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Balance sheet buffers

What is a fiscal buffer?

The Crown needs mechanisms to cope with unexpected expenses and falls in revenue. Fiscal buffers play a key role in the event of a shock such as the global financial crisis. The extra financing capacity provided by fiscal buffers can be used to bridge the shortfall between taxes and spending and allows the Crown to absorb the impact of the shock.

A particular case in point is the response to the Canterbury earthquakes, where the Crown is assisting with the replacement of key assets to restore valued public services and reduce further disruptions to economic activity. To date the Canterbury earthquakes have directly cost the Crown around $15 billion. This has been able to occur without undue effects on sustainability because of the Crown's strong balance sheet position prior to the earthquakes.

Considerations for a prudent fiscal buffer 

A strong balance sheet provides a fiscal buffer by allowing governments to either sell assets or increase debt in order to raise finance.

There are few international benchmarks to help guide governments on what constitutes sufficient balance sheet strength. Therefore, attaining and maintaining prudent debt has been a focus of successive governments.

A focus on debt constrains balance sheet size. If debt is to be kept at a prudent level any significant future capital expansion would need to be funded by reprioritising existing assets, or from operating surpluses mainly generated from tax revenues.[56]

Determining a prudent level of debt

Section 26G(1) of the PFA requires that government pursue policy objectives that include moving to prudent debt levels and maintaining them over a reasonable period of time. The focus in New Zealand is net core Crown debt. It is defined as gross sovereign-issued debt less core Crown financial assets that are liquid. It excludes advances, and NZSF financial assets as these are held for public policy purposes (see Box 7.1 for a fuller discussion of reserve assets).[57]

Box 7.1 - Determining levels of reserve assets

Current practice

The Treasury holds reserves consisting of liquid assets available on demand to help finance general government activities. Sufficient assets are held to fund core government needs in case funding markets are closed for short time periods. In addition, around $76 billion in CFI and RBNZ financial assets are held for specific reasons, respectively to mainly match non-debt liabilities or to manage financial market stability. Accordingly, these assets are unavailable for general fiscal purposes.

Why hold reserves?

In rare instances, maintaining a prudent net core Crown debt level may be an insufficient buffer to adequately cope with the financial implications of an extreme shock. This may be because it is difficult for the government to borrow immediately following a shock. Additionally, reserves can be a more cost-effective source of financing than borrowing during a shock. Accordingly, there could be a case for the Crown holding some additional assets, available on demand irrespective of the state of credit markets - a form of permanent self insurance for risk management and resilience purposes - to help cope with fiscal shocks.

Size of reserves

The level of reserves required depends on what scenarios it would be reasonable for the Crown to plan for. This depends on the fiscal, contingent and implicit risks the Crown faces. However, it is unlikely that any country could insure itself through reserves alone against the sort of shocks that were faced during the global financial crisis.

Type of reserves

Different types of reserves carry different benefits and risks that depend on the circumstances. Given managing a domestic crisis is a more likely scenario, carrying reserves in the form of liquid foreign assets is likely to provide the most benefit because the asset value would be less likely to be related to the onset of a New Zealand specific shock.

Alternatives

Extra resilience can also be sought through alternative arrangements, including pre-arranged emergency credit facilities through organisations such as the IMF. These sorts of facilities have their own set of pros and cons.

There are several factors that need to be considered in determining what constitutes a prudent level of net core Crown debt, including:

  • ensuring there is an adequate financial buffer for the fiscal risks posed from shocks
  • maintaining the sovereign credit rating at a level that provides for diverse sources of funds at low cost to the Crown and the economy as a whole[58]
  • ensuring that debt servicing expenses remain at a reasonable proportion of tax revenues
  • spreading the financing cost of assets with long-term benefits over time, and
  • consideration of present and projected economic and demographic impacts on expected fiscal revenues and expenses, asset and financial markets, and the level of external debt.

Many of these factors will depend on circumstances, which change through time. Nonetheless, the current Government's objective to reduce net core Crown debt to no higher than 20% of GDP by 2020 will return debt to prudent levels. This level is low by international standards and reflects New Zealand's relatively high level of foreign indebtedness and a relatively narrow range of commodity exports, which can create vulnerability to international investor sentiment and shocks.

Figure 7.1 compares New Zealand's net international investment position and gross Crown debt against other OECD countries. It shows that one of the key differences between New Zealand and several OECD countries under financial stress is New Zealand's relatively low level of Crown debt.

Short-term cyclical issues 

The speed at which a prudent level of debt is achieved through saving can have macroeconomic stability implications. In particular, an emphasis on debt reduction during an upswing in an economic cycle as New Zealand is currently experiencing could help take the pressure off monetary conditions and allow interest rates and the currency to be lower than they otherwise would be. The timing of Crown investment in fixed assets also has impacts on the economic cycle, particularly if these are large.

A better mix between fiscal and monetary settings could be helpful to wider economic objectives by rebalancing towards a more investment and tradables led economy.

Figure 7.1 - New Zealand's Relative Government Debt and Net International Investment Positions (2012)
Figure 7.2  - New Zealand's Relative Government Debt and Net International Investment Positions (2012)   .
Source:  The Treasury

Notes

  • [56]Reprioritising assets would change the mix of services government provides. Taxation has associated economic costs, but also using tax to fund capital expenditure means it cannot be used for other purposes (ie, there is an opportunity cost).
  • [57]The definition of net core Crown debt is not determined by GAAP.
  • [58]Credit rating agencies have a balanced approach to sovereign credit rating, that includes consideration of economic, institutional, government financial, and event susceptibility factors.
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