Monday, 8 February 2016

Of debt and derivatives

Trading Places: Running NZ like an investment fund

6 February, 2016

NZ Inc has mutated into NZ funds management: the modern way to run an economy.

Can you make sense of modern economics? Why is the world so worried about deflation these days? Didn't inflation used to be the big, hairy monster so far as finance ministers were concerned?
Yet the other week the Reserve Bank was talking about how the New Zealand inflation rate – down at 0.1 per cent – is languishing stubbornly below its target 2 per cent. We've got to get it up somehow.

The penny dropped when someone explained that in today's debt-soaked world, inflation is your newfound friend. Every month it shrinks the dollar value of what you owe a little more. You get to pay back yesterday's $1 borrowed, with eventually a dollar worth something more like 90 cents.

And as a nation, New Zealand now carries $120 billion in debt. It is paying $6b in interest annually to keep its credit card lifestyle going. So we really can't afford to drop into deflationary territory where this ginormous lump of yesterday's dollars are suddenly going to start costing us a whole lot more.
Aha! It makes sense. In a backward, wrong-end-of-the-telescope, kind of way.

Public finance and national economic policy do seem the black arts of modern life. And in fact the experts say New Zealand is riding a wave of changing practice that is far more radical than most people understand.

Former Canterbury University accountancy lecturer Dr Susan Newberry, now professor of accounting at Sydney University's business school, still keeps a fascinated eye on the "New Zealand experiment". And some of what she sees she finds a little alarming.

In a paper published by Public Money and Management in January, she fingers the mythical nature of our Earthquake Recovery Commission's (EQC) Natural Disaster Fund – which she sees as part of a bigger story about how the government now freely shuffles its assets around within the national balance sheet.

And in another heavy-hitting paper published in Critical Perspectives in Accounting last year, Newberry raised a red flag on New Zealand's financialisation of its sovereign debt.

Does the average Kiwi know the country's balance sheet now has a derivatives exposure of $180b, she asks? That is rather a lot of those "financial weapons of mass destruction".
Prof Sue Newberry of Sydney University: track record for uncovering uncomfortable truths.
Prof Sue Newberry of Sydney University: track record for uncovering uncomfortable truths.
Yes, Newberry is taking something of a poke at what is happening over here. However she has a track record for uncovering uncomfortable truths in the national accounts.
There was the 2003 Transpower deal where a majority stake in the South Island electricity grid was sold to Wachovia Bank as part of an elaborate tax minimisation scheme.
But really, says Newberry, she is posing an open question. How is New Zealand being run in terms of economic theory? And does the ordinary voter – being dazzled by rather spurious "back into surplus" election targets – understand anything well enough anymore?

There is a feeling that New Zealand has been through its neoliberal revolution with Rogernomics. During the late 1980s and early 1990s, it made a wrenching transition from old school public accounting to the lean corporate model – the start of a "New Zealand Inc" approach to politics.

Newberry says we had legislative changes such as the State Sector Act 1988 which brought in private sector disciplines like accrual accounting. There were the state-owned enterprises, public-private partnerships, and other new structures that put the delivery of state services on a commercial footing.

The idea was to run the national economy as if it were a business, with taxpayers as the shareholders hoping for a general dividend return on a thriving concern. It caused much angst at the time, but now New Zealand seems settled into that NZ Inc groove.

However Newberry says in fact the past decade has seen the running of the economy evolve in a way that keeps New Zealand at the forefront of small country innovation – like maybe Ireland, Iceland, even Greece.
What goes up ... even the experts can find high finance a puzzle at times.
What goes up ... even the experts can find high finance a puzzle at times.
In a nutshell, NZ Inc has mutated into NZ funds management.
Newberry says successive governments have financialised the economy through the creation of all kinds of notionally ring-fenced public funds – the Accident Compensation Corporation (ACC) being an example – matched by galloping international borrowing and an ever increasing reliance on risk-hedging derivatives.
The grand goal is to free up the national balance sheet so it can be fully leveraged for growth. The government in effect becomes a portfolio manager, directing taxpayer capital – or rather the greater capacity for borrowing thus created – into whatever activities seem the most long-term profitable.

