really.

- Can we move on from the Auckland vs. the rest of New Zealand mentality?

Auckland is critically important to NZ.Inc. It has size and scale.

Auckland’s comparative advantages are not solely Auckland-centric. Auckland is the natural representation and gateway to access and facilitate the broader New Zealand story.

Embracing this is the upside for Auckland, and New Zealand. Auckland and the rest of New Zealand’s fortunes are intertwined.

This is not a complete list, but highlights just a selection of examples of what we are looking for over the year.

It is not a list of criticisms. It offers a glass half-full view of where New Zealand is headed if progress in such microeconomic areas continues. They are not big-bang initiatives, rather a combination of little things in the microeconomic arena, which if executed well, will deliver macroeconomic punch.

Many of our flagged bellwethers are underway. It’s been tremendously encouraging to see significant shifts over the past few years.

Certainly New Zealand looks well ahead of Australia in the microeconomic arena and particularly in the rural scene.

We’re simply looking for it to step up a gear further.

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*This report was written by the ANZ New Zealand economics team which consists of chief economist Cameron Bagrie, head of global markets research David Croy, senior economists Sharon Zollner and Mark Smith, economist Steve Edwards, strategist Carrick Lucas, and rural economist Con Williams. It is used with permission. Theme 6, the final one, will follow tomorrow.