The Minister of Finance and The Treasury appeared before Parliament’s Finance and Expenditure Committee yesterday. It was encouraging to see National MPs asking questions about the Reserve Bank’s Large Scale Asset Purchase programme, which was undertaken with the agreement of both the Minister and The Treasury and which has now run up staggering losses for the taxpayer.
A standard way of estimating those losses is the mark-to-market valuation of the Bank’s very large LSAP bond portfolio. As of the latest published Reserve Bank balance sheet, for 31 October, those losses were about $5.7 billion. When the 30 November balance sheet is out, probably next week, the total losses will be lower (bond rates fell over November), but with a very large open bond position still on the books taxpayers are exposed to large fluctuations in the value of the position (up or down), with no good basis for supposing that the expected returns are likely to compensate for the risk involved. If there was a case for putting on a large open bond position early last year – I doubt it, but take that as a given for now – there is no case for one now, in a fully-employed economy with rising inflation, and with the conventional instruments of monetary policy – which expose taxpayers to no financial risk – working normally and effectively.
A post from a few weeks ago set out the issues.
I didn’t watch the whole 2 hours (link to the video above) but from exchanges with various people I think I have seen all the questions and answers relevant to the LSAP issues.
First, at about 43 minutes in, National’s Andrew Bayly asked the Minister of Finance (a) why, when Crown indemnity was approved the Minister did not then require a plan for unwinding the position (the Bank is currently talking about having a plan early next year, almost two years on), and (b) why there was no limit to the indemnity.
I’m not sure either question was that well-targeted, and the Minister had no real trouble responding. As he noted, the LSAP programme had been initiated in the middle of a crisis, time was short etc. And although there isn’t a limit on the indemnity itself there is a limit of how many bonds can be bought, and the government determines which bonds are on issue which amounts to much the same thing. That said, both responses take as more or less given that the idea of an LSAP had never occurred to anyone on any corner of the Terrace/Bowen St triangle until late March 2020. We know the Bank had been (rather idly) talking about the option for several years, including saying they’d prefer not to use it, but it seems they had not done the hard ground work, and neither had The Treasury nor the Minister insisted on it, well in advance. There is no sign any cost-benefit analysis for something like the LSAP was ever done, no analysis of likely Sharpe ratios, no analysis of potential peak taxpayer losses and so on. The Bank should be held accountable for that, but…the Minister is primarily responsible for holding them to account, and The Treasury is the Minister’s principal adviser (and the Secretary is a non-voting member of the MPC).
After the Minister left, Bayly returned to the LSAP (at about 68 minutes), supported by National’s new finance spokesman Simon Bridges. Bayly asked the Secretary to the Treasury whether an increase in the OCR would increase the liability for the Crown for the indemnity. The Secretary responded that the indemnity was net neutral from a whole of Crown perspective. What followed was a slightly confused discussion with Bridges ending up suggesting that the Secretary was “plainly wrong”. I don’t think the Secretary answered well, and she certainly didn’t answer in a way designed to help clarify the issues around the LSAP, but she is correct that the indemnity itself does not affect the overall consolidated Crown financial position (the claim the Bank currently has on its balance sheet is fully offset by an obligation the (narrowly defined) central government has on its balance sheet. It is quite likely that without the indemnity the MPC would have been very reluctant to have run a large-scale LSAP programme (the Bank’s own capital would not support the risk), but once the programme was established what determines the financial gains or losses is, in short, just the movement in market interest rates. The indemnity just reallocates any losses within the wider Crown accounts. In that particular exchange, The Treasury made none of this clear, and Secretary herself seemed a bit confused when the discussion got onto the different ways the bond position might eventually be unwound (there is little or no indemnity if the bonds are held to maturity, but that doesn’t mean there are no costs to the taxpayer). And thus (reverting to Bayly’s initial question) an increase in the OCR – particularly one now expected – doesn’t itself change the Reserve Bank’s claim under the indemnity
About 25 minutes further on, Bridges returned to the fray and a rather more enlightening conversation followed. Bridges asked whether the LSAP did not represent a significant increase in Crown financial risk. The Secretary agreed and both she and one of her colleagues explained – as I have here repeatedly – that what had gone on was that the Bank had bought back long-term fixed rate bonds, effectively swapping them for the issuance of settlement cash, on which the interest rate is the (variable) OCR. Unfortunately some of the discussion still got bogged down in matters of Crown accounting (the difference between the purchase price of the bonds and the face value, which is of no economic significance), and the Secretary was very reluctant to allow herself to be pushed into acknowledging that the position of the LSAP portfolio – implemented with her support – is deeply underwater. As a simple matter of analysis, she was never willing to distinguish between the mark-to-market loss to now, and the potential gains, losses, and risks on continuing to hold a large open position from here on. One is a given – now a sunk cost – and conflating the two (in the hope “something will turn up”) obscures any sense of accountability, including for the choices to keep running the position. She and her staff wouldn’t accept that sort of explanation from any other government agency running large financial risks.
