Download Connect – IFSA Annual Conference 2 – 4 August 2006

The Macro Settings: What IFSA Members Need to Know
IFSA Annual Conference
3 August 2006
Gold Coast
Mike Callaghan
Executive Director
Revenue Group
Treasury
The objective of my remarks is to highlight the connection between the
macroeconomic settings for the Australian economy, and policy challenges, with the
activities of IFSA members. (slide 1)
Some may say this is a case of stating the obvious, for the Australian economy and
all its developments are the backdrop, or the context, in which fund managers, the
superannuation industry and life insurance companies conduct their day-to-day
business.
But we readily take things for granted, such as assuming that strong economic
growth will be maintained, the investment environment will remain benign and that
fund managers will continue to achieve high returns. As stated, however, these are
assumptions rather the established facts. Moreover, they will not be turned into
reality without decisive actions, and the outcomes are all interdependent.
Perhaps as an example of how things can be overlooked, for many years
representatives of the superannuation industry focused their lobbying efforts on
reducing the tax on contributions, saying it would improve retirement incomes. The
same attention does not appear to have been devoted to how fund managers could
improve retirement incomes through lifting the return on superannuation savings. Yet
a 0.5 percentage point increase in the rate of return over 35 years would lead to an
extra lump sum benefit of $35,000 in today’s dollar terms for a male on average
earnings. This represents an increase in an individual’s retirement benefit of over 9
per cent. Conversely, a decline in the rate of return on an individual’s superannuation
savings would see a comparable decline in their retirement benefits.
What does it take to lift the rate of return on the savings entrusted to IFSA members?
What does it take to ensure that individuals have a steady employment history over
their working lives and rising real incomes such that they can improve their standard
of living as well as having the capacity to lift their savings for retirement? Australia’s
macroeconomic settings and policy developments are central to answering these
questions.
A strongly growing economy will provide the opportunities that will allow fund
managers to lift their returns. It will provide the opportunity for individuals to have a
continuous employment history and rising real wages. A flexible economy will not
only allow new opportunities to be realised, it provides the resilience to counter
negative shocks and reduce volatility in aggregate economic outcomes. Competitive
markets and people having the freedom to choose what they want will help ensure
that resources are directed to their most productive uses. Reducing excessive
complexity will remove deadweight costs that will drive down the economy’s overall
performance. Importantly, these are the outcome of policy choices. In summary,
what IFSA members need to know is what it will take to maintain Australia’s strong
growth performance.
Timeframes
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In elaborating on this challenge, it is worthwhile first to comment on the timeframe
involved. (slide 2) From a policy perspective, there has been a progressive
lengthening of the time horizon. At one stage the focus was on the yearly budget,
with little consideration, at least in fiscal terms, of the implications of developments
beyond the budget year. A four-year timeframe was then introduced for budget
purposes, with attention directed to not only the impact of a measure in the budget
year, but for the following three-year projection period. The release of the first
Intergenerational Report in 2002 lifted the policy horizon to beyond 40 years, as we
consider the implications of demographic and longer term trends on the economy.
While there is a lengthening in the time horizon for policy considerations, there
appears to be a shortening in the timeframes for many fund managers, with most
funds turning over the majority of their assets within 12 months. However, I would
venture to say that to be effective, fund managers need to be alert to the implications
and opportunities posed by long-term trends, as do policy advisers.
Australia’s growth performance
As regards Australia’s recent economic performance, it has clearly been impressive.
(slide 3) A widely used measure of economic performance is GDP per capita
growth. Australia’s real GDP per capita is over 2.5 times the level it was in the
1960s, with average wages now around $56,000. What would be the working
environment for IFSA members if there had been significantly lower growth in per
capita incomes and average incomes were now less than $20,000? More
importantly, what will be the environment in which the funds management industry
operates over the next 40 years? Will we see comparable growth to the past?
