The Outlook for New Zealand - Garth Carnaby

1. Our Starting Position

New Zealand is a very fortunate country with many opportunities. If I first put on my Royal Society of New Zealand hat, and noting that our brief today extends into the social sciences and the humanities, I would start by observing that here in New Zealand we already have quite a solid starting position in terms of social harmony and freedom from internal conflict. We score strongly on democracy, freedom from corruption and freedom of expression. We have safe streets. But for all that we do have challenges ahead. We have a large income disparity; we have a high level of imprisonment and unresolved issues around national identity, racial disharmony and bi-culturalism. The simple egalitarianism and imposed monoculture of my own youth has gone and so too has the unquestioned purity and cleanliness of our surroundings. We are a fortunate bunch and in world terms, wealthy. But for all that, our aspirations to national wealth are very high and we all know that our ability to finance sophisticated healthcare, deal with natural disasters such as the Christchurch Quakes, and social problems is – well let’s just say its constrained. We know that the Aussies are doing better financially and it really bothers us that we are coming second. We would now need another $40B of activity every year to catch up. But for all that our starting position – our current status is not bad.

We are heavily indebted with private sector debt, mostly money borrowed by the banks and secured against our properties and farms. There is now a polarized political debate starting over whether a capital gains tax is the way to address our love affair with property. But we do not yet have the financial exposures of Greece and Ireland or exposures to some of the other toxic international financial problems.

We have been riding a commodity boom since the mid 90’s. Throughout the 1980’s and early 90’s it was a given that the value of commodities would fall year on year. We were urged to get out of them and into differentiated or manufactured products. Commodities were even seen as somehow a dumb thing to do. The prosperity of New Zealand since colonization has however been linked to them. They have suited us as they do not require consumer market support and knowledge and we can ship and forget them. But we should change our model, said Michael Porter and the Foresight project. McKinsey’s gave lectures on how we should make a living instead through the growth in the share values of start-ups which never need make a profit.

However, instead a number of new factors have emerged and combined to fuel global shortages of agricultural commodities – the growth of new consumption from vast populations in China, South East Asia and India, the removal of agricultural subsidies in Europe, and land competition from biofuel production. We were not very successful at creating new economy businesses based on supplying the world with mobile phones or flat screen TV’s, biotech or clean tech. Thank goodness that the renewed value in commodities came when it did for New Zealand. They suddenly don’t look so dumb anymore.

Even sheep farmers have stopped moaning. The relocation of manufacturing of New Zealand’s new commodities to lower cost centres such as China has lowered conversion costs and by permanently changing cost structures enabled primary producers to capture a larger share of the same consumer spending. So my first point to you today is that our economy is not spectacular but it is solid and our ability to pay our way in the world will probably continue to be sound. It’s a good starting position. Indeed the explosion of new middle class consumers in the emerging mass markets of Asia augurs well for our traditional commodity type exports. If they are no longer falling in real value, or even increasing in real value we can actually get wealthier without having to produce more of them.

2. The outlook for our Economy

So what is the outlook for NZ? Personally, I am very optimistic. Our traditional farming products such as dairy, meat, timber, fish and food all look very sound indeed to me. Why would the world want less of them? The development of post European New Zealand and our early wealth came from the application of the knowledge generated in the industrial revolution to New Zealand’s land resources. We grew rich by feeding the Europeans more cheaply than they could feed themselves. The free trade agreement with China and the one mooted now with India promise to recreate those circumstances.

And then in addition due to our location and geography, we have stumbled on the fact that New Zealand is 96% under water and that we have at our disposal as a nation the fifth largest area of Continental Shelf. It’s bigger than Europe, there are only 4.4 million of us, and we know very little about it or how to use it sustainably. What an opportunity! We will almost certainly end up having an internal argument about who owns it, but from the national perspective we are the beneficiaries of the evolution of the international laws of the sea. Forget mining the National Parks – focus on what’s out on the shelf.

Our good fortune doesn’t end there. Like all other modern economies, the New Zealand economy is now dominated by the provision of services. Of the 1.5 million New Zealanders in work over 1 million of us provide services. Most of the rest work in secondary industry and only a tiny fraction work in the big primary export industries, on the farms producing dairy, meat timber and fish. The fastest growing export sector in New Zealand is services. Aren’t we lucky that someone else started the global communications revolution enabling our New Zealand based service industries to easily export for the first time? In my role at Canterbury Development Corporation (CDC), we did a survey of Canterbury businesses to look for growth opportunities. This revealed that in Christchurch there was a proliferation of small professional service companies who were exporting. These were companies with say only twenty staff, many of whom earned well north of $150k p.a. But 30% of their turnover was from abroad. The companies ranged from provision of personnel services, through marketing services to accounting software services. Related fast growing companies were found in software and coding, animation and multi-media. I really don’t think that we have put enough effort into understanding the impact on our economy of the services sector in New Zealand even big sectors like education, health and consultancy services. Why, given that this sector represents 60% of our economic activity, do we not have a CRI dedicated to growing the sector and its exports?

