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Cullen Address to the Public Sector Conference

Michael Cullen Address to the Public Sector Finance Conference

I have been asked to talk to you about ongoing sound fiscal management for the public sector. My topic is a timely reminder that prudent fiscal management requires constant vigilance. We should always be looking forward to both the emerging numbers and to the capacity of our fiscal systems to deliver the results we want.

On the back of a period where the New Zealand economy has been one of the top performers in the OECD, our economic indicators are stacking up better than they have for some time. The numbers around growth, inflation and unemployment have translated into a marked improvement in the government’s fiscal position.

At budget time the government reported a healthy operating balance surplus and forecasts for it to continue growing. There is an equally encouraging picture of debt levels. Gross debt was expected to be 27 per cent of GDP and net debt 14 per cent of GDP by 30 June 2003.

In the 2003 Fiscal Strategy Report I signalled that there may be scope to make further adjustments to fiscal policy settings. Before making these decisions however, it is important to consider the structural fiscal balance and the direction it is heading in.

The risk of a focus on the numbers that have emerged after a relatively long and strong economic upturn is that we can overstate the fiscal position going forward and change tax and spending plans in a way that compromises future budget management. There are plenty of lessons from the past and overseas that demonstrate this - what look like healthy fiscal surpluses can disappear very quickly when the economy enters a downturn.

This year the government is forecast to earn $45.5 billion, including SOE surpluses, and spend $41.7 billion. If there are small adverse changes to either or both of these numbers it is easy to see how the forecast surplus of $3.8 billion can change quickly.

Good financial management requires good management tools. This rule applies to Ministers of Finance as much as it applies to you. The focus and complexity may differ but the need for good management tools remains.

To that end, the government has taken a number of steps to develop effective tools to achieve our fiscal goals.

Firstly, there is now a greater focus on overall progress towards fiscal objectives, like keeping total debt at prudent levels, rather than managing new spending initiatives within a somewhat arbitrary and inflexible three-year fixed cap. Secondly the government’s spending intentions are now more regularly reassessed in light of changes to the economic and fiscal environment. It is very difficult to set a fiscal limit in year one and expect it to be completely relevant to the economic and fiscal conditions of Year Three.

Another key tool that has been developed is the OBERAC. The tradition in New Zealand has been to judge budgets on a single measure: the operating balance. Early on in my term I tried to widen the focus of the analysis and produce a suite of indicators so that analysts could get a richer picture of the fiscal position and of its underlying trends.

In particular I wanted a supplementary indicator that allowed analysts to strip valuation and accounting changes out and look at what was happening with what were essentially changes in the cash flows around current operations. Not only did these valuation changes have a major and volatile impact on the size of the residual between total revenue and total spending, but they often reversed out over the course of the interest rate cycle. Hence the OBERAC: the operating balance excluding revaluations and accounting changes.

The problem with the OBERAC is that in some ways it has been too successful. At budget time almost every media commentator focused on the OBERAC, which was then $4 billion, and very little attention was given to the actual operating balance of $1.4 billion.

It’s important to link use of the OBERAC, alongside the operating balance, to the other fiscal management changes I’ve discussed.

Of course annual financial performance is important, but what some commentators have failed to grasp is the fact that the operating balance, or the OBERAC, or a mix of the two, is no longer the primary goal of fiscal management. They are merely a means to an end.

The government now manages more directly to our debt objective of gross sovereign debt below 30 per cent of GDP - the end rather than the means.

There are a number of reasons for this. It is possible to run surpluses or deficits for short periods without having any significant impact on the government's ability to spend. It can do this by covering the difference through running down or building up debt.

It is when debt becomes too high that problems emerge as too much of the government’s revenue ends up having to service that debt. Equally, too little debt can reflect poor financial management. It may be a consequence of neglecting infrastructure, or under-funding education and other social programmes.

There are also financial management challenges that arise as the government builds up its capital assets. It is important we build up our capital management tools to match the growth in assets.

It is important to keep in mind the significance of the capital budget. For example, the whole of the public sector, including SOEs, is forecasting that it will spend $4.2 billion on physical assets in 2002-03.

And that’s just physical assets. The Crown also has a significant portfolio of financial assets – including New Zealand Superannuation Fund assets. In fact, financial assets are expected to increase from around 21 per cent of GDP currently, to around 27 per cent of GDP in 2005/06.

To manage capital investment, we are constantly reviewing our capital management tools to ensure that we have the best possible information to hand. In the past this has meant better aligning capital budgeting with the rest of the Budget process. It has also meant raising awareness of the range and scale of investments the Crown makes.

Looking forward, we are facing ongoing challenges on two fronts.

First, as we have previously signalled, this government is keen to explore different means of financing investment so that the most can be made of opportunities as they come to light. One possibility, for example, is using partnerships with the private sector.

Using finance from sources other than the Crown means we can take up opportunities as they arise, and provide better infrastructure for New Zealanders without compromising the government’s long-term fiscal objectives. However at the end of the day, infrastructure can be financed in one of three ways: out of taxation, through user charges, or by a mix of the two.

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. It doesn’t take all of the cost off central government but it rebalances it and can accelerate infrastructure development and expand the suite of options for consideration.

Secondly we also need to make adjustments to the post-privatisation environment for SOEs – to get the right balance between allowing SOEs to grow and diversify, and ensuring that Crown capital is available for the government’s other priority areas. Over the next few months, we will be working to develop our capital management tools to impose some more financial discipline on SOEs while ensuring they have sufficient capital to make operational investment decisions without recourse to shareholders.

Underpinning all decision-making is the quality of information those decisions are based on. New Zealand has one of the few public sectors which produces all financial statements in accordance with independently established Generally Accepted Accounting Practice.

