3.3 Implementation of the Local Government Act 2002 – incidental arrangements in foreign currency

Local government: Results of the 2004-05 audits.

This article discusses whether or not section 113 of the Local Government Act 2002 (the 2002 Act) is consistent with the requirement for local authorities to manage their resources prudently.

Section 113 of the 2002 Act provides that no local authority may borrow or enter into incidental arrangements, within or outside New Zealand, in currency other than New Zealand currency.

Section 112 of the 2002 Act contains a very broad definition of incidental arrangement, which includes “... a contract or arrangement for the management, reduction, sharing, limiting, assumption, offset, or hedging of financial risks and liabilities in relation to any investment or investments or any loan or loans or other incidental arrangement …”.

While the definition is broad, it can be seen that it applies only to incidental arrangements made in relation to borrowing, investment, or other incidental arrangements. It does not apply to an incidental arrangement made for some other purpose, such as a foreign currency hedge designed to protect a local authority purchasing an asset from overseas from foreign exchange fluctuation in the period between agreement to purchase and payment. Also, the prohibition in section 113 applies to borrowing in foreign currency, but not investing in foreign currency.

During the 2004-05 audit, a council that had disposed of a large shareholding in an energy company received advice from its investment advisers that it should invest some of the sale proceeds in the United States market. The Council received legal advice that it was permitted to invest funds overseas provided it was prudent to do so, having regard to the decision-making provisions in Part 6 of the 2002 Act and the Council’s relevant financial management policies, such as its revenue and financing policy and the investment policy.

In the interests of prudent financial management, and in accordance with standard business practice, the Council wished to enter into incidental arrangements to hedge itself against foreign exchange rate risk in relation to the proposed overseas investment. The Council received legal advice about a way of entering into incidental arrangements that would have the same effect as a foreign currency hedge but would not breach section 113, but the matter was not clear cut and the Council’s approach carried some risk.

Our discussions with the Council raised the bigger issue of whether or not prohibiting incidental arrangements in relation to foreign currency investments is a useful prohibition, given that it appears to be inconsistent with the principle of prudent financial management. A local authority’s investment policy is required to address risks of particular investment and how those risks will be addressed. Where a local authority’s investment policy permits investment of funds overseas, it is likely to be prudent to enter into incidental arrangements such as hedge contracts to address the foreign currency fluctuation risk associated with such investments.

We recommended to the Department of Internal Affairs that it review this aspect of the 2002 Act in consultation with the local government sector, to see if it fulfils a useful purpose or could be revised or repealed.

The Local Government Law Reform Bill, introduced in Parliament in April 2006, proposes to amend section 113 to clarify that an incidental arrangement in relation to a foreign currency investment is not prohibited.

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