NSW Treasurer changes tune on using tens of billions of taxpayer debt to punt equities

Christopher Joye

Coolabah Capital

All roads in this scandal lead to the potentially career-defining decisions made by the NSW Treasurer Dominic Perrottet. Until now, Perrottet stayed conspicuously silent in a debate where NSW Treasury and NSW Treasury Corporation ("TCorp") faced torrents of criticism from several sources, including:

  • credit rating agencies, 
  • banks, 
  • the bond market, 
  • the NSW Shadow Leader and Shadow Treasurer, 
  • senior former treasury and TCorp officials, and 
  • sovereign wealth fund leaders (see the Australian Financial Review's coverage here and here yesterday, and the NSW Shadow Treasurer Daniel Mookhey with an excoriating op-ed today).

Reporting in the AFR today, economics editor John Kehoe reveals that Perrottet has for the first time publicly declared that the $15 billion-going-to-$27 billion squirreled-away in the NSW Generations Fund's (NGF) Debt Retirement Fund could, in fact, be used to repay debt immediately rather than gambling this money on Aussie stocks, global stocks, private equity, hedge funds, junk bonds, and other, even more illiquid, asset-classes. 

Previously, NSW Treasury and TCorp had publicly advised that there was no current intention to use the Debt Retirement Fund to repay actual debt, and that this money would be punted by TCorp on global markets in the hope that the returns (rather than risks) earned on stocks would outpace the cost of NSW's debt, and thereby drive a reduction in what is loosely known as "net debt" rather than real or actual gross debt. (Under the NGF's legislation, the NGF's money can only be used to repay real debt - reducing "net debt" is never contemplated.)

Note: TCorp is the for-profit, NSW government-owned private entity that both raises money for NSW by issuing government bonds, and if NSW does not use this money for normal public expenditure, and gives the cash to TCorp, then TCorp gets to be paid as a "fund manager" to invest the money in stocks etc. As I touched on here, TCorp was paid $85 million in investment management fees by NSW in 2020. The NGF represents about 15% - soon to be around 25% - of TCorp's total funds under management.) 

So TCorp clearly has a theoretically very strong commercial incentive to try and convince the NSW government to keep the money in the TCorp-managed Debt Retirement Fund, and not to use the money to repay debt, fund infrastructure, or help pay for NSW's fiscal stimulus (and corresponding deficits). 

All of this makes Perrottet's comments to the AFR today that the NGF's Debt Retirement Fund could be used to immediately repay debt under this NSW government, and in turn fund infrastructure, a very important development:  

“The NGF does this by ensuring all funds invested are strategically managed to maximise the scope for NSW governments – present and future – to pay down debt.
“The NGF, as its name implies, has a firm focus on the medium and longer term. That clear focus means the NSW government may choose to pay down debt in some years and not in others, and even that a loss in any given year could be absorbed provided long-term strategy remained sound.”

Perrottet further explicitly signaled that given the record budget deficits and debt being racked-up by NSW, whereby debt has exploded from the $35.5 billion that existed when Perrottet created the NGF in 2018 to what is forecast to be more than $117 billion this financial year, the NGF's strategy might appropriately shift gears into debt repayment mode to help address the fiscal challenges NSW faces, which includes the highest cost of debt of any major State in Australia. On the strategy shift, Perrottet commented: 

“For this reason, the NSW government has always and will continue to review and, if necessary, adapt its NGF strategy, ensuring the fund in turn continues to deliver for current and future generations.”

So Perrottet is flagging that NSW will "continue to review" the NGF strategy, and will if necessary "adapt" it, to ensure it delivers on its legislated goals for both current and future taxpayers. 

But who knows, maybe this is all political spin? Maybe Perrottet is talking about only a symbolic amount of debt repayment, or a small amount of funding for new infrastructure investment, of, say, $1 billion to $2 billion (rather than $27 billion). Maybe he has not intention of keeping his public promise to use the $20 billion realised from the sale of WestConnex for building new infrastructure. Only time will tell, but the change in NSW's position in the last 24 hours is certainly encouraging.

It is incredibly easy for Perrottet to immediately solve all his fiscal problems with the huge amount of cash he has prudently built up in the NGF (ie, the soon-to-be $27 billion). Specifically:

  1. Perrottet can have the NGF start paying down debt by simply buying existing NSW government bonds, which is permitted under the NGF Act 2018. This would both reduce NSW's cost of debt and move it closer to recovering the AAA rating it lost in 2020, and/or
  2. Perrottet can have NSW issue the NGF new NSW government bond(s) via a private placement, which the NGF could buy, thereby giving the State access to the NGF's soon-to-be $27 billion in cash pile to be spent on COVID stimulus payments to households and business, the $108.5 billion of infrastructure that NSW has committed to paying for over the next 4 years, and other general NSW public expenditure

Crucially, this second option allows NSW to avoid having to issue extra NSW debt to cover the $20 billion of WestConnex money that will shortly be sitting in the NGF. If he does not do this, the WestConnex money will be just punted on stocks and global markets.

It's worth quickly recapping the summary of the scandal, and covering additional developments today, including the opinion piece published in the AFR by NSW's Shadow Treasurer, Daniel Mookhey.

In 2018, when NSW was running huge, $4 billion budget surpluses and had negative net debt, Perrottet had the sense to create a "rainy-day" fund in which he could place his surpluses and any privatisation money. It was called the NSW Generation Fund's Debt Retirement Fund, and it has the sole legislated purpose to repay NSW debt to maintain NSW's AAA credit rating (this was lost in December 2020) and reduce the cost of NSW government debt, which has recently soared to be above the cost of all the other major State governments for the first time.

