Cameron Preston questions whether the Government's using risky gambling on the movements of interest & currency rates to achieve a surplus

Cameron Preston questions whether the Government's using risky gambling on the movements of interest & currency rates to achieve a surplus

*By Cameron Preston 

This Wednesday the Minister of Finance will announce he has succeeded in his long held goal of getting the Government books back into surplus.

But will it really be a surplus, and will it be one New Zealanders should be proud of?

In 2007 Treasury moved its focus away from the bottom line Operating Balance (OB) as a measure of whether, in any particular year, the Government was in surplus or deficit.

It was recognised that short term changes in variables such as inflation and interest rates would result in large fiscal swings called ‘actuarial gains and losses’ in growing funds such as the Cullen Super Fund and ACC Fund.

These (sometimes volatile) movements were thought to unfairly skew the annual bottom line OB measure as these variables are perceived to be largely out of the Government’s control and neutral over a longer horizon.

So OB was ignored in favour of the more stable and structurally reflective Operating Balance Excluding Gains and Losses (OBEGAL).

Last Wednesday the Accident Compensation Corporation (ACC) announced a large surplus of $1.6bln, twice as much as budgeted.

However closer examination of its books show large costs included in that $1.6bln surplus are in fact ‘actuarial’ losses.

Add these losses together and I conservatively estimate ACC’s OBEGAL surplus for 2015 to be much higher, at least $4.4bln (in comparison to $1.9bln in 2014).

I don’t doubt that ACC have a crack investment team, and ACC’s investment revenue of $4bln (compared to $1.5bln the previous year), will be a welcome shot in the arm to the Crown’s consolidated OBEGAL surplus due out this Wednesday.

But it is what is hidden in this massive $4.4bln ACC contribution to the Crown’s OBEGAL surplus that is interesting.

Derivatives.

While many differ over the triggers of the Global Finance Crisis that began in 2008, most agree that the use of complex financial instruments, or derivatives, turned what started as a sniffle into a full blown financial pandemic.

Derivatives are commonly used to hedge against adverse movements in interest rates and foreign currency fluctuations, but as the world found out back in 2008, they can be dangerous, overly complex, somewhat unpredictable and can drive as much risky behaviour as they seek to hedge against.

The valuation of derivatives for accounting purposes is more of an art than a science, because of such, their contract, or notional values, aren’t actually shown on a balance sheet.

ACC’s derivative contract positions, as disclosed in the notes to their accounts, show their exposure has increased from $5.1bln in 2008 to $12.6bln in 2015:

ACC provides a paragraph in their 2015 Annual Report that is designed to ease concerns:

“We are conscious that ACC incurs credit exposure to counterparties when undertaking derivative transactions such as foreign exchange forwards or interest rate swaps. We aim to only use derivatives when there is no equally good alternative. We also have limits and controls governing derivative use and credit exposures.”

However it is not just the ‘counterparty’ that ACC needs to be careful of, later in its Annual Report it states:

“The Investment Committee allows ACC’s internal Investment Unit to vary the actual level of foreign exposure taken by each Account from the benchmark level of foreign exchange exposure, within fixed ranges determined by the Investment Committee. For most of the year ACC maintained a higher level of foreign currency exposure than the neutral levels inherent in ACC’s benchmarks.”

The fact that derivatives are playing a leading role in the country’s return to ‘surplus’ is ironic at best, and alarming at worst.

Only two weeks ago the Reserve Bank announced it was to pay the Crown a special one off $510mln dividend from monies it acquired when it ‘shorted’ the New Zealand dollar back in August 2014, again using foreign currency derivatives.

Soon after that profitable intervention was formerly announced in September 2014, the Prime Minister, somewhat disturbingly, was happy to share views on where he thought the exchange rate should be: “the Goldilocks rate, not too high, not too low, just about right, I don’t know, [US]65 cents maybe” .

In the world of derivative trading, especially forward foreign current contracts, it appears a jolly good wink wink, nudge nudge, from your ex-currency trading PM can be very profitable to your “position”, provided you have taken the right one, at the right time.

I find it naive to think that any government entity with a material interest rate derivative position would have been taken unawares by the Reserve Bank’s “surprise” decision on 11 June to cut the overcooked OCR just prior to the close of the financial year.

