B. What is fiscal sustainability and why does it matter? - continued

New Zealand needs the buffer that low government debt provides

New Zealand, as a small open economy that is reliant on a relatively volatile natural environment, is vulnerable to shocks of various kinds. Maintaining a lower level of debt ensures the Government has the ability to respond to such shocks to its financial position without requiring unexpected service cuts.

Responsible fiscal management by successive governments meant that New Zealand entered the recent recession with a level of government debt that was low by historic and international standards. The Canterbury earthquakes of 2010 and 2011 further weakened the Government's financial position. An operating deficit emerged in 2009, owing to an increase in expenses and a decrease in anticipated tax revenue, and persists still. Borrowing has been required to cover the shortfall.

New Zealand's low government debt provided a buffer in that the Government had room to borrow when it needed to react to these events. However, that has meant that New Zealand's government debt has increased markedly in recent years. Net government debt increased from under 6% of GDP in 2008 to around 24% of GDP in 2012.[24] Although there is no hard rule about what level of debt is too high, the Government's room to borrow in response to another shock has been reduced (although with net government debt at around 24% of GDP, the Government's debt level is still relatively low by international standards).

One lesson from the recent financial crisis is that government debt can rise much faster than it falls.

A longstanding gap between national saving and investment means New Zealand has a large net external liability position, as foreign funding was used to meet some of our consumption and investment demands. Most of this net liability position is attributable to the private sector but this has not always been the case.

In a crisis, private debt can quite quickly become public debt. We have seen this recently with the United States and various European governments taking on debt from failed banks, or banks that might otherwise have failed. We have even experienced this effect to a limited extent in New Zealand, with the collapse of finance companies that were covered by the Retail Deposit Guarantee Scheme. The cost of servicing debt can also change quickly if investor sentiment toward an economy sours. This is usually reflected either in sharply higher interest rates, as we have seen in some European countries in recent years, and/or a declining currency. Both can have adverse impacts on the economy and wider living standards.

Maintaining a low level of public debt over time is one indicator to foreign lenders of solid economic and fiscal management. This provides one offset to the risks associated with the external debt position and contributes to New Zealand holding a high sovereign credit rating.[25] The Treasury takes the net external position into account when recommending a prudent level of government debt.

Furthermore, "refinancing risk" - the Government's ability to raise debt when required - is generally considered to be higher where debt is predominantly held by non-residents. Two-thirds of New Zealand government bonds are held by non-residents, which suggests our risk is fairly high.

So what is a prudent level of debt for New Zealand?

The Treasury's advice to governments over recent decades has been to maintain prudent and low average levels of debt over time. Taking into account New Zealand's particular characteristics, as described above, the Government has indicated that it intends to bring net government debt back to a level no higher than 20% of GDP by 2020.[26] This goal is consistent with the Treasury's advice.[27]

Achieving this target by 2020, and a prudent debt level beyond that date, will require firm fiscal management. As the next section will discuss, fiscal pressures will make achieving and maintaining a prudent debt level more challenging.