An establishment perspective

John McKinnon is a quintessential New Zealand establishment figure.  He fairly recently returned from a second stint as New Zealand’s Ambassador to the People’s Republic of China, and between those two stints he was first Secretary of Defence for several years and then head of another of those taxpayer-funded influence organisations, the Asia New Zealand Foundation.   And that is not to speak of the extensive family connections, including his brother, the former Deputy Prime Mininster, former Commonwealth Secretary-General, and current chair of the (largely) taxpayer-funded New Zealand China Council.

Having relatively recently retired, McKinnon is now free to speak more openly than during his official career.

On Saturday, McKinnon was interviewed on Newshub Nation about the relationship between the New Zealand government and the authorities of the People’s Republic of China.  It was fairly soft interview – so he was never put on the defensive – and the former ambassador was fluent and endlessly emollient. In many ways, it was quite impressive.  MFAT will have appreciated it, as will senior figures in both government and opposition.  He did far better in spinning a quasi-official line than either the Prime Minister or the Minister of Foreign Affairs could have done.  The Executive Director of the China Council was particularly impressed

And to many, what McKinnon had to say  probably sounded quite plausible.  He has an impressive way with words, sounding very calming without actually saying much.  Thus, we shouldn’t read “too much” into the long-delayed visit for the Prime Minister to Beijing, but presumably it is okay to read something into it.  “It will happen” we were told, but “not necessarily soon”.

The relationship was not, in his words, “in trouble” but “changes are afoot, in China, in New Zealand and in the world”.  “Navigating the relationship” has become “more difficult, more complex”.    There was the occasional reference to our “very different” political and social systems, but it wasn’t clear that Mr McKinnon thought these differences should make any difference to the relationship.  There had been, we were told, lots of conversations in private about things like the South China Sea and it was, on his telling, “helpful” (to whom, for what) to have these “private diplomatic exchanges”.   Treating the PRC –  arch-abuser of human rights, military expansionists of this century –  as some sort of normal country, we were told that New Zealand ‘respects’ PRC concerns, even if we don’t always agree.  Which sounds good I suppose until one remembers what sort of concerns they have –  taking Taiwan, imprisoning a million people in Xinjiang, systematic denial of political or religious freedom, claims that overseas ethnic Chinese have obligations to Beijing, state-sponsored intellectual property theft, and so on.   (Why, if they were serious about an open and reciprocal relationship, the PRC might even have condemned their former national and former intelligence official, Jian Yang, for bringing the good name of the PRC into disrepute by misrepresenting his past on his immigration/citizenship forms.)

And so the emollience went on. It was good that David Parker had been invited to, and would attend, next month’s Belt and Road Forum –  this PRC geostrategic initiative, that seems to have contributed to the intensified repression in Xinjiang.  Good for what one could wonder, except perhaps to reinforce the message last month when the Prime Minister made obeisance to Madame Wu.    Don’t worry, we’ll come quietly.

What of the sought-after upgrade to the preferential trade agreeement with the PRC?  It was not, the former ambassador thought, “at risk” but was “challenging” –  which does have the feel of reframing and re-expressing much the same thought.   It was, he accepted, harder than in 2008.

And the interview ended on an upbeat note.  We might have a very different background and history but the PRC could quite reasonably claim to have (the old line) lifted more people out of poverty than any other society in history.  Which isn’t much claim to fame when (a) you are the biggest country (population) in world history, (b) you immiserated your people (indifferently allowing tens of millions to die) for the first thirty years of your regime, and (c) even now, the material living standards of your people languish far behind the leading east Asian economies (including the one facing a constant military threat from you).  McKinnon did note that, of course, human rights matter.  In what sense –  given the rest of the interview –  wasn’t clear.

Between interviewer and interviewee it was in many ways an impressive performance.  Had many people been watching, who were not familiar with the story beyond recent headlines, it would probably have served the cause of emollience –  go back to sleep, nothing to worry about here.  As it is, I suspect it mostly had value for making those who’ve already thrown in their lot with the “never ever upset Beijing” line feel a bit better on a Saturday morning.  Thus Jacobi’s praise.