While there are plenty of examples of creative moves on the expenditure side of the Crown’s surplus such as delayed Treaty settlements and capitalising or deferring of the recognition of earthquake recovery costs, it would be remiss of me not to mention the fact that Treasury made a policy decision in 2007 to treat actuarial gains and losses for EQC differently to those of ACC.

The result being more than $1.5bln of “unrealised gains” in the reduction of EQC’s liability has positively hit OBEGAL, for the last three financial years, including this one.

Given it appears deeply unfashionable to look at the size of the debt on the Crown’s balance sheet these days, I will spare you my thoughts on such.

But on Wednesday afternoon, as many bask in the glow of the “first OBEGAL surplus since 2008”, ask yourself: is OBEGAL the best measure? And if this surplus has been achieved by profiting from risky gambling on the movements of interest and currency rates, while at the same time ignoring the effect of those adverse movements on the underlying assets on the balance sheet – is this really a surplus New Zealanders should be proud of?

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*Cameron Preston is a Christchurch accountant and homeowner who has longstanding unresolved quake insurance claims.

We welcome your help to improve our coverage of this issue. Any examples or experiences to relate? Any links to other news, data or research to shed more light on this? Any insight or views on what might happen next or what should happen next? Any errors to correct?

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What about future unfunded liabilities

I don’t doubt that ACC have a crack investment team, and ACC’s investment revenue of $4bln (compared to $1.5bln the previous year), will be a welcome shot in the arm to the Crown’s consolidated OBEGAL surplus due out this Wednesday.

Standalone winners - outliers in fact.

The average hedge fund has produced a worse investment performance in the first half of this year than a portfolio consisting of a savings account at your local bank and a random collection of stocks picked by a blindfolded monkey.Stop me if you’ve heard this one before.

According to the benchmark HFRX Global Hedge Fund Index, tracked by Hedge Fund Research Inc., the average hedge fund has earned its investors just 2.4% so far this year net of fees. Read more

Yet another example of poor headline grabbing journalism - If you had investigated a little more - you would have worked out that expressed as a % of the funds total assets investment in these derivatives has dropped over the period you have given by around 4% - 5.1 billion of 13.1billion assets in 2008 to 12.6 of 36 million in 2015.

Given that the fund has consistently outperformed the market in this period - at the same time as reducing the risk exposure from these assets - perhaps your article should be celebrating a fantastic Kiwi success story

The actual figures suggest - exceptional performance with a reduced level of risk and exposure set against a very risky and volatile financial climate - GREAT JOB !

Re:RBNZ

“A lower NZD resulted in a $379 million gain from foreign exchange rate changes on the Bank’s open foreign currency position as at 30 June 2015, compared with a $198 million loss in the June 2014 financial year,” it says.

“The open foreign currency position at 30 June 2015 was $3.5 billion, an increase of $1.0 billion on 2014, arising from a combination of foreign currency purchases and depreciation of the NZD.

And yet if one runs a cursor down Column I in RBNZ spread sheet labelled hf5 starting at row 40 - Jun 2007, where the previous net open NZD position is recorded at $-58 million, the total NZD short position adds to $2.442 billion. Where's the missing $1.103 billion position?

It certain is a "kiwi" success story unfortunately - Again Kiwi's are happy to be indirectly taxed to create a large "fund" for the Crown where the interest and speculative revenue (including shorting and swapping) gains are a "great job". Hi-Five Team Key. Personally I would have preferred to have kept the levies lower, or see the interest rates come down long ago, more money in my pocket - but I don't think that would have fitted with the political surplus plan...

its not about a political surplus plan - its about creating a fully funded service which will soon no longer require any levies to sustain itself - Already it able to sustain a huge part of its lifetime liabilities from its asset base, and if we continue to invest the tiny existing levies it will be entirely self sustaining. Its a service, that despite some weaknesses and concerns it the envy of the developed world - and without which we would see taxes rise massively to fund the healthcare and DHB costs that ACC currently are a huge contributor to -

Even the best alternatives - that provide free healthcare options - Scandinavia - overall tax rates at %50 UK - National Insurance of 12% personal and 13% employer on top of similar base tax rates and higher VAT - or maybe the American model suits you - only the rich can afford it

I would like to keep levies exactly where they are and then once ACC reaches the point that its long term liabilities and its annual new costs are fully funded by investments the surplus can be redirected to a DHB health fund for the same purpose - Lets start thinking long term and not I want now

Kpunts - I don't disagree that ACC is great in theory. But the ACC "Fund" in practice is a myth. It is simply money (as you point out earlier a very much larger pool than in 2008) and the Crown can, and do, use for anything - interest free.....to think ACC is separate from the Core Crown is like believing the RBNZ is separate - its simply not the case.