And Newberry agrees on one level it is absolutely sound. In the Asian century, with all the opportunities of the Pacific rim, New Zealand can hope to be a tiger economy. Speculate to accumulate.

A possibility is being created at the level of a whole country about the investor profile it wishes to choose. In the jargon of financial advisors, do we as a nation want to be a "conservative", "balanced" or "growth" managed fund?

So the economic theory is as modern as it can be. But do Kiwis understand the downside risk of a financialised economy employing all the latest investment bank and hedge fund tricks, Newberry asks?

"Shareholders in a business aren't ever going to lose anything more than what they put in. It is limited liability investing. But the difference with corporate-style governmental accounting is that it is unlimited liability. It is New Zealand's taxpayers and residents who are on the hook if there are any problems."


This is not a secret change, even if it has gone over most people's heads, says Newberry.

She cites Treasury documents starting 2007 where: "Treasury has begun to represent its role as that of an investment fund manager, even to the extent of recasting the government's statement of financial position into an (unaudited) investment statement, and referring to the assets and liabilities as an 'investment portfolio'."

And every year, that language has become more pointed, says Newberry. In 2012: "Treasury has reported that although the assets in this 'investment portfolio' are classified into social, commercial and financial assets, the Treasury as investment manager intends to advise the government 'on the allocation of capital to its highest value use'."

And others are remarking too. In a Budget 2014 commentary, accountants KPMG noted that increasingly the national balance sheet is being "monetised" – another way of saying the government is taking trading positions by owning investment stakes in physical assets, rather than owning the physical assets themselves.
Christchurch accountant Cam Preston: derivatives form the economy's "base isolator" now.
Christchurch accountant Cam Preston: derivatives form the economy's "base isolator" now.
KPMG says this is most obvious with funds like the EQC, ACC and New Zealand Superannuation – a portfolio of three Crown entities representing $60b alone.

KPMG was cautiously positive, noting that in terms of the "market evaluation" of the government as an investment entity, New Zealand voters are making known their shareholders' view every three years. So it must be doing all right.

However others, like Dr Jane Kelsey, law professor at Auckland University, have shown more concern. Last year Kelsey wrote The FIRE Economy, arguing New Zealand was gambling too much on the neoliberal bets of finance, insurance and real estate.

And internationally, as academics pore over how the 2008 global financial crisis (GFC) caught out European "periphery" nations like Ireland, Iceland and Greece, the talk is of how they allowed themselves to be financialised – open to sudden inflows of off-shore debt.

Though the counter-argument – the one heard from New Zealand Treasury – is that New Zealand has made its own big moves only after the credit crunch. So we should be hitting the investment cycle at the proper moment, right when money is cheapest and the rest of the world still rocking on its heels.

But what are the mechanics of this new investment portfolio approach? commentator and Christchurch chartered accountant Cameron Preston – who coincidentally was a student of Newberry's and has now joined her in her analysis – offers the simple version.

In essence, he says, it comes down to accrual accounting, balance sheet leveraging, and derivative hedging. And as Newberry acknowledges, the theory is rational. After all, it is how the world's most successful investor, Berkshire Hathaway's Warren Buffett, made his fortune.

Preston says Buffett spotted value in the balance sheets of the rather staid world of insurance. Pots of money were being created and parked by people paying premiums in advance of misfortune. If you could own those funds, you could then leverage them to invest more adventurously.

"He started making his money from insurance and reinsurance because effectively what you end up building is large sums of free money that you can then go and use to do other things."

Buffett of course was unusual both in the astuteness of his investments and his readiness to pursue the long-term, Preston says. But the general principle is the same with the government's current economic philosophy – get the national balance sheet liquid in ways that today's capital can be used to purchase tomorrow's best revenue streams, whatever those might happen to look like.
The change started with the shift to accrual accounting right back under Rogernomics in 1988.
Preston says in simple terms, accrual accounting is about recognising "economic events" regardless of when the actual cash transactions occur. So what are recorded are the decisions to incur a liability matched against the financial assets thus being created.