In a sense, you can’t blame McKinnon too much.  He’s been a career diplomat, and if he had some hand in shaping the New Zealand government’s approach to the PRC over the years, mostly he has been sent abroad to do the bidding of successive governments. MFAT might be a problem, but responsibility ultimately rests with successive governments. McKinnon on Saturday was about as on-message as he no doubt was throughout his stellar career.   And you can’t really expect him to answer questions he wasn’t asked: not only was there nothing about Taiwan or Xinjiang (“don’t you find shaming, Mr McKinnon, to serve governments that keep quiet in face of such evil?), let alone the PRC activities closer to home, or Messrs Jian Yang and Raymond Huo.  That will have suited the government and officialdom.  But McKinnon is still evidently very much with the programme.  I don’t suppose political party donations are his focus, but trade will have been….and other stuff only to the extent it couldn’t be avoided.  Perhaps when his older brother retires he’ll be considered as next chair of the China Council?

The bottom line for now is that there doesn’t seen to be any material disruption to trade or related matters.  If PRC student numbers and residence visa numbers are down, that has been underway for some time, and most likely not related at all to the recent heightened “complexities” in navigating the relationship.  That’s mostly good of course, and yet the great flurry of concern last month –  led from the craven National Party side –  was a reminder of how readily New Zealand governments seem able to be brought to heel, at the merest hint of a fluttering of the feathers.  That is more concerning.

The interview with McKinnon reminded me of a speech he had given late last year, after he had retired, to the New Zealand Institute of International Affairs.  I meant to write about it at the time, but one thing succeeded another and I’d never got round to it.

The speech is worth reading. It is interesting, and much the most impressive example of its genre (New Zealand establishment re the PRC) I’ve read.  Rereading it today over lunch I was struck by that same effortless emollience we’d seen in Saturday’s interview.  He is very skilled, and still very much the bureaucrat –  he’s retired now, but it was hard to see anything in the speech that he might not have said as Ambassador in Beijing.  And so much skill was devoted to minimising, time after time, the evil of the regime in Beijing and its representatives and champions.

Predictably, the New Zealander Rewi Alley who lived in Beijing for decades under the PRC and wrote propaganda defending its evil gets a positive mention.    Any possible “unfair exploitation of the multilaterial trading system” is “beside the point”. If there is any worry in New Zealand about what Beijing gets up to here, well that seems to be of concern mostly for making life tougher for bureaucrats and politicians (“making for a more complex China policy making environment than we have had hitherto in this country”).    Endlessly understanding too, passing on the message that Beijing “would be troubled” if any measures singled it out –  that suggestion again, that the PRC is just another normal state.    The elevation of Xi Jinping Thought wasn’t a concern, but a sign that “China can evolve”, and while he couldn’t exactly bring himself to praise the decision to remove the term limits for the PRC presidency, he wouldn’t criticise it either, and noted that it did have the upside of aligning the state rules with those for the Party.  He’s good is McKinnon.

He goes on to note that the PRC is now “an internationalised society, where information abounds”.  Just so far as that is information the Party wants people to have, but a shame that the blocks on various social media platforms, major foreign media websites, let alone the re-intensified censorship of domestic opinion didn’t get a mention.   “Arbitrary actions by the state” might look odd to New Zealanders but, he tells us, we have to understand what China has gone through.   The other side of the civil war eventually turned itself into a robust prosperous democracy, but even in retirement McKinnon couldn’t acknowledge the relevance of that.

What of suggestions of PRC interference (“a very contentious debate”) in other countries, and with ethnic Chinese abroad?  Well, none of this should be at all surprising we are told (apparently because a few overseas resident Chinese many decades ago had previously played a role in developments back in China), and shouldn’t (it seems) be troubling to us (or, presumably, the ethnic Chinese, citizens of other countries, on whom the pressure is put).  On that sort of logic, presumably it would be just fine for New Zealand to be seeking to interfere in the domestic politics of the UK –  look at the difference those Brits made here.

