Transcript of Question & Answer Session International and Domestic Adjustment

Well thank you Dr Lowe, thank you so much for that presentation that has covered the global economy, the Australian economy, talking particular about China and its effect on Australia, and significantly of course around the Australian adjustment and the strategies that are there. Some very strong messages I think you've left us with. Now the process of course is that questions can be asked and there will be a roving microphone coming around. But as Chairman I'm exercising the right to ask the first one, which doesn't surprise you I'm sure. The current circumstances of Australia have been described as something of the new normal if you take into consideration the two plus two plus two. 2 per cent interest rates, 2 per cent GDP, 2 per cent or thereabouts rates of inflation. If Australia is adjusting, is the two plus two plus two scenario something that really we have to be taking into even more detailed consideration and in fact adjusting ourselves even more so to accommodate?

I think that's too pessimistic an assessment, because I think in the medium term we can grow faster than 2 per cent. Estimating potential output growth is fraught with difficulties, but a number closer to three rather than two I think would be what most of our analysis would suggest. So it's a matter of the economy transitioning through this period of decline in mining investment and then returning to something that I think is likely to be more sustainable. And as I said in my remarks, for that to occur we need business investment to increase. I think that will eventually happen, but we need to see that happen, and if that happens and I think we can grow at a number closer to three than two, after all the population is still growing at 1½ per cent a year. So if you think 2 per cent is our potential growth rate you're really saying the growth in labour force productivity output per hour worked is only around half a percent, I think that's way too pessimistic in assessment. So I think we can do better than that and in time we will do better than that.

Whoever you are, ask a question rather than perhaps engage in a dialogue that would be great. Thank you.

Ben Potter from the Australian Financial Review, thank you Dr Lowe. Recently, or in the last several months, the Governor has talked about business hurdle rates of return, expected rates of return for CAPEX being too high or not having adjusted to the new environment regarding growth and costs of capital. I notice it was left out of your address and I just wondered whether that's an idea that you've dropped, you've had where you had some pretty strong push back against it from directors, well one individual who's a director of BHP and Transurban who said we invest for 50, 60 years and we're not going to change our approach because of what may turn out to be a short-term change in the outlook. So I'm wondering if the Bank's view on that has changed at all or you still think business could adjust its sights, thank you.

Our view has not changed there at all. I've spoken to a lot of businesses about this and what I detect is quite a range of experience here, some businesses have lowered the hurdle rates of return as the cost of financing has come down, but there are many that haven't, that are still using hurdle rates of return that they were using prior to the financial crisis. And the point we have been making is if the weighted average cost of capital had come down through lower bond costs and lower cost of equity then firms should also be considering at least lowering the hurdle rates of return on their investments. And as I said some have but some have not. And if we are in a world of low growth I don't think it's as pessimistic as the one you're articulating Stephen, but if we are in a world of low growth then hurdle rates of return do need to come down because the physical capital stock would not be able to generate the type of returns that we historically have become used to. I'm not that pessimistic, but I think it is an issue for many firms about what rate of return they're actually expecting to earn on their capital.

Maria Wilton, Franklin Templeton. You spoke about improving the business climate and we talked earlier about the role of animal spirits and the ability for governments and regulators to jawbone, do you see that there is a role for government to improve the business climate, are there things that they should be or could be doing to help things along?

I don't want to be kind of offering gratuitous advice here, but there are certain things that when you talk to business and you talk to people in public policy that repeatedly come up and the things here that I think it's worth focusing on, and I'm not sure what the answers on each of those are, but the culture of innovation, how do we increase the incentives for innovation, how do we increase the reward for innovation, to improve the climate of innovation? Another would be how do we develop the human capital that's required to drive a high value-added economy? I think there's a role probably for increased investment in infrastructure in some places, not only to support aggregate demand in the economy, but to improve the productive capacity of the economy, and I think generally improving the competitive environment. Because I'm struck again when I talk to businesses how often they cite competition from another firm as the reason for them to do something better. So improving innovation climate, improving our human capital, improving competition and improving infrastructure. It seems to me that's the basis of a kind of a set of reforms that could in fact create this business environment where people feel like, yes it is worth taking a risk and investing in capital again. How you do on each of those things, you know I'm a central banker, but I think these are the issues where we should be focusing on.

Graham Craig, BlueScope Steel. Philip, hearing you talk about the investment, lack of business investment and some good reasons for it, it seems to me the other factor at play is we've come through massive transition and unwinding and that other side of the transition is equally massive. We get very quick response from consumers to things like exchange rate movements and so on and you'd expect that. But business investment is going to take longer I think, the lag, the natural lead time is greater, so I'm not quite as pessimistic as one would suggest about the lack of business investment, perhaps with the exception of I guess government-sponsored, government-led infrastructure investment, I wonder what you think about that comment in terms of the lag time on that sort of business investment in an area that's been smashed for five years and the upside of the resources boom they're going to take a bit of time before they start investing again I would have thought.

