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Address to ABN AMRO client function - Cullen

Hon. Michael Cullen
3 July 2003
Speech Notes

Address to ABN AMRO client function

In my opening remarks to this function, I have been asked to switch my attention from the operating side of the government’s finances to the capital side.

I am told that you would like to hear my comments on – among other things – funding the ballooning infrastructure spend in New Zealand.

From where I sit, I have to say that from time to time infrastructure spending does indeed look like it is ballooning. The big problem the government has is the sheer range of items that need attention if we are to catch up on the 1990s decade of infrastructure neglect.

Without trying to be comprehensive, but looking at the state sector in its broadest sense, I can list new prison facilities, a modernisation of defence force equipment, replacement of old hospital facilities in a number of localities, building new schools as the population shifts and grows, recapitalising the national airline, installing new electricity generating capacity, upgrading the electricity transmission grid, building many expensive roads and even, - to borrow a phrase from Richard Prebble and the 1984 election campaign – saving rail.

Putting a price tag on this is a bit like costing Concorde in the 1960s – think of a number and keep doubling it.

Then I open the budget and the spending doesn’t look at all unmanageable. Leaving aside the money we are owed on things like student loans, and ignoring the assets accumulating in the New Zealand Superannuation Fund, gross sovereign issued debt is forecast to rise only modestly over the next four years: from $35 billion to $35.5 billion or a 1.5 per cent increase in total. That is well below the rate of inflation, and reflects a rapidly falling debt burden. Gross debt is a bit over 27 per cent of GDP now and is forecast to fall to 23 per cent by 2007.

If we add back Crown financial assets and Superannuation Fund balances the net debt plunges to 2.7 per cent of GDP by 2007.

That raw figure has to be qualified.

Firstly, we must acknowledge that our demographic structure is fiscally benign. In historical terms, there are relatively few young people and relatively few older people: the two demographic cohorts that cost governments money. This means we have a structural surplus that is – at least for the moment – partly driven by demographic rather than tax or spending alignments.

It is also possible – but much less certain – that the tax and spend configurations are producing a structural budget surplus. And finally we have had a reasonably long and strong economic expansion so there is a cyclical element in the numbers.

These three factors combine to allow a significant contribution to infrastructure spending to be financed out of current operating surpluses. I am keen not to overdo that: the demographic element of the surpluses will turn for the worse relatively soon – starting in about a decade. That is the reason that I want the Superannuation Fund assets preserved and not spent on an infrastructure upgrade.

Overall, though, cash flows are sufficiently strong to allow us to manage a sensible level of infrastructural investment without any radical increase in Crown debt.

A second reason that we can have a long and expensive infrastructure shopping list and flat debt is that a lot of the infrastructure upgrade is financed within the balance sheets of state owned enterprises. They borrow, the core Crown does not. Even there, the numbers are not frightening. The SOEs will also only have to increase their debts to the extent that cash flows fall short of their capital spending needs.

I will put some numbers on this.

Current forecasts are that the Crown will spend about $14 billion on physical assets over the next four years. The main components of this are:

$3 billion to be spent by government departments, with defence equipment, corrections facilities and school building and maintenance taking the lion’s share.

$6 billion will be through Crown entities like hospitals, Housing New Zealand, and, of course, Transit on the roads.

$4 billion will be spent within the SOEs, and a large portion of that will be in the electricity sector.

It is important to remember that a substantial element of the infrastructure is owned, operated and financed by regional and local government, and by private enterprise. That is a double edged sword: while central government is relieved of the need to make and finance investments, it loses the ability to ensure adequate maintenance, anticipation of future demands on infrastructural capacity and an expansion of it to cater for the demands that exploding technology creates.

This highly fractured ownership of infrastructure has some advantages. It avoids the perils of excessively centralised control. Under a highly centralised planning regime there are risks of inefficiency, over-supply and slowness of response to new demands for service. Decentralisation, does, on the other hand, create its own problems. The problems arise because operators understandably pursue their own interests which may, but equally may not, coincide with the national interest.

As an example, with electricity generation, narrow interests suggest that it is best to match generating capacity with a retail customer base, and to avoid locking too much capital up in reserve generating capacity which may not generate an ohm in anger for many years. From a national interest point of view, limited reserve capacity in the system exposes electricity users to high prices when rapid increases in demand for power, dry years, or plant outages for maintenance stretch the ability of base load generation to meet demand. The government’s recent announcements address this while leaving baseload capacity management decentralised.

The same can be said for transport. Ideally, the national interest is best served through an integrated and complementary set of transport modes. Individual users will seek a mode that is quick and flexible: the result is clogged roads and a struggling rail system.

As with many areas of policy, the second half of the last century saw us go from one extreme to the other, and we are now trying to pull back to a sensible middle ground.

The ground we are searching for is not one of heavy handed central management or regulation of infrastructure providers. There is a mix of interventions needed: a bit of co-ordination, some new approaches on financing, rebalancing the legal and regulatory framework and a clarification of when and how the government intervenes directly to safeguard the national interest.

