Australia's Productivity Renaissance - The Second Stanza

It has been well over a decade since the ‘Goldilocks economy’ was de rigueur amongst economists.  The US, Australian and other developed economies delivered a cocktail of strong growth, declining unemployment and disinflation from the mid to late 1990s that confounded many analysts and led some to believe that the business cycle was dead.

The Chairman of the Federal Reserve at the time, Alan Greenspan, attributed the Goldilocks Economy to a renaissance in US productivity growth.  Non-farm business productivity (real GDP per hour worked) expanded at an impressive compound annual rate of 3% from 1995 to 2003, double the growth achieved from 1972 to 1994.  In an influential study, two Fed staffers, Stephen Oliner and Daniel Sichel, ascribed the pick-up to the IT revolution.  Using a standard neoclassical model, they showed that innovation within IT producing sectors (ie. multi-factor productivity) and adoption amongst IT intensive sectors (ie. capital deepening) underpinned the productivity enhancing effects of the IT revolution.

Other Anglo Saxon economies also experienced a productivity renaissance thanks to the IT revolution.  Productivity growth in Australia lifted to an annualised rate of 2.9% in the first stanza of its renaissance from mid-1995 to mid-2002, well above the growth of 1.3% pa achieved in the prior two decades.  Rapid diffusion of information & communication technologies across the economy accounted for the lion’s share of the acceleration, given Australia’s small IT producing sector.

Over the past decade, productivity growth in the most developed countries has slowed, in part due to the lingering effects of the financial crisis.  US productivity growth has returned to the trend growth of 1.5% pa that prevailed in the 1970s and 1980s, while productivity growth in Australia moderated to less than 1% pa from 2002 to 2010.  Most industries in Australia experienced a productivity growth slowdown between 1995-2002 and 2002-10, but two sectors in particular posted large outright productivity declines in the past decade: mining and utilities.  The decade long boom in commodity prices has meant that previously marginal or low productivity mines became economically viable, while there are long lead times to production associated with large and complex mining projects.  And the construction of desalinisation plants and a generational upgrade in electricity network and transmission assets has pulled down productivity in utilities.

But Skeptikoi believes that the second stanza of Australia’s productivity renaissance is already well underway which will have important macroeconomic implications.  In the eight quarters since March 2011, productivity growth has picked up to 2.6% pa.  The industry level productivity statistics are not up to date, but a number of developments point to cause for optimism that elevated rates of productivity growth are sustainable.

First, the mining sector will transition from being a significant drag on aggregate productivity growth to being a strong contributor.  The peak in mining sector capital expenditures is imminent and the supply side response to the generational shift in commodity prices is now coming through.  The key iron ore producers in Australia – RIO, BHP and Fortescue – are expected to lift aggregate production by 60% over the next five years, from 500 million tonnes in 2012 to 800 million tonnes in 2017.

Second, the hump in water related capital investment is largely behind us.  In the past eight years, desalinisation plants have been built in Australia with the capacity to treat a total of 1,000 mega-litres per day.  Most of that capacity is currently shut down thanks to record rainfalls in recent years.

Third, upgrades to the electricity network – the wires, poles and other infrastructure used to transport power to consumer from generators – that have been designed to replace ageing assets and improve reliability across a number of states, are largely complete.  The Productivity Commission estimates that capital investment in transmission and distribution assets has contributed no less than half of the 100% rise in NSW retail electricity prices over the past five years.

Fourth, Skeptikoi expects the relentless focus on cost control by the ASX200 companies to continue.  The penny has dropped for corporate Australia that the anaemic revenue environment is the new normal.  Aggregate sales revenue for the ASX200 companies is up by less than 10% - in nominal terms – from the prior peak five years ago.  The outlook for nominal GDP growth – a more reliable top-down indicator than real GDP for company sales revenues – is expected to continue to deteriorate.  In its updated Economic Statement released on Friday (2^nd August 2013), Treasury downgraded its growth projections for nominal GDP to 2.5% (FY13) and 4.25% (FY15), which represents a dismal outlook considering that the economy has posted nominal GDP growth of at least 5% in seventeen of the past eighteen financial years.

The large listed companies – which typically have high operating leverage - are at the forefront of the drive to lift efficiency and contain costs.  Both BHP and RIO continue to divest under-performing businesses.  Telstra, ANZ and QBE are incrementally offshoring back-office operations, while the banks have cut back on staff in areas burdened by excess capacity – institutional and corporate lending for instance.  There has been generational change amongst senior management committees and boards in the new cost conscious environment.  Boards are hiring more cost disciplined CEOs than their predecessors; BHP announced that its new CEO, Andrew McKenzie will be ‘laser like’ on costs and operations.  CEOs and Chairmen that have a demonstrated track record of delivering strong acquisition led growth during the boom years no longer command a premium in the managerial market.

The renewed cost discipline is already paying dividends in terms of the pick-up in aggregate productivity growth in the past two years.  While some express concern that the profitability payoff to cost cutting is one-off in nature, what is often thought of as cost cutting really amounts to a re-organisation of priorities and business processes, and ultimately a lift in efficiency at the enterprise level.  At a macro level, innovation or capital deepening best captures the productivity enhancing benefits associated with business re-organisation.

The corporate focus on cost control represents a rational response to the new normal of weak revenue growth.  But there is a growing risk that companies simultaneously undertaking efforts to lift efficiency will lead to a shortfall in aggregate demand.  The prospect that inflation expectations remain well contained and unemployment continues to rise ought to provide the Reserve Bank ample scope to further ease policy and for the Overnight Cash Rate to stay lower for longer.

The divergence in Australia’s relative economic and stock market performance since the financial crisis has puzzled some commentators.  Although Australia managed to avoid a recession, the ASX200 remains 25% below its prior peak in late 2007, in line with the performance of the Euro Stoxx index, but well below the S&P500 and FTSE indices, which are at or above their respective prior peaks.  The ASX200’s underperformance mirrors poor relative EPS growth.  Skeptikoi is optimistic that the renewed cost discipline willunderpin a catch-up in Australia’s EPS growth and relative market performance, provided that the Reserve Bank continues to ease policy to cushion the effects of the ensuing shortfall in aggregate demand. 

Against the backdrop of rising unemployment and sub-trend growth in nominal GDP, the ‘Goldilocks economy’ is unlikely to be trending on Twitter any time soon.  But the second stanza of Australia’s productivity renaissance promises to be a boom for corporate profitability and stock-market returns.