Balance sheet risks
The Crown's future fiscal position is exposed to risk owing to the uncertainty around future revenues, expenses and the values of assets and liabilities.
A recent model-based analysis of aggregate Crown risk found that the uncertainty surrounding tax revenue and social expenditure represented just over two-thirds of the Crown's aggregate financial risk, with the remainder attributable to volatility in conventional balance sheet assets and liabilities.It is unsurprising that the uncertainty of future tax revenue is a key source of fiscal risk since it is the Crown's main source of financing. As the tax base rests on New Zealanders' capacity to earn, fiscal risk is intertwined with broader macroeconomic risk. Government expenditure, while controllable to a large extent, has its own set of risks: transfer payments are indexed to economic variables such as inflation; the cost of public services is impacted by the wider labour market; and there are myriad pressures that create uncertainty about future expenses (eg, the fiscal cost associated with the Canterbury earthquake). In extreme stress events such as a financial crisis, there may be pressure for the Crown to take on risks that are currently borne by the private sector.
The recent domestic recession and global financial crisis are a reminder that major economic shocks do occur and can put profound pressure on public finances. It is likely that one or more sharply negative economic shocks will occur at some point over a multi-decade horizon. Providing a resilient buffer against potential future shocks is part of the rationale for ensuring the strength and sound management of the Crown balance sheet.
A more detailed discussion of fiscal risk can be found in the HYEFU 2010 which includes information on forecasting risks and scenarios, specific fiscal risks arising from policy decisions and some discussion of “tail” risks such as large economic shocks and natural disasters. Below is a qualitative discussion of the major sources of risk to the values of assets and liabilities.
The volatility and uncertainty of asset and liability values have direct implications for the Crown's financial resources, and therefore how much tax revenue needs to be levied. For example, a 0.1 percentage point higher (or lower) return on the Crown's $110 billion financial and commercial asset portfolio equates to higher (or lower) revenue of $110 million per annum. Debt can be thought of as deferred taxation, and a higher risk premium on Crown debt means greater debt-servicing costs. Obviously higher returns tend to be associated with higher risk, and thus it is important that the mix of assets and liabilities strikes an appropriate balance - generating sufficient returns (or reasonable cost) for the risk taken on behalf of taxpayers and ensuring that the Crown does not unduly expose itself to the risk of financial distress.
A conventional approach to asset and liability risk management is to assess broad classes of risk such as market risk, credit risk, liquidity risk, operational risk and business risk. Different parts of the balance sheet are exposed to these risks to different degrees. At present there is no systematic quantification of these risks and indeed some types of risk may not be possible to measure or even know about (so-called “black swans”).
Much risk management is delegated to individual entities with strong reliance placed on transparency and strong governance with accountability to boards and Ministers. This approach tries to ensure that risks are managed by those with the best incentives, information and capability. Institutional design and clear accountabilities are important in this respect. For instance, SOEs are limited-liability companies that operate on a commercial basis without a Crown guarantee. Nonetheless, the exposure to risk as an investor in assets is ultimately governed by decisions taken by the Government and borne by taxpayers. The Government is committed to improving the understanding and management of Crown risk as part of the overall focus on the balance sheet.
Market risk arises from movements in market variables, in particular relating to interest and exchange rates and equity prices.
The sensitivity of the value of financial instruments to key market movements is shown in the table below. A caveat is that these measures only partially capture Crown risk because they quantify the impact only on financial instruments such as bonds, shares and derivatives. The commercial portfolio is also exposed to these factors through the impact on commercial transactions (eg, exchange rate impact on export sales) and the valuation of commercial investments. Moreover, the drivers of market risk can be correlated as they are influenced by common domestic and global factors and economic variables such as inflation.
Sensitivity of financial portfolio to market movements
|Scenario||Impact on net worth, 30 June 2010 ($billion)|
|NZ interest rates decline by 1% (100 basis points)||(0.5)|
|NZ exchange rate depreciates by 10%||(0.3)|
|Share prices fall by 10%||(1.2)|
Source: Financial Statements of the Government of New Zealand, 2010
The Crown's exposure from normal market volatility is manageable from an aggregate perspective. The low net sovereign debt position limits the impact from interest rates, although debt is forecast to rise over the next few years. The NZDMO does not issue net foreign currency-denominated debt which limits risks from the exchange rate. The Crown is exposed to equity price movements mainly owing to the investments of the CFIs - which can suffer losses as well as reap upside gain.
Credit risk refers to the risk that a counterparty will default on their contractual obligations resulting in a financial loss to the Crown.
Credit exposures are managed by individual entities with information collected centrally and reported in the notes to the financial statements. The figures below show that around half of credit exposure is to creditors with a credit rating of AAA, AA and A. The remainder is mostly with counterparties that are not rated, in particular Kiwibank mortgages and student loans. Kiwibank is a registered bank subject to prudential regulation. The management of the student loan portfolio is discussed earlier in Section 3.
- Figure 37 - Credit exposure by credit rating, 30 June 2010 ($billion)
- Source: The Treasury
- Figure 38 - Credit exposure by sector, 30 June 2010 ($billion)
- Source: The Treasury
Liquidity risk refers to the risk that an entity will encounter difficulty in meeting financial obligations as they fall due.
On a day-to-day basis, individual entities generally manage their own liquidity. The NZDMO is the primary manager of the core Crown's liquidity by managing cash flows and ensuring sufficient bonds are issued to meet funding requirements. SOEs borrow on their own behalf, without Crown guarantee, and generally aim to have investment-grade credit ratings.
Major liquidity problems for sovereigns generally arise when they cannot raise debt at a reasonable price because market sentiment doubts the credibility of a government's commitment to fiscal discipline. Therefore the Government's fiscal strategy of keeping net debt within prudent limits, and maintaining a high credit rating, is a key part of ensuring that the Crown is able to access market funding as required in the future.
Operational risk is the risk of loss which could result from inadequate or failed internal processes or systems.
The public sector comprises a large and complex set of entities and businesses each with a unique set of operational challenges. The Government does not attempt to centrally measure or manage operational risk and is reliant on individual Ministers, chief executives and boards to be accountable for managing most operational risks. Generally, the potential financial losses from operational failures are thought to be manageable, partly because of the diversification entailed by the range of entities and businesses.
Business risk refers to the residual sources of risk affecting the performance of an enterprise, such as from changes in the commercial environment.
The commercial portfolio includes many business risks including the volatility of international coal prices (Solid Energy), demand for international air travel (Air NZ), rainfall levels (Meridian), regulatory factors (Transpower) and technology substitution (NZ Post).
In addition, the Government's various social assets contain business risk relating to both demand and supply factors. In particular, all governments face an inherent challenge to distinguish between investments with a genuine social payoff and those in which there is pressure for cost escalation owing to a lack of innovation or insider capture.
The Government is focusing on ensuring that capital allocation is directed toward investments and projects in which there is a return commensurate with the degree of business risk. Specific initiatives include stronger monitoring and governance for SOEs and improving the core Crown's capital budgeting processes.
- Timothy Irwin and Oscar Parkyn (2009) “Improving the Management of the Crown's Exposure to Risk”, New Zealand Treasury Working Paper 09/06. See: http://www.treasury.govt.nz/publications/research-policy/wp/2009/09-06/