Discrediting the credit-rating threats

BY ROD ORAM

OPINION: One player above all will dominate the National-led government's first budget this Thursday: Standard & Poor's.

The prime minister and finance minister say repeatedly that unless they present an unpalatable budget, S&P could downgrade the government's credit rating.

But is the threat real or phoney?

The Treasury kicked off the issue with its economic forecasts last December. It said the budget deficit was widening fast. A contracting economy meant tax revenues were falling and government spending was rising.

Thus, the government would have to borrow $50 billion more by 2013 to plug the gap. This would raise gross government debt to 39% of GDP by 2013 and 75% by 2025.

But Treasury's forecast was nonsense. It assumed the government would make no change in spending strategy or priorities. Yet Treasury knew that any government, whether National or Labour-led, would have adjusted its fiscal policy.

Nonetheless, S&P jumped on Treasury's forecast and put the government's debt on credit watch. But it was the only one of the three major credit rating agencies to do so. Moody's and Fitch, using different methodology, came to more balanced and reassuring conclusions.

Here's the nub of the conflict between them. S&P bases its sovereign debt ratings on a government's financial performance and wider economic measures such as the current account deficit. In our case, it noted that government debt, even in a worst-case scenario, would be moderate by international standards but our current account deficit was big.

Potentially, it said, we could find it harder to fund the deficit the shortfall between what we earn abroad from trade and investments and what we spend abroad on imports and interest on our very high private sector debts.

Yet, three pieces of evidence overturn S&P's case: the current account deficit is reducing thanks to fewer imports, more exports and reduced borrowing for mortgages and consumer spending; the deficit is financed largely by bank borrowing overseas, not government borrowing; and global financial markets for bank borrowing are showing the first glimmers of recovery.

Thus, argues Moody's, government debt ratings should focus primarily on the government's books.

"We don't think the current account deficit is a huge problem when rating government finances," says Steven Hess, a New York-based Moody's vice-president involved in New Zealand's rating.

The New Zealand government is one of only 18 in the world with the top rating of "Aaa". To understand how those governments' finances are responding to the global economic crisis, Moody's stress-tested their balance sheets and published a report in February.

At the end of 2007, our gross government debt as a percentage of GDP was the third-lowest of the 18 and interest payments were only 3.2% of government revenues. While we are increasing our debt, many other countries are borrowing more because they have to bail out their banks.

The report also analysed ability to adjust to the economic crisis. We ranked 14th of 18, not because of government debt but because of weak scores by the wider economy.

Thus, Moody's concluded, we had only a "moderate" ability to adjust government revenues and spending, and only a "moderate" ability to "grow our way out of debt".

Only two other countries of the 18, Ireland and Spain, also scored "moderate" on both. And both are on Moody's credit watch. But there is an enormous difference between the state of our their economies and finances and ours.

For example, Ireland's GNP (economic activity excluding dividends repatriated by foreign companies) will fall 9.2% this year and unemployment will reach 16.8% next year, according to recent forecasts by the country's Economic and Social Research Institute.

Yet our Treasury persists in making very misleading comparisons. If we were to suffer the same downgrade as Ireland, we could expect to pay an additional 1.5 percentage points interest on our debt, John Whitehead, the Treasury secretary, said 10 days ago in a budget scene-setting speech, the first ever by Treasury.

That would equate to another $600m a year in interest on government debt "the same as two new Wellington hospitals".

By invoking Ireland, and in such emotive language, Treasury sounds like a stooge of the government. Yet, as Moody's analysis shows, we are far from another Ireland waiting to happen.

We have none of Ireland's problems. For example, its banks blew out their assets to six times GDP and so they need tax-funded rescue; and its labour costs are 20% higher than its European competitors.

But Ireland can't use its exchange or interest rates to make the necessary adjustments. It is locked into the regime run by the European Central Bank. Ireland can only adjust by very painfully cutting wages and other costs.

This difference between Ireland and us also shows up on the sovereign financial risk ratings of IHS Global Insight, which rates some 200 countries on a scale of 0 to 100. Our score of 6 equals Australia's and is ahead of Ireland's 9 and Spain's 11.

While our current account deficit is a factor, financial markets are focused on "the need to re-engineer" the private sector side of the economy rather than government debt, says Jan Randolph, IHS's London-based head of sovereign risk.

So we have plenty of work to do to make businesses more internationally competitive and to ensure government finances are sustainable. The work is under way. The government has made some sensible decisions on cutting some spending and almost certainly postponing tax cuts.

But it has made some very bad ones, such as axing the R&D tax credit. Similarly it has replaced the previous government's $700m contribution to the primary sector's Fast Forward research fund with $50m for food innovation. It argued Labour had never allocated the $700m. That's dead wrong. It was sitting in the bank account of the fund's holding company.

By hiding behind the skirts of S&P, the government is dodging the debate about what is good and bad spending.

The chances are very high it will make a lot more bad spending decisions in the budget.

Two very big dangers arise from the government's focus on its debt rather than the private sector's.

First, it will deliver an excessively conservative budget in order to make its books look good. That means it will save money it should be spending at times like this when private sector activity is so weak. This is the classic mistake National made in its budgets in 1991 and 1997, thereby worsening those two recessions.

Second, it will seriously under-invest in economic transformation, the very thing the private sector needs so companies and their employees can earn a bigger living in the world economy, and thereby pay down some of their towering debts.

Thus, the government is making the economy worse, not better, by conjuring up the spectre of an S&P downgrade.

 

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