English Conference Speech

Bill English delivered a well received speech on the economy to the conference. The key focus will be his comments on debt, so I’ll deal with them at the end and cover the other stuff first. First his summary of the economic picture:

On the negative side:

• The economy will continue to struggle.
  
• Inflation is high.
  
• Interest rates are high.
  
• The business outlook is grimmer than it has been since 1988.
  
• There is considerable uncertainty about some parts of the investment market, given the collapse of many finance companies.
  
• Oil prices are much higher than they were a year ago and, despite some short term relief, are likely to remain high.

On the positive side:

• Commodity prices are at an all-time high.
  
• Provincial areas are doing reasonably well, and the further south, the better.
  
• The dollar is dropping, pushing up export incomes.
• The economy is tilting more towards the export sector.

A good round-up.

First, we are going to have tax cuts. New Zealanders have been taxed too high for too long.

Even the Labour party has grudgingly conceded the argument. But it has come awfully late to the party. Australia is in its sixth year of significant personal income tax cuts and has signalled further cuts to come. It’s time we got started.

Tax cuts will put some cash in people’s pockets and that’s good. But the longer-term reason for cutting taxes is to improve the incentives to work, save, and invest – and that’s what National is committed to doing.

This is worth remembering. Tax cuts are great in that people get to keep more of their own money. But having tax cuts leading to higher economic growth is the bigger goal – for that is the way we get better services, and have more money.

Secondly, New Zealanders are not getting value for money – their hard-earned money – from government services. Too much is caught up in a burgeoning Wellington bureaucracy designed to make the government feel big and ministers to feel powerful.

And commercial property prices in Wellington keep going up.

Thirdly, we will cut red tape.

This is easy to say and hard to do. People wonder how we can be in favour of small workplaces, soundly build houses, and yet achieve it with fewer rules.

We will do it in two principled ways.

We will use bureaucracy against the bureaucrats. Let officials and ministers jump the hurdles, fill out the forms and incur the cost of compliance before they can have a new regulation. We will also attack specific costs, like complexity in the tax system, the time and costs of the RMA, and the extensive new rules and bureaucracy under the new Building Act.

Fight fire with fire – I like it.

Fourthly, we will introduce national standards in education.

Almost 10,000 young New Zealanders leave school every year without the basic competence to learn more skills….

We will introduce national standards in literacy and numeracy. This will be a spur to taking the best teaching practise from schools that are succeeding and spread this across the whole system. If every child is assessed and taught appropriately, we can help the thousands who now miss out.

This will take time but again we will not lift economic growth without improving our education outcomes.

Finally, we will lift the quality and quantity of New Zealand’s infrastructure investment, to remove the blockages that are currently holding our economy back.

New Zealand under Labour is virtually the only country in the developed world that refuses to use private sector financing and risk management techniques to help spend taxpayers’ money effectively and make it go further.

Over the next 10 years, central and local government will spend between $60 billion and $70 billion on infrastructure. We can do it badly or we can do it well. Let’s do it well.

That’s a lot of money!

So now let us look at the reports of deficits and borrowing – from NZPA:

But deputy leader and finance spokesman Bill English told delegates National was prepared to borrow more to fund infrastructure.

He said New Zealand had one of the lowest levels of debt of any developed country and “additional borrowing” for infrastructure would boost economic growth.

Any increase in debt for infrastructure would be transparent and voters could trust National to be a “conservative” manager of the economy.

“So that will be extremely clear cut and rather hermetically sealed.”

Mr Key argued that increased borrowing overall — ostensibly to fund infrastructure — could be separated from National’s tax cuts.

“What effectively will be happening is you will be able to see exactly what our tax cut programme costs, exactly what Labour’s cost, exactly what we are delivering, what differences or priorities we’ve chosen over Labour’s.

Now one is going to hear a lot of rhetoric around this, so I am going to try and explain the situation by looking at a normal company’s accounts.

A company has three major financial statements – the income and expenditure, the balance sheet and the cash flow.