On the standards setting side, New Zealand has an enviable international reputation for such a small country. It was one of the five countries, along with the United States, United Kingdom, Canada and Australia that made up the membership of the G4 + 1, a pre-eminent international accounting standards setting group. New Zealand is now one of only nine countries that are recognised as partner national accounting standard setters to the IASB.

For the government, the most substantial development in its financial statement reporting over the last year has been the move to line-by-line consolidation within the Crown financial statements and forecasts. Over the last year, the Crown financial statements have provided a much richer and far more useful set of information on the activity of the entities making up the public sector because of the move to line-by-line consolidation.

But rather than dwell on the developments of the last year or so, I want to discuss the next big challenge to the public sector – the move towards international accounting standards.

The New Zealand Accounting Standards Review Board announced on 19 December 2002 that International Financial Reporting Standards will apply to financial reporting by both public and private sector entities from 1 January 2007, but with the option to adopt from 1 January 2005. Additional material will be added to the standards to make them relevant to the New Zealand public sector and not-for-profit entities. They will be referred to as New Zealand International Financial Reporting Standards or NZ IFRS.

This decision signals a significant shift in accounting standards that will impact on all general-purpose financial statements produced in New Zealand, including the Crown Financial Statements.

Treasury is beginning to plan the implementation of international standards to the Crown financial statements and consequently to consider the implications for public sector entities such as SOEs, Crown entities and departments.

To provide a reference point for planning, I have decided that the time for implementation in the Crown financial statements will be as part of the 2007 Budget, meaning the first audited set of Crown financial statements under NZ IFRS will be as at 30 June 2008. There are essentially two main reasons why I have decided that the Crown should not seek to adopt at the earlier date of 2005.

The first reason is that a number of existing international accounting standards are likely to be substantially affected by a proposed standard on changing the way financial performance is reported. The new financial reporting standard should be in place by 2007 along with the necessary changes to existing standards and so it would be less disruptive and confusing to implement on the 2007 track.

Secondly, a number of international standards to be issued by 2005 are likely to be revised further to harmonise with US GAAP, creating a likely period where international standards may still be changing rapidly. Implementing at 2007 may avoid some of this potential disruption.

I am sure that this position will be welcomed by many of you here today, as it will provide a more realistic period for you to address the many transition issues involved.

However, the timeframe is still likely to be tight, as the first published set of information will be the first quarter accounts to 30 September 2007. With the need for prior year comparative information, processes to provide the necessary information will need to be in place sometime in 2006 anyway.

I will certainly be taking a close interest in how the challenges are being met, especially in preserving all the good work that New Zealand has done in the past in producing sector neutral standards.

The last major initiative that I wish to discuss today is the upcoming bill on public finance and management. This bill wraps up a lot of the work which was signalled in the Review of the Centre, and is aimed at having a public service which is less fragmented and more outcomes focussed. My colleague Mr Mallard has been leading the work clarifying the State Services Commissioner’s mandate, and improving the governance of Crown Entities.

My focus has been on the review of the Public Finance Act and the Fiscal Responsibility Act. These Acts are important because they provide for reporting on both the government’s intentions and the performance of government agencies, and also generally provide for methods for managing public finances and government spending.

The two Acts are at the forefront of legislation in this area internationally. However the PFA has been in place for 15 years so it is a good opportunity to update and future proof the system for the government of the 21st Century – as we move to Managing for Outcomes.

In developing this package of proposals I have had to run a balancing act. On one side is the desire for flexible financial and reporting arrangements that provide for differences between entities and take account of future needs. On the other side is the need to ensure that Parliament retains final control over public finances and receives appropriate information to hold the government to account.

Because of the fundamental nature of this legislation, I would like to gain cross-party support for this Bill. Many of you may have already had input into the Bill through earlier discussion papers issued by the Treasury and the State Services Commission.

Experience shows that the fundamentals of the two Acts are sound, which is of course good to know. But it has become clear that some improvements can be made to strengthen and enhance the management and reporting of public finances.

In summary, the proposed changes have four broad aims.

The first is to provide a legislative base for the recent development of departmental SOI’s by setting expectations and standards for reporting non-financial information, including information on outcomes and organisational capability as well as outputs.

The second is to increase the Executive’s flexibility in appropriations by allowing appropriations to cover more than one output class, while maintaining the information provided to Parliament at output class level.

The third is to enable flexibility in vote management by allowing more than one Minister to be responsible for a Vote, therefore allowing increased coordination and cooperation.

The fourth goal is to ensure Parliament has an effective check on the level of expenditure through changes to the Audit Office Controller function.

The other major parts of the Bill complement the work on the Public Finance Act, and have been led by Mr Mallard. They relate to the Crown Entities and the State Sector Acts.

Crown Entities spend 50 per cent of the State sector budget and employ two thirds of the staff in the sector, so it is crucial that the legislation provides for an effective accountability and reporting regime. The new legislation will provide clear and consistent roles, duties and powers for Ministers and boards.

The aim is to bring a more comprehensive and consistent approach to Crown entity governance, while recognising that Crown entities are a diverse group, and that some entities are expected to operate more independently than others. This is a major piece of legislative change, with consequential changes to more than 60 statutes.

The bill also involves changes to the State Sector Act. There are two main initiatives; to clarify the respective roles of departmental chief executives and the State Services Commissioner and to give the Commissioner responsibility for providing advice and guidance, and setting minimum standards of integrity and conduct for a wider range of organisations in the state sector.

That concludes all I want to cover today. There is a lot of work and change happening in public management. Indeed many of you have contributed to the work that has been completed or is on the agenda.

For that I thank you and I hope that with your continued involvement New Zealand will maintain its international reputation for extremely high standards of public sector financial management.

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