Brian Gaynor: String of disasters calls for tough decisions

Earthquakes in Canterbury have added to capital spending costs and cut individual tax revenues. Photo / Dean Purcell

It is difficult to see how a 2015 surplus can be achieved unless ... political leaders make a genuine attempt to cut expenditure.

The release of the Crown's financial statements for the eight months to February 28 highlights the predicament faced by our political leaders, whether in power or in opposition.

The Government is living well beyond its means, as reflected by its negative operating balance before gains and losses (obegal) of $9.2 billion for the first eight months of the June 2011 year (see table).

The Crown has been forced to borrow to finance this deficit and additional capital expenditure. Thus, Crown debt has ballooned from $49.4 billion to $63.4 billion - an increase of $269 million a week, or $38 million a day, in the year ended February 2011. This is not sustainable and our political leaders have to make a number of difficult decisions, particularly as the latest Christchurch earthquake will cost the Government an estimated $5 billion to $10 billion.

The first area to look at is revenue, which has declined from $39.3 billion to $36.6 billion since the eight months ended February 2008, the first period in the table. There has been a reduction in individual tax take from $17.9 billion to $15 billion, because of income tax cuts, a weaker economy, higher unemployment and less overtime. The Christchurch catastrophe will put further pressure on tax revenues because many individuals either lost their jobs or suffered a sharp fall in income.

Government expenditure has continued to increase, particularly social security and health, even though tax revenue has been declining. Superannuation alone has grown from $4.8 billion in the eight months to February 2008 to $5.8 billion in the latest period. Yet the big surge in spending here has yet to occur, as those aged 65 and older will grow from 16 per cent to 32 per cent by 2050.

Health is another area that will be impacted by an ageing of the post-World War II baby boomers. Politicians have some tough decisions ahead because New Zealanders expect to be looked after by the state when they have health problems, regardless of cost.

The other big expenditure areas are core government services ($2.5 billion) and law and order ($2.2 billion). Expenditure in both areas continues to increase year on year.

The second Christchurch quake is a serious setback to the Crown because it doesn't have enough reserves. The Government will be forced to finance the restoration of water, stormwater, sewerage and roads. It will also incur costs of land remediation, wage subsidies, temporary accommodation, community and other support.

Hospitals, schools, state housing and state highways are largely covered by insurance, but the AMI Insurance bailout indicates the Crown may have to help one or two insurance companies to ensure they meet their obligations. These costs do not include the impact of a reduction in tax revenue or other revenues because of the quake.

The Government was originally forecasting an obegal deficit of $8.6 billion for the full June 2011 year but this was raised to $11.1 billion in December. However the deficit is now $1.7 billion in excess of the December forecast, indicating a 12 months' deficit of probably around $15 billion.

That is equal to 7.5 per cent of GDP, compared with an overall OECD deficit average of 5.2 per cent. Greece, Iceland, Ireland, Spain, Britain and the United States are the only countries to have had fiscal deficits in excess of 7.5 per cent of GDP in recent years.

The first four have all experienced recent funding problems, while Britain and the US are in the "too big to fail" category.

The Treasury's half-year fiscal and economic update, released in December, predicted that the obegal deficit would fall to $6 billion in the June 2012 year, $4.4 billion the following year and $1.5 billion in 2013-14. A small surplus is predicted for the year to June 2015.

These forecasts are based on large increases in tax revenue and minimal growth in health, education and law and order expenditure. It is difficult to see how the June 2015 year surplus can be achieved unless the economy has a sharp upturn, there is a dramatic increase in tax revenue - and political leaders make a genuine attempt to curtail Government expenditure.

The Treasury predicts gross Crown debt will climb from $63.4 billion at present to $84.3 billion in June 2015.

This forecast also seems to be on the light side, because Christchurch costs are likely to be higher than expected, the Crown will continue to have fiscal deficits in the June 2012, June 2013 and June 2014 years and it will be required to fund additional capital projects, including roads, hospitals, schools, prisons and other Government facilities.

It is clear that there will have to be more public-private partnerships as far as these capital expenditure projects are concerned because the Crown won't be able to fund these on its own.

The latest Crown financial statements have reignited the debate over Allan Hubbard and South Canterbury Finance because it revealed that there was "a $331 million revision in the estimate of recoveries relating to the deposit guarantee scheme". Most of this appears to be related to SCF.

The Timaru-based finance company was placed in receivership last August after numerous failed attempts to recapitalise it.

The Crown paid $1.58 billion to depositors under its deposit guarantee scheme and the return on this will be highly dependent on the receiver's ability to realise assets, particularly the loan book.

The receiver's only report on SCF to date, which was released on November 1, was relatively uninformative but it indicated that the Crown could expect to get no more than $1.3 billion of its $1.58 billion back, at best.

However, the Crown has now made provisions for expected net losses of $1.1 billion (after recoveries) in relation to finance company collapses.

A high percentage of this relates to SCF.

The second receiver's report, which will be published on or before May 1, should give us more insight into the likely recoveries from Hubbard's finance company.

The Key Government has been hit by the perfect storm in the form of two earthquakes, AMI's problems, the finance company debacles, a weak economy and rising oil prices. The problem is that it doesn't have much headroom to deal with these adversities.

Governments have two choices when they experience a huge blowout in the fiscal deficit and gross debt: they can either deal with the situation by making dramatic spending cuts or let the situation drift and leave the country at the mercy of credit rating agencies and foreign lenders.

New Zealand governments, whether National or Labour, find it very difficult to make the tough decisions because well over 50 per cent of the electorate receive some kind of direct or indirect government assistance. In addition there is a huge resistance to asset sales and public-private partnerships because of our experiences two decades ago.

Brian Gaynor is an executive director of Milford Asset Management.

bgaynor@milfordasset.com