The income and expenditure is the measure of profitability and to a degree of sustainability. The difference between the two is your profit/surplus or deficit/loss. Asset purchases, borrowing, investment in infrastructure doesn’t directly show up here. However depreciation on assets does show up as an expense, as does interest on any borrowing. So if you borrow too much, you will face pressure on your surplus, as interest costs go up. In the bad old days before Ruth, interest on borrowing was something like over 20% of all expenditure.

In the 11 months to May 2008, the surplus is $5.3b and the underlying surplus (excluding one offs) is $7.3 billion. These are forecast to reduce massively in the next few years due to a weaker economy which means less tax, plus tax cuts plus increased spending.

Interest expenses are currently $2.8b out of total expenditure of $66.8b – so less than 5% of expenditure. However the Crown also gets revenue from investments it has – and they totalled $3.0 billion. So in fact the Crown made $200 million more from investments than it paid on debt.

You do want to make sure interest expenses do not get too high – but as Bill English said we do not have a debt or interest problem at the moment – we have a productivity problem.

So you do want the income and expenditure to be in surplus, or at worst for any deficits to be temporary – with there being a surplus over the medium term.Companies really want to be profitable every year without fail. A country isn’t quite the same – instead of paying dividends through profits, you pay dividends through tax reductions.

Next we have the balance sheet. These are your assets and liabilities. Many major transactions happen here, and don’t even directly affect the income and expenditure. If you buy a frigate for $1 billion then you simply have an increase in assets of $1 billion and an increase in debt of $1 billion or a decrease of the cash asset.

Now many asset purchases are funded through borrowing. Why would you do this? Well a couple of reasons. The first is if one gets the value from an asset over 30 years, then it is fairer to spread the cost over 30 years.

The second, and more important arguably, is that the value you will get from the asset, is greater than the cost of the interest of borrowing to purchase it, so that the company/country as a whole becomes more profitable.

Let’s take an example of say a polling company. You may want to buy 40 computers with CATI software on them at a cost of $400,000. But you don’t have $400,000 in the bank. So you might borrow $400,000 which will mean an interest cost of $32,000 a year. And if they are expected to last for 10 years depreciation of $40,000 a year so it will add $72,000 to your annual expenditure.

But having that software may mean you can call people 30% faster. So if your annual wages bill was $500,000 it shrinks to $350,000. Hence the $72,000 a year expenditure leads to $150,000 of savings and you profit increases by $78,000.

So what this means is borrowing for infrastructure and assets can be both fair and a good way of increasing profitability,

But it does increase risk. If you lose some customers and revenue drops, then you have fixed costs with interest and depreciation instead of variable costs such as wages, and your chance of going bust is higher.

Hence it is not universally good or bad to borrow for asset purchases. It depends on how much existing debt you have, and what you are going to buy with any borrowing.

Finally we have the cashflow. This is where you track the cash in and out from both your operating account and your capital account (plus some others). Now there are linkages. If you have a small cash surplus in your operating account and a larger cash deficit in your capital account, then you have an overall cash deficit. And as I said before the more cash you borrow the more it adds to expenditure.

But there is a difference between cashflow for operating and capital. It is quite normal for there to be a cashflow deficit in the capital account – an expanding business often is purchasing assets faster. The challenge is whether the borrowing on those assets overwhelms your operating account.

If we look at the Government, Dr Cullen himself is saying he will run a cash deficit – he will (just) have a cash surplus in the operating account but have a cash deficit in the capital account. Bill English is saying he will have a larger cash deficit – but again it seems in the capital account primarily. They have not ruled out a cash deficit in the operating account, but if so it is expected to be minor and temporary.

Until we see the actual figures from National in October, it is silly to get too worked up about it – after all Cullen is already running something like a $10 billion cash deficit over three years. The issue is not the size of the cash deficit per se – but what impact it will have on net debt (gross debt is far less important than net debt) and what impact it will have on interest. And most of all what is the long-term forecast in terms of the operating surplus.