Before turning to what the future may hold, Australia’s performance in terms of
growth in per capita incomes has varied significantly over the past 40 years. (slide 4)
In the 1970s and 1980s Australia’s average annual growth lagged that of the OECD
and the ‘benchmark’ economy---the United States. That situation reversed in the
1990s and early 2000s. What has changed and will it be sustained? What is different
is the policy framework. (slide 5) To quote from last year’s discussion on the
Australian economy in the Executive Board of the IMF:
‘Executive Directors commended the authorities for the sustained strength of
Australia’s economic performance, which they attributed to an exemplary setting of
economic policies and institutions supported by broad consensus on many issues’. 1
Other important features of Australia’s recent economic performance are not only its
strong growth, but its reduced volatility. (slide 6) In contrast to previous periods of
‘boom-bust’ economic activity, Australia has experienced 14 years of continuous
growth. It is therefore not surprising that economic volatility in the late 1990s and
early 2000s is well below that of the 1980s and early 1990s. Perhaps this is nowhere
more evident then looking at movements in official interest rates. (slide 7)
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IMF Public Information Note, 29 August 2006
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But the past 14 years has not been free of external and internal shocks, including the
Asian financial crisis, the US equity bubble collapse, a downturn in the world
economy, terrorist attacks on the US, global health scares, a rapid escalation in oil
prices, and the most severe drought in 100 years. We have also experienced
positive shocks, such as the current terms of trade boom which is largely a
consequence of the rapid rise in the price Australia receives for some of its mineral
exports, particularly iron ore and coal. Yet the dramatic rise in the terms of trade has
not been accompanied with a rapid rise in inflation outcomes or unsustainable boom
conditions in the overall economy. We have seen significant movements in some
asset prices over the past decade, although ‘booms’ in asset price movements have
not been accompanied with ‘busts’ and IFSA members have been operating in an
economy with a more stable aggregate economic performance than was the case in
the 1970s and 1980s.
Why has Australia managed to navigate successfully such positive and negative
shocks? The answer lies in the policy settings and institutional arrangements that
have been introduced, including a market-determined exchange rate; a credible
medium-term inflation targeting regime implemented by an independent central
bank; prudent fiscal policy with a medium-term focus; and flexible and competitive
markets, including product, labour and financial markets. Such institutional
frameworks will allow the economy to adjust to external shocks, but they will not
make the economy immune from sufficiently large shocks nor the problems that can
arise from policy ‘mistakes’. Moreover the business cycle is far from dead. Ongoing
vigilance is required in setting the course of economic policy just as it is required in
taking business decisions.
As noted at the outset, continuing strong economic growth should never be taken as
a given. Yet it would be interesting to know how many in the funds management
industry have only operated in the context of a strongly growing economy. With 14
years of continuous strong economic growth, there would be an increasing
proportion of the industry that have not experienced a macroeconomic environment
of declining real growth, rising unemployment and declining real wages.
Drivers of growth
The drivers of growth are productivity (GDP per hour worked), participation (the
numbers of hours worked by people of working age) and population (the number of
people of working age). (slide 8) For all countries, the main driver of growth is
productivity. Some, however, have had a positive contribution from population and
participation; while for some others, population and participation have detracted from
growth, a consequence of an ageing society.
Over the past 40 years Australia averaged real GDP per capita growth of 2¼ per
cent a year. (slide 9) The increasing proportion of the population of working age over
this period contributed on its own around one-half of a percentage point a year to
average GDP per capita growth. Participation subtracted one-quarter of a
percentage point a year, with increasing female labour force participation being more
than offset by a trend increase in the unemployment rate and falling average hours
worked.
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Based on the projections in the first Intergenerational Report, over the next 40 years,
an increasing proportion of the working-age population will be of ages that have
lower rates of labour force participation, such that participation is projected to
subtract three-eighths of a percentage point from annual growth. Over the next 40
years we expect a continuing decline in the proportion of the population made up of
children, substantial increases in the population aged 55-64 and 65 plus, and a
falling proportion of the population aged 15-54. With labour productivity growth
expected to be 1¾ percentage points per year, all this adds up to future GDP growth
of some three-quarters of a percentage point less than what we experienced over
the past 40 years. If such an outlook were realised, have IFSA members considered
what this would mean for their industry?
In the face of these expected trends, the challenge is to maintain Australia’s growth
performance and this will depend on encouraging greater labour force participation,
particularly among older workers, and maintaining Australia’s good productivity
performance. (slide 10)
Lifting participation
In terms of lifting participation, the focus has been on tax and welfare reforms, and
more recently superannuation reforms. The latter is of particular interest to IFSA
members. (slide 11) The plan in the 2006 Budget to streamline and simplify
superannuation provides a very strong incentive for individuals to postpone their
retirement until age 60 — for after age 60 superannuation payments from a taxed
fund will be free of tax from 1 July 2007. (slide 12) This is important, for Australia’s
participation rate for ages 55 to 64 is below that of New Zealand, the UK and the US.
And as noted previously, an increasing proportion of the population will be moving
into this age cohort.
But what of the incentive to improve labour force participation among those over age
60, where there is a significant fall in participation? While preventative health and
retraining will be important, a key policy response to improving participation is to
lower the tax impost on any extra dollar earned. This is achieved in the Plan to
Simplify Superannuation. With superannuation benefits removed from assessable
income, the result is a significant reduction in the effective marginal tax rate on
earned income for people over 60. This will have a positive impact on the incentive
to remain engaged in the workforce.
