11 New Zealand1
- International Monetary Fund
- Published Date:
- August 2003
The New Zealand Debt Management Office (NZDMO) was established in 1988 with the aim of improving the management of risk associated with the government’s debt portfolio. It is responsible for managing the government’s debt, overall net cash flows, and some of its interest-bearing assets within an appropriate risk management framework.
This chapter outlines the evolution of public debt management in New Zealand, the portfolio and risk management framework in which the NZDMO operates, and the development of the market for government securities.
Developing a Sound Governance and Institutional Framework
Objective of the NZDMO
The objective of the NZDMO is to maximize the long-term economic return on the government’s financial assets and debt in the context of the government’s fiscal strategy, particularly its aversion to risk. That objective requires the NZDMO to balance the likely risks incurred in minimizing cost.
In terms of managing the government’s debt portfolio, the NZDMO adopts a risk-averse approach for a number of reasons. For instance:
Evidence suggests that individuals tend to be risk averse in their decision making and expect the government to reflect that preference in managing its interests.
Losses incurred in the government’s portfolio impose costs that taxpayers are unable to avoid.
The government does not have a competitive advantage over other market participants in attempting to derive excess returns from its portfolio management, except for its privilege as an institution exempt from taxation and regulation, which the NZDMO does not consider ethical to exploit.
The debt management objective has changed through time, with earlier versions placing an emphasis on risk reduction. That position reflected the significantly higher net debt levels in the late 1980s and early 1990s and the fact that nearly half of the debt was denominated in foreign currencies. Since then, net debt has been reduced by 65 percent, and foreign-currency exposure has been eliminated.
Responsibilities of the NZDMO
The NZDMO’s major responsibilities involve
developing and maintaining a portfolio management framework that promotes the government’s debt management objectives;
financing the government’s gross borrowing requirement, managing foreign currency assets required to meet net foreign currency interest and principal payments, and settling and accounting for all debt transactions;
managing the six principal types of risk—market, credit, liquidity, funding, operational, and concentration—in a manner consistent with the government’s fiscal strategy and the NZDMO’s internal policies;
determining a portfolio structure in terms of currency, maturity, and credit exposures consistent with the government’s risk aversion and having regard for costs;
implementing a sound framework for measuring performance on a risk-adjusted basis;
maximizing the value added to the portfolio, on a risk-adjusted basis, subject to limits set in respect of market, credit, and liquidity exposure;
disbursing cash to government departments and facilitating departmental cash management;
undertaking lending to government organizations and state-owned enterprises and facilitating and executing derivatives transactions in accordance with government policy;
providing capital markets advice for other areas of the New Zealand Treasury, other government departments, and government organizations;
providing debt-servicing estimates and accounting reports for fiscal forecasting and reporting purposes; and
maintaining and enhancing, where appropriate, relationships with investors who hold, or are potential holders of, New Zealand government securities, financial intermediaries, and the international credit-rating agencies.
Establishment of the NZDMO
The NZDMO was established because a large volume of government debt created considerable risks for the taxpayer, and those risks needed to be managed in a comprehensive manner.
Beginning in the 1970s, large fiscal deficits became the norm in New Zealand, and ineffective monetary policy led to one of the highest rates of inflation in the Organization for Economic Cooperation and Development (OECD). By the early 1980s, a price and wage freeze had been introduced, and monetary policy was exercised primarily through direct controls and regulation. At the same time, to limit the rate of monetary growth, financial institutions were subject to lending-growth guidelines, which in practice were largely ineffective. Increasingly restrictive measures were introduced by tightening reserve-ratio requirements for banks and raising the government-securities ratios for finance companies and building societies. An attempt was made in 1983 to absorb excess liquidity through auctions of government securities. The effectiveness of the auction program to neutralize the fiscal injection through higher voluntary holdings of government securities was severely constrained by a requirement that upward pressure was not be exerted on interest rates. In that environment, most of the government’s borrowing was in foreign currencies, which also served to finance the country’s persistent balance of payments deficits.
Following the election of a new government in 1984, dramatic changes occurred in economic management through a series of macroeconomic and microeconomic reforms that enabled the price system to emerge as the dominant signal for investment, production, and consumption decisions. Major changes included
the removal of controls on prices, interest rates, and wages;
a free float of the New Zealand dollar and the removal of capital controls;
a reduction in marginal tax rates and a broadening of the tax base;
the elimination of subsidies and price supports;
the removal of reserve-asset requirements for financial institutions;
extensive deregulation; and
substantial reforms of the public sector.
Transparency around fiscal policy improved, and deficits were reduced. As was typical of most OECD countries at the time, New Zealand had no separate objective regarding debt management. There was a growing view, however, that a more professional approach to portfolio and risk management was required to manage the stock of public sector debt, particularly the large foreign currency component. Against that backdrop, the NZDMO was formed in 1988 to manage the public debt denominated in both foreign currency and New Zealand dollars under the authority of the minister of finance.
