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Dr Muriel Newman

Financial Tremors

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Our hearts go out to people caught up in Christchurch ’s devastating earthquake and we wish them well in days ahead as they go through the difficult process of rebuilding. We can all be thankful that no lives were lost.

Early estimates of the cost of repair and rebuilding are in the region of $2 billion and central government will provide a fair proportion of that. That this unexpected expense comes hard on the heals of the government’s $1.6 billion bail out South Canterbury Finance (SCF) under the provisions of the retail deposit guarantee scheme, serves as a reminder of how important it is that a government’s balance sheet is healthy enough to be able to cover such unanticipated events.

There has been a lot of justifiable criticism over the SCF bailout. Not only is it the largest in New Zealand’s history – dwarfing the $600 million bailout of the Bank of New Zealand in 1990 and the $885 million bailout of Air New Zealand in 2001 – but it is a private sector institution that does not have the same national strategic importance that was argued for Air NZ.

The Labour Government introduced the Retail Deposit Guarantee Scheme on October 12th 2008 during the dying days of their administration. It was seen as a necessary step to maintain depositor confidence in New Zealand ’s financial institutions, in light of Australia ’s introduction of deposit guarantees. A Wholesale Guarantee Facility was introduced a few weeks later on November 1st to ensure banks had access to international funding markets during the worst of the global financial crisis. While the wholesale guarantee facility was closed down in April this year, having issued 24 guarantee certificates covering $10.3 billion – and netting the government $290 million in fees – the retail deposit guarantee scheme has been extended until December 2011. To date, 8 companies have been accepted into the extended scheme, including SCF.

According to the Regulatory Impact Statement issued by Treasury over whether or not the retail deposit guarantee scheme should be extended, it was noted that the scheme was having a perverse effect on institutional behaviour, creating distortions in financial and capital markets.[1] These included “encouraging guaranteed depositors and deposit taking institutions to make riskier investment decisions since the gains from these riskier decisions will be accrued by the depositors and deposit taking institutions, while potential losses to depositors (of up to $1 million per depositor per institution) will be borne by the taxpayer”.

Treasury goes on to define this as a “moral hazard” problem, and explains that as a result of the guarantee, “finance companies (which tend to be involved in higher-risk and higher-return lending) have grown their deposit books by approximately $880 million (19%) since the guarantee was introduced in October 2008. Before the guarantee, the deposit books of many finance companies were shrinking. In some cases, finance companies have used retail funding to replace their bank funding lines.”

In other words, the retail deposit guarantee scheme has given new meaning to the expression ‘privatising profits and socialising losses’, since investors in failing finance companies not only get their money back if the institution defaults, but they also receive the full interest due to them – even though they were being paid higher interest rates to cover the higher risk they took when they invested in a finance company rather than a bank. Meanwhile taxpayers are forced to wear the full costs of the company’s bad management practices.

In spite of the apparent benevolence of the Hubbards, the facts about SCF tell the story of a finance company that grew far too quickly, and invested far too much of its funds in the risky property development sector. With the company reputed to have been in trouble as early as mid 2008, there are legitimate questions as to not only how it was able to gain approval for acceptance into the scheme in the first place, but also why it was able to enter the extended scheme on 1st January 2010.

The Herald’s Brian Gaynor describes how SCF was a train wreck waiting to happen: instead of using the scheme in a prudent way, to consolidate and reduce its exposure to risk, it took reckless advantage of the scheme to expand its speculative activities, increasing borrowings between 2008 and 2009 by $418 million to a record $2.1 billion, and increasing loans by $308 million to a record $1.7 billion. However, cash reserves, which stood at $322 million in December 2008, had plummeted to $22 million by December 2009. Not only that but investors were wanting to pull out before the end of the guarantee period, with a massive 99.2 percent of total borrowings ($1.877 billion) due to be repaid over the following 12 month period.[2]

As at the end of May, 73 financial institutions had joined the retail deposit guarantee scheme with $133 billion in deposits guaranteed by the government. A total of $228 million in fees was collected by the government from these institutions during the last financial year, with $934 million set aside in a fund for potential payouts.

