Cameron Preston questions whether the Government's using risky gambling on the movements of interest & currency rates to achieve a surplus

*By Cameron Preston 

This Wednesday the Minister of Finance will announce he has succeeded in his long held goal of getting the Government books back into surplus.

But will it really be a surplus, and will it be one New Zealanders should be proud of?

In 2007 Treasury moved its focus away from the bottom line Operating Balance (OB) as a measure of whether, in any particular year, the Government was in surplus or deficit.

It was recognised that short term changes in variables such as inflation and interest rates would result in large fiscal swings called ‘actuarial gains and losses’ in growing funds such as the Cullen Super Fund and ACC Fund.

These (sometimes volatile) movements were thought to unfairly skew the annual bottom line OB measure as these variables are perceived to be largely out of the Government’s control and neutral over a longer horizon.

So OB was ignored in favour of the more stable and structurally reflective Operating Balance Excluding Gains and Losses (OBEGAL).

Last Wednesday the Accident Compensation Corporation (ACC) announced a large surplus of $1.6bln, twice as much as budgeted.

However closer examination of its books show large costs included in that $1.6bln surplus are in fact ‘actuarial’ losses.

Add these losses together and I conservatively estimate ACC’s OBEGAL surplus for 2015 to be much higher, at least $4.4bln (in comparison to $1.9bln in 2014).

I don’t doubt that ACC have a crack investment team, and ACC’s investment revenue of $4bln (compared to $1.5bln the previous year), will be a welcome shot in the arm to the Crown’s consolidated OBEGAL surplus due out this Wednesday.

But it is what is hidden in this massive $4.4bln ACC contribution to the Crown’s OBEGAL surplus that is interesting.


While many differ over the triggers of the Global Finance Crisis that began in 2008, most agree that the use of complex financial instruments, or derivatives, turned what started as a sniffle into a full blown financial pandemic.

Derivatives are commonly used to hedge against adverse movements in interest rates and foreign currency fluctuations, but as the world found out back in 2008, they can be dangerous, overly complex, somewhat unpredictable and can drive as much risky behaviour as they seek to hedge against.

The valuation of derivatives for accounting purposes is more of an art than a science, because of such, their contract, or notional values, aren’t actually shown on a balance sheet.

ACC’s derivative contract positions, as disclosed in the notes to their accounts, show their exposure has increased from $5.1bln in 2008 to $12.6bln in 2015:

ACC provides a paragraph in their 2015 Annual Report that is designed to ease concerns:

“We are conscious that ACC incurs credit exposure to counterparties when undertaking derivative transactions such as foreign exchange forwards or interest rate swaps. We aim to only use derivatives when there is no equally good alternative. We also have limits and controls governing derivative use and credit exposures.”

However it is not just the ‘counterparty’ that ACC needs to be careful of, later in its Annual Report it states:

“The Investment Committee allows ACC’s internal Investment Unit to vary the actual level of foreign exposure taken by each Account from the benchmark level of foreign exchange exposure, within fixed ranges determined by the Investment Committee. For most of the year ACC maintained a higher level of foreign currency exposure than the neutral levels inherent in ACC’s benchmarks.”

The fact that derivatives are playing a leading role in the country’s return to ‘surplus’ is ironic at best, and alarming at worst.

Only two weeks ago the Reserve Bank announced it was to pay the Crown a special one off $510mln dividend from monies it acquired when it ‘shorted’ the New Zealand dollar back in August 2014, again using foreign currency derivatives.

Soon after that profitable intervention was formerly announced in September 2014, the Prime Minister, somewhat disturbingly, was happy to share views on where he thought the exchange rate should be: “the Goldilocks rate, not too high, not too low, just about right, I don’t know, [US]65 cents maybe” .

In the world of derivative trading, especially forward foreign current contracts, it appears a jolly good wink wink, nudge nudge, from your ex-currency trading PM can be very profitable to your “position”, provided you have taken the right one, at the right time.

I find it naive to think that any government entity with a material interest rate derivative position would have been taken unawares by the Reserve Bank’s “surprise” decision on 11 June to cut the overcooked OCR just prior to the close of the financial year.

While there are plenty of examples of creative moves on the expenditure side of the Crown’s surplus such as delayed Treaty settlements and capitalising or deferring of the recognition of earthquake recovery costs, it would be remiss of me not to mention the fact that Treasury made a policy decision in 2007 to treat actuarial gains and losses for EQC differently to those of ACC.

The result being more than $1.5bln of “unrealised gains” in the reduction of EQC’s liability has positively hit OBEGAL, for the last three financial years, including this one.

Given it appears deeply unfashionable to look at the size of the debt on the Crown’s balance sheet these days, I will spare you my thoughts on such.

But on Wednesday afternoon, as many bask in the glow of the “first OBEGAL surplus since 2008”, ask yourself: is OBEGAL the best measure? And if this surplus has been achieved by profiting from risky gambling on the movements of interest and currency rates, while at the same time ignoring the effect of those adverse movements on the underlying assets on the balance sheet – is this really a surplus New Zealanders should be proud of?


*Cameron Preston is a Christchurch accountant and homeowner who has longstanding unresolved quake insurance claims.