Australia’s Future Is Through Innovation Not Financial Services

The macro and micro economic reforms of successive Australian governments since 1983 are widely acknowledged as having provided the foundations of the continuous economic growth over the last 21 years. Over this same time horizon the economies of many Asian countries, notably China and India have grown rapidly through export trade and today each of those countries have an estimated middle class of 300 million. This net exporter trend is likely to continue for the foreseeable future as Asian economies have a lower cost of production.

Importantly, we can learn from the USA on how it responded to the same challenges that Australia has today. Labour market reform is only one of many initiatives that have allowed the USA to transform its economy. Despite the current budget deficit issues, the USA is well positioned to continue sustained economic growth, whereas Australia has a long difficult path ahead.

There are two important factors that will impact on Australia’s economic growth over the coming decade that require Government focus. Firstly, the Australian financial services sector is too large and is becoming a drag on economic growth. Secondly, Australia’s poor history in commercialising its innovations.

Role of Financial Institutions

A robust financial services industry provides the foundation of a strong economy. The Global Financial Crisis (GFC) has highlighted this and the recent experience in Cyprus demonstrated the fragility of banking systems. Furthermore, Quantitative Easing (QE) is being used as a mechanism to address bank insolvency.

Financial institutions are mobilisers and astute allocators of capital, and are an enabler to sustainable economic growth. They are not in their own right producers of real of economic growth. Interestingly, in the current reporting cycle, the “major” banks all announced profitability growth, whereas many of the other listed companies reported earnings falls.

Financial Services Sector

In July 2012 the Bank for International Settlements (BIS) reported on a study it completed on the banking systems of 22 countries over a 30-year period. Its key findings were that if a financial services sector was too small in terms of size, then it was an inhibitor to economic growth, whereas if it is too large, it is a drag on economic growth. The report indicated that Australia’s financial services sector is too large. The following comparative analysis supports the BIS findings.

Industry Segmentation Analysis – Australia v USA

A comparison with the United States, arguably the most innovative economy in the world, suggests that the industry composition of Australia’s economy is not optimal for growth and development.

Graphs 1 and 2 exemplify the contrasting composition of the two economies by considering the top thirty companies by market capitalisation in each country. Of the top thirty companies in Australia, approximately 10 (33%) can be considered financial institutions (including Westfarmers insurance arm), according to the Global Industry Classification Standard.

Comparatively, only three of the top 30 companies in the United States are financial institutions. These being, Bank of America, JP Morgan and American Express who rank 14th, 19th and 30th on the list of top companies by market capitalization. In contrast, four of the top five companies by market capitalisation traded on the Australian Securities Exchange (ASX) are financial institutions. These institutions are CBA, Westpac ANZ and Nab, hence the financial services sector is now the largest sector.

In terms of Earnings Before Income Tax (EBIT) Australian financial institutions represent approximately 27% of all EBITs of the top 30; whereas, in the USA this figure is 12%. This metric for Australia is not sustainable.

Australia 1982 v 2013

In the past 30 years, the Materials sector, e.g. BHP (comprising a wide range of commodity-related industries) has declined significantly, while the Industrials sector has all but disappeared. The Materials sector has fallen to now be the second largest sector represented in the top 30 companies in Australia. Since the mid-1980s, the financial services sector has doubled its share of the economy; yet, no other industries have grown alongside these financial institutions.

In the top 30 companies listed on the ASX there is not one information technology or health technology company, unlike in the USA. Arguably, the only innovative global Australian company is Cochlear and it is not a top 30 company.

USA 1982 v 2013

An examination of the progression of the US economy in the past three decades shows a very different picture. Similar to Australia, many of the largest American companies in the 1980s were in the Materials and Industrials sectors. Just as it happened in Australia, these sectors are now significantly smaller, because of lower cost of production economies. However, unlike Australia these sectors have not been replaced by financial services.

As shown in Graph 2 companies in the Telecommunications, Healthcare, Consumer Discretionary and Information Technology sectors have replaced those in the Industrials and Materials sectors as the key drivers of USA economic growth. More specifically, the past 30 years have been characterized by considerable growth in Information Technology and Healthcare, which are two Research and Development intensive industries at the forefront of pioneering innovative business processes, products and technologies.

In comparison, Australia lacks the IT corporations, such as Microsoft, Apple, Oracle, Google, Yahoo, Facebook, Twitter, Amazon, and Cisco Systems and pharmaceutical and biotech companies of like Merck, Gilead Sciences and Pfizer that through innovation are helping to transform the US economy.

Innovation & Commercialisation

Australia has failed to embrace an innovation culture which is reflected by its 23rd ranking in the Global Innovation Index. This is lower than other countries with similar GDP per capita. For instance, Sweden and the Netherlands rank 2nd and 6th, respectively. Moreover, Australia’s measure of innovation efficiency compared to income ranks our nation 107th on the list. Many Australian entrepreneurs have moved overseas and successfully raised capital and taken their product to market. This trend will continue until there is a better approach to commercialising Australian innovations.

Until now, successive Australian governments have been focussed on macro and micro economic reforms rather than widening our economic base. If Australia is to remain internationally competitive and experience continued growth in the future, the Australian government should begin implementing strategies that will encourage and allow innovative and sustainable industries to flourish. Real innovation comes from new players not constrained by existing models, as has been seen in the USA where 30 years ago Google, Yahoo, Amazon and Facebook did not exist, while Apple and Microsoft were not yet house old names.

Michael McAlary, Chairmont Capital - 1 September 2013