The NZDMO was established as a self-contained unit within the New Zealand Treasury, rather than as a separate entity, because at the time it was thought that important linkages would otherwise be lost. In addition to debt-servicing forecasts for the budget and other fiscal releases, the NZDMO provides a range of capital markets advice to other sections of the treasury. Location within the treasury also allows close monitoring of the NZDMO’s development and its effectiveness in managing the government’s asset and liability portfolios.
Later restructuring of the treasury, prompted by a heightened emphasis on the government’s aggregate balance sheet, led to the NZDMO being folded more closely into the treasury’s branch structure. Since 1997, the NZDMO has formed part of the asset and liability management branch. Activities of the branch that are not the responsibility of the NZDMO include managing the government’s contingent liabilities and advising on the financial management of departments, state-owned enterprises, and other institutions in which the government has an ownership or balance-sheet interest.
Structure of the NZDMO
The secretary of the treasury is directly responsible to the minister of finance for the actions of the NZDMO. The head of the NZDMO is the treasurer, who reports to the asset and liability management branch manager, who is a deputy secretary.
In addition to normal accountability arrangements, the NZDMO’s operations are also overseen by an advisory board, which provides the secretary of the treasury with quality assurance on the NZDMO’s activities, risk management framework, and business plan. Members of the advisory board are selected on the basis of their experience in supervising portfolio management, payments, and banking activities; finance and risk management theory; and operational risk and reporting requirements. The advisory board currently includes a senior partner with a major accounting firm, the director of a corporate treasury and risk management advisory firm, and a finance academic.
By design, the structure of the NZDMO resembles that of a private sector financial-markets institution, with separate front, middle, and back offices. That structure leads to clearly defined responsibilities and accountabilities, procedural controls, and the segregation of duties, which is consistent with best practice. The portfolio management group is responsible for portfolio analysis, developing and negotiating transactions, managing the government’s liquidity and cash disbursement system, and relationship management with international investors and rating agencies. The risk policy and technology group is responsible for measuring the NZDMO’s performance in adding value, measuring risk, monitoring compliance with the approved policies for managing the government’s net debt portfolio, maintaining the NZDMO’s portfolio and risk management framework consistently with international best practice, and maintaining the NZDMO’s information technology (IT) systems. The accounting and transactional services group is responsible for the NZDMO’s accounting and forecasting functions and ensuring that transactions are settled in a timely, efficient, and secure manner.
When the government had a significant proportion of its debt in foreign currencies, the NZDMO maintained an office in London. It was responsible for a range of foreign currency transactions, including commercial paper issuance, and for relationship management with financial institutions in the European and North American capital markets. This enabled the NZDMO to maintain a 24-hour transacting capacity, mitigating the effects of the time-zone differences between New Zealand and major financial markets. The London office was closed in 1997, after the elimination of net foreign currency debt.
The NZDMO’s staff currently numbers 24, with legal and some administrative services provided by other personnel within the treasury.
Legal framework for borrowing
The legal framework in which the NZDMO carries out its functions includes the Public Finance Act, 1989, and the State Sector Act, 1988. In general, the powers in those acts are vested in the minister of finance, but many of them have been delegated to the secretary to the treasury and then subdelegated to specified personnel within the NZDMO. One power that cannot be delegated is the power to borrow in the name of the government, and the NZDMO recommends and obtains approval for its borrowing activities.
The NZDMO must operate within the strategic parameters approved by the minister of finance, but much of the discretion over day-to-day operations has been delegated to the treasurer of the NZDMO.
Coordination with fiscal policy
The NZDMO coordinates with other parts of the treasury that advise the minister of finance on the content of the government’s annual budget and prepare budget documents and the government’s financial statements.
The Fiscal Responsibility Act, 1994, requires the government to act in accordance with the principles of responsible fiscal management. The act establishes five principles:
reducing debt to a prudent level,
maintaining debt at a prudent level,
achieving and maintaining the government’s net worth at a level that provides a buffer against adverse future events,
prudent management of fiscal risk, and
reasonably predictable tax rates.
The act does not define a prudent level of debt. Rather, each government determines and publicly discloses what it regards as prudent. However, the current official gross debt target is 30 percent of GDP on average over the economic cycle.
Coordination with monetary policy
During the mid-1980s, debt management was secondary to monetary policy. The priority at the time was to stabilize the economy. By the end of the decade, the NZDMO was established and the Reserve Bank, the central bank, was made independent in the implementation of monetary policy. Under the Reserve Bank Act, 1989, the objective of maintaining price stability was identified as the central bank’s primary role.
The NZDMO is responsible for managing the government’s debt and ensuring that the government’s cash management is conducted efficiently. The Reserve Bank is responsible for the formulation and implementation of monetary policy. The two organizations have a close working relationship, which is formalized in agency agreements.