Were the position to be liquidated today – as, at least in principle (crisis having passed, economy full-employed) it should be – a large loss for the taxpayer would be realised. At a narrow financial level it is as simple as that. If the position continues to be run – in the limit through to maturity, finally in 2041 – what will matter is where the OCR averages relative to what is currently priced into bond yields, but it won’t change the fact that the portfolio is starting behind – the OCR is already much higher than was expected at the time most of the bonds were bought. And if the portfolio is let continue to run, taxpayers are exposed to ongoing large risk for no expected return (there is no reason to suppose the Bank is better than the market at guessing where the OCR will need to go over the next 10-20 years).
(The current agreement between the Minister and the Bank requires that if the Bank looks to sell the LSAP bonds it do so only to the Treasury itself. Such a sale, of course, changes nothing of economic substance (purely intra-Crown transactions don’t) – the high level of settlement cash balances would still be there, earning whatever OCR the macro situation requires – but from a political perspective it would be convenient, as there would no longer be monthly updates on the Bank’s website as to the extent of the losses caused by the MPC’s rash choices (backed by The Treasury).
Treasury officials did chip in a couple of caveats. First, the Secretary noted that in assessing the overall LSAP programme one had to look also at the (any) macroeconomic benefits. In principle, of course that is correct, but (as I’ve argued previously) any such gains are unlikely to have been large:
- the LSAP was designed to lower long-term bond rates, but these are a very small element in the New Zealand transmission mechanism,
- it is hard to see much evidence here or abroad of sustained effects of LSAP-like programmes on long bond rates (eg movements beyond what changing expectations of future OCR adjustments themselves would simply),
- the Bank always had the option of cutting the OCR further (on their own telling, to zero last year, and lower still since the end of last year), at no financial risk to the taxpayer, and
- if there is a macro effect, perhaps it was modestly beneficial last year, but must be unhelpful now (recall that the literature suggests it is the stock of bonds that matters, not the flow of purchases, and we now have an overheated economy with above-target inflation.
And one of her deputies chipped in noting that there might have been some savings to The Treasury from having been able to issue so heavily at such low rates last year, the suggestion being that without the LSAP the Crown might not have been able to get away so many bonds so cheaply. There is probably something to that point, in an overall accounting, but (a) the effect is unlikely to have been large relative to the scale of the subsequent rise in bond yields, and (b) especially with hindsight a better model would have been for the Bank not to have been purchasing bonds and the Crown to have been issuing fewer.
The Select Committee discussion ended with the offer that National MPs could lodge a follow-up question for written response by the The Treasury. I hope they avail themselves of that offer.
The Treasury could be, and should be, much clearer and more upfront about the analytics of the LSAP issues, but it isn’t clear – given their involvement all along – that their incentives are in this case that well-aligned with the interests of the public in scrutiny, transparency, and accountability.
13 thoughts on “LSAP losses”
The first loss was already incurred in the setup costs of the NZ QE. RB paid a market premium price ie $59b for $54b worth of bonds. It is incorrect to say that $59b has no economic effect because the Banks have already booked a $5b profit in March 2021 recording between 40% to as high as 74% record profits above March 2020. You also need to stop using the term “Settlement Cash Account” because it misleads every dumb NZ economists and journalists out there who think the RB undertook money printing. Lets be very clear, the Settlement Cash Account is a Liability account. A Liability is an IOU cash account. Not a I paid U cash account. RBNZ QE was debt driven and not money printing.
