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.