Paper by Department of the Treasury

Canberra, October 1979

CONFIDENTIAL

Closer Economic Integration between Australia and New Zealand Possible Impact on the Australian Economy

A. Introduction

This paper attempts to provide a broad analysis of the possible impact on the Australian economy of closer economic co-operation with New Zealand. In particular it canvasses the possible impact on resource allocation, domestic economic activity and the external economic position.

Five broad types of co-operation were identified in discussions on this topic between Mr Fraser and Mr Muldoon at Lusaka. These options were defined as follows:-

• — an extension of NAFTA, i.e. continued operation within the NAFTA framework, although some relaxation of the present ‘no-injury’ criterion may be necessary if Schedule A coverage is to be significantly expanded;
• —a full free trade area, i.e. the elimination of all trade barriers between the two countries;
• —a customs union, i.e. elimination of all trade barriers and adoption of a common external tariff and commercial policy towards third countries;
• —a common market, i.e. the extension of a customs union to remove all impediments to factor movements; and
• —an economic community, i.e. the extension of a common market by the harmonization of commercial laws and industry policies.

This paper concentrates on the first three options. Given the relatively few impediments to Australia - New Zealand factor movements the difference between a customs union and a common market may not be great. The final option-economic community-is considerably more ambitious, involving a far wider range of issues. There would seem to be little real prospect at this stage of either country contemplating a movement directly to an economic community.

Analysis of this type can only be indicative, giving a very general assessment of the possible economic impact of closer co-operation. Apart from the general uncertainty associated with analysing the future impact of policy changes (and data limitations), the impact of any arrangement will depend critically on the precise nature of the arrangement and the manner and timing of its implementation. The options identified above can all potentially encompass a wide variety of arrangements. In addition they can all be introduced over varying time horizons and subject to a diversity of conditions. The bilateral removal of tariffs and quantitative restraints is only one factor determining trade flows and structural change. The impact of closer association may be insignificant compared with say developments in the broader international economy or significant changes in transport costs.

Economic links between Australia and New Zealand are already close. Approximately 75 per cent of trans-Tasman trade is covered by NAFTA while both labour and capital flows are subject to relatively few restrictions.

Before proceeding with any analysis it is important to place the proposals for closer economic relations in perspective. New Zealand is a relatively minor trading partner for Australia, buying only about 5 per cent of our exports. This places it fifth behind Japan, US, the EEC and the ASEAN block in relative importance. Although New Zealand has managed to increase its share of Australia’s imports from about 1.3 per cent in 1961-62 to 3.2 per cent in 1977-78, the growth in market penetration has slowed significantly in recent years and Australia still maintains a sizable bilateral trade surplus. Available statistics suggest that Australia runs a small net bilateral surplus on invisibles1 and a bilateral deficit on capital account with New Zealand. None of these net flows however have any significant impact on Australia’s overall balance of payments position. In any case a significant change in the trade balance of one or both countries would need to be accompanied by appropriate policy adjustments (particularly in exchange rates).

The main significance from a longer viewpoint of any reduction in trade barriers for the respective economies will be the impact on the industrial structure and whether it contributes to a more efficient allocation of resources.

B. General analysis

The gains to be had from closer economic co-operation of the type envisaged in the current exercise arise from the possible beneficial structural changes and the larger domestic market induced by the removal of trade barriers. Both static and dynamic gains are possible. The static gains are the net result of trade creation (a measure of the gains resulting from the replacement of a protected higher cost domestic product by a lower cost import from the partner country) and trade diversion (a measure of the losses resulting from the replacement of a lower cost source of supply in a third country to a higher cost source of supply in the partner country). The dynamic gains are those associated with a larger domestic market, for example, producers can move to more efficient levels of production thereby reaping economies of scale; the level of competition could be expected to increase (including the possible breaking down of national monopolies or the promotion of the aggregation of small inefficient producers); and, some stimulus to both domestic and foreign investment might be expected in response to new trading opportunities. A customs union may also have stronger bargaining power in international negotiations than its individual constituents.

