Part 2: The Crown's balance sheet and NZDMO

Background

2.1
NZDMO was formed in 1988 to ensure better co-ordination and management of the Crown’s foreign currency and domestic debt under the authority of the Minister of Finance. NZDMO was established as a unit within the Treasury to ensure that important linkages were maintained in relation to the fiscal and macroeconomic effects of NZDMO’s activities on the Crown and, ultimately, the economy.

2.2
Since its establishment, NZDMO has maintained an environment of continuous improvement. Over the last 10 years, NZDMO has reduced staff numbers by achieving operating efficiencies (in part from information technology improvement) and closing NZDMO’s London branch. This has resulted in NZDMO’s annual operational cost reducing from $7.4 million to $3.7 million by 2005/06.¹

2.3
The Treasury and NZDMO continue to consider how NZDMO should interact with other government agencies in terms of wider Crown financial risk management. In 1997, NZDMO was included within the Treasury’s Asset and Liability Management Branch to provide a greater emphasis on the management of the government’s aggregate balance sheet.

2.4
In early 2007, the Treasury undertook a change programme. The key purpose of this programme was to ensure that the Treasury as an organisation:

... focuses its resources more intensely on issues which are of the highest priority to the living standards of New Zealanders now or in the near future.²

2.5
As part of that programme, NZDMO has become part of the Treasury’s Macroeconomic Group. The intention of this change is to improve the quality of advice by linking macroeconomic and fiscal issues with Crown balance sheet management.

Structural considerations

2.6
The institutional arrangements for governments’ borrowing activities vary globally. However, many countries have adopted a similar approach to NZDMO or a variation of it. Generally, there have been two types of arrangements, as Figure 1 shows.

Figure 1
Institutional arrangements for government borrowing activities*

* This analysis is based on information from chapter 3, Governance Issues in Managing Government Debt, in the 2004 World Bank publication Sound Practice in Government Debt Management.

2.7
The key driver cited for maintaining the function within a country’s finance ministry or treasury relates to the linkages to broader economic and fiscal management activities.

Strategy and objectives

2.8
The main strategic objective of NZDMO is to maximise the long-term economic return on the Government’s financial assets and debt in the context of the government’s fiscal strategy, particularly its aversion to risk.³ This objective requires NZDMO to balance the likely risks incurred from issuing various debt instruments against minimising finance costs to the Crown. NZDMO’s objectives have focused more on matching financial assets and liabilities as the Crown’s fiscal position has improved and allowed the reduction of both gross and net debt.

2.9
To execute this strategic objective, NZDMO’s core responsibility is the development and management of a portfolio framework to manage the key risks arising from the Crown’s gross borrowings, such as market, credit, settlement, liquidity, and funding risks. Broader responsibilities include providing capital market advice and transaction execution services to other agencies within the Crown, and promoting a well-functioning, liquid domestic capital market.

2.10 The strategic objective has changed over time. Earlier policy settings placed an emphasis on risk reduction given high levels of foreign currency debt. NZDMO has increasingly adjusted its operating framework from reducing the debt portfolio to increasing the financial asset portfolio. It has migrated towards an asset and liability management framework.

Change in Crown fiscal position

2.11
The Crown has achieved fiscal operating surpluses over the last six years. In little more than 10 years, the Government has reduced gross debt from around 50% of GDP (the OECD average) to close to 25% of GDP as is shown in Figure 2.

Figure 2 New Zealand Government debt 1993-2006

Source: The Treasury

2.12
The Government’s current fiscal strategy is committed to keeping gross debt at around 20% of GDP over the medium term. This strategy has enabled NZDMO to reduce net foreign currency debt to zero and maintain a stable domestic debt portfolio. At the same time, the NZDMO’s asset portfolios have increased significantly as a result of:

• foreign currency lending to the RBNZ (this lending increased by $1,200 million between 2001 and 2006);
• a larger liquidity portfolio (marketable securities have increased by $3,200 million between 2001 and 2006); and
• on-lending to New Zealand government agencies (lending increased by $2,300 million between 2001 and 2006).⁴

2.13
The Crown’s financial assets have grown strongly in the last 10 years from $14,000 million to $56,000 million, or 30% growth on an annual basis.⁵ The fiscal improvement has enabled the Government to introduce policy initiatives with respect to future demographic retirement needs. Other policy initiatives include the building up of foreign currency reserves by the RBNZ. At the same time, other major New Zealand public investment institutions have also grown their financial assets.

Crown financial policy and NZDMO

2.14
Since the 1990s, NZDMO has considered how wider macro-variables may influence its operational activities. For example, how could the risk characteristics of NZDMO’s strategic portfolio off set variability in the Crown’s balance sheet or minimise overall risk to the Crown?

2.15
As a result of identified exchange rate risk associated with its foreign currency debt, NZDMO put in place the steps necessary to achieve the Government’s policy objective of a net foreign debt position of zero and extend the duration of New Zealand dollar debt. NZDMO also considered broader theoretical views on optimal debt composition and practices with respect to principles for prudent debt management and wider macroeconomic influences.

2.16
The Treasury has continued to review the possible relationships between government debt and broader Crown variables. Frameworks questioned have included:⁶

• economic variables – Can a government’s debt portfolio be constructed to “hedge” against economic cycles as a whole, or shocks to national income/net worth?;
• government variables – Can a government’s debt portfolio be constructed to “hedge” against fluctuations specifically relating to its tax base (referred to as “tax smoothing”)?; and
• balance sheet variables – Can a government’s debt portfolio be constructed to “hedge” against variability in the government’s own balance sheet, or more specifically its assets?

2.17
NZDMO and the Treasury periodically review these frameworks when resources and priorities allow.

1: Operational cost information has been sourced from the output reporting section of the Treasury’s annual reports.

2: The Treasury 2007, Stepping Up change document.

3: Strategy and objectives are based on information available at www.nzdmo.govt.nz and from NZDMO’s Portfolio Management Policy document and its associated technical appendices.

4: This information is based on a comparison of the NZDMO’s management accounts from 2001 to 2006.

5: This information is from the 2005/06 New Zealand Government financial statements.

6: Analysis undertaken by KPMG using NZDMO papers.