In the old days, the country's accounts were run on a cash basis. Tax-payer revenue came in, the government spent it on public goods and services. The Auditor General was still very much also the financial controller.

"In the cash accounting world, the Auditor General could say you can do whatever you want, but I'm putting the cheque book in my back pocket now, so you come and see me when you want to actually do something."

But accrual accounting has become the norm for corporations. And with New Zealand as one of the pioneers, increasingly so for countries.

Again the theory is good, says Preston. It gives governments the flexibility to borrow in the name of future growth. The cost of a debt created today can be matched in the public accounts against its expected future pay-back.
Auckland University's Dr Jane Kelsey: warning of the financialisation of the economy.
Auckland University's Dr Jane Kelsey: warning of the financialisation of the economy.
It brings a certain purity of thought as well, says Preston. Everything a nation owns is considered in terms of its dollar value.
When crown agencies and state enterprises were formed under the corporatisation model, they had to start accounting for their assets. So the New Zealand Transport Agency (NZTA), for instance, calculates the fair market value of the nation's road network.
"You could hardly sell off the land underneath our highways," Preston admits. Yet accrual accounting allows our roads to be included in the national pot of assets.

And Preston says that is great when the international credit rating agencies come calling and give our sovereign debt an AA tick of approval, lowering the government's cost of borrowing – the interest rate that must be paid in the world's capital markets.

Preston says if in theory everything is up for sale, then – like the first-time home buyer wanting to borrow as big as possible to get aboard a growing property market – this frees New Zealand to pursue its brightest possible future.

Although as Newberry also says, it does mean the New Zealand tax-payer is on the hook if it all goes wrong and there is – as with Greece, Iceland and Ireland – the international equivalent of a bank-imposed mortgagee sale.


That is accrual accounting. And so to derivatives.

In her "Critical Perspectives" paper last year, Newberry asked why the New Zealand government's use of derivative instruments had increased so dramatically – what policy did it represent?

In fact Newberry was following up on complaints she made to the Auditor General in 2013 that the national accounts were not even revealing the true extent of derivative use.

Newberry says the figures reported were net positions – a fair value assumption about whether the individual deals were in profit or loss – not the total amount of exposure. The Auditor General changed the reporting practices, given Newberry the full figures to analyse.

Now Newberry notes their astonishing yet generally unremarked rise. She says New Zealand's derivatives exposure has gone from $18b in 2002, to $86b in 2007, to – by her reckoning, adjusting for some accounting changes – today's figure of $180b.

Newberry says of course the overall economy has grown too. But that is still a change from 14 per cent of GDP in 2002, to 52 per cent of GDP by 2007, to 90 per cent of GDP today.