As for New Zealand

I have more confidence than some that in New Zealand [I don’t presume to speak for other countries] we have the wherewithal in terms of our law, practices and values to respond if we need to, and to deal constructively with both allegations and facts of interference, whatever country they come from, and so far as China is concerned, in a manner which is in accord with the mutual respect that subsists between us.

But Jian Yang is still in our Parliament, not (at least in public) something that seems to bother either main political party.  Raymond Huo does still chair the Justice Committee and the electoral inquiry.  Wealthy business people, with close ties to Beijing, secure royal honours, in effect for services to Beijing.  The Chinese language media is largely controlled from Beijing.  Ethnic Chinese here comment on the climate of fear many face if they speak up at all.    But the former Ambassador is confidence there is nothing to worry about.  After all, their government respects us (yeah right) and our governments respect them (well, do the kowtow).

And still it goes on.  There is a recognition that New Zealand and China disagree on the South China Sea (although has our current PM ever stated a substantive view on that?) but then the construction and militarisation of artificial island is itself relativised with the totally irrelevant observation that (good guys like) “the Dutch are past masters at it”.  Antarctica?  Anne-Marie Brady has written extensively about PRC interests in polar regions, and some of the threats that poses. For the former Ambassador, just a case of “China is now more present in …Antarctica than it was 10 or 20 years ago”.

New Zealand apparently has little interest in such issues as theft of intellectual property, subsidisation of SOEs, access to the Chinese market for services exporters –  someone else’s problem apparently.  Meanwhile, in perhaps the most obeisant quote in the speech  there was this

New Zealand, as a country which invests in and benefits from the international rule of law, has expectations of China, as it does of other great powers.  That they will comport themselves appropriately, especially towards those who have less power than themselves.  That is the true mark of greatness.  It is pleasing to see how China has responded to these expectations

Unbelievable. The same state that only two months later our own intelligence services would accuse, in a joint effort with other countries, of state-sponsored intellectual property theft.   Most observers believe the recent cyber attacks on Australian political parties and the Parliament was directed from, and for, Beijing.   One could go on of course.  Some “marks of greatness”.

Relativising to the end, we are told it is important to realise how different we are

China is of course very different from New Zealand…  It is important to realise this, as without this understanding we can be blindsided by aspects of China, especially in areas such as the definition and protection of human rights and the like, where our values are very far apart, and where we see or hear of developments in China which are at odds with those of our own.

It isn’t as if Chinese people want repression, abhor democracy, regard the rule of law of law as some irrelevant concept, and have no interest in speaking up and speaking out.  The big differences that count aren’t those between New Zealanders and Chinese citizens, but between New Zealanders, decent people of all races and ethnicities, and the PRC Party/state.  It is as if the retired Ambassador is invoking some quaint trope about the inscrutable oriential, rather than just playing defence for a near-totalitarian evil regime, lest any concerns threaten the flow of dollars (deals and donations).

McKinnon ends noting it doesn’t matter how much we agree (actually, it usually does –  decent enduring relationships, between individuals and states, are usually based on a set of shared values) but on how much “mutual respect” and “mutual benefit” there is.   Ambassador McKinnon can respect the butchers of Beijing –  this 60th anniversary year of the suppression of  the Tibet rebellion, 40th anniversary of Tiananmen Square, 70th anniversary of the regime itself – but I suspect few New Zealanders would choose to do so.

I’m a retired bureaucrat myself, so I can admire the technical skill of a well-honed, nicely rounded, piece of bureaucrat-speech: it is fluent, apparently thoughtful, and emollient.  And yet in a cause that decent people really shouldn’t be championing and defending.  You can –  as McKinnon does –  seek to relativise and minimise almost anything, but to what end?  Other than keeping the deals and donations going.

Late last year, I ran this extract from a speech by the (soon to be former) Australian Prime Minister, Scott Morrison

Our foreign policy defines what we believe about the world and our place in it.

It must speak of our character, our values.  What we stand for. What we believe in and, if need be, what we’ll defend. This is what guides our national interest.