Until SCF came along, seven institutions had defaulted, triggering the government guarantee – Allied Nationwide Finance, Mutual Finance, Viaduct Capital, Vision Securities, Strata Finance, and Mascot Finance. These collapses, which involve some 10,000 investors and deposits of $250 million, are dwarfed by SCF, which has 35,000 investors and deposits of $1.6 billion.

All in all, the events of the past week, whereby large sums are needed to cover unexpected contingencies, highlights the fragile state of our economy. The reality is that the National-led government has placed us in the very vulnerable position of having to borrow $240 million a week to stay afloat. This is essentially because it has failed to cut its cloth and reduce government spending to levels it can afford – and no manner of excuses can hide that simple fact. The present high level of external debt, which puts the country at risk, is forecast to spiral out by 44 percent from $170 billion this year to $250 billion by 2014. The obvious question of why it is that the government doesn’t reduce spending so that the country is not in such a precarious position has never been satisfactorily answered.

Don Nicolson, the President of Federated Farmers and this week’s NZCPR Guest Commentator, explains, “The indisputable fact is this; in the early 1990’s Government accounted for 35 percent of all economic activity but by 2009, that has grown to 45 percent. The 10 percent difference in 2009 dollars is an amazing $19 billion. The state sector is a direct competitor for capital and is seeing some perverse policies.”

In his article Are we in 1978?”, Don goes on to observe that with a policy advice bill of $900 million, it is the public service itself that influences much of the government’s policy agenda and that, without having a direct responsibility for creating wealth and providing best value for money to taxpayers, they can get their policy prescriptions badly wrong:

“The cognoscenti who scare me are in departments or working as parliamentary advisors. Their view of farming is locked in the mid-1980’s lie of agriculture’s eclipse. While farmers today hear platitudes over how ‘important we are’, you just know there’s an inevitable ‘but’ coming. That ‘but’ explains why state sector policy is directed at a different economy. A ‘nice’ economy if you like, where agriculture is really for the tourists, where all rivers and streams have potable water and New Zealand is a clean-green marvel. In tight groups, they mix, talk and socialise reinforcing in one another, a sense of righteousness. Anyone who disagrees is belittled in background briefs to friendly confidants and commentators. They wholeheartedly back businesses that promise a low impact on ‘our’ but read as ‘their’ environmental and cultural values.”

The problem is that the public service is now so vast, that many institutions have a mind and personality of their own, determined to push their own self-interests rather than serving the taxpayers who pay their inflated salaries.

According to a Statistics New Zealand survey of salaries i

n December 2009, while the average hourly earnings of private sector employees was $23.48, the rate for public sector workers was 38 percent higher at $32.36! Further, the State Services Commission provides information on salary bands which shows that more than 4,700 public servants, who work in the core public service earn over $100,000, with the top salary in the range of $490,000 to $499,999. And when it comes to the 35 chief executives of the ministries and departments, all of them earn over $240,000, with the top earning between $550,000 and $559,000 – although when extras, like pension schemes and vehicles are added in, the top salary rises to a rate of between $600,000 to $609,999.[3]

Irrespective of the excuses given by the government, New Zealand can no longer afford a bloated public sector. As at June 2009, there were 44,672 full time equivalent employees in the core public service. This compares with 43,297 in 2008 and 29,463 in 1999. But in particular, we cannot afford public servants who are ideologically driven, in the way that Don Nicolson describes and are pushing damaging growth-constraining agendas onto the country. More than anything right now, we need to be encouraging wealth creation and policies that will lift living standards. That’s why everything that emanates from the public service should have to pass a litmus test to ensure that it will help not hinder New Zealand getting ahead.

1. Treasury, Regulatory Impact Statement 
2. Brian Gaynor, South Canterbury and inevitable train wreck
3. State Services Commission, Annual Report 2009