In itself, Newberry says there is nothing wrong in the use of financial derivatives – futures, options and swaps of various kinds. But it all depends on whether they are being used to hedge assets or instead to leverage speculate investment.
Masters of the portfolio strategy: PM John Key and Finance Minister Bill English on Budget day.
Masters of the portfolio strategy: PM John Key and Finance Minister Bill English on Budget day.
Again trying to explain it simply, Preston says a derivative is a contract between two parties. So it relies on each being around long enough – and having deep enough pockets – to fulfil both sides of the bargain.
As a balance sheet tool, derivatives can be used to tune investment risk either way. By betting against the possible downside of an investment – say a change in exchange rates which makes the future cost of finishing some national road-building project unexpectedly more expensive – you can insulate your risks.
Or you can do the exact opposite, the equivalent of doubling down on your bets, by applying leveraging that only pays if all your investment strategies pan out.
Preston says the claim is the New Zealand government only employs derivatives for hedging – targeting the neutral outcome. And by being such an active user now – creating a market of $180b – it is deepening the New Zealand capital markets in a way that is good for the whole country.
"Capital markets in the form of insurance businesses, pension schemes and derivative instruments, are really a way of protecting against shocks. So in New Zealand we had the oil shocks and so forth – a lot of economic upheavals through the 1980s.
"Having a mature capital market is seen as a way of insulating a country from those external shocks, like the base isolators under a building in an earthquake."
Modern economic theory is that a financialised economy is self-correcting because the money represented in a nation's assets becomes divorced from the physical ownership of those assets themselves.
Markets are smart. So letting the money to flow through complex webs of derivative transactions is a way to stabilise the economy as a whole. And Preston says this fits in with the value investing philosophy.
If economic storms are brewing one year, the worst will be hedged in advance – already allowed for in the national accounts. This would allow New Zealand to hold its nerve, pursue its long-term strategies, despite passing bouts of financial turbulence.
And Preston agrees as usual the theory is fine. The problem though is derivatives by nature are not transparent. In his work, valuing derivative positions for companies feels more like alchemy.
"The government's full derivative exposure is now massive at 90 per cent of GDP. While those are different positions, all meant to offset each other, and you would never have a scenario where they all went wrong at the same time, you still end up with this opaqueness," says Preston.
Like a fund manager, the government is asking the public to take its skill in managing the nation's trading position mostly on trust.
So accrual accounting allows for the financialisation of the economy. It puts the entire nation on the balance sheet in a way that lets taxpayer assets find their best investment home.
And derivatives provide the base isolators, ensuring these national investment positions are not derailed by the occasional global financial wobble.
No wonder New Zealand has a former derivatives trading star as its prime minister, quips Preston. Who better to understand such a game? Likewise Australia now has an investment banker, Malcolm Turnbull, in charge. The portfolio approach looks to be spreading.
But opaqueness itself is an issue. Which brings up the use of various increasingly notional – indeed Preston would call them mythical – national investment funds.
Preston says once more the beginnings had the noblest of intentions. Labour finance minister Michael Cullen's 2001 NZ Superannuation Fund was set up as a pot of government money that would be invested today to pay for the pensions of tomorrow.
The deal was the government would put in $2b or so every year. An investment team would place the money wherever it would make the best returns. Then by 2028, there would be bank of savings the government could start to draw on to cover its pension promises.
Preston says it was responsible finance – a change from constantly loading the cost of superannuation onto the next generation. And the super fund has been making stellar investment returns.
Likewise ACC was set up to become eventually self-funding. ACC contributions were set so they would build up a pot big enough to cover the expected lifetime costs of looking after the seriously injured. And again, says Preston, employing sharp traders to play the world markets, ACC now sits on its own nest egg of $32b.
EQC's Natural Disaster Fund is another such rainy day story. Once just a government promise to cover the cost of any major earthquake, EQC was eventually set up as a Crown entity that used premiums to buy reinsurance and also steadily build up a further $6b fighting fund.
So on paper, all good. But Preston says just as Buffett likes owning insurance companies because they have parked assets which could be doing more exciting things, public funds are tempting for a government which thinks building a nation may be a better investment than putting the cash into overseas long-term assets.
Preston says the super fund has survived largely intact. But in 2008, an incoming National Party did say it wanted to see 40 per cent of the fund going into "New Zealand investments".
It didn't happen. Instead National simply said the fund was doing so well it could afford to suspend further contributions for a decade.
