How much of a debt burden can a New Zealand council carry?
That question can be answered in many different ways. NZ Local Government magazine has written about council debt on numerous occasions, including our April issue when local government financial analyst Larry Mitchell said his study of council books told him some 15-20 per cent of our councils were in a serious financial state.
LGNZ manager, governance, Dr Mike Reid says LGNZ agrees with Mr Mitchell that “there are around ten or so that are at or just above their prudential limits” but he says the councils involved recognise this. “And we will see next year when they adopt their 2012 long term plans how they plan to manage the debt.”
“A key difference between our approach to debt and that of Larry Mitchell is that we attempt to recognise the fact that since 1996 councils have had to apply the inter-generational equity principle that means in fact a proportion of their long-life infrastructure should be paid for by future generations, to reflect the benefits they receive.
“We also need to note that like central government, during the recession councils have made more use of debt than otherwise would have been the case, which is what we would expect them to do.
Are councils carrying too much debt?
“When the time comes for asset replacement the cupboard will be bare … and debt levels are mostly at their maximum.”
There is nothing like the issue of council debt to excite interest in local government, particularly during elections; after all no politician wants to be blamed for having caused debt to skyrocket. But is debt necessarily bad, and if not, how do we determine when a council’s level of debt is imprudent or excessive?
In their seminal report on local government funding in 2007 the Local Government Rates Inquiry recommended that “local government look favourably on making more use of debt to finance long-term assets”. (Inquiry p. 21). As it turned out the Inquiry’s observations were prophetic; debt is indeed increasing, but should we be worried?
Quick facts
- In 2009 councils spent, on average, 2.5 per centt of total operating revenue on interest payments (excluding income from development contributions).
- Total local authority debt in 2001 was $1.8 billion, however by 2016 this figure is expected to reach $11 billion, and then decline.
- Debt is growing most quickly in councils with fast growing populations (60 per cent of debt is held by only 10 councils).
Whether or not a council’s debt is reasonable ultimately depends on the benchmark employed for making the judgement. A commonly used international benchmark recommends that interest payments should be less than 10 per cent of total revenue. In relation to New Zealand local government we find that councils on average spent less than 2.5 per cent of their total revenue on interest payments. However seven councils exceeded the 10 per cent benchmark and four councils were close to the benchmark.
Discussion
Councils borrow to invest in assets and infrastructure which have long lives that benefit not only today’s generation but generations to come. This is consistent with the principle of “inter-generational” equity. Inter-generational equity ensures the costs of an asset are spread over the life time of that asset so that future generations also contribute through their share of the loan repayments.
Councils are required by law to set a ceiling on their debt levels in consultation with their citizens and it is the responsibility of the Office of the Controller and Auditor General (OAG) to ensure that councils’ debt ceilings are prudent and that councils operate within them. Any council seen to be imprudent in its use of debt is likely to be noted in the OAG’s