Under a static analysis a customs union or free trade area is more likely to have net welfare gains:

• — if participating economies are such that it is appropriate to specialize in different activities. If the most economically efficient industries are broadly the same in both countries (assuming relatively similar cost structures and productivity levels) or if both countries are already closely integrated, the scope for trade creation is more limited. This is not to deny, of course, the scope for intra-industry specialization;
• — the higher the initial levels of protection in participating countries. This implies the existence of relatively inefficient industries. A country with low levels of protection is already largely exploiting the gains from trade and has less to gain from a customs union;
• — the lower the external tariff after economic integration. This minimizes trade diversion;
• — the fewer industries excluded from the arrangement (eg especially sensitive industries, or industries exempted for security or regional employment considerations); and
• – the larger the union. This maximizes the scope for trade creation and reduces the possibility of trade diversion. (A large union would also seem to provide greater opportunities for the realization of the dynamic gains of integration).
  In light of these considerations a few general observations can be made.
• — New Zealand is a relatively small country (with GDP of $US14.3 billion and population of 3.1 million in 1977 in comparison with $US95.7 billion and 14.1 million respectively for Australia). While integration would represent a significant percentage increase in the size of the domestic market available to each country the combined market would still be one of only 17 million. The smallness of the resulting market has clear implications for the likelihood and magnitude of any gains from integration.
• — As approximately 75 per cent of trans-Tasman trade is already duty free and labour and capital movements relatively unrestricted, it must be acknowledged that there is already a considerable degree of integration between the two economies. The potential for trade creation gains in the future lies mainly with those industries whose output currently face tariffs or quantitative restrictions.
• — The economic structures of the two countries suggest that the scope for efficient rationalization of production between Australia and New Zealand lies principally in the manufacturing sector and possibly in some areas of rural industry (eg, dairying).
• — Both countries have certain industries which receive a high degree of assistance, for example, the textile, clothing and footwear, motor vehicle and household appliance industries. Some of the restructuring flowing from closer integration might simply represent the substitution of an inefficient domestic industry by a partner country industry which is slightly more efficient but still inefficient by world standards. While this is trade creation it is not in the longer term interests of either country to foster the development of industries in which they do not have an international comparative advantage.
• — There might be considerable resistance from the highly protected industries to any form of association which would threaten their existing position.Clearly such resistance needs to be overcome if integration is to generate benefits.
• — Care would need to be taken to ensure that the structural adjustment and trade flows resulting from a removal of trade barriers were not seriously distorted by domestic subsidies and export incentives.
• – While the adjustments required in both economies suggest that any new co-operative arrangements should be phased in carefully, those considerations would need to be weighed against the fact that the longer the transition period the longer any benefits would be in coming.
• — Given the greater importance of quantitative import restraints in New Zealand, Australia would have less to gain in terms of increased trade from a form of integration which did not involve the removal of such restrictions.
• — Since 1973 the New Zealand economy has suffered from quite subdued global demand for its important agricultural exports, a situation that has been exacerbated by limited access to major markets, especially the United Kingdom. New Zealand has also felt the full impact of oil price rises being almost totally dependent of imported oil. Domestic economic policies have not been appropriate for a resolution of these difficulties. Consequently, New Zealand’s economic performance in recent years has been dismal. There has been no significant increase in real GDP since 1975-76 and since 1973 real income per capita has declined alarmingly, by far the worst performance of any of the OECD countries. There has been a steady net emigration, mainly to Australia. Economic policies have been directed at the establishment of an advanced form of welfare state, allowed excessive wage rises, maintained stringent import controls, paid large export subsidies and (until recently)imposed widespread price control. Fiscal and monetary policies have been of a ‘stop-go’ nature with policies being eased whenever their short-term costs became apparent. Although recent policy decisions, including the implementation of an adjustable exchange rate, display some turning towards a more market-oriented approach for New Zealand, they are inadequate to correct the fundamental deficiencies which beset the economy. In the medium term, therefore, to the extent that these deficiencies remain, New Zealand is likely to be a sluggish market for Australian exports. The New Zealanders on the other hand could be expected to see economic integration mainly as an opportunity to increase their penetration of the Australian market with manufactured exports.