The NZDMO manages the government’s liabilities. Financial assets, in the form of bank deposits and high-grade marketable securities, are held to enable the NZDMO to meet that function. The Reserve Bank manages the government’s foreign currency reserves of about $NZ 4.9 billion as of July 2002, which are maintained to mitigate serious liquidity problems in the New Zealand foreign exchange market, should they ever occur. Although these reserves are available to the Reserve Bank for intervention when needed, the Reserve Bank has not intervened in the foreign exchange market since the New Zealand dollar was floated in March 1985. The foreign currency reserves are funded by loans to the Reserve Bank from the NZDMO. An agency agreement clarifies the responsibilities of both organizations, including in the event of foreign exchange intervention.
Another agency agreement between the NZDMO and the Reserve Bank clarifies the central bank’s roles where it provides services for the NZDMO. The Reserve Bank acts as the NZDMO’s issuing agent, registrar, and paying agent in the domestic market. It conducts auctions of treasury bills and government bonds on the NZDMO’s behalf, but the NZDMO retains responsibility for all pricing decisions on these instruments. In addition, the Reserve Bank publishes information on domestic government securities that supports the market in those securities.
The Reserve Bank offers advice to the NZDMO on the structure of the government’s domestic borrowing program. The NZDMO, however, has sole responsibility for advising the minister of finance on the size and structure of the domestic borrowing program.
An important provision in the agency agreement on cash and wholesale debt management is that all functions carried out by the Reserve Bank as agent for the NZDMO are conducted without reference to monetary policy considerations.
Transparency and accountability
The Fiscal Responsibility Act requires the government to be explicit about its objectives and explain any changes to them and ensures the provision of comprehensive financial information for informed and focused debate about fiscal policy. Two documents called for in the act are the Budget Policy Statement and the Fiscal Strategy Report. The government is required to table them in parliament to show that its actions are fiscally responsible. They outline the government’s short-term fiscal intentions and long-term fiscal objectives, including those regarding gross and net debt, and explain the consistency of those intentions and objectives with the four-year forecasts in the Economic and Fiscal Updates, which are published with the budget and at midyear.
The government’s monthly financial statements are prepared according to generally accepted accounting practice and are made public. They show how public resources have been used and report the government’s assets and liabilities, revenues and expenses, cash flows, borrowings, contingent liabilities, and commitments. The annual financial statements, in particular, provide detailed information on the stock of outstanding New Zealand dollar and foreign currency debt, the maturity profile and interest rate structure of that debt, and cash flows during the year associated with issuance, redemption, and servicing of debt. The notes disclose information on the NZDMO’s risk management practices and the extent of off-balance-sheet positions. The Public Finance Act requires the audit office, an office of parliament, to audit the annual financial statements presented by the government and express an independent opinion on them.
The NZDMO’s responsibilities are not codified in legislation. For the past decade, it has operated at arm’s length from the minister of finance, but that is a matter of custom and practice as opposed to statutory independence. Nothing in the Public Finance Act or the Fiscal Responsibility Act explicitly constrains the minister of finance in his or her relations with, or power to direct, the NZDMO.
Management of internal operations
The basis of operation, strategic objective, risk management framework, and performance measurement framework for the NZDMO are specified in its portfolio management policy, and the NZDMO’s activities are audited for compliance with it. Internal operations are managed through a body of policies, reporting and performance management requirements, procedural manuals, established processes, limits, formal delegations, and segregated duties. Managers within the NZDMO warrant compliance with those controls.
The NZDMO has in place procedures and resources to mitigate risk to its operations caused by natural disasters, infrastructure failures, or other disruptions. Live tests of the business continuity plan are routinely conducted.
The State Sector Act establishes the standards and general obligations of the public service, and the treasury’s corporate policies and code of conduct establish the guidelines for behavior expected of treasury personnel. Additional guidelines for ethical behavior apply to NZDMO personnel to ensure that they are free from real, potential, or apparent conflicts of interest and that the NZDMO conforms to the practices and conduct expected of a participant in the financial markets.
The NZDMO recruits successfully from the private sector and places a strong emphasis on staff training and professional development within the organization. Among other reforms of the public sector in the late 1980s was the decentralization of remuneration to departmental chief executives. As a result, the NZDMO is able to offer terms and conditions of employment that are competitive with private sector financial institutions, in the context of the unique opportunities that can be offered.
Information management systems
An information management system that integrates the front, middle, and back offices underpins the NZDMO’s operations.
The information management systems used by the NZDMO have evolved through the years. Until 1987, prior to the establishment of the NZDMO, the official recording of outstanding debt and interest payments was contained in manual ledgers and informal spreadsheet tools that lacked adequate control and verification. Innovations in the financial markets during the 1980s also gave urgency to the development of an effective information management system. At the time, no commercially available product could satisfy the most pressing needs for valuation, performance measurement, and sensitivity analysis, owing in large part to the diversity of instruments in the government’s debt portfolio. Consequently, a custom-built information management system was developed that, with near continuous development, served the NZDMO through 1997.
