Summary

The New Zealand Debt Management Office

The New Zealand Debt Management Office (NZDMO) was established 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 operates as a separate unit of the Treasury, and is primarily responsible for the efficient management of the Crown’s debt and associated financial assets within an appropriate risk management framework. NZDMO’s broader responsibilities include:

• providing capital market advice;
• providing transaction execution services to other agencies of the Crown; and
• promoting a well-functioning, liquid domestic capital market.

NZDMO manages gross debt of about $40,000 million and financial assets of approximately $18,000 million.

Our audit

We engaged experts from KPMG to undertake a performance audit of NZDMO on our behalf because of the specialist and technical nature of the work of NZDMO. The audit looked at the effectiveness of NZDMO’s operations, including its governance and policy framework.

We compared NZDMO’s policy framework to the following internationally recognised guidelines produced by the Organisation for Economic Co-operation and Development (OECD), Bank of International Settlements and the International Monetary Fund.

We also compared NZDMO’s operational activities to OECD central government debt statistics, other similar entities such as the Australian state/Commonwealth borrowing authorities (CBAs), and similar financial institutions or corporate entities that undertake financial risk management activity within Australasia.

We focused on the following areas:

• the Crown’s balance sheet and the role of NZDMO;
• assurance mechanisms used for governance;
• debt management – strategic portfolio;
• debt management – tactical portfolio;
• use of derivatives;
• internal systems; and
• key personnel risk.

The Crown’s balance sheet

The Government’s fiscal strategy emphasises a commitment to maintaining gross debt at around 20% of Gross Domestic Product (GDP). This strategy has resulted in NZDMO reducing net foreign currency debt to zero, and maintaining a stable domestic debt portfolio. At the same time, NZDMO’s asset portfolios have increased significantly due to:

• foreign currency lending to the Reserve Bank of New Zealand (RBNZ);
• a larger liquidity portfolio; and
• increased lending to government agencies.

The Crown’s financial assets have grown strongly in the last ten years, from $14,000 million to $56,000 million. This equates to 30% growth on an annual basis.

A decentralised approach to Crown financial policy has resulted in debt and asset management responsibilities being spread over a number of departments and agencies. There is a lack of clarity in NZDMO’s current policy framework in terms of translating Crown balance sheet and financial policy considerations into NZDMO’s debt management strategy.

Assurance mechanisms used for governance

NZDMO’s Advisory Board (the Board) provides the Secretary to the Treasury with quality assurance on NZDMO’s activities, risk management framework, and business plan. Some oversight is also provided by the Treasury’s Risk Management Committee.

Our review of documents and discussions with Board members indicated that the Board’s role is to confirm to the Secretary to the Treasury that NZDMO is operating within an appropriate policy and risk management framework. This role is consistent with the functions of advisory boards of a number of similar sovereign debt managers internationally.

However, in recent years, the Board has tended to provide more strategic advice as particular initiatives are considered by NZDMO and the Treasury. This has introduced some uncertainty into the Board’s role. Accordingly, the Board’s terms of reference should be reviewed and clarified with the Secretary to the Treasury with respect to assurance versus strategic advice.

Debt management

Policy framework

NZDMO’s debt portfolios are designated as either “strategic” or “tactical”. NZDMO’s activities are focused more on managing the relationship between its assets and liabilities than on discretionary risk management activities. Hence “strategic” and “tactical” designations may not be the most appropriate terms within the current environment. In our view, “traded” and “non-traded” risk are better terms for NZDMO’s current portfolios.

We have identified several components of NZDMO’s policy and risk framework that require review. NZDMO’s key policy document is its Portfolio Management Policy (PMP). While this has been regularly updated for certain operational changes, we consider that the policy requires a fundamental revision to reflect the current asset and liability management philosophy within NZDMO. NZDMO has acknowledged that the PMP requires updating and has been planning to do so when resources allow.

A high proportion of the PMP is principles-based. The document is less specific about risk settings under an asset and liability framework. Revision of the PMP would provide the opportunity for NZDMO to better reflect current practice as well as consider revised risk management practices within the PMP, particularly those associated with:

• interest rate risk;
• foreign exchange risk;
• risk measurement;
• funding risk; and
• liquidity risk.

Strategic portfolio

The strategic portfolio provides funding to core departments and agencies of the Government.

NZDMO has moved to an asset and liability framework to assess performance of parts of the strategic portfolio. It has also developed “quasi-tactical” portfolios. There is a degree of active management of these “quasi-tactical” portfolios. These steps have progressively reduced the size of the non-traded components of the strategic portfolio. This trend is expected to continue over time, as the risks associated with NZDMO’s assets and liabilities are progressively matched with each other. Given these changes, NZDMO does not believe that extensive benchmarking or cost/risk analysis is necessary under the asset and liability framework. We agree with this approach.

