Cullen - Institute of Finance Professionals
Thursday 9 June 2005
Address to the Institute of Finance Professionals
PWC Gallery, St James Theatre, Courtenay Place, Wellington
It has been slow in coming, but I believe that only now, three weeks after the budget, we are starting to have the proper debate about the choices it contained. That proper debate is the one that moves beyond unadorned self-interest and starts to consider what the real alternatives are for fiscal policy and what they mean.
It is easy to criticise a budget for not delivering more spending on one’s pet project without saying where the resources should come from. And it is easy to propose a cut in tax without specifying what current government service or what investment should be sacrificed to pay for it.
There are three important facts that I believe must be accepted before we can have a real discussion about the budget:
The first is that, contrary to what some may say, under the Labour-led government expenditure has been falling as a proportion of GDP. In fact if one looks at core Crown expenditure (that is, excluding, as one ought, the expenditure of Crown-owned companies) my government has reduced expenditure to GDP from 32.7 per cent in 1998/99 to a forecast 29.7 per cent for the current financial year. Indeed the last National-led government presided over government expenditure that never fell below 32 per cent of GDP.
The second is that any significant cuts in government expenditure mean cuts in the services that New Zealanders value. There is a perception that large savings could be made almost overnight by cutting head office bureaucracies, generally regarded as ‘bad guys, leaving intact frontline capability in the form of nurses, police officers and fire fighters, who are generally regarded as ‘good guys. This is quite false. If we want more nurses and police officers we need to maintain capability in those back office functions that keep them functioning on the front line.
The third fact is a kind of law of fiscal karma: higher debt creates a liability that cannot be ignored. It harms the future generation that has to repay it, in particular if that debt is used to fund current consumption rather than investment in productivity from which they might benefit. And the prospect of weaker public finances has an immediate impact upon perceptions of sovereign risk and hence interest rates.
With that as background, there are several aspects of Budget 2005 that are of particular significance to finance professionals:
The first is the maintenance of a stable long-term fiscal environment characterised by low public debt;
The second is the initiative to create a larger domestic savings market aided by increased rates of participation in workplace savings schemes;
And the third is a set of moves towards a more fair and transparent tax regime for investment and savings. I think I can take it for granted that you are supportive of running fiscal policy aimed at reducing public debt and maintaining it at prudent levels.
The cash deficits forecast in the budget flow through into a flattening of the debt track just above 20 per cent of GDP. The net debt track is likewise somewhat flat around 7 per cent of GDP, while the Crown is forecast to move into a net positive financial asset position for the first time ever in 2006-07.
This is a satisfying goal to achieve and reflects the government’s focus on building up assets now to ensure the fiscal position remains sustainable in the future. The major risk we are addressing is the need to maintain pensions and health care during the decades when our demographic profile ages significantly.
Hence the New Zealand Superannuation Fund which continues to grow through new injections of capital and retained earning. As time goes on, its necessity as a piece of public policy is gaining wider acceptance, as is its positive impact on liquidity in the New Zealand capital markets.
It is in this context that we need to consider the ongoing need for strong fiscal surpluses. If we look at the figures in cash terms we are looking at a surplus for the current year of $2.4 billion. However, this reduces to a cash surplus of only $30 million for 2005/06, followed by an average cash deficit of about $1.9 billion in each of the following three years.
In operating balance terms, these figures translate into an operating balance excluding revaluations and accounting changes of $7.4 billion this year, $6.7 billion next year and an average of $4.8 billion in the following three years.
As large as these figures sound, they are just sufficient to fund contributions to the New Zealand Superannuation Fund and meet other capital needs. Those capital needs include essential infrastructure spending, such as the $8.4 billion available to the Land Transport Fund over the coming four years. After a marked slowdown during the 1990s in the rate of public investment in roads, electricity, water and so on, we have increased by over 70 per cent the net purchase of physical assets by government.
What this means is that our fiscal options are limited if we are serious about meeting head on the need for future stability. This was affirmed last week by the OECD Economic Outlook on the New Zealand economy, which stated that “any additional fiscal stimulus beyond that already planned could put the projected soft landing at risk and would need to be offset by higher interest rates in order to bring the economy back onto a sustainable growth path.”
Over the next three budgets the allowance for new spending has been set at $1.9 billion a year, thereafter growing by inflation. That is a target that will require careful prioritisation and some moderation of expectations.
The undoubted centrepiece of Budget 2005 was the savings package aimed at achieving over time a significant increase in the level of domestic savings and hence a reduction in the current account deficits which have plagued us for decades.
The fact is we have a low level of household savings (among the lowest rates in the OECD), and a correspondingly high level of dependency on foreign capital. Overseas investors naturally factor in an additional risk premium to their expectations of a return, tend to be less interested in the venture capital end of the New Zealand market and, of course, repatriate a portion of our national income and, all things being equal, are less likely than New Zealand investors to reinvest it in this country.
Low savings and a high external debt to GDP ratio also puts pressure on our current account balance, and makes New Zealand vulnerable to shifts in the availability and price of international capital, and adds a premium to our interest rates.
The new savings strategy is aimed at encouraging individual investment in long term asset accumulation, as well as strengthening New Zealand’s capital markets. Increasing our pool of domestic savings should lessen our exposure to the risks of global capital markets. It could also strengthen the flow of finance to New Zealand businesses, given that investors tend to prefer to invest in their home market.