Well business investment is always frustratingly slow to come. In Australia we haven't had that many business cycles recently but I'm old enough to have seen at least one or two of them and it's a recurring theme that business investment just takes a while to come. And a point I was trying to make in my remarks was that a number of the preconditions for this to actually take place are now there; the exchange rate is much lower, interest rates are lower, the population is still growing strongly, in many industries the capital stock or investment in new capital has been barely enough to replace depreciation so the capital stock through output has declined. And you see businesses being confident enough at the moment to hire workers, employment growth has been relatively strong and business conditions as I showed in one of my charts actually above average, businesses are reporting that current conditions right today, almost in every industry, are above average. So many of the conditions are there, I think this is why we are fundamentally optimistic that the economy will return to a period of stronger growth because the basic conditions for a pick-up in business investment are there. It's just frustrating I think for the community at large that this kind of not happening, but I think it will come and I hope you're right.

Councillor Rod McDonald from the City of Greater Geelong. Sort of a double question, around China perhaps a decade ago I was given numbers that up to 80 per cent of Chinese economy was driven by domestic demand, because of their strong growth in the country and the changes that you outlined in your speech before, but does that sort of number still stack up in light of that growth now? And probably the second part you've sort of answered but with it was around the economy in the fluctuations because was subject to you know obviously the vagaries of the resource prices, what sort of policy settings do you see that could encourage for example advanced manufacturing or structural change? I note some of the specifics that you said before but just thinking about some of the settings that we could actually get the structural change within the country.

I'll take the second part first. I don't really have a long list of reforms that would make a difference here. The lower exchange rate though does make a difference again in discussions that Reserve Bank of Australia staff have with business in recent months, and quite a number of businesses are focused on the fact that the currency is lower, is at least raising the possibility now that they might be competitive and given their underlying strengths and particular advantages that certain businesses have, that the lower currency is now giving them hope that they can actually leverage those in a way that previously they might not have been able to do. And I think the type of things that I talked about to an earlier question at a structural level would help as well.

In terms of China, I don't know, there's the 80 per cent number, but what we're seeing in China, and this process I think is going to go on for a couple of decades, there's a fundamental re-orientation of the economy. The growth model to date has been based on exports and building infrastructure, and as a result of that the share of consumption in national income has been unusually low, unusually low relative for China's history, but also unusually low internationally. So the household sector has not got a very large share of national income and of the share they've got they've saved a lot of it because people weren't sure about social security, they weren't sure about education, they weren't sure about the health system, so people save for these things and the economy is now going through a period of transition where more income is going into the household sector, and over time hopefully households will be prepared to spend a greater share of that income that they get. And so that's changing the nature of Chinese growth, it's no longer in the next decade it won't be as heavily emphasis on exports or on infrastructure and that has implications I think for us about the type of trade relationship we need to develop with China, it needs to go beyond exporting resources to other areas of our comparative advantage, that would include agriculture, services, tourism as you highlighted, high-tech manufacturing. So as China evolves, I think our trade relationship with China does and we'll evolve as well.

Russell Yard, I'm on the board of NICTA, soon to become Data 61 with CSIRO. I am encouraged by your comments about focusing on the issue of innovation. When you look at the indices Australia is usually in the OECD 30 out of 30 in terms of collaboration around innovation and science. What sort of you know financial incentives, what sort of financial reforms do you think are needed to help encourage the investment in innovation and science and research?

I'm straying way beyond my area of competency here, so I can only reflect the type of things that I read, and the two things that kind of strike some resonance with me are the relatively poor record that Australia has of collaboration between the universities and businesses. Some people dispute that but the international scores we do not rank particularly highly there, so that is obviously one area that is kind of a candidate to look at. And the other is I think kind of the general incentives that are set up through the tax system and the bankruptcy code. Most economic actions are driven by incentives, something you learn very early on in economics. And so what can public policy do to change the incentives for innovation and I think the tax system and the bankruptcy code are two areas again that is worth taking a look at. But I don't want to kind of advocate particular policy changes here, but I think they're the areas, and back on the universities, the kind of the incentive structure again within the universities for them to collaborate with business, there are some kind of fantastic examples but there aren't enough of them. And you know, how do universities change their own internal incentive structures to encourage a deeper relationship with business?

Well case studies of course, Philip, the University of Wollongong, but if I could just jump in with a question? There has been an emphasis in any of the discussion about Australia adjusting around reform and the word itself is sort of grown in meaning to different people. The Governor recently at the economic reform summit in Sydney suggested that the word reform needed to be replaced and I think he talked about growth. I wonder in terms of the Bank's attitude to just growth as opposed to any reform mechanisms that might be needed to sustain that growth, are the two mutually exclusive or are we in fact you know we're talking about something different? Are we talking about something that actually is the same? Doesn't matter what it's called.

