Most of the contributions to the Government’ s Super Fund are being funded by debt. The household sector
equivalent is increasing the mortgage to punt on equities.
Thursday, November 1st 2001, 6:04PM
The Government
justifies the approach, arguing the return on the fund will exceed
the opportunity cost. The
proposition that the Government (or some arm s length organisation)
has a comparative advantage in net
investment runs counter to all international experience and fails
the simplest litmus test. Why not underwrite the
fund completely with debt now rather than progressively increase
contributions? Our bottom up estimates suggest returns on the
funds would not exceed the opportunity cost (see
annex 1).
The proposed scheme has little to offer on economic grounds. Competition
and economic efficiency will be
eroded, the sandwich generation pays twice, the scheme does little
to address long-term fiscal pressure and self-provision will fall.
The scheme adds to the plethora of policies that will negatively
impact on savings, investment and potential growth, the keys to
wealth creation and sustainable superannuation policy.
More recently, some clear costs have appeared,
manifestations of the additional borrowing.
Higher interest rates. Additional government
borrowing to stake the fund (even though net worth remains
unchanged) has widened the fiscal risk premium on long-term interest
rates. Markets care about debt not net worth. Our bottom up estimates
suggest an additional 0.25% of fiscal risk is now included in
the 10
year bond rate (see annex 2). In short,
there are signs the market is adjusting to a permanently higher
equilibrium level in light of higher debt issuance. Higher interest
rates reduce discretionary income and raise the hurdle rate new
investment projects must achieve to become viable. The cost is
borne by the entire economy as movements in government bond yields
are also reflected in private sector borrowing rates. Our modelling
work using a general equilibrium model suggests a permanent 0.25%
increase in long-term interest rates lowers economic growth by
around 0.2% per year.
Reduced fiscal discretion. Fiscal policy
can be a strong tool leaning against economic weakness and
governments should not be afraid to use it as a stabilisation
device. By already borrowing heavily, the
Government s ability to respond to economic frailty via
a fiscal expansion is curtailed. The markets ability to
soak up more debt is limited.
Leaning against monetary policy. In an
economic upswing [slow-down] the risk premium on long bonds
normally widens [narrows] as the current account worsens [improves]
and inflation ticks-up [moderates]. An improving current account
and easing inflation at this stage of the economic cycle would
normally be assisting monetary policy by lowering the risk component
built into government bonds. Instead, a widening of the fiscal
component has increased the risk premium and is leaning against
monetary policy.
Market perceptions on the size of the Government
s bond tender program are negative. The Government has
indicated an unwillingness to reduce Super Contributions to protect
the bond tender program from escalating
further. As the scheme currently stands, there is no flexibility
to permanently reduce contributions should medium-term fiscal
forecasts not be achieved (i.e. potential growth may be over-estimated
or spending growth under-estimated).
An evaluation of the economy-wide costs
of staking the Super Fund via debt should have occurred. Costs
are
being imposed on the economy for a scheme that offers little.
Medium-term fiscal pressures are intensifying
and it will be a struggle for the government to meet their Budget
forecasts (annex 3). We expect fiscal slippage, with negative
implications for the out-year bond tender program.
The Government should condition the market to the expectation
that Super Contributions will be lowered if fiscal
objectives are not met.
A failure to lower Super Fund contributions
could see bond tender programs head towards $6 billion and widen
the
risk premium further, placing additional costs on the economy.
Annex 1: Rate of Return
The Treasury expects the Fund to out-perform
the opportunity cost. Returns on the fund are expected to average
9%, roughly 2% above the debt funding costs. Within the portfolio,
equity returns are expected to be around 12%.
We disagree.
Estimates from our World Interest Rate
Model suggest long-run or equilibrium fair value for NZ bonds
(the
opportunity cost of debt repayment) is around 7%.
The fund will attract a management fee
(around 1%) requiring the fund to attain an even higher return
than
long-run debt funding costs (7%) to break even.
The Fund portfolio should be conservative.
Stakeholders in the fund are NZ taxpayers who on average are
risk averse and this risk cannot be diversified.
Diversification will require that most
of the fund be invested offshore.
Estimates from our World Interest Rate
Model suggest an international bond portfolio would yield around
6% (5% after fees). NZ bonds (the cost of debt) already trade
at a risk premium to offshore investment
opportunities.