Bit of a mess but assuming monetary policy can be effective even with the current stock of LSAP holdings (which seems likely given the exposure of household/business sector to short term rates), what is the best option for the bond portfolio to minimise taxpayer risk/loss?
Probably either (a) the Bank sells the bonds back on market in a announced predictable schedule of auctions (perhaps over 18-24 months) or (b) they sell the portfolio back to Treasury and DMO,in effect, replaces the bonds by increasing issuance, again over some mid-length period.
Holding to maturity just means running unnecessary risks for up to 20 more years, and of course, liquidating the portfolio v quickly would push pricing systematically against the taxpayer.
b) above is consistent with the current indemnity agreement, altho in principle – RB operational independence etc – I’d prefer a). In substance, prob not a great deal between them.
Although Michael is reluctant to admit it, the fact that the indemnity requires RBNZ to sell its bonds back to the Treasury means no losses will show up anywhere on the government books. So all this talk of $5.7 billion losses is scaremongering. The only cost involved will be opportunity cost I.e. the Treasury will have to use most of the cheaply raised $38 billion it currently has on hand to buy the RBNZ bonds and then replace that funding by issuing more expensive bonds. But “opportunity cost” is not an item that will show up in government accounts.
Simply disagree. Even if the LSAP bonds are held to maturity there will ( in expected value terms based on the current yield curve) still be an adverse impact on the Crown accounts, in the form of reduced RB profits and lower dividends to the Crown (reflecting the higher expected interest rates on sett cash than was implicit in the yield curve at the time the bonds were purchased).
True, carry costs on the RBNZ portfolio will grow as the OCR rises. But I think the program will be unwound before that has much effect. In effect, Treasury sold bonds to RBNZ at an average price of, say, $100. Today those bonds are worth $90. So, using some of its $38 billion cash on hand, Treasury buys those bonds back for $90, booking a $10 profit. RBNZ books a $10 loss on the sale. Under the indemnity, Treasury transfers its profit to RBNZ. All square………….the RBNZ, with the funds it received from selling its bond holding, reinvest the proceeds in newly issued short-dated Treasury Bills. The RBNZ gradually sells these to the banks to clear out their excess settlement account balances. So Treasury gets its $38 billion back, the RBNZ has switched from holding long-dated bonds to short dated T Bills, and no “loss” appears anywhere in Crown Accounts. Everyone’s a winner !
No, that’s not how it works.
LSAP purchases of NZ Government Bonds is approx. $53.5bio. On a stylized basis so as to simplify things, and assuming the RBNZ bought the bonds roughly at the price where the NZDMO issued, then the RBNZ balance sheet would look like this:
Asset :$49.7bio LSAP ( at Fair Value) + Indemnity – $3.8bio.
Liability: Crown Settlement Cash -$38bio & ESAS balance $15.5bio
The Treasury/NZDMO would see this:
Liability: $53.5bio Bonds (at Cost)
Liability: $3.8bio for Indemnity
Asset: $38bio Crown Settlement cash.
Again, recognising the oversimplification on a pro-rata basis 71% ($2.7bio), of the indemnity could be attributed against the Intra-Government ( CSA balances) position with the rest ($1.1bio) against ESAS balances.
The Crown could ‘exchange’ its $38bio of cash (CSA) for Bonds, but it would still leave LSAP holdings of $15.5bio on the RBNZ’s balance sheet, with a loss of $1.1bio.
This would be the new position:
Asset :$14.4bio LSAP ( at Fair Value) + Indemnity – $1.1bio.
Liability: Crown Settlement Cash -$0. & ESAS balance $15.5bio
Liability: $15.5 bio Bonds (at Cost)
Liability: $1.1bio for Indemnity
There is no buying of T Bills, it would mean the balance sheet wouldn’t balance.
Well, regardless of the accounting treatment, it appears “J” agrees that the Treasury’s $38 billion cash on hand can be used to buy back RBNZ bonds at market (with the Treasury’s gain on buy back offsetting the RBNZ’s loss on sale) leaving $15.5 billion bonds on the RBNZ balance sheet. Large maturities begin in early 2023 so it’s likely the RBNZ will just let those bonds mature. The OCR could be close to 2% by then but the average carry cost since LSAP began would probably roughly match the yield being earned on the bonds.
