By Mike Thrush A close look at the government's accounts show most of the equity on the nation's balance sheet is made up of unrealised capital gains on property. Also, recent revaluations to the rail network mean a railway land that was returning NZ$1 per year is now valued at NZ$6 billion, and a network bought for NZ$1 is now worth NZ$5.5 billion after about NZ$500 million was invested in track improvements. The government has just released the monthly accounts for October. The has been a bit of comment on the tax and expenditure estimates, but not much said about the balance sheet. The balance sheet is the most fundamental of the financial statements. It is the balance sheet that distinguishes the rich from the poor, the strong from the weak, and the reckless from the cautious. Balance sheets, however, are harder to read and certainly less sexy than cashflow or income statements. These have much more pizzazz, but much less substance. They tell you only what has changed, not where you are, or where you have come from. As a result focus merely on cashflow and incomes leads to a sort of financial bipolar syndrome. One year things are fantastic and growth is limitless. The next year the sky is falling.
So it is with the Government. Not so long ago the government was making seemingly massive surpluses that made conservatives bay for tax cuts like aroused vampires in an Anne Rice novel. Now the government faces huge deficits and the conservatives have gone all Dickensian and tell us we can no longer afford to feed the poor, heal the sick or teach the young. But things are not so stark. Labour was right to resist the call to give away the surplus in tax cuts, just as National is right now to resist the call to dish out nothing but gruel. In the long run we do need to build our assets and lower our liabilities "“ leaving our children more equity to inherit in the form of better roads, schools, hospitals and retirement security. Government equity is also one measure of our sovereign power and as a small country we need equity so that we are not beholden to any medium sized trans-national corporation that we should cross paths with. As citizens we should talk more about the government balance sheet. We should ask questions about the balance of debt and equity; the mix of assets, what they are for and how they are valued; and the mix of liabilities, why we have taken them on and how they are valued. New Zealand is very well placed to do this, as we have national accounts that have been prepared very carefully in accord with the best accounting standards developed to date. The accounts are well presented and have very good notes. Unfortunately those standards (IFRS) were developed for large corporates, especially ones that issue securities. Even though there are some modifications for Public Benefit Entities such as the government, the focus is on providing credit worthiness and profitability information for creditors and shareholders. The credit worthiness information is largely irrelevant because the government has the sovereign power to tax. A much better measurement of credit worthiness is government debt as a percentage of the tax base i.e. GDP. Among shareholders, there is no argument that profitability is always a good thing. However there is plenty of reasonable argument about the proper level of government surplus. It depends on your view of how much equity New Zealanders should have invested in their government. Anarchists say nothing. Communists say everything. The sensible answer, as always, is somewhere in between. So with reservations about IFRS, lets take a look at the Government balance sheet at 31 October 2009 Assets (billions) Cash 7 Debtors 13 Securities, Deposits and Derivatives 45 Shares 13 Advances 16 Inventory and Other Assets 5 Property, Plant and Equipment 110 Equity Account investments 9 Total Assets 218 Liabilities Issued Currency 4 Creditors 8 Deferred Revenue 2 Borrowing 66 Insurance liabilities 26 Retirement Plan Liabilities 9 Provisions 5 Total Liabilities 120 Equity Tax Payer funds 35 Revaluation Reserve 63 Total Equity 98 The first point is really obvious. The balance sheet is strong. With net equity of $98b and liabilities of only $120b, we have room to run a deficit of a few billion for a few years. We can weather the recession without resorting to discontinuing any core operations, e.g. closing the schools and selling our children for scientific experiments. Our credit worthiness is OK too. Core crown net debt is $21b or 11.8% of GDP. Tax is roughly 30% of GDP, so that means net debt is only 40% of the annual tax revenue. Imagine if your mortgage was only 40% of your annual income. Let's take a closer look at that $98b in equity. The government accountants have listed what in a corporate would be called "shareholders funds" as "tax payers" funds. This is a fundamental mistake. In a corporate, this part of equity is not called shareholders funds because the shareholders provided the funds. If the company has been run well for a few years the customers will have provided most of them. The terms "shareholders funds" is used because the shareholders have control over the company and own the residual assets after the liabilities have been paid. It is all New Zealanders that have such rights of control and ownership of the New Zealand government regardless of whether they pay any taxes. Some tax payers have no such rights of control or ownership (such as foreigners and merely legal persons such as companies and trusts). The $35b in New Zealander's funds is the result of a surplus over time of revenue (tax and trading) over expenditure. About $8,750 each. The other $63b is a result of unrealised capital gain (largely on real estate) of $15,750 each. So most of government equity, like most New Zealand personal equity, is unrealised capital gain on real estate. That should give us some pause. To look at assets and liabilities in a bit more detail, let's go back to the accounts dated 30 June because the notes are much more comprehensive. Among the liabilities, the most interesting is the $26b in insurance liabilities. The is mainly the future costs of ACC payments for injuries and accidents that have already happened (EQC and other liabilities are included in this figure as well, but only come to $120m, less than half a percent). The liability is discounted so that, roughly speaking, if we invested $26b now, the $26b plus investment income would