By the mid-1990s, however, it was apparent that the closed design of that system would be inadequate in the long run. By that time, as well, commercial systems had advanced to the point where they could accommodate most of the NZDMO’s requirements. In 1995, contracts for the purchase and maintenance of a commercial system were signed. Implementation was completed on time and within budget in 1998. Although the new system adequately met front office needs, significant customization, accomplished in-house, was necessary to satisfy requirements of the back and middle offices. That said, the new system provided tangible benefits in terms of
enhanced pricing, reference benchmarking, and risk management functionality;
greater system integrity; and
reductions in in-house development costs, system maintenance overhead, and key person dependency.
Over the years, the system has been continually developed to meet the NZDMO’s ongoing requirements. That development has taken place outside the commercial system. Although it generally meets the NZDMO’s current requirements, the commercial system lacks the flexibility for the agency’s increasingly sophisticated requirements. The NZDMO is currently considering its IT strategy for the next three to five years. The preferred approach is likely to be a series of incremental solutions rather than an entirely new system, with the high cost and risk that would entail.
Debt Management Strategy and Risk Management Framework
Strategy for debt management
Over the past decade, the NZDMO has undertaken a considerable amount of work to analyze the structure of the government’s liabilities within an asset-liability framework. There are several points of departure for such a framework.
One approach is to argue that the government should concern itself with constructing a debt portfolio with the aim of hedging the economy as a whole against shocks to national income or net worth. Under such an analysis, domestic debt is regarded as an internal transfer, and the objective is to determine a configuration of net external liabilities that would fall in value if a shock negatively affected the collective economic balance sheet of residents.
A second, narrower approach is to consider the assets and liabilities that relate to only the government as an entity. Even if public accounting conventions do not extend to the publication of a balance sheet, it can be constructed in a notional manner.
A third way to define the relevant assets and liabilities is to adopt definitions that accord with generally accepted accounting practice. In such a manner, the asset side comprises physical infrastructure, lending by government, securities, receivables, and so on. In addition to debt, liabilities include payables, provisions, and unfunded pension liabilities.
To help identify the characteristics of a low-risk portfolio of liabilities, the NZDMO researched private sector best practice and the academic literature. It was concluded that decisions on the government’s asset and liability management should be taken with reference to the government’s balance sheet. In particular, the risk characteristics of the government’s liabilities should match as closely as possible the risk characteristics of the government’s assets.
With that principle in mind, the NZDMO commissioned specialists in duration theory to quantify the risk characteristics of the assets in the government’s balance sheet. Although there were sizable standard errors around the estimates of the interest rate sensitivity of the assets, three important recommendations emerged, which were implemented over the course of the 1990s:
The duration of the assets tends to be quite long, implying that the debt portfolio should also have a long duration.
The assets are sensitive to changes in real interest rates, implying that there is a case for issuing some inflation-indexed debt.
The asset values are not sensitive to exchange rate movements, implying that there is little reason to hold foreign currency debt in the government’s debt portfolio.
Tax-smoothing considerations support those conclusions as well. The objective there is to structure total public debt to hedge against fluctuations in the tax base, with a view to stabilizing tax rates over time and reducing deadweight costs. The government’s revenue flows exhibit little sensitivity to the exchange rate, implying that the level of foreign currency debt should be reduced. Similarly, the susceptibility of New Zealand to negative supply shocks, which have the effect of increasing inflation and reducing real income, leading to a deteriorating fiscal position, favors a debt portfolio of predominantly nominal long-term debt.
Recently, the NZDMO developed a stochastic simulation model to improve understanding of the trade-off between financial cost and risk associated with the composition of the portfolio of domestic borrowing. The NZDMO is using the model to identify opportunities to reduce the cost or risk of the portfolio, stress-test alternative strategies, and inform decision making when establishing the borrowing program for the coming years.
Going forward, debt strategy is likely to be influenced by analysis that is under way in the treasury aimed at understanding financial risks across the government from a whole-of-government perspective and how the government’s balance sheet is likely to change through time. Financial assets will increasingly dominate other assets, allowing more flexibility in terms of implementing a desired composition to meet net worth–related and other objectives, while necessitating new approaches to government-wide financial risk management.
Management of domestic currency debt
Within the asset-liability framework, the domestic debt portfolio is shaped by a set of subobjectives, or principles, that support the NZDMO’s debt management objective, rather than one strategic benchmark. They are used to manage the risks and costs of the domestic debt portfolio and help the NZDMO issue debt cost-effectively.
At the highest level, the issue of debt composition has been tackled by thinking about the government’s balance sheet. The conclusions from that work have helped identify the rationale for holding nominal and inflation-indexed debt. Underlying that work, however, are differences in theoretical opinion and considerable empirical challenges. To date, it has not been possible to identify with any precision the proportions of each type of debt that should be held.
An additional reason for using a set of subobjectives to manage the domestic debt portfolio is because existing risk-pricing models do not address the trade-offs between different types of risk. In addition, they do not help the NZDMO understand the risk preferences of a sovereign, a sovereign’s appropriate level of indebtedness and creditworthiness, the implications for the New Zealand economy as a whole, or intergenerational equity issues.