As a point of clarification, the indemnity used number isn’t the current level which is actually $5.67bio as at 31 October 2021, but the concept is scalable based on the current quantum of LSAPs & CSAs.
However, while the Crown could use its CSA Balance in ‘exchange’ for a portion of the RBNZ’s LSAP holdings, it also has to retire or rollover maturing bonds which are privately held. The table below shows LSAP holdings along with the outstanding amounts of particular lines of stock. The cumulative maturity amount indicates, all else being equal, how quickly the $38bio CSA balances could be run down unless the Crown issues more debt and/or it posts positive Core Crown Residual Cash numbers in the years ahead.
Additionally, rather than allowing a natural run off, should the RBNZ sell the bonds directly back to the Treasury before maturity it would reduce the ‘float’ in lines of bond stock potentially causing market dysfunction, in turn generating refinancing (funding) risks for the Crown.
Your comment on the carry is odd: Looking at the coupons on the bonds issued last year (25bps to 50bps), indicates the yield on the RBNZ’s LSAP holdings is in that vicinity. So, should the OCR rise to 2%, as you indicate, then the cash flow implications will be that the RBNZ will remunerate (pay) ESAS balances at 2%, whilst generating revenue of only 50bps on their LSAP bond holdings. This will, in effect, be a net-expense for the Crown – this is what happens when you swap a fixed rate debt for a floating rate debt.
In its very simplest form, the LSAP programme creates risks, along with associated costs, to the Crown’s balance sheet– that would seem to be an immutable fact.
Bond Issue LSAP Amount On Issue Cumulative Amount
Apr 2023 7,471 15,945 15,945
May-2024 5,130 13,400 29,345
Apr-2025 6,363 13,450 42,795
Sep-2025 615 5,200 47,995
May-2026 930 5,800 53,795
Apr-2027 6,350 11,900 65,695
May-2028 930 5,800 71,495
Apr 2029 7,000 13,800 85,295
Sep 2030 570 4,200 89,495
May 2031 5,216 11,700 101,195
Apr 2033 3,780 8,250 109,445
Sep 2035 402 4,300 113,745
Apr 2037 4,563 10,100 123,845
Sep 2040 580 4,950 128,795
May 2041 2,100 6,100 134,895
Well yes, my point all along has been that while the loss on the LSAP can mostly be accounted for internally between Treasury and RBNZ, there will be an opportunity cost i.e. if Treasury use the cheaply raised $38 billion it has on hand, it will need to replace that at the current higher rates. But “opportunity cost” won’t show up anywhere in government accounts.
As for the carrying costs on the shorter dated bonds the RBNZ decides to hold to maturity rather than sell back to Treasury, it seems we don’t know what the yield on the portfolio is. What we do know it was carried for at least 12 months at an OCR of 0.25%, then a couple of months at 0.50%, now for another three months at least of 0.75%. If the OCR eventually rises to 2% in a year or so (a big if) before the short-dated bonds mature, then the average carry cost will probably end up being around 1%, not far off where the average yield on the portfolio is.
When New Zealand can no longer afford to pay off its debts, you will see what the country’s backbone is truly made of. Can it withstand fiscal disruptions of a magnificently tall order, or will it collapse into chaos and artificial ruin?
Isn’t this all accounting tricks? It’s the government lending to itself. If there is no need to pay it off and it can be kept on the books in perpetuity- is that really debt? For there to be debt, there needs to be money owed to an external party. Typically, small countries cannot do this without a run on the currency with the resulting devalued purchasing power. But because everybody was doing it, relatively, we were fine.
I think relative real costs occur if the government decides to pay back the Reserve Bank for ‘temporary borrowings’ for money created from thin air, that will result in loss of money from the system?
Although I am usually fiscally conservative, this program has allowed the government to convert the real debt, i.e. debt owed to others, into fake debt. It’s analogous to money owed to your parents but with no expectation of repayment, with the understanding that you will inherit their assets.
So I don’t really understand those that say the program is costing the taxpayer money. In my mind, it has taken the once-in-a-lifetime opportunity to reduce external debt.
Or have I misunderstood the program?