After Perrottet put $3 billion from budget surpluses, $7 billion from the sale of the first-half of WestConnex, and more stealthily, and what appears to be more than $2 billion of debt late last year (note it is hard to repay debt using debt!) into the Debt Retirement Fund, its value has swollen to $15 billion, which will shortly go to $27 billion next month when the second-half of WestConnex is sold.

As noted above, Perrottet publicly promised to only use the WestConnex money for the purposes of buying new infrastructure, not to punt in global markets (see more here). In November 2020, the SMH reported that:

“Mr Perrottet said money generated from the sale of the remaining WestConnex stake would be used to fund government infrastructure projects and other capital works. 'Proceeds from any potential transaction will be invested into the NSW Generations Fund and allow us to continue to build world-class infrastructure such as the Metro West train line from Sydney to Parramatta,' he said.”

The budding scandal unveiled by the AFR has three key concerns:

  1. First, if the $12 billion to $13 billion from the sale of the second-half of WestConnnex next month is put into the NGF, it will not be used to build infrastructure, but rather gambled on global equities and other risky financial markets. That is what the DRF currently does. Of course, Perrottet has now flagged that this strategy could change;
  2. Second, if NSW is running large budget deficits, and does not use DRF's $27 billion to repay debt and/or fund new debt (and hence infrastructure and stimulus spending), and instead keeps punting this money in markets, then Perrottet is forcing NSW taxpayers to issue large amounts of extra debt to cover for the fact that they don't have access to the DRF's $27 billion. As CBA, NAB and S&P have all highlighted, Perrottet would be aggressively leveraging-up the NSW government's balance-sheet, directly increasing fiscal risks, undermining NSW's AA+ credit rating further, and increasing the cost of NSW debt (all of which is a possible breach of the NGF's 2018 Act, which requires Perrottet to comply with the Fiscal Responsibility Act 2012 that has a singular objective of maintaining NSW's AAA credit rating for the purpose of reducing the cost of NSW debt); and 
  3. Third, NSW Treasury and TCorp proposed in the latest Budget to divert a total of $19.2 billion of taxpayer revenue into the NGF and other investment funds (notably increasing TCorp's FUM, the fees it is paid to run this money, and potentially the salaries and bonuses of TCorp executives). Since NSW is running big budget deficits, this money has to be replaced by NSW issuing $19.2 billion of extra gross debt. NSW would once again be leveraging-up its balance-sheet to punt on stocks etc. And what happens every time there is a serious crisis and/or recession: the value of stocks can easily fall 30% to 60%, which would instantly drive a massive increase in NSW's net debt at the worst possible time, in turn further increasing the cost of that debt. 

This is clearly madness and has turned the NGF's DRF into a strategy that massively increases fiscal risk, and NSW taxpayer risk, in all downside scenarios (the DRF lost money in 2020), and only works in upside scenarios when equities do not suffer catastrophic losses.

The many public criticisms have been well-documented by the AFR's John Kehoe here and here. Writing on Twitter, Dr Nick Birrell, the founding CEO of Credit Suisse Asset Management Australia, the second CEO of County Investment Management, and a former adviser to State governments, commented:

I've taken an interest in sovereign asset-liability management for about 40 years, including some time as advisor to State Govs. This is one of the strangest plans I've read of. I set myself the task of finding a sane rationale for it but have failed so far!

With ABC Radio, 2GB and the Today Show covering the scandal yesterday, the impressively detailed and forensic NSW Shadow Treasurer, Daniel Mookhey, has published an op-ed in the AFR today outlining some salient criticisms. A key summary of his thoughts follow:

There’s a fine line between fearless innovator and fiscal cowboy and I think Dominic Perrottet just crossed it. The NSW Treasurer is using the state’s credit rating to borrow more than $10 billion to play in risky financial markets through the NSW Generations Fund. This is the most exotic public financing scheme since Rex Connor picked up the phone to Tirath Khemlani, albeit without the secrecy. 
Perrottet is essentially running amok in a regulatory dead zone. Unlike the major banks, superannuation funds and insurers, no one can stop him from taking absurd risks if he so wishes. State governments answer to no prudential regulator. They decide for themselves the rules that apply to their investment funds. 
As soon as interest rates rise from their historic lows, and equity markets climb down from their record highs, NSW taxpayers can expect the NSW Generations Fund to take a debt-magnified beating. Just when this rainy day fund was meant to kick in and act like an umbrella shielding them from the economic storm.
This is why two major banks and one major international rating agency are ringing the alarm bells about the Treasurer’s risky strategy.
They warn that borrowing more than $10 billion to bet on the sharemarket hikes the interest rates NSW must pay as bondholders demand more compensation for tolerating the higher risks.
For example, if the Treasurer was running a superannuation fund he wouldn’t be allowed to use debt to buy shares. That’s illegal. And, I suspect, as a private citizen if he asked his bank to let him use his home equity to bet on the stock market they would ask some very hard questions. But Perrottet is not a hedge fund manager. He is a public servant. His job is to steward NSW’s finances responsibly.
When he borrows $10 billion he doesn’t do so with his own reputation. He is using the good name of his state and its 8 million people. Right now he’s taking advantage of trust that doesn’t belong to him.
By the end of this financial year, NSW will have racked up a whopping $117.1 billion of debt. That is before taxpayers meet the full cost of the NSW lockdown.
Embracing debt to buy stocks - and billing taxpayers - is controversial in ordinary times. But right now, the state cannot afford to bankroll Perrottet’s huge bet. He might have a big risk appetite. NSW taxpayers do not.

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Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs $7 billion with a team of 33 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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