I do know from discussions with Michael Kelly of Cambridge University that his analysis of the US economy showed that much of their growth was occurring due to increased productivity in their services sector. The single biggest lever in his opinion was that they had achieved huge efficiency gains in retailing led for example by Wal-Mart and by internet shopping. The Warehouse in New Zealand created similar gains here in our retail sector.

So without us needing to use our brains too much at all, here we are with a sound starting position and conditions for growth which are in my view strongly positive.

Add to this our advantage that, unlike Australia, we have a plentiful and dependable supply of water and a diverse range of microclimates which will give us flexibility in a warming climate. We are well educated, innovative and energetic. We are favoured with excellent factor advantages which will lead to increasing comparative advantage for our economy.

3. The Role of Innovation

So how much greater then is the opportunity for us to build on those inherent advantages in the factors governing our economy. Surely we can also use our collective imagination, our skilled workforce and our innovative capacity to add further competitive advantage to our economy. We can innovate. I want to talk about this next. Sir Paul Callaghan has given a series of talks recently in which he has identified one possible solution to closing the $40B gap with Australia. He has made the point that we in New Zealand choose to be poor because we choose to work in low paying areas of employment. He has calculated that at current levels of GDP and with 1.3 m FTEs we generate about $120k per job. He points out that many jobs in tourism – such as making beds or coffee are lowly paid and if we insist on working in jobs which generate only $80k per job or less the problem will get worse. He points to companies like Apple which creates $2m per job or Google at $1.4m/job/year.

His solution is to create in New Zealand around 100 companies which match the average performance of the top 10 high technology companies. These top 10, companies like Rakon and F&P Healthcare, produce $4B p.a. So 100 of them would create $40B. No pressure on the environment (unlike dairy), no need to exploit natural resources (with attendant Treaty issues), just brains and IP tied up in niche engineered products servicing high value specialized industries.

It’s a good idea. I was amazed for example to find that New Zealand hosted a manufacturer of the specialized magnets that do most of the heavy lifting in the Australian Synchrotron.

But this idea of Sir Paul’s is not the only option. It is too easy to generalize and overlook the options in other areas.

Take the food industry in New Zealand. Here we have $21B of gross output created by 68,000 people. That works out at around $300k per job – not bad. And some of the jobs in the sector are producing well below this figure. So it follows that some parts of the sector (probably dairy) must be very attractive indeed.

One thing Michael Porter did convince me of is the importance of clusters. We may be making less than $120k per job in producing bales of greasy wool for example, but scourers, wool testers and carpet yarn spinners do rather better. We can easily achieve world leading technology positions in the knowhow associated with our farm commodities. Did you know for example that we test the Chilean wool clip in NZWTA’s labs in Napier or that 90% of the worlds scouring machines are made by ANDAR in Timaru. We can do these things because a cluster of critical mass has been built up around this core commodity activity and the companies in this cluster have highly specialised technical capability and critical mass on a global scale. In your own sector you have companies in the Waikato exporting stainless products based on dairy processing expertise – for example Stafford Engineering who export ice-cream making plant. In fact the whole Waikato Innovation park is building its business model on the collaborative export of agri-services by its resident companies.

There are other high level public interventions available to New Zealand Inc which will accelerate innovation in New Zealand in a generic sort of way and I will just touch on a couple of them.

The first and rather obvious one is the roll out of faster broadband. The government should be congratulated for its strong resolution here. It has many other calls on its resources just now but it has held the line on broadband. Faster broadband will help all of us, but it is particularly relevant to the group of business services companies I alluded to earlier. There is no other single intervention more likely to get more of them exporting services and software more quickly. What are the science, maths and technology issues needing to be addressed by research to advance the exports of the services sector?

And finally under this innovation banner I would like to refer to angel and venture capital. The McKinsey boys were right. You can make a good living by burning some-one else’s capital in a start-up. Maybe Kiwi’s find capital so hard to accumulate that they are not as keen as Americans to part with it. But the fact remains that in New Zealand it is particularly difficult to access early stage capital to fund risky start-ups. Now it used to be said that the small number of block busters would cover the cost of all the failures and that if an investor spread his or her risk across a significant number of start-ups, their average return would justify the high and variable risk.

I am no longer sure that I believe this. Indeed I am currently of the view that investment in high technology start-ups probably has a return on equity of less than 1:1, i.e. it is a loss making activity. How then are we ever going to get Paul Callaghan’s 100 new technology companies off the ground?

