The Government’s Super Scheme: Leveraging Up

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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.

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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

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