Cullen wriggles in self-made straitjacket

By BRIAN FALLOW

Next Tuesday we will be treated to the spectacle of Finance Minister Michael Cullen wriggling and writhing in a fiscal straitjacket.

As he prepares the December economic and fiscal update, Dr Cullen has to struggle with three constraints.

First is the structural limit that confronts any New Zealand finance minister who wants to balance the Budget.

Because New Zealand's trend rate of economic growth is between 2.5 per cent and 3 per cent a year, and given that Government revenue is equivalent to around a third of gross domestic product, the real growth in revenue will be no more than 1 per cent of GDP.

That means a finance minister can count on only an extra $1 billion a year, on average and after inflation, to fund fiscal initiatives, whether increased spending or tax cuts.

The second constraint is cyclical. Next year will be a below-average year for economic growth and therefore tax revenue, as the effects of this year's global slowdown catch up with us.

In the May Budget the Treasury forecast GDP growth of 3.3 per cent in the year to March 2003. Clearly that is no longer plausible.

Dr Cullen has indicated that the Treasury will not be revising its growth forecasts down as much as the Reserve Bank did. The bank is forecasting growth of around 1.5 per cent for the March 2003 year.

A 1 per cent cut in GDP growth cuts about $350 million from the fiscal bottom line.

The third constraint is a self-imposed one.

When it came to power the Government set itself a limit of $6 billion of new spending over its three-year term. That is the cumulative effect of an extra $1 billion a year.

That spending cap has already been breached in the May Budget.

The increase in spending was heavily front-loaded in Dr Cullen's first Budget.

Only around $800 million was left for next year's Budget, and half of that has just been committed to health.

And next year is an election year.

"The pressure is really likely to be on the Minister of Finance," says ANZ chief economist David Drage, "even more than in the past year, from a range of sources for additional spending, which it doesn't take a lot of to mop up what's left."

Given the very tight fiscal outlook, Mr Drage says, "any slips at all add directly to the funding requirement, which is already looking particularly large".

He expects the Government to issue more than $5 billion of bonds next fiscal year, compared with the $4.5 billion forecast in May, unless some of that is brought forward to add to this year's $3.5 billion bond tender programme.

It would be the highest level of debt issuance since 1991-92.

The two main factors driving the expected increase in Government borrowing are the prospect of weaker-than-expected tax revenues as the economy slows, and the $1 billion bailout of Air New Zealand.

So far revenues have been holding up. By the end of October, a third of the way through the fiscal year, tax receipts were running 0.7 per cent ahead of budget, as higher-than-expected GST flows offset a disappointing corporate tax take. But it is early days yet.

There is no sign the market would have any difficulty digesting the extra debt.

The Government may find itself issuing the additional bonds at a time when global debt markets are being sold off and yields rising.

However, Deutsche Bank fixed-interest strategist David Plank sees no evidence that the supply of bonds drives either the absolute level of bond yields or the difference between New Zealand and United States Government bond yields, known as the spread.

Instead, he says, the spread reflects expectations of New Zealand short-term interest rates, relative to short US rates.

"If the market is selling off next year - for instance, if people decide the Federal Reserve is going to take back this year's rate cuts very quickly - then New Zealand will outperform, and the 10-year bond spread might narrow, because people will say the Reserve Bank didn't cut rates by much so it won't have to raise them by much," Mr Plank says.

"In fact, that is what has been happening in the past few weeks. The spread has narrowed from nearly 200 basis points to a little over 150, even though there has been all this talk about extra issuance."

The expectation of an increased bond tender programme has already been priced in.

It might look as though increased bond issuance next year was driving up rates, however.

"There is a reasonable chance that the financial market will reassess just how quickly the Fed raises rates, and as that reassessment takes place it might cause the US market to outperform New Zealand's," Mr Plank says.

"That might be coincidental with an increase in bond issuance, but it would be caused by a reassessment of US prospects, not a downgrade of New Zealand's."

Dr Cullen has more room to manouevre on the capital side of the budget than on the operating side because the Crown's balance sheet shrank dramatically over the 1990s as state assets were sold and debt repaid.

That policy has now swung into reverse, although the Government remains committed to keeping the ratio of net debt to GDP below 20 per cent "on average over the economic cycle".

The key question is whether the assets to be acquired with this burgeoning Government debt are of a high quality.

Time will tell whether Air New Zealand and Kiwibank are good investments.

But the bulk of Government borrowing is used for other things.

The May Budget projected a need to borrow an additional $7.6 billion over the five fiscal years to 2004-05. (Additional, that is, to replacing debt that matures over that period).

Together with a total of $11.7 billion from operating cash flows, that will be invested in:

* $6.1 billion in contributions to the New Zealand Superannuation Fund.

* $4.7 billion of loans (mainly to students).

* $800 million of capital injections for state-owned enterprises and crown entities (that was before Air New Zealand).

* $4.5 billion to maintain and $3.4 billion to increase the physical asset base (roads, schools, frigates and so on).

Dr Cullen bristles at the suggestion that the Government is borrowing the money to set up the NZ Superannuation fund.

But if that $6.1 billion was not going into the fund, the borrowing requirement would be $6.1 billion lower.

Partially prefunding NZ Superannuation is the major new policy that coincides with what looks like being an $8 billion-plus increase in Government debt by 2005.

The wisdom of borrowing money to buy financial assets - hopefully returning more than Government bonds, but by the same token riskier - is questionable.

The Budget projected the stock of student loans outstanding to grow from $4.6 billion this year to $7.3 billion in 2005.

But the Government evidently expects to get only 89 per cent of that back: the level of bad debt provisions on student loans grows from $580 million this year to $778 million in 2005.

Even if that level of provisioning is conservative, it is way above what any commercial bank would consider tolerable.