We have received the following comment from The Treasury, Fiscal Reporting team:

"

As mentioned, we were concerned at the number of factual inaccuracies in your article today “Cameron Preston questions whether the Government’s using risky gambling on the movements of interest & currency rates to achieve surplus”.  A number of statements are incorrect, and we feel it’s important that the facts are made available to your readers so they are not misinformed.

The factual errors in the article, and the related corrections are as below:

• “Add these losses together and I conservatively estimate ACC’s OBEGAL surplus for 2015 to be much higher, at least $4.4bln (in comparison to $1.9bln in 2014). I don’t doubt that ACC have a crack investment team, and ACC’s investment revenue of $4bln (compared to $1.5bln the previous year), will be a welcome shot in the arm to the Crown’s consolidated OBEGAL surplus due out this Wednesday.  But it is what is hidden in this massive $4.4bln ACC contribution to the Crown’s OBEGAL surplus that is interesting.”

The vast majority of ACC’s profit for the year relate to gains and losses which are excluded from OBEGAL.  ACC’s contribution to OBEGAL in 2014/15 was only $81 million (not the $4.4 billion reported in your article).  The $81 million OBEGAL surplus in the current year is significantly lower than the previous year reflecting increased insurance expenses and reduced levy revenue.

• “The fact that derivatives are playing a leading role in the country’s return to ‘surplus’ is ironic at best, and alarming at worst.”

Derivative transactions are excluded from OBEGAL so play no role in the return to surplus.

• “In 2007 Treasury moved its focus away from the bottom line Operating Balance (OB) as a measure of whether, in any particular year, the Government was in surplus or deficit.”. 

The Treasury has continually reported the operating balance as well as the OBEGAL, not instead.  In 2011 the Government, not the Treasury, announced a fiscal target of reaching OBEGAL surplus in 2014/15 financial year.

• “It was recognised that short term changes in variables such as inflation and interest rates would result in large fiscal swings called ‘actuarial gains and losses’ in growing funds such as the Cullen Super Fund and ACC Fund.”

Short term changes to inflation and interest rates are called “gains and losses”  Actuarial gains and losses on ACC and GSF are also excluded from OBEGAL but are different and separate to other gains and losses.

• “So OB was ignored in favour of the more stable and structurally reflective Operating Balance Excluding Gains and Losses (OBEGAL).”

The “OB” is not ignored as it is a vital component of net worth – which is part of the Government’s fiscal strategy.

Also included in the article is the inference that the Reserve Bank recently announced special dividend of $510 million somehow impacted the surplus.  This is not the case.  This dividend is not included in OBEGAL.  It is a redistribution of profits between government entities (i.e. the Crown and the Reserve Bank). 

"

Was Solid Energy over geared, under instruction from Simon Power, to facilitate ..a redistribution of profits between government entities..?

Ahh - "Net Worth". Glad you brought that up Treasury - Would you like to comment on the fact that 'net worth' of the Crown is now primarily made up of pumped up asset revaluations for land using the Government Entities like QV? - all in order to keep the balance sheet looking good for more overseas borrowing? Keep them rating agencies happy to access more debt? - I guess its true what they say - Auckland is New Zealand. Keeping the pump going Auckland - Team Key have your back!

But they [Treasury] didn't refute this statement:

Treasury made a policy decision in 2007 to treat actuarial gains and losses for EQC differently to those of ACC.

The result being more than $1.5bln of “unrealised gains” in the reduction of EQC’s liability has positively hit OBEGAL, for the last three financial years, including this one.

That says a lot.

How will NZ achieve a surplus? I keep thinking of that episode of Letter to Blanchy with the garage sale.....