But Preston says it shows how supposedly ring-fenced funds can be tapped to divert their wealth into buying government stock – a roundabout way of raising capital for whatever a government thinks the country ought really to be doing, like paying for irrigation schemes or new motorways.
Post-GFC, this is exactly what has happened in Ireland, where its Pension Reserve Fund first helped bail out Irish banks, and now is being ploughed into "economy-stimulating infrastructure projects" as part of its own national rescue plan.
With ACC, Preston says its investments are being actively used to support the government's balance sheet.
In 2008, $820m, or 9 per cent of ACC's portfolio, was placed in New Zealand government stock. That has soared to about $10b, or 31 per cent of the $32b.
Preston says it worries him ACC is also now reporting profits from derivatives trading – $250m last year on a $12b total exposure.
It shows ACC must have a crack team to come out on the right side of the deals. But following on from the Reserve Bank reporting a profit on shorting the over-valued New Zealand dollar, is the hedging starting to tip over into bolder trading?
That is the problem with derivatives, Preston says. There is a tendency for people to start getting creative with them unless they are closely watched.
Then Newberry has now written about the EQC and how the Canterbury earthquakes reveal the extent to which there was no real pot of savings there. The fund in reality consisted of $4b in overseas reinsurance and $6b which the government had directed EQC to invest into government stock.
So the $6b fund was in fact an IOU on premium income already long spent on general "nation-building" projects, says Newberry. To repay actual cash to EQC, the government has had to go out and borrow that money. Or as some have argued, find ways to trim the cost of Canterbury's recovery.
Newberry says it is going to be future taxpayers who will repay those loans gradually through higher EQC premiums for many years. There won't be much scope for "topping up" EQC ahead of further natural disasters.
"The average person would think that there was a pot of money there, and if we used up that pot of money, nothing else would be affected. But that's not the case."
In Preston's view, the super fund is still 100 per cent a real fund as it has so far fended off a government financialisation of its assets. But ACC is now 30 per cent a myth, and EQC 100 per cent of a myth, as they are gathering premiums which are being channelled into the government's general balance sheet rather then earning real money in international markets.
And then the definition of a fund keeps getting looser, he says. The 2013 sale of state-owned power companies – half shares in Meridian Energy, Genesis Power and Mighty River Power – was justified by the setting up of a Future Investment Fund.
Preston says the cash raised was put into a pot meant to be spent on nation building projects. And it is true, it has.
But the projects are such things as education, broadband, roads, KiwiRail, and a few odds and sods like the $5m to repair roof leaks in the Beehive – the usual things taxpayers would expect to see money spent on anyway.
Preston says the $5.5b Canterbury Earthquake Recovery Fund is another such stroke of an accountant's pen.
It was a number plugged into the national balance sheet early on to suggest the probable cost – signal a level of government commitment. But Preston says that is not the same as real money – cash which has been appropriated in a Budget and can't so easily be spirited away.
However Preston adds this is not necessarily any criticism. It largely reflects the logic of accrual accounting and a move towards a deliberately fluid investment portfolio approach to the economy.
The physical assets that taxpayers thought they owned are being monetised – converted to pure investment flows. To paint some stability of public understanding over that requires the kind of social contract which a "fund" represents.
Preston says at least there is a national investment statement that tells us in general terms the various good things our taxes and various extra premiums should eventually be doing.
The theory sounds good. No one could mind being compared to Warren Buffett. But the fear is how hard it is becoming to follow what is really going on under the covers of the New Zealand economy.
Newberry says it gets back to voters being able to understand what they are really voting for.
"I don't think anyone should relax and assume they're being taken care of here. Rather there is a need to engage with these kinds of financial matters. And it is the ability to engage that's become difficult," she says.
The government's latest audited accounts show that it has total liabilities (mostly borrowed debt) of $186b, and total assets (half of them financial stakes) of $279b. So on paper, according to this annual investment statement, New Zealand's net worth stands at $92b – safely in the black and healthy sounding.
But this is accrual accounting, says Newberry. A claim about borrowings today and earnings tomorrow, anchored by what is now a very large hedging position.
It all seems to be working out so far. New Zealand's economy has been performing. It has managed to borrow substantially and invest on the global financial down swing. It may prove to be among the most nimble market players in this dawning Asian century.
However Newberry says New Zealand is continuing to make deep structural changes in going beyond its NZ Inc corporate revolution and now entering the NZ funds management era.
And how well is that understood in a world where a positive inflation rate is still a wee bit baffling to most folk? Which reminds me. Perhaps explain that one to me just one more time again?
 - Stuff

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