Budget 2003 provided $550,000 for a stock take of the quality and availability of physical infrastructure and of the existing policy frameworks. I convene a special Ministerial Group that is now focussed on clarifying what the government needs to do ensure an effective whole of government approach on infrastructure development and regulation. The other members are the Ministers of Economic Development, Energy, Transport and Environment. The list signals where the government sees the need for more momentum on the policy front in this area. The immediate focus is on the economic development imperatives, and the pressing demands are in transport and electricity. The use of water is a looming infrastructure issue, and all initiatives need be taken in an environmentally sustainable way.

Earlier on I was talking about the availability of - or supply of - finance. The other side of the coin is the demand for finance. My experience is that demands on the infrastructure expand rapidly, but supply responds slowly. Roads and electricity are two recent high-profile examples, but this is a generic problem. I would illustrate this by pointing out how long it has taken to get a new prison built. Because the construction of infrastructure is inevitably slow, and almost always delayed, we can plan new infrastructural investment with enthusiasm and commitment, but it is very slow to come on stream and so there is never a great deal of pressure to come up with the ready cash quickly.

Capital budgeting, in my experience, is a process of constantly pushing the timing of anticipated spending into later budget cycles.

Those delays are frustrating, but it is important not to overreact. I see three delay factors inherent in almost every capital project that the government has entertained. The first is technical, or engineering delay. Do not underestimate this. If, for example, we were to give the go-ahead to a major upgrade of the electricity transmission grid, or in roading to Transmission Gully, getting the design right and the engineering specs finalised would take months if not years.

Then there is the resource consent delay. We must have an efficient RMA process, but we must equally avoid populist demands to downgrade or bypass proper resource management controls. I find that demands for fast-tracking projects evaporate when the project impacts on the back yard. There are real environmental, cultural and neighbourhood concerns associated with prisons, roads and almost any other infrastructure project that we ignore at our collective peril.

Finally, there are construction delays. You will note that I have not included financing delays. I believe that in this day and age, public infrastructure is much more likely to crowd out private sector construction capacity than private sector access to finance.

This leads on to the issue of whether or not we should be exploring other methods of financing infrastructure development; moving down the continuum of private sector building, leasing, owning, operating or tolling parts of the infrastructure.

As a general rule the answer is no. There is no rocket science in deciding what level of debt is prudent, manageable and sustainable. With that qualification, the government has set itself a long-term goal of managing sovereign issued debt at below 30 per cent of GDP over the economic cycle. The figures I have given you earlier establish that there is some headroom to expand, or bring forward, some infrastructure spending without compromising that target. As I have also said, I would probably be more concerned about what pressures that would place on construction resources than on public debt.

In particular cases, though, it may be sensible to look at other methods of financing infrastructure. The BOOT regime has a lot of backers, for understandable reasons. As a prominent former politician who shall remain nameless once said to me, a very dangerous place to be is anywhere between construction companies and their bankers and a large bag of money.

There are big limitations on a more generalised use of BOOT funding in New Zealand, for reasons that I don’t have time to fully explore today. We are, as we usually are, limited by the tyrannies of scale and distance. We have a small population spread out across a thin and lumpy country. We simply do not generate the consistent, twenty-four by seven, high volume infrastructure use that would make a project like the Sydney Harbour Tunnel viable.

That is not to say that in particular instances, forms of public-private partnerships cannot be used, or used alongside non-traditional financing arrangements. I have asked government officials to think about imaginative ways of financing specific elements of the infrastructure. I stress that imaginative does not mean magical. There are no miracle cures.

At the end of the day, infrastructure can only be financed in one of three ways: out of general taxation (which includes rates in a local body context), by charges on users, or by a mix of the two. If, for example, a private operator builds and operates a service and the government pays a lease type fee, it is still taxpayer funded: instead of paying interest on a loan the government is paying a rental to the private developer to cover their cost of capital. If a private operator charges a toll, that does not create new money: the government itself could have decided to apply a toll.

What private-public partnerships do is get a better mix of risk distribution in the design, construction and operation phases. Non-traditional financing arrangements seek to get a better or more appropriate allocation of costs. For example, a reserve generation capacity levy on electricity users shifts the cost of covering dry year risk away from generators, but does not shift it back to the government. An Auckland specific charge – be that a regional petrol tax, or congestion charging, or any of the other options that have been floated in the public arena recently – shifts part of the cost of relief of congestion onto the users of Auckland roads. It doesn’t take all of the cost off central government but it rebalances it, and can accelerate infrastructure development and expand the range of options that can be considered.

Even though central government may be doing the borrowing, this type of charge can provide a funding stream to finance the costs associated with that borrowing. The effect is that if there is a desire to accelerate infrastructural investment, the users meet the costs associated with bringing forward the project in the national queue.

There is no finality on any of this, but I hope that I have conveyed a greater sense of urgency, a more integrated approach, and the application of more lateral thinking to this important area of policy.

It is easy to neglect the infrastructure because the problems are not immediately apparent: we tolerate a slight extension in the time it takes to get to work, reallocate prison musters, ride out the occasional electricity price spike, keep on using the rail carriages even though replacements would be nicer, and so on. People adapt. Then, as demand growth outstrips the capacity to adapt, action gets more and more urgent. Unfortunately, with infrastructure, quick fixes are seldom on offer.

The challenge for governments is to think around a ten year or longer planning horizon, during a three year election cycle, apply it to the annual budget process and design responses when other players control many of the crucial levers.

It is a big part of the agenda for the remainder of this term of office.

Thank you.


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