5.4  Capital, debt and interest rate assumptions

The projected Statement of Financial Performance (and hence the operating balance), records a non-cash depreciation expense rather than capital expenditure. The LTFM assumes that expenditure on purchases of physical assets equals depreciation (so that non-cash depreciation is neutral in terms of the gross debt calculation). This expenditure can be interpreted as that required to maintain existing physical asset levels. These assumptions shift the projected operating balance towards a cash balance after operating and investing (physical asset) activities. Over and above this, the LTFM in “bottom-up” mode allows for some increase in the level of physical assets (see Appendix for details).[13]

In the LTFM, fiscal surpluses over and above capital and investing requirements are used to pay back gross debt, specifically New Zealand-dollar debt. (The New Zealand dollar value of foreign-currency debt is held constant at the level of the last year of the fiscal forecasts - with offsetting foreign-currency assets to ensure net foreign-currency debt is around zero). If New Zealand-dollar debt is fully repaid, and the level of foreign-currency debt is held constant, the government starts to accumulate “financial assets arising from debt elimination”. Should fiscal deficits re-emerge it is these financial assets that are used to finance the shortfall. Once they are extinguished, gross debt increases through an increase in domestic debt.

The fiscal gap targets a definition of gross debt-to-GDP that allows for these additional financial assets. This target variable becomes negative when additional assets are accumulated (see Figure 4).

Finally, it should be noted that in general the LTFM assumes dynamic efficiency with r > g. Various differences between the interest rate and the economic growth rate can be considered as alternative scenarios. Drawing on the discussion in Section 4.2, the Baseline scenario assumes a real interest rate of 5%.[14] Estimates of generational accounts for New Zealand have used real interest rate assumptions of 7%, 5% and 3% (see Baker, 1999 and the discussion in Section 2.4 of Auerbach and Kotlikoff, 1999). Given typical assumptions about labour productivity growth and labour input growth, these rates are above the real GDP growth rate. Wells (1996) also assumes that the economy operates in an efficient region (using r = 5% and g = 3.2%). The LTFM also applies the long-term government bond rate to both debt and “financial assets arising from debt elimination”.