I fear foreign policy these days is too often being assessed through a narrow transactional lens.   Taking an overly transactional approach to foreign policy and how we define our national interests sells us short.

If we allow such an approach to compromise our beliefs, we let ourselves down, and we stop speaking with an Australian voice.

We are more than the sum of our deals. We are better than that.

Wouldn’t it be great if our politicians really acted as if they believe that, especially in their dealings with the PRC.  And found a new crop of officials at MFAT who would effectively implement such a policy.

In defence of capital charges (and higher public sector discount rates)

I don’t usually see the National Business Review but a copy of the latest issue turned up at home and I flicked through it on Saturday afternoon.  On page 2, I found a very strange article, in a column called (Tim) “Hunter’s Corner”, about health funding and (in particular) the application of the “capital charge” to DHBs.  It is, we are told, a “knuckleheaded approach” and should, in Tim Hunter’s view, be abolished.

Capital charges have been around for a long time now, since 1991 in fact.  Here is one description

The charge is levied on the net worth (assets minus liabilities) of departments and some Crown entities. The assets are assessed on the basis that they are valued in financial statements and may include buildings and other fixed assets, cash appropriated for depreciation or held as working capital, inventory, or receivables. The capital charge represents the opportunity cost of money – what the government can expect to earn in alternative investments entailing similar risk. It may be thought of as an internal rate of return on the government’s investment in its own entities.

and here is one articulation of the point of the charge

The capital charge has a dual purpose: it signals that capital is not costless and should be managed as would any other cost of production, and it spurs managers to include the cost of capital in comparing the cost of outputs produced by government entities with the cost of obtaining the outputs from outside suppliers. The charge puts internal contracting on the same footing as contracting out and encourages full cost recovery of outputs sold to governmental or private users.

It has always seemed eminently sensible to me.  Don’t charge for the cost of capital and government agencies will be incentivised to use lots of it, and to do things themselves that might be more efficiently provided by private sector firms (whose owners will, reasonably enough, expect to cover the cost of capital).   Without a capital charge, any hope of limiting those tendencies requires (even) more centralised adminstrative edicts.

I couldn’t see any information on The Treasury’s website about the current rate of captial charge, so I’ll take Mr Hunter’s word for the fact that it is “typically about 6-8%”.    Eight per cent (nominal) is the standard discount rate Treasury recommends for project evaluation.

So what bothers Mr Hunter?  His article seems to imply that capital charges squeeze the funds available to deliver health services to the public.  Waive them and suddenly DHBs will have more money.  Except that, were capital charges to be scrapped, one would expect to see an entirely-commensurate drop in central government funding to DHBs.  Of course, the Crown could decide it wanted to spend more on health service delivery but logically that is a quite different decision.  One can increase health spending with or without the capital charge.  All else equal, just scrapping the capital charge would increase the overall government deficit, and it would weaken the incentives in government agencies for capital to be used wisely and abstemiously.  Crown capital costs –  and that costs fall on citizens and taxpayers.

Hunter also seems worried about incentives

“…charging 6-8% on net assers provides an incentive to sell property and lease it back where the rental cost is below the capital charge”

Indeed, and so long as the capital charge is designed reasonably well, that is a feature not a bug.  Recall that the purpose was to help efficiently allocate resources and not artifically favour in-house solutions.

Getting still more specific, he goes on to argue that

“However, the actual cost to the Crown of the capital is more like 2% (the latest bond tender achieved a weighted average yield of 1.8%) and the chances of a DHB achieving a lease cost at or below that level are zero.  This means the capital charge incentivises the DHB to increase the actual cost to the Crown.”

It has to be pretty worrying that a senior business journalist thinks an appropriate measure of the Crown’s cost of capital is the rate it can raise debt at.

Just as for any private sector entity (businesses most obviously, but the concept applies more broadly), the cost of capital is better represented by some weighted some of the cost of debt and the cost of equity.    That is what The Treasury is trying to mimic in its recommended discount rates (and, I assume, in calculating rates of capital charge).  You can see the various assumptions (including the equity risk premium and leverage) laid out at the link.