C. Economic adjustment

Economic growth is facilitated by countries developing and maintaining the economic flexibility needed to take up new opportunities and to phase down activity in those areas which become least efficient. One aspect of this process is the continual change in the areas of comparative advantage open to industries on international markets. Within a framework that allows the exchange rate to be set at an appropriate level given the overall balance of payments position, the competitiveness of some industries engaged in international trade can be expected to decline over time, while there will be increases in the competitiveness of other trading or non-trading industries. The desire to slow down the process of change in order to reduce the adjustment costs involved in the movements of labour and capital resources into new activities can impose substantial net costs on the community in terms of the opportunities for growth forgone. Failure to permit economic change can only diminish the future wealth of the community and its capacity to sustain high levels of employment in the longer run. A closer relationship with New Zealand should not be considered as an option that will obviate the need to adopt more broadly based trade liberalisation policies or domestic policy actions designed to improve economic flexibility and efficiency.

The long-term objectives of industry policy in Australia, and, in particular, protection policy, were expressed by the Government in the White Paper on Manufacturing Industry and were reiterated by the Minister for Industry and Commerce in his statement on the Crawford Report of 23 Aug 1979. Mr Lynch noted that the Government had made clear,

‘that tariff reductions to induce changes in industry structure and encourage greater specialisation in industry have a role to play in the process of encouraging a more efficient manufacturing industry in Australia. As a long-term objective the community will be best served by a manufacturing sector with a structure requiring minimum levels of Government support’.

In view of the substantial long-term benefits to the Australian (and New Zealand) economy of the move to a less protected industrial structure, it is essential that any program for closer economic integration between Australia and New Zealand does not inhibit progress toward the White Paper objective. The costs of adjustment to change that could be faced by some sections of particular industries already comprise a significant barrier to reductions in protection levels generally. There is no economic case for measures which achieve closer links with New Zealand only at the cost of increasing resistance to measures designed to encourage international competitiveness and a more efficient trading relationship with the world as a whole.lt would not be in Australia’s interest, for instance, if obligations to New Zealand prevented us from implementing desirable reductions in protection afforded against imports from third countries. Such a constraint would reduce the potential for economic growth in both countries. These considerations mean that:

• — Australia should not be prepared to accept any form of closer economic association with New Zealand which would involve a raising of Australian trade barriers against imports from third countries. Since New Zealand’s effective protection levels for a wide range of goods are currently higher than those applying in Australia, New Zealand would face a larger adjustment burden than Australia in any movement to a customs union with a common external tariff set at or near Australian levels. (It would also of course have more to gain in terms of allocative efficiency.)
• — In the case of a customs union, where a common external tariff was implemented, it would be necessary to devise arrangements for the conduct and implementation of tariff reviews involving the two countries. Necessarily this would reduce the autonomy both countries now have in determining protection policy.
• — Any decrease in the tariffs (and other trade restrictions) applying to goods moving between Australia and New Zealand would induce adjustment by Australian industry as production of some goods increases to take advantage of freer access to the New Zealand market and production of other goods decreases in the face of New Zealand competition. Where the shift to freer trade with New Zealand would impose adjustment costs on particular Australian industries, it must be asked whether that adjustment cost would be significantly less than the adjustment costs involved in permitting freer trade with all countries. If the adjustment costs are similar, a general freeing of trade would be preferable as the efficiency costs of trade diversion from third countries to less efficient New Zealand producers would be avoided while the benefits of trade creation would be retained.

Of the options for closer economic co-operation currently under consideration, the establishment of a full free trade area, with the removal of quantitative restrictions could be expected to encourage more widespread structural change than an expansion of NAFrA, as currently operated.

In the case of a customs union, the initial Task Force report 2 on the possibilities of closer co-operation suggests that the industries most likely to require significant readjustment as a result of a general freeing of trade with New Zealand would be dairying (with the exception of fresh whole milk suppliers), certain horticultural industries and production of wool carpets. In the longer term it is possible that a number of labour intensive industries including textiles, clothing and footwear and printing could develop or expand in New Zealand if their lower labour costs (relative to Australia) are maintained. (Assuming differences in wage levels are not offset by higher productivity in Australian industry.)