pay all future insurance liabilities. The ACC liabilities are very hard to estimate. Of the estimated undiscounted liability of $65b, about half is forecast more than 25 years in the future. That is a vast amount of time in financial terms. Nobody knows what medical care will cost in 25 years, what technology will be available, or what our children will agree is the socially acceptable level of care. Similarly, how much we need to invest now, to deliver $65b over the next 50 or so years depends critically on the rate of return. Again, nobody knows. None of this is news, and these points are made by the government accountants who prepared the accounts. They also helpfully lay out some of their key assumptions and show how sensitive the result is to change in the assumptions. There is room for a lot of discussion, but these concise notes provide an excellent starting point. It is also seems fairly clear that reasonable people could disagree about the ACC liability by plus or minus six or seven billion dollars. So we can conclude that ACC is either over-funded, under-funded, or funded just right. Anyone who argues that ACC is obviously broken is either uninformed or disingenuous. Nothing about ACC is obvious. (For more detail, see note 25 of the June 30 accounts, pp. 100-6). Let's look at the rail network. This was valued at $12,506m at year end (p. 73) and is included in the property plant and equipment total above. This is the value of the land the rail lines sit on, as well as the rail lines, bridges and tunnels. These assets are managed by Ontrack. This should not be confused with the rail freight and passenger business that the government recently bought from Toll for $690m, subsequently wrote down by $320m and renamed KiwiRail. KiwiRail is analogous to a trucking company. Both own or lease vehicles and sell freight services. Neither owns nor maintains the roads or rails. Ontrack's annual report for 2008 lists the rail network at $11.8b (see p. 51). $6b for land, $5.5b for tracks, tunnels and bridges and $300m split between buildings and assets under construction. The land, while always crown owned, had been leased until 2070 for $1 per year to TranzRail and subsequently Toll. This lease was surrendered in the deal where the other rail infrastructure assets were sold back to the crown for one dollar in 2004. Toll had the tracks, bridges and tunnels on its books at $349m prior to the sale (see Toll NZ Consolidated Ltd accounts 2004 available on companies office website, search under KiwiRail Ltd). So somehow, an asset that was returning $1 per year is now valued at $6b, and an asset bought for $1 is now worth $5.5b. While the rail infrastructure has been improved, this at most accounts for $761m of the increase (value at 1 July 2006 plus additions). The bulk of the increase is due to revaluation upwards by $10.3b in the year ending 2007 and by a further $1.1b in 2008. This is a result in a change in valuation method in 2007. Ontrack now values the rail infrastructure on a "depreciated replacement cost basis". This means estimating how much it would cost to rebuild the tracks, tunnels and bridges and then depreciating them according to age. Never mind that most of it was bought for a dollar from a willing seller. The market value of the rail infrastructure should be proportional to the track access revenue from KiwiRail less maintenance costs. If Ontrack's accounts and Toll's willingness to sell at $1 are anything to go by, the market value is probably negative. But both market value and depreciated replacement cost look at things the wrong way. Depreciated replacement cost is wrong because the rail infrastructure is already built. The money has been spent. It is irrelevant how much it would cost to do it again. If we now faced the choice of building the rail network from scratch, we wouldn't. What matters is how much it costs to maintain, and what value it delivers to New Zealand. Market value gets it wrong because it only values the income from KiwiRail. The rail system delivers benefits far beyond that. The rail system services the ports in a way that is just not practical by road. Without rail, many of our importers and exporters would be seriously impacted. Rail provides the cheapest bulk transport solutions for coal, forestry and dairy. Rail removes a lot of heavy cargo from roads which dramatically reduces road maintenance costs. Finally rail provides commuter passenger services reducing urban congestion and long distance scenic trips for tourists. These are all benefits that accrue to most New Zealanders and are spread unevenly across the economy. But it is a mistake not to count them. So what about land values? Finally I want to look at the practice of valuing land "using an opportunity cost based on adjacent use as an approximation to fair value." (from NZ accounts June 2009, p. 44). The land under our schools, roads and railways is all valued this way. It is this principle that results in most of the revaluation reserve in the equity section of the balance sheet. Using opportunity cost seems the right way to value land. On the face of it, it is reasonable to use the market price of adjacent land as an approximation. Assuming, of course, that the land market is rational and efficient. However, it doesn't make sense to value pieces of land used for infrastructure this way, as they change the value of the surrounding land. Consider the land under Auckland Grammar School. Should it be valued at the price of adjacent land currently used for housing? Such land carries a hefty Grammar Zone premium. If the land were used for something else, there would be no Grammar Zone. All the surrounding land would be worth much less. What if we sold all the roads and all the schools in Auckland? The surrounding land would be virtually worthless. Beyond a certain level, there is no opportunity cost to land used for infrastructure, because we don't have the opportunity to live without it. It is like asking the opportunity cost of breathing and eating. Which not to say that the land used for infrastructure is not valuable. But to find out how valuable we need to consider what benefits the infrastructure delivers. We can then debate whether infrastructure projects are worth the land they consume. There are lots of ways to put numbers to this, but that is another discussion. * Mike Thrush works as an accountant in Auckland.
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