The fact that the Crown doesn’t pay dividends and isn’t listed on the stock exchange doesn’t change the fact that equity capital has a cost.   When the government takes our money – and that is how the government raises equity, coercively through the tax system –  we can’t use that money for other things.   As citizens we, presumably, expect them to use that money wisely, and at least as well (for things at least as valuable) as the alternative options we have open to us.  Opportunity cost matters.    And, of course, the Crown’s cost of issuing debt isn’t just kept modest by the actual equity the Crown has accumulated, but by the ability of the Crown to raise our taxes whenever necessary to service the debt.   Lenders know that; in fact, they count on it.   And yet in evaluating state projects that option cost (to citizens) isn’t internalised.

I wrote a post a few years ago on the question of what price we should put on government projects.  Here are a couple of key paragraphs.

The Reserve Bank of Australia recently ran an interesting and accessible Bulletin article on the required hurdle rates of return that businesses use in Australia.  They report survey results suggesting that most firms in Australia use pre-tax nominal hurdle rates of return in a range of 10-16 per cent (the largest group fell in the range10-13 per cent, and the second largest in a 13-16 per cent band). Recall that nominal interest rates in Australia are typically a little lower than those in New Zealand, and their inflation target is a little higher than ours.   In other words, it would surprising if New Zealand firms didn’t use hurdle rates at least as high in nominal terms as those used by their Australia peers.     The RBA reports a standard finding that required rates of return were typically a little above the firms’ estimated weighted average cost of capital. The literature suggests a variety of reasons why firms might adopt that approach, including as a buffer against potential biases in the estimated benefits used in evaluating projects.

As a citizen, it is not clear why I would want to government to use scarce capital much more profligately than private businesses might do. I use the word “profligately” advisedly – using a lower required rate of return puts less value on citizens’ capital than they do themselves in running businesses that they themselves control.  And if the disciplines of the market are imperfect for private businesses (as they are), the disciplines on public sector decision-makers to use resources wisely and effectively are far far weaker. Fletcher Challenge took some pretty bad investment decisions in the 1980s and 1990s: its shareholders and managers paid the price and the firm disappeared from the scene (along with many more reckless “investment companies”). The New Zealand government, architect of Think Big debacle, lives on – citizens were the poorer, but ministers and officials paid no price.

And here was a chart from J P Morgan that I used in a recent post

hurdle rates

I also noted

If anything, there are several reason why governments should be using higher discount rates than private citizens would do:

  • Governments raise equity (“power to tax”) coercively rather voluntarily, and effectively impose near unlimited liability on citizens.
  • Governments are subject to fewer competitive pressures and market disciplines to minimise the risk of resources being misapplied.
  • Many government investment projects exaggerate the exposure of citizens to the economic cycles (the projects go bad when the economy goes bad)

The last of those isn’t really relevant to use of capital in the health sector, but the other two certainly are.  They represent what looks like a pretty good case for requiring something well above 8 per cent to used in evaluating public sector capital projects, both when seeking new funding from the government, and when making ongoing management choices within organisations.

Note that none of this is about taking a view on the appropriate level of health services the public sector should provide, it is simply (but importantly) about helping to get closer to recognising the true costs and risks associated with the capital devoted to funding these services.

There is no perfect system for allocating capital, whether within a private multinational company, or within a government.  “Perfect” is never the relevant benchmark.  But if the capital charge regime isn’t perfect –  and that is almost inevitable –  we are materially better off with it than without it.   I hope the Minister of Health pays no attention to the siren call from Tim Hunter to scrap capital charges, at least as they apply in the health system.    There is probably a stronger case to scrap DHBs themselves, but even if that were done much the same challenges around the efficient use of capital, getting the best mix of labour and capital, would still face health system managers and those funding them.   Capital costs, and those (true) costs are quite high, especially when politicians and public officials are making the decisions, and rarely face sufficiently strong incentives to utilise capital as efficiently as possible.