The answer in my view, once again, is public intervention. Who is this socialist, I detect you thinking?

Well let me put it to you this way.

If you get a Ministry of Science and Innovation R&D grant to study something for a year, do you capitalize the grant into your balance sheet at Plant & Food? No, you do not. You write it off 100% in the year the expenses are incurred and everyone is happy. Why is this OK? Well basically it is too hard to capture all the value from R&D and appropriate it to a company balance sheet. And there is a public benefit in the creation of the new industry knowledge which can be shared across the sector.

But suddenly just because we have now put an idea into a company and raised money to explore the idea we suddenly capitalize all this cash onto the balance sheet and write it off as losses through the P&L. Are there not public benefits here too? A start-up company is often quickly copied and the “me too” companies can be like the second mouse – the one that gets the cheese.

So a bit of public intervention here in the so called valley of death stage of new company creation is good. If it has to be written off, it differs only in degree from R&D funding which is always written off. Investing in start-ups may justify public funding leverage. We need the 100 new companies.

For the last few years one of my own main activities has been to try and create a Regional Innovation System here in Canterbury. The two key building blocks have been to use the expertise of Powerhouse Ventures Ltd and combine this with access to local government capital.

Powerhouse Ventures Ltd grew up as the management company supporting Cii, the Canterbury Innovation Incubator. They quickly realised that their incubated companies were starved of angel capital. So they set about creating an angel investment group and leveraging their funds 1:1 with VIF capital from central government. Then enter CDC with access to the Canterbury Economic Development Fund, CEDF, provided by the city of Christchurch. Now we can double the private angel funds with CEDF funds and then double that again with VIF funds creating serious capital resources available to assist companies which Powerhouse Ventures is strongly placed to identify. One of the companies we became involved in last year was Crop Logic, a Plant and Food spin-out company, so Plant & Food has already been a beneficiary of our creation of the Canterbury Regional Innovation System.

So here we are in New Zealand with a good starting position and lucky to find ourselves surrounded by favourable factors for strong comparative advantage. But we can add to that by using our brains.

In my view we should be able to create additional competitive positions in high technology engineering, in the clusters which have grown up around our traditional commodity businesses, by accelerating the export capacity of our large service sector, and by making available angel and venture capital to companies trying to cross the valley of death. If we further leverage them withTechnology New Zealand funding once they are cash flow positive, we can expect them to keep innovating and even to grow their global points of difference.

So that brings me then to the third aspect I have been asked to cover in this talk to you today. And that is the special role of R&D.

4. The Role of R&D

At Plant and Food you are charged with “assisting New Zealand Companies” achieve sustainable growth in New Zealand’s plant and marine based food industries. I took the liberty of adding that bit about “assisting New Zealand companies” since it seems to me that it is actually the companies who will do this and that Plant & Food’s role is a service role – a role which will empower the companies rather than Plant & Food itself. You have some wonderful companies in the sector you service. Companies like Sealord, Talleys, Ngai Tahu Fisheries, Heinz-Wattie, McCain’s, Zespri and Cedenco. You are servicing a growth sector. Horticulture alone has gone from $100m of exports in 1980 to over $2B today. The enormous range of products points to an equally enormous range of possible R&D projects. Will your current R&D portfolio of better cultivars, residue free pest control, sustainable production and propriety foods survive scrutiny in the post reform CRI world? Is this the portfolio that will help your sector make its contribution to the $40B of added value we need. $2B is good but even if you double that again its well short of the target of $40B for New Zealand Inc.

I guess I have a number of questions, or provocations if you like, which you can respond to during the discussion time should you wish.

So my first provocation is this. I think some CRI’s have heaved a sigh of relief They think that the extra core funding they will be getting will be able to be spent on what the CRI thinks best and will relieve some pressure from the need to engage with companies in the industry. My proposition or provocation is that this idea is 180° wrong. I believe that CRI’s should see the new core funding as a way to leverage more funding from the private sector rather than less. This is not to help their own position but rather so they can do more research better targeted to market needs.

Of course the Boards of the CRI’s now have a new role and new accountabilities. Just putting a staple through the corner of several unrelated projects chosen by FoRST is now in the past. CRI Boards now have a strategic accountability for allocating resources themselves which the old system denied them. As CRI’s come under public scrutiny on their outputs and impacts, it will be more rather than less necessary for their boards to be able to demonstrate impact on the companies in the sector being serviced. Having such an impact will be more likely and easier if the companies are engaged from day 1 in project selection and co-funding. The good news is that core funding enables you to leverage company funding, making projects more affordable and better value to companies. In the food sector in New Zealand this is particularly important. The food industry historically has not been seen as an R&D intensive sector. Maybe it has been investing back into R&D as little as ½% of turnover. Compare this with high technology or big pharmaceutical companies – companies which generate high turnover per employee by selling embedded IP in their products. We in NZ can do better here particularly in your fourth product orientated research theme. The companies I mentioned earlier are nice companies- but they are not particularly research intensive, or at least they aren’t seen as being so. There’s the challenge.