The principles for managing the New Zealand–dollar debt portfolio include the following:
To manage risk with respect to refinancing, the NZDMO maintains a relatively even maturity profile for term debt across the yield curve to reduce pressure on the domestic bond market when supply increases unexpectedly and provide the government with greater flexibility in an environment of fiscal surpluses.
The funding program is calculated on the basis of the cash required within one financial year.
The NZDMO builds benchmark bonds of around $NZ 3 billion to improve liquidity in the market and, consequently, reduce the government’s cost of borrowing.
When deciding which benchmarks to build up in the current financial year, the NZDMO trades off the size and number of benchmarks to be offered.
To diversify interest rate risk and lower the cost of the portfolio, the NZDMO maintains a mix of fixed-rate and floating-rate debt and uses interest rate swaps. Inflation-indexed debt makes up a component of the portfolio and is issued when it is cost effective to do so.
When issuing debt, the NZDMO samples interest rates throughout the year by conducting about 10 tenders of government bonds.
The NZDMO is committed to transparency, predictability, and evenhandedness.
The NZDMO seeks to lower the government’s cost of funds by reducing price uncertainty and encouraging competitive bidding through an efficient auction program. The NZDMO issues all domestic debt securities through auctions. Reserve pricing is used only in very exceptional circumstances, on only two occasions since 1993, to encourage investors to cover the government’s borrowing requirements.
Nominal bonds and treasury bills are auctioned through a multiple-price system. Inflation-indexed bonds have not been issued since 1999, because it has not been cost effective to do so. They had been auctioned through a uniform-price system to reduce the potential “winner’s curse” problem, which is viewed to be greater for a less liquid instrument that is more difficult to price.
Transparency surrounding the government’s domestic borrowing intentions is enhanced by the publication of the details of the borrowing program when the annual budget and midyear fiscal updates are released. For instance, the NZDMO issues a press release that states the financing arithmetic for domestic currency borrowing and sets out the schedule for bond auctions. It states the parameters of the treasury bill program and notes whether the NZDMO intends to undertake New Zealand–dollar interest rate swap transactions. Similarly, the NZDMO consults the market before introducing new policies and practices, which reduces uncertainty around the process of policy change. That predictability enables market participants to plan with confidence, helping the market absorb sizable amounts of government securities.
Although these principles limit the NZDMO’s ability to borrow opportunistically or engage in secondary market intervention, the possible opportunistic gains are outweighed by the benefits of being transparent.
This debt management framework also assists other public policy objectives. It seeks to enhance the development of the domestic capital market, including a derivatives market for managing risk, and reduce the cost of capital for private sector borrowers by improving New Zealand’s sovereign creditworthiness.
Management of foreign currency debt
Since the float of the New Zealand dollar in 1985, the government has borrowed externally only to finance foreign exchange reserves. All other borrowing has been in the domestic market. At the same time, more than $NZ 18 billion of foreign currency debt has been retired, largely through the proceeds from asset sales and, since 1994, sizable fiscal surpluses. Net foreign currency debt was eliminated in 1996.
Unless otherwise directed by the minister of finance, net foreign currency debt is kept close to zero. The NZDMO aims to
maintain a foreign-currency liquidity buffer;
hedge the remaining foreign currency debt in a low-risk and efficient manner, having regard for the government’s overall balance sheet;
fund the Reserve Bank in a low-risk and efficient manner, having regard for the government’s overall balance sheet; and
manage funding risk through the maintenance of adequate reserves and diversified and long-term funding.
The decision to reduce net foreign currency debt to zero was an outcome of the analysis of the government’s debt in an asset-liability framework, which indicated that the value of the government’s assets are sensitive to movements in domestic interest rates but not movements in the exchange rate. Other considerations were the volatility of New Zealand’s terms of trade and susceptibility to exchange rate shocks, which could not be effectively hedged, given the magnitude of the overall external debt portfolio and the capacity of the New Zealand foreign exchange market.
Prior to the elimination of net foreign currency debt, the strategy for the foreign-currency debt portfolio drew insights from mean-variance modeling that consistently showed that the U.S. dollar represented the dominant currency when attempting to reduce risk. The mix between yen and European currencies was unstable, and rebalancing costs were prohibitive. Consequently, the NZDMO adopted a benchmark for the net liability of 50 percent in U.S. dollars, 25 percent in yen, and 25 percent in European currencies. Those allocations corresponded approximately to relative GDP weights of the currency blocs, and so were also consistent with a “sell the market” strategy. For the target duration for each currency subportfolio, the NZDMO adopted the duration of the government bond market in each currency.
Strategic and tactical portfolio management
The portfolio is managed at both a strategic and a tactical level. Strategic management refers to the management of the overall parameters of the portfolio, in terms of currency mix and interest rate sensitivity, within the constraints established from time to time in respect of the mix of New Zealand dollar and foreign currency debt. The strategic parameters are disclosed in the government’s annual financial statements. The minister of finance approves the strategic parameters of the portfolio and the annual New Zealand dollar borrowing program on the recommendation of the NZDMO.