These adjustments would be offset by growth in a wide range of Australian industries. The Task Force report identifies transport equipment, man-made fibre carpets, sugar, certain fresh and canned fruits and wine as areas which might benefit especially. However, the major benefits would be widespread across these and other industries, their users and suppliers. As is often the case with proposals for the reduction of trade barriers, the potential short-term ‘losers’ (the people in the industries adversely affected) may be more concentrated than the potential ‘winners’ (expanding industries and consumers in general). In the longer term both groups could benefit if the resources displaced moved into more productive uses.

[matter omitted]3

F. Economic Union or Common Market

The more ambitious forms of economic integration-economic union and common market-clearly involve the consideration of a far broader range of issues and would presumably have a more wide ranging impact on the Australian economy. As noted at the beginning of this paper, any comments on the likely effect of these options can only be expressed in very broad terms.

The removal of all restrictions on factor movements and the further significant step of co-ordinating commercial and industrial policies would remove some of the barriers to the attainment of a more economically efficient structure in the two countries. Factors would be free to move to those areas where they could be most efficiently used with fewer distortions arising from differences in government policies in each country.

To the extent that these further options did permit a more complete integration of the two economies and the more efficient allocation of resources within them, trade creation and the dynamic gains of integration should be more fully achieved. The possible effects of integration on domestic and external economic activity outlined earlier in the paper could, therefore, be expected to be more marked under these options. Possible impacts on foreign investment and on banking issues are considered in separate papers.

As noted earlier there is nothing to suggest that Australia and New Zealand would share equally in any benefits generated by economic integration. If these more comprehensive forms of integration were ultimately adopted and if one country were to benefit disproportionately, pressure might be expected from the other for some form of income redistribution, perhaps among the lines of the EC’s Regional Fund. A further consideration is that co-ordination of economic policies would impose restrictions on the flexibility of domestic economic policy makers. Any change in a common policy would need the approval of two governments. To take a very simple example, the establishment of a common external tariff reduces the ability of an individual country to use tariff adjustment as an economic policy measure.

G. Conclusions

While the impact on Australia of closer association with New Zealand would depend on the precise arrangements entered into, there are a number of general observations which can usefully be made.

Firstly there is little doubt that removal of inter-Tasman barriers must be part of a broader multilateral tariff reduction program if Australia is to gain really significant benefits from trade liberalisation. Nothing done in the Australia - New Zealand context should be such as to inhibit Australia’s freedom to reduce tariffs and other trade barriers with third countries.

Secondly, while any freeing of trade can be expected to increase both exports and imports between the two countries, any resultant effects on the overall trade balance of either country are likely to be very small because either

1. there will be a diversion away from trade with other countries, with offsetting effects on the overall trade balance; or
2. offsetting policy action will be taken eg an adjustment to the exchange rate. In these circumstances, the major impact of any freeing of trade on overall levels of income and output is likely to come as a result of changes in the structure of Australian industry i.e. from the relative expansion of some industries and the relative contraction of others.

Thirdly, given the small size of the two economies and the degree to which trade is already free, the overall impact of any freeing of trade with New Zealand would be likely to be small.

Fourthly, whether the relative expansion and contraction of industries as a result of freer trade with New Zealand will result in higher overall levels of income and output than would otherwise be the case is far from clear cut. If the Australian industries that expand are, although more efficient than their New Zealand counterparts, not efficient by international standards, income and output would tend to be lower than would otherwise be the case (unless those industries that contract relatively are even less efficient).

Fifthly, it is clear that some forms of closer association would have an overall adverse impact on Australia. For example, a customs union with a common external tariff above the current Australian level would encourage the expansion of industries which are inefficient by world standards, with clear adverse implications for Australia’s economic structure and future growth potential.

[NAA: A1838, 37011/19/18, ANNEX 5]

• 1 i.e. items such as financial services and insurance.
• 2 Document 22.
• 3 Two sections have been omitted: D. ‘Domestic economic activity’; and ‘E. External economic activity’.