I think it's really an issue of semantics, but an important one. Because when you talk about reform, the general public you often get sense that oh it's all a bit boring.

Not for this audience.

Not for this audience, but for the community as a whole it's kind of technical, it's hard work, it's kind of not that interesting, I've heard this before so people don't really relate to the kind of the need for reform but the idea that the economy needs to grow more strongly, it needs to generate stronger growth in wages, stronger growth in real living standards, stronger growth in our collective wealth, that's something that people can relate to and so it's really about the framing, if we frame the question of how do we reform, then we lose people straight away. If you frame the question of how do we grow, how do we grow the pie? How do we grow our real incomes? How do we grow our wealth? That's something that's much easier, I hope, for people for people to kind of capitalise around. But you obviously need to do the hard work on reform to get the growth, but maybe framing the question about how do we get growth is a better way of framing the question. And if you look, as I remarked in my talk, if you look at real income per capita in Australia today it's no higher than it was in the beginning of 2008, so that's a pretty good measure of kind of average living standards.

If you go the 15 years before that, real income per capita grew at around 2½ per cent a year, for 15 years. In the 1990s it was productivity growth, then in the 2000s it was the lift in the terms of trade, and right through that period we had a very favourable demographic with the share of children in the population declining. But the demographic dividend's over, the terms of trade are declining, and productivity growth is lower than it was in the 1990s, so the whole wealth generation mechanism, the way our average living standards were rising, that's all changed and we need to refocus the discussion on how to get back to having a real income per capita which is ultimately the measure of economic success, how can we get that to grow again?

I'll jump in again. Reflecting on the Chinese circumstance, and the fact that on best estimates approximately 7 per cent GDP, now that's still not bad compared to the rest of the world. But I did read recently where I think a Minister suggested that perhaps Australia had fallen into a trap of fundamentally putting all its eggs in the one Chinese basket. If we are to sustain the growth narrative that you've just alluded to now, does that mean in terms of the way in which Australian businesses engage with the rest of the globalised village in which we operate, it is about perhaps diversifying a little more, and a little more quickly instead of simply relying on a major player that's been able to sustain us through a commodities boom?

Well diversification is always good, it's hard to argue against that proposition, but China still offers us tremendous opportunities. I spoke in my remarks, I think a bit earlier, about the shift in demand that's going on there and that opens up tremendous opportunities for us. So I don't think we should worry that too much of our economic effort is devoted towards China, but we do need to diversify where we can, and if you think about India you know it's quite possible that the next decade and a half or two decades is a very good period for India. And again we have strong business relationships and a large number of Indian nationals have migrated to Australia, so I think they're kind of opportunities right across the region. We shouldn't kind of feel bad about having a deep developed relationship with the economy that will ultimately be the largest economy in the world one day.

Perhaps the final question, Governor – see to Governor Graham Craig, second bite of the cherry only because you're a Governor.

Thank you. Philip just in support of that last comment about China remaining a big opportunity, I think we tend to get locked into the thinking about 7 per cent growth it used to be 7½ and it used to be 8, but all of that ignores the fact that 7 or 8 years ago the Chinese economy was half the size of what it is today, so the increment of growth of 7 per cent today on an economy much bigger than what it was 10 years ago is still not at all shabby. The opportunities remain very substantial but they are a bit different because of the changing nature of the Australia, sorry of the Chinese economy, is that a fair comment?

Well 6 or 7 per cent growth is the new 12, or it's really the same 12 because China's economy growing at 7 per cent now is very similar in terms of the quantum of additional output, is very similar to 12 per cent growth not that long ago. I don't think we should worry too much that the Chinese growth is not 12 anymore. It's going to be in the next couple of years probably 6 or 7, roughly 6 or 7 per cent, and that's still a large increase in the quantum of global output. And as I've said a couple of times, the nature of the opportunities that China offers us is changing, but there are opportunities there and I can see them right across the board, you just look at the tourism industry the number of Chinese nationals that are now taking holidays in Australia, its staggering the growth there, and we're probably only on the early cusp of that. And a number of other services industries where Australia has a reputation for delivering high-quality innovative services, there is tremendous opportunity and in agriculture one could say the same. So you know China's obviously going through difficult transition in the same way we are, but we shouldn't lose sight of the fact that in the end this is going to be good for us if we can take advantage of those opportunities. There are risks of course, the more concentrated your portfolio the greater the risk, so they're risks that we need to manage, but we shouldn't become so risk averse that we want to minimise that risk and give up the fantastic opportunity that still lies ahead of us there with that relationship.