Real international equity returns have
averaged 7% for the past 100 years. Equity returns have shown
a
tendency to return to this long run trend although cycles tend
to last 15-20 years.
While recent equity market returns (past
20 years) have been higher, a continuation of this would require
labour s share of income to continue to fall.
While historically the case for equities
over bonds is strong, it is weakening. Current P/E levels suggest
lower future equity returns.
Bottom-up estimates using current estimates
of the equity risk premium suggest a return on equities of 9-10%.
The AON investment survey puts before
fee investment returns on equities at 10% and fixed interest
investments at below 6% for the next five years.
Assuming the portfolio is weighted 50-50
between bonds and equities, returns on the fund would broadly
match the opportunity cost (i.e. 7%=0.5*5%+0.5*9%).
Annex 2: Fiscal Risk
Our estimate is based on an average of three
methods.
Estimates taken from our World Interest
Rate Model. The long-run component of our World Interest Rate
Model estimates the fundamental 10-year interest rate for each
OECD country. A key feature of the model is that key determinants
(i.e., long-run factors such as the current account balance,
net debt, inflation expectations) are priced equally across all
countries so that countries with the same fundamentals should
enjoy the same interest rates.
Eyeballing the sell-offs in government
bonds after the 2000 December Economic and Fiscal Update, 2001
Budget and other fiscal announcements in association with anecdotal
feedback from bondholders.
Stripping out changes in the 10-year bond
yield over the past six months after removing the term structure
of interest rates. Remaining changes in the NZ 10-year bond yield
should reflect changes in the risk premium 1 .
Annex
3: Fiscal Accounts Under Pressure
The Treasury projected reasonable operating
surpluses in the Budget but net debt was expected to rise by around
$1 billion per year. Any additional spending needs to be financed
by further borrowing. Treasury signalled a bond tender program
around $3.5 billion for 01/02 and the bond tender program
to sit around $4.5-5 billion for the following three years in
the Budget.
In addition the GSF plans to tender around
$2 billion worth of government stock (potentially $3 billion)
over the next 2 years as it moves to a diversified portfolio mix.
The change in GSF s portfolio mix (from roughly 85% to 14%
NZ bonds) also removes a major bond purchaser going forward.
Pressure on the bond tender program is also
intensifying and Treasury look set to signal higher bond tender
programs in the December Economic and Fiscal Update.
Economic growth is shaping up around 1%
lower than Treasury was expecting in the Budget forecasts as
the economy goes through a cyclical downturn. This should add
around $500 million to the 01/02 bond tender program.
The Government is bailing out Air NZ to
the tune of $900 million. While some of this can be financed
via
excess cash-flow from 00/01 and capital withdrawals from
SOE s, around half will need to be financed via debt.
Treasury expected nominal GDP growth to
average 4.75% per year in the Budget (i.e. potential growth).
This looks optimistic to us. Most economist views on potential
growth sit around 4-4.25%. A structural by-product of Sept 11
th may also be a less efficient global economy for the next five
years with flow-on for NZ s potential growth rate.
Globalisation has fostered significant
efficiencies in the production and supply chain but the chill
winds of protectionism are blowing and risk aversity is weighing
on outsourcing. For example, just-in-time inventory management
is replaced by just-in-case and the economy may shift to a permanently
higher stock to sales ratio.
Systematic expansionary fiscal policy
may crowd out more productive private sector investment.
Higher business costs (insurance, airport
security) lower output per unit of input.
Spending pressures are all heading one
way. District Health Boards are likely to require their own bailout
packages (oops I mean equity injection).
Based on historical spending trends and
upcoming pressures the discretionary spending assumptions built
into the Government forecasts ($900 million per year) are light
on reality. Risks not fully accounted for include:
An inflation adjustment to maintain the
real value of existing programs (and wages) costs around $400
million per annum.
A continuation of recent health and education
spending trends. Collectively they have been growing by a combined
$700 million per year recently.
A host of initiatives such as Paid Parental
Leave, Teachers pay parity etc.
Operational funding to match the surge
in capital spending.
The official government forecasts invariably
prove to be optimistic as spending pressures emerge. Consensus
expectations are for the Government s medium-term projected
surpluses not to eventuate and this will place further pressure
on debt issuance.
This article is an opinion
piece from the National Bank's Treasury department