Tactical management refers to the discretionary management of the net debt portfolio within established limits around the strategic portfolio. Within those limits, portfolio managers have discretion as to the use of instruments and timing of transactions to effect movements in the portfolio. Arguments in favor of providing the NZDMO with the flexibility to manage tactical positions within established limits, as opposed to adhering to the strategic parameters, include the following:
Temporary pricing imperfections do sometimes occur, making it possible to generate profit from tactical decision making.
Tactical trading brings with it knowledge of how various markets operate under a variety of circumstances, which improves the NZDMO’s understanding in managing the overall portfolio. It is important, for instance, to maintain high-quality information flows about markets or sectors where intermediation transactions occur but are infrequent. Intermediation transactions occur when a substantial proportion of the value of tactical management is realized.
Tactical trading enables the NZDMO to develop and maintain skills in analysis, decision making under uncertainty, negotiations, and deal closure. The immediate benefit is a reduced risk of mistakes when transacting and the projection of a more professional image to counter-parties.
Consistent with its commitment to transparency, predictability, and evenhandedness, the NZDMO does not engage in tactical trading with respect to the domestic debt portfolio.
With ministerial approval, the NZDMO maintains a portfolio and risk management framework within which it operates. That includes the NZDMO’s strategic objective, objectives for New Zealand dollar–denominated and foreign currency debt, the instruments in which the NZDMO may transact, limits regarding market and credit risk use, and composition requirements for the liquidity asset portfolio.
The NZDMO manages six principal types of risk: market, credit, liquidity, funding, operational, and concentration.
The NZDMO manages market risk associated with tactical trading through the use of value-at-risk (VaR) limits and stop-loss limits. It maintains a VaR limit for the overall tactical portfolio and also VaR limits for individual currency subportfolios. The limits are expressed over daily, monthly, and annual time horizons at a 95 percent confidence level and reflect the risk tolerance of the government in respect of tactical activity undertaken by the NZDMO. The limits are set so that the NZDMO
can efficiently operate its daily business activities within the limits,
has sufficient capacity to intermediate transactions on behalf of departments and other government organizations and manage the funding requirements for the Reserve Bank, and
can absorb increases in market risk as a result of changes in global volatilities and correlations within the risk tolerance of the NZDMO.
The limits have evolved with the reduction of the foreign currency portfolio to a net zero position and in step with the evolution of international best practice. When the tactical trading limits were first approved by the minister of finance in the early 1990s, interest rate exposure and exchange rate exposure were managed separately, whereas the current VaR-based limits recognize diversification benefits.
Stop-loss limits are in place to protect the NZDMO from further losses once actual losses reach a certain point. They reflect the tolerance of the government in respect of maximum acceptable losses over monthly, quarterly, and annual time horizons.
The NZDMO uses back-testing to evaluate the performance of its VaR model. Actual profit and loss are compared with the market risk estimates calculated using the VaR model to determine its integrity and performance. Consistent with industry best practice, the NZDMO supplements VaR with stress-testing to understand how extreme or unusual events would affect the portfolio.
The NZDMO manages credit risk associated with transaction counter-parties and security issuers through the use of credit exposure limits. Because the NZDMO maintains credit exposures only with highly rated institutions, for which the probability of default is low, it is primarily concerned with losses arising from downgrade. Credit risk is further controlled by incorporating credit support annexes into the NZDMO’s master swap agreements with swap and foreign exchange counter-parties.
The nature of the NZDMO’s business is such that large amounts may be settled on one day. For that reason, monetary limits are not placed on the NZDMO’s exposure to transaction banks, custodians, fiscal agents, and clearing brokers. The NZDMO manages risk with respect to those institutions through its procedures for selecting and monitoring its transaction settlement agents.
The NZDMO measures credit risk using an in-house credit model, because no suitable external product was available when it was developed in 1996. The model has been reviewed, and inputs to it have been updated, periodically since then. The model can be characterized as a mark-to-market model, which allows for credit losses as a result of changes in credit quality; a multiyear time horizon model, which spans the entire life of each transaction; and a bottom-up model, which calculates the credit risk for each individual transaction and then aggregates those individual credit risks at a portfolio level.
The objective for managing the NZDMO’s foreign-currency liquidity portfolio is to have sufficient liquid assets available to meet all the government’s obligations as they fall due. Liquidity risk is managed through policies that require the NZDMO to hold assets of appropriate quantity and quality.
To manage funding risk associated with New Zealand dollar borrowing, NZDMO establishes a relatively even maturity profile for term debt across the yield curve to manage the funding requirement, and the uncertainty around it arising from fiscal shocks, flexibly and without putting undue pressure on interest rates. With respect to foreign currency borrowing, the NZDMO establishes a maturity profile for term debt that reduces the likelihood of the government being unable to access markets in a timely manner or raise funds at an acceptable cost.
Operational risks in the NZDMO are managed in a number of ways. Operational risk policies span, for instance, transaction processing, legal and regulatory issues, ethical standards, physical and systems security, and business continuity. They are supported by close communications and regular management meetings that, in turn, reinforce a strong team ethic. Independent experts, such as external auditors, and specific initiatives provide additional support in managing operational risk. The combination of soft and hard practices provides the basis by which operational risks are managed and serves to heighten awareness of relevant risk events.