NZDMO expects that, for the foreseeable future, a portion of the strategic portfolio will continue to remain as net debt, with no financial assets linked to it. At the time of our audit, less risk analysis and performance reporting was undertaken for the strategic portfolio than for the tactical portfolio.

We suggest that, for monitoring and reporting purposes, NZDMO should progress the application of benchmarks that allow the matching explicitly or notionally of similar assets and liabilities. In the absence of such benchmarks being developed, it would be appropriate for NZDMO to consider setting a national “target duration” for its unmatched sub-portfolios within the strategic portfolio.

Tactical portfolio

NZDMO’s tactical activities have evolved over time. One of the first uses of the tactical portfolio was as a way for NZDMO to achieve the Government’s policy objective of a net foreign debt position of zero, without having to actually repurchase the gross debt. Since then, NZDMO’s tactical activities have expanded to include increased funding of the RBNZ’s foreign reserves as well as foreign exchange (FX) activity for the New Zealand Superannuation Fund and other Crown entities and government departments. In recent years, government surpluses have added to the investment of funds within NZDMO’s tactical activities.

NZDMO’s tactical portfolio activities involve matching assets and liabilities to off set risks (interest rate and FX), while minimising credit risk and securing a margin through this activity. At the time of our audit, NZDMO had a very low appetite for taking outright risk positions with a view to profiting from market movements.

NZDMO’s tactical activities are both necessary and valid, and have the potential to add value to the Crown within a managed risk framework. However, they are more in keeping with prudent asset and liability management and FX activity than traditional tactical trading.

Management of NZDMO’s tactical portfolio is appropriately performed within a limits framework. This framework establishes the maximum extent of risk that Portfolio Managers in NZDMO can take on from their discretionary activities. The limits framework has evolved over time. At the time of our audit, it included limits to protect against potential market losses (Value at Risk limits), as well as limits to protect against exposure to further losses once actual losses reach a certain point (stop loss limits). Credit exposure limits are also applied to limit the risk of financial loss from a counterparty credit rating downgrade. These limits are set to reflect the level of risk acceptable to the Crown, as approved by the Minister of Finance.

NZDMO’s risk management processes over the tactical portfolio are appropriate for NZDMO’s current activities. The low level of risk taking and high quality of credit within the tactical portfolio minimise the risk profile for NZDMO. However, some better practices should be considered to minimise residual risks within the portfolio.

We found that NZDMO’s daily reporting under its risk and performance reporting framework is timely, and provides management with high-level information on the portfolio performance, position, and compliance with the risk policies. However, we consider that the monthly reports to senior Treasury management and the Advisory Board should contain more information on key changes within portfolios to assist with comparative analysis.

We also consider that the risk-adjusted performance measure (RAPM) that NZDMO uses to report the performance on the tactical portfolio should be reviewed. We consider the key refinement needed is to more precisely report returns from risk-taken activity against one-off gains achieved by borrowing funds at the New Zealand Government rate and investing them in marketable securities that attract a higher rate.¹

Use of derivatives

Derivatives are financial instruments (such as options, futures contracts or swaps), the value of which is determined by reference to an interest rate or underlying asset (such as a stock, currency, or commodity). The derivative instruments used by NZDMO in the strategic and tactical portfolios are consistent with the exposures being managed, and the activity is well-controlled within NZDMO’s risk management framework. All the derivative instruments used by NZDMO have been authorised by the Minister of Finance.

Internal systems

NZDMO’s Information Technology (IT) systems meet key business requirements. This has been achieved using significant levels of in-house development. Processes exist for IT staff to regularly collaborate with other NZDMO staff to identify their strategies and needs relating to technology.

Processes to identify and manage IT risks are integrated with business processes. There is some risk with developers having access to the production environment, which is inevitable given the small size of the IT group. This access risk is largely mitigated by the level of daily review of the system-generated reports.

Key personnel risk

The skills of key NZDMO personnel typically align with their roles. NZDMO has continued to achieve operational efficiencies that have allowed staff numbers to reduce. However, if transaction volumes continue to grow, and other strategic changes introduce greater responsibilities, the relatively small team may be stretched. This is particularly the case below management level in key areas such as settlements, portfolio management, and risk analysis.

A risk that NZDMO may face in the future is that, given the existing resourcing levels, any further change in its operating environment could restrict its ability to maintain a strong control culture or respond to new operational requirements within an acceptable timeframe.

Recommendations

We have made 19 recommendations throughout our report. These identify some improvements that NZDMO could make in the following areas:

• governance;
• risk management;
• portfolio management policy; and
• performance reporting.

All of the recommendations are listed in the Appendix.

1: At the time of fieldwork for our audit, typical New Zealand Government borrowing rates were more than one percentage point lower than typical benchmark borrowing rates (New Zealand swap market interest rates). For example, NZDMO could borrow at 6.5% and then invest at 7.5%.