This is not a compulsory scheme like Australia’s, but it is a definite tilting of the playing field towards participation. New employees will automatically be enrolled in the KiwiSaver scheme and will have to opt out if they do not wish to participate.
The emphasis from the contributor’s point of view is on choice, with competing providers and a capacity for contributors to specify their preference for risk. Nevertheless, there are clear expectations that savings will be locked in for retirement or, under certain circumstances, for the purchase of a first home.
Our working assumption is that 25 per cent of the eligible workforce will have enrolled in KiwiSaver by 2012. All things being equal, the scheme should lead to a general increase in the liquidity of New Zealand’s capital markets. It represents a significant opportunity for financial intermediaries at both the retail and the wholesale level.
What the savings package does is bring into sharper focus the need for a fair and transparent taxation regime. Budget 2005 made important moves towards this goal through addressing the issues raised last year by Craig Stobo in his report on the taxation of investment.
As you are aware, direct investments in New Zealand companies are presently taxed at the company level, with imputation to alleviate double taxation. For most direct investors, these investments will be on capital account, with the result that capital gains on sale are not taxable income.
Investments through a financial intermediary, such as a unit trust or superannuation fund, are typically taxed according to the nature of the intermediary as a business and are on revenue account as a result. This means any resulting capital gains are considered taxable income. As a result, direct investments are generally in a superior tax position relative to indirect investments.
The 2005 Budget included announcements to solve the distortion against using financial intermediaries. In particular, investments by intermediaries that qualify as Collective Investment Vehicles, because they take portfolio investors and facilitate access to portfolio investments, will generally be on capital account so that investments through such vehicles are not disadvantaged relative to direct investments.
This treatment will apply to equity investments, and is not designed to change the treatment of debt, where similar distortions do not exist. Equity investments designed to exploit the boundary between debt and equity, will remain on revenue account. This is important to prevent the reform adding new distortions, and to maintain the relative desirability of interest bearing investments.
While domestic equity investments will have an impediment removed, these investments will still face tax at the New Zealand company level, as is appropriate.
Overall, the demand for interest bearing assets should remain strong, especially from the potential increase in the use of collective investment vehicles for portfolio investments. As a result, I do not see interest bearing investments going off the radar screen of New Zealand investors any time soon.
As stated in the budget, the taxation of offshore investment is a much more difficult matter, but it is one that is critical to get right if we are to avoid New Zealand's scarce domestic capital being encouraged to chase offshore tax advantages. The government will shortly be releasing a discussion document with proposals to address this issue.
In addition to making progress on the tax regime, we are continuing to work on effective regulation. That is crucial if we want to entice more New Zealanders to build up financial assets.
The government has recently announced a review of financial products and providers. The Ministry of Economic Development is leading the review. The key objective for the review is to develop an effective and consistent framework for the regulation of non-bank financial institutions, financial intermediaries and financial products, including unit trusts and collective investment vehicles. The aim of the framework is to promote confidence and participation in financial markets by investors and institutions, and which results in a sound and efficient non-bank financial sector.
Policy decisions are expected to be taken by late 2006, with legislation planned to be passed in 2008.
The other current initiative is the Task Force on the Regulation of Financial Intermediaries. The Task Force was appointed to review the regulation of financial intermediaries to ensure financial intermediaries provide quality financial information and advice to the public, and assist New Zealanders make the most of their savings.
The Task Force has been asked to take into account the regulatory regimes in other countries, including Australia. However, it must consider the costs and benefits on industry participants, consumers and the economy generally of any changes it proposes to ensure that any proposed solution provides the best outcome for New Zealand.
Responses to the initial questionnaire indicated people had different perceptions, some positive others negative, of their experiences in dealing with financial intermediaries. Some common themes were about possible conflicts of interest, bias towards high risk products, incompetent advisers and issues with fees.
The Task Force is due to reports back to the government mid year.
This immediately raises the question of our ties with Australia on Financial Supervision and Regulation. Through changes to taxation, business law and work underway establishing a mutual recognition regime for cross-border securities offerings we are moving ultimately to a single Australasian investment market.
For example, with respect to securities offerings the current proposals would allow issuers to offer securities in both Australia and New Zealand using the same offer documents and offer structure. A mutual recognition regime would reduce the costs of raising capital in both countries, while maintaining investor protection through appropriate disclosure.
It will also promote investment between Australia and New Zealand, enhance competition in capital markets, and increase the choice for investors. The treaty establishing the regime is likely to be finalised within the next two to three months.
Standing back from these specific initiatives, I think the finance professionals in New Zealand have many reasons for optimism.
We have an economy that is growing, that has strong underlying fundamentals, and that is hungry for investment in new capacity and in infrastructure. We have strong public finances which allow us to make provision against future shocks that would be felt first of all as unwelcome shocks to the finance sector.
With last month’s budget we have a new emphasis on getting New Zealanders more focused on asset accumulation and therefore more engaged with sectors of the economy outside of the labour market and the residential housing market.
That gives us both an opportunity and a challenge to strengthen our financial markets and increase the level of sophistication in financial services that are offered to New Zealanders.