The NZDMO manages concentration risk as a second-order risk that forms part of the other risks that are managed. The NZDMO’s approach is to ensure that risk concentrations are managed prudently within the context of the other individual risks.
The NZDMO’s risk management framework has been in place since the NZDMO was established. However, the specifics of implementation have been, and are, subject to continuous improvement as resources allow and as IT capability and analytical techniques have improved. Careful prioritization has been required to ensure that scarce resources are allocated to managing the most significant risks first and fundamental risks are covered. In addition, the NZDMO periodically commissions reviews of its risk management framework and practices, including the strategic parameters of the portfolio, by external experts.
The NZDMO measures performance on a risk-adjusted basis. The performance measurement regime provides these benefits:
NZDMO management has information regarding the magnitude of risk associated with discretionary decisions, which assists thinking on alternative financing or investment strategies.
Portfolio managers have information to assist them in managing the controllable risks for which they are responsible and feedback on the quality of their decisions.
Information necessary to generate incentive structures that ensure staff incentives are aligned with those of the NZDMO.
The NZDMO undertakes performance measurement as a tool for internal management purposes, including the allocation of resources and the assessment of performance of individuals. It is not a requirement under generally accepted accounting practice, which establishes the framework for the NZDMO’s public reporting. For that reason, the performance out-turn is not publicly disclosed.
As noted previously, the overall portfolio managed by the NZDMO is divided into strategic and tactical portfolios. Performance measurement applies to only the tactical portfolios, which are considered “performance” portfolios, whereas strategic portfolios are considered “nonperformance.” All activity with respect to domestic currency borrowing is strategic. The daily profit or loss for each tactical portfolio is calculated as the difference in the present value of the portfolio from one day to the next.
In 1999, the NZDMO implemented a transfer-pricing regime (TPR) to allocate the change in the end-of-day valuation from one period to the next. The TPR enables transactions and risk positions to be transferred under agreed-upon rules from one sub-portfolio to another and better track the attribution of value added by activity. Prior to the implementation of that program, performance was measured relative to a shadow, or benchmark, portfolio. It was also measured on a cost basis alone with respect to liquidity management, investment, and foreign exchange transactions. The introduction of the TPR made it possible to measure performance on a risk-adjusted basis.
Value added—that is, profit or loss—is measured for each day, month, quarter, and financial year by the tactical portfolio and also by currency. Risk positions are measured against the net zero foreign-currency debt strategic benchmark. Risk use is calculated for the total tactical portfolio and also by currency.
Risk-adjusted performance measurement (RAPM) refers to the return of tactical management relative to the risk undertaken to achieve that return. RAPM provides information, in addition to simple profit and loss or risk use, that NZDMO management can use to assess the performance of tactical portfolio management activity. The practical effect of RAPM is to encourage portfolio managers to take on risk only when the potential upside is high compared with the size of the risk.
The risk-adjusted performance return is defined as net value added divided by notional risk capital. Net value added accounts for profit or loss and recognizes the expenses incurred in tactical management. It is defined as gross value added, less expenses attributable to tactical management. Notional risk capital accounts for market, credit, and operational risk use. Market risk is measured relative to the strategic net zero foreign-currency debt position and is based on the average total monthly VaR. Credit risk is measured relative to a credit risk–free position, which the NZDMO defines as a portfolio with exposure to only AAA-rated entities, and is based on the average monthly deviation from that AAA benchmark. It is estimated using the NZDMO credit risk model. Operational risk is assumed to be either zero or the maximum of market or credit risk, because the NZDMO does not have a model to quantify that risk.
Risk-adjusted performance is calculated monthly. The NZDMO compares current risk-adjusted performance against historical performance, instead of a static benchmark. Annual risk-adjusted performance is measured as a moving average of the monthly returns in the previous 12 months.
Developing the Markets for Government Securities
In 1989, net foreign currency debt was $NZ 13 billion, equivalent to 19 percent of GDP and 43 percent of total net debt. Given the government’s borrowing requirements at the time, the scope for reduction in the foreign currency exposure of the public debt to meet the NZDMO’s balance sheet objectives was limited by the capacity of the New Zealand market to absorb additional borrowing. That encouraged the NZDMO to give a high priority to the development of the domestic debt market.
The preconditions with respect to securities market regulation and market infrastructure were already in place. There was a long-standing, sound legal framework, as well as appropriate accounting and auditing practices. Banking, clearing, and settlement systems were efficient. An independent central bank was able to implement monetary policy and manage market liquidity.
To develop the primary market for government securities, the NZDMO established a commitment to the principles of transparency, predictability, and evenhandedness in its activities, as described before.