This then brings me on to the second provocation I would like to advance. This is that CRI’s will need to develop new types of excellence criteria for assessing the excellence of their science. The universities have grabbed the high ground here and adopted as gospel the international science culture which has it that you can measure science excellence by metrics such as the following

• Publication of papers in high impact journals
• The number of times papers are cited
• The H index
• Peer recognition through international academic awards
• Fellowships and invitations etc.
• There is nothing wrong with these metrics for discovery of new knowledge in the pure sciences. It is a global culture and these metrics are used everywhere.

But a big part of what CRI’s must do in New Zealand is “applied science”. It may be the application of known science to a new or New Zealand problem. It may be seeking a competitive advantage for New Zealand companies, the development of a new proprietary product, or consultancy or it may be technology transfer. These activities are not any less original, innovative or challenging.

My second provocation to you is that Plant & Food like many of the New Zealand based CRI’s needs to develop more appropriate excellence criteria for assessing individual contribution to the outputs sought from the institution by its funders.

• Secret working leading to a surprised market may be more in the national interest than publication in American Journals.
• Publication in New Zealand Journals may be relevant even though they have lower impact factors.
• Inventiveness and economic impact may be more appropriate measures of research excellence.
• Time spent visiting companies and listening for needs may be just as valuable as time spent in the lab.

Both at the Royal Society and via the Tertiary Education Commission I have been working for several years now to get applied science excellence measures given equal weighting to the pure science discovery measures. At the Royal Society we are pro-actively asking the CRI’s to assist us with this and I would appeal to you to engage with us on this matter.

My third provocation under R&D issues concerns capability. I was interested to see that the Plant & Food portfolio of research had less than 25% on new food products. New food products-especially new food products with embedded IP would seem to me to be what it is all about. I have put my own effort where my mouth is by agreeing to chair one of the new food product development facilities, Food Innovation South Island. I suppose the surprising thing for me is why Plant & Food is not in that space already. Surely that program will link company and industry back into new product creation and ultimately to new food science?

I know that Plant & Food has put a lot of emphasis on what might be called “Smart Food”, topics such as “personalised nutrition”, “human health benefits”, and wellness attributes. I can understand Plant & Food wanting to be in those new areas of science but not unless it is well linked into actual product development. Are these going to be the skills you need to accelerate the differentiation of New Zealand’s food exports?

It seems to me we could do more research on the processing and preservation of food. It all gets washed sorted and packaged. So in terms of capability development with NZ impact I would strongly support the emergence of a stronger engineering and product development capability connected to the food companies and the new product development facilities now being created. It is R&D which will give our companies the skills to differentiate and niche market our commodities. Your research on new cultivars on residue free pest control, sustainable production and propriety foods based on personalized nutrition and health benefits all seems relevant and potentially will help add further value to commodity products.

So in addressing the brief given to me by Peter today, I have tried to make a few points which may not be either generally accepted or recognised:

Firstly I made the point that production in NZ of agricultural commodities as the world’s most efficient producer is not such a dumb thing to do as has been often mooted. We have comparative factor advantages. Farming has given us a sound starting position reinforced by a fairly high level of social cohesion. Agricultural commodities have recently been getting more valuable, not less. Even if production volumes are constrained we can earn more if they become scarce or we learn to differentiate them and market them better.

We have several opportunities for high level intervention which will add to this position if we use our imagination. These opportunities include free trade deals with emergent manufacturing giants, doing a more energetic job in exploring our huge continental shelf, accelerating the role out of broadband fibre to lift our export of electronically delivered services, creating one hundred high technology engineering type companies to match the average performance of our current top ten, supporting the export of specialised services from our agricultural clusters, and by making available angel and venture capital to companies trying to cross the valley of death.

In R&D we have a special leverage on these opportunities for innovation and intervention. I have suggested that the CRI reforms provide an opportunity to get closer to the companies in your sector. However that process of engagement faces the risk that it will be restricted by the application of an inappropriate set of science excellence criteria best reserved for academic science discovery work in the universities. And finally in this context I have pointed to the need to more strongly integrate product development activity in food as the glue which will connect your institute to the companies in the sector and provide needs driven signals to your research efforts. R&D has a critical role to play in differentiation and adding value to commodities.

Acknowledgement

This paper was influenced by the recent talks given by Sir Paul Callaghan and draws on a number of points first made by him.