Mark Brighouse: Balancing NZ's risks and assets

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On May 28, Minister of Finance Bill English will present a Budget using accrual accounting principles and a balance sheet detailing an accounting representation of net worth (the Crown's assets less its liabilities).

This process will be familiar to many households that have completed loan application forms which focus on net worth as a measure of financial strength and, in most respects, the two exercises differ only in terms of their scale and complexity.

But for progress to be made on generating wealth in New Zealand the focus must shift from the concept of net worth as an accounting residual to a concept of asset-liability matching. We should establish a new focus on what is left after we match off the economic risks in our assets with the economic risks in our liabilities.

To illustrate the difference between the two approaches it is useful to contrast an investor who has an unleveraged property worth $200,000 with an investor who has 10 such properties and $1.8 million of debt.

While the accounting net worth of these two investors is the same, the second is exposed to a great deal more risk. This risk comes from the fact that the value of the properties and the value of the debt can easily move in quite different directions.

When wealth is the difference between two large numbers one has to be aware that a mismatch beyond the drivers of the two numbers can have serious consequences. The Government's assets total almost $200 billion and range from majority stakes in businesses such as electricity companies, an airline and a bank, to minority stakes in a large number of listed companies via its various funds, and one day may even include the finance companies that it has guaranteed.

An asset that doesn't appear on the Government's balance sheet is its future ability to collect tax which will be driven by working age population, productivity and inflation.

Against this it has liabilities that might or might not match the assets. The liabilities range from future payments for workplace injuries to wage-linked pension obligations and of course a rapidly growing amount of fixed-rate debt.

Not surprisingly, given the financial turmoil there is now a reduced appetite for the risks that such a balance sheet might carry. While running a deficit to soften the sharp edges of a recession is seen as acceptable, running a deficit to take asset price risk is becoming far less palatable. But decisions are being made to modify this balance sheet at a time when some asset prices have seen extreme movements. Any changes could have far-reaching consequences and given the volatility of asset prices could either cost or save taxpayers billions of dollars.

It is conceivable that now may be the very time to increase exposure to certain assets as they may now provide attractive cashflows that will achieve a liability matching objective.

What is needed before we make any changes to the financial exposure of the Crown is an analysis of the extent to which its assets and liabilities share common drivers and the degree to which they can, over time, be modified so that they are more aligned.

Mechanisms to achieve a better asset-liability match could include:

Following the recommendations of Craig Stobo's Taupo Group and introducing centralised oversight of asset and liability management. It could well be the case that changes to the individual portfolios of Crown entities are not the answer to the risk-reduction question.

Reducing the mismatch created by the Government owning businesses and funding this investment with fixed-rate Government debt. If businesses are of strategic importance then we should seek equity co-investors or use funding instruments that share the economic interest while maintaining control interest.

Where equity portfolios are held to hedge future pension liabilities we should see what can be done to better align the assets and liabilities. This could include coming to an arrangement with the beneficiaries for them to bear more of the market, inflation and longevity risk in return for sharing in the savings that are achieved.

Developing incentives for workers to choose a retirement age that optimises their own individual lifetime productivity.

The financial crisis is likely to make balance sheet management one of the Government's biggest challenges. In an environment of stiff competition for debt funding it will become more important to understand the connections between the parts of the Government's balance sheet.

* Mark Brighouse is managing director of Brook Asset Management.