In 1988, the minister of finance agreed to concentrate the issuance of bonds in benchmarks of large-volume, standardized securities. The aim of that approach is to reduce debt-servicing costs by achieving greater liquidity in the market, thereby attracting investors for whom liquidity is a major requirement. The domestic debt market until that time consisted of many tranches of relatively small volumes. By 1993, it had been transformed into eight benchmark maturities, each with up to $NZ 2.5 billion in outstanding volume. That pattern has continued through today, although the maximum outstanding volume is now around $NZ 3 billion.
A major consideration when first establishing benchmark bonds was that the maturity of a bond with a large outstanding volume involves a major out-flow from the government to the private sector, which requires careful handling through the Reserve Bank’s liquidity management operations. In New Zealand, benchmark bonds are large relative to the size of the economy, at about 3 percent of GDP, so their redemption represents a major flow through the financial system. That has been mitigated by buying back bonds in the final six months of life. The Reserve Bank also undertakes reverse repos in open market operations with maturity dates that coincide with the maturity date of a benchmark bond. A number of benchmark bonds have matured since 1993, and those processes have worked well, without distortion to the cash market.
To accelerate the building of benchmark bonds, the NZDMO introduced bond switches in 1989. They involved the issuance of new benchmark bonds in exchange for existing illiquid bonds. The process that was used included both reverse auctions, typically when a switch window was first opened, and negotiations with individual investors. The pricing for those negotiations was framed as a spread to the benchmark bond curve, on a duration-adjusted basis. At times, the savings to the government were substantial, of up to 30 basis points per year.
A further development was the lengthening of the maturity of government securities to reduce funding risk. The original benchmark was for 5 years. A 7-year benchmark was introduced in 1990 and a 10-year benchmark in 1991. The timing of each successive extension was a judgment about the level of demand in the market and, in New Zealand, it was closely associated with disinflation. The 10-year maturity has become an important pricing point in the market for international investors, because it is a common point of comparison across markets.
The NZDMO has not found it necessary to introduce primary dealers or officially appointed market makers to assist with the distribution of securities. Instead, the NZDMO considers that a better outcome is market making in government securities on the basis of commercial decisions by market participants themselves. New Zealand’s banking system is efficient and open to new entrants, and this was also the case when a liquid government bond market was developed in the late 1980s and early 1990s. The banking system has been characterized by a high degree of foreign ownership for more than a century, and financial market reforms beginning in the mid-1980s included the removal of any limit to the number of registered banks. It has been comparatively easy for New Zealand banks to develop the necessary skills and systems required for a domestic bond market.
All market participants, including end-investors, may bid in auctions, subject to criteria related to creditworthiness. The arrangement has worked well, with a core group of about six to eight market makers at any one time, who agree among themselves on secondary market standards for liquidity, such as ticket size and spread. A similar approach applies in the New Zealand–dollar foreign exchange market.
A further development that was important for the expansion of the market was the effective removal of nonresident withholding tax. The NZDMO had been aware for some time that this was an issue with international investors, but earlier action had not been possible because of a number of considerations relating to tax policy. Although investors were able to avoid the tax by not holding securities on coupon payment dates, that procedure imposed costs and inconvenience, and many international investors were not prepared to take those measures for ethical reasons.
Holdings by nonresidents of New Zealand government securities increased markedly from 1993. According to surveys by the Reserve Bank, nonresident holdings peaked at 62 percent in 1997, slipping back to 33 percent in 2000. The reduction has been orderly and has occurred for a number of reasons, including a fall in differential interest rates between New Zealand and major markets and a depreciation in the New Zealand dollar as an adjustment process to a weak external position.
One potential concern about high levels of non-resident participation is the threat that those investors could attempt to exit the market all at once. Over the years, there have been periods of divestment, but they have tended to be orderly. Part of the reason is that the number of foreign investors participating in the market has increased over time, so the exit and entry of individual investors is based on their individual views, which tend to vary over time. Another reason is that successive governments have adhered to transparent and prudent fiscal and monetary policies, which provide an anchor of stability for the market.
Another feature of the maturity of the market has been its ability to weather a number of crises in international markets. Events such as the 1994 international bond market sell-off saw yields adjust upward, but the market continued to function continuously and prices generally adjusted smoothly.
One development in recent years that has improved the efficiency of the secondary market has been the increased use of repos. The NZDMO, along with the Reserve Bank, encouraged the development and use of standardized repo documentation, which assisted in that process. The increased use of swap transactions, by both residents and nonresidents, has also had spin-offs for the liquidity of the bond market.
Over the last 13 years, the NZDMO has undertaken continuous improvement in all aspects of its management of the government’s debt. The latter half of that period has seen a considerable improvement in the government’s finances and a reduction in debt levels. That has created its own technical challenges in relation to debt defeasance and management of uncertainty surrounding asset-sale proceeds and the size of surpluses. Changes in government policy and other initiatives have seen the NZDMO’s role expand in the areas of intermediation and risk management. That is likely to continue in the future and, combined with finance industry–driven improvements to risk management techniques, will lead to further evolution of government debt management in New Zealand.
The case study was prepared by Greg Horman from the New Zealand Debt Management Office.