Sustaining productivity growth
As regards productivity growth, capital deepening has remained an important
component, but in the late 1990s there was a significant increase in multi-factor
productivity growth. (slide 13)
The strong growth in multi-factor productivity resulted in labour productivity growing
faster in the late 1990s than in any comparable period over the past 30 years. This
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strong productivity performance has generally been attributed to the dividend from
past structural reforms. In the early 2000s, however, the rate of productivity growth
has eased to be around the average of the past four decades.2 Maintaining the
structural reform momentum is essential if productivity growth is to be maintained.
The agenda is well established, including the need to address some of the issues in
pricing, competition and competitive neutrality in transport, energy and water
markets, as well as labour markets and advancing human capital policies,
particularly in education.
It will also be essential to ensure that capital deepening is maintained if productivity
growth is to be sustained. This will require maintaining strong rates of growth of
investment expenditure. This investment can be financed domestically or
internationally — the difference reflected in the current account deficit. If strong
investment expenditure is maintained but there is no lift in domestic savings, the
result will be a rise in the current account deficit. Or to pose this another way, for any
particular net level of investment in Australia, then an increase in domestic saving
will reduce the current account deficit.
Lifting savings
IFSA members have a keen interest in Australia’s saving performance — it is the
lifeblood of much of their business. At the macro level, the focus is on national
saving. (slide 14) But over the past two decades there has been a shift in net saving
from households to the government sector, with the corporate sector largely moving
into balance. In the most recent few years, Australia’s national saving rate has been
close to its two-decade average. A significant strengthening in the budget balance
has offset a decline in household saving rates. Does this mean there is some
public—private sector trade-off? Perhaps, although it is relevant that in many
countries there has been a significant reduction in private saving, even in the
absence of a corresponding lift in public saving. The forces influencing private saving
are likely to include the combination of financial deregulation and housing booms.3
What can be done to lift Australia’s national saving? Continued fiscal restraint is
clearly important. Without the strengthening in the budget balance evident over the
past decade, Australia’s national saving rate would have been significantly lower.
The introduction of the Superannuation Guarantee levy has likely increased national
saving, although it is not straight forward to quantify the effect as allowance has to
be made for a reduction in other private-sector saving in response to the compulsory
levy.
Similarly, it has been difficult to quantify the aggregate impact of past government
incentives to promote particular forms of private saving, for it may result in a shift
Ben Dolman, Lan Lu and Jyoti Rahman, ‘Understanding Productivity Trends’, Treasury Economic Roundup,
Summer 2006
2
See David Gruen, ‘Perspectives on Australia’s Current Account Deficit’, Australian Business Economists
Forecasting Conference 13 December 2005
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from one form of saving to another. However most of these studies have dealt with
minor and incremental changes. The Plan to Streamline and Simplify
Superannuation is expected to boost superannuation savings significantly. Will this
largely reflect a shift in forms of saving or will it result in an increase in aggregate
saving?
A distinguishing aspect of the Plan is the magnitude and nature of the incentive to
invest in superannuation and the fact that it is part of a comprehensive package
which will substantially reduce complexity and enhance the attractiveness of
superannuation as a saving vehicle. Moreover, through reducing complexity and
restrictions around pension products, the Plan provides IFSA members with an
opportunity to develop innovative products which should encourage saving. Such
factors suggest that the Plan is likely to have a positive impact on aggregate private
savings. However even if there is a change in the composition of how individuals are
saving for their retirement, this could have an overall beneficial impact on the
economy’s performance if a greater proportion of saving is directed to the financial
markets where it can be used to finance investments which offer the highest returns.
Reducing complexity
Reducing unnecessary complexity is another key component to sustaining
Australia’s growth performance. While some complexity is inevitable, if not beneficial,
in order to ensure markets work efficiently, resources devoted to dealing with
excessive levels of complexity can be diverted to more productive pursuits, thereby
raising productivity. Excessive complexity increases the cost of doing business and
limits the effectiveness of markets, leading to a misallocation of resources. As we
have seen in the case of superannuation, excessive complexity can increase the
cost of investment services, confuse consumers and impede their investment
decisions.
Conclusion
It is not possible to cover everything that IFSA members need to know when it
comes to Australia’s macroeconomic settings. (slide 15) I would venture to say,
however, that the performance of the Australian economy over the past decade or so
has provided a highly favourable operating environment for IFSA members. It can
not be assumed that this environment will be maintained indefinitely. Sound
institutional policy frameworks have reduced the volatility in the economy, however if
the same rate of growth in GDP per capita is to be maintained in the face of an
ageing population, then steps are necessary to lift participation and to maintain
productivity growth. IFSA members should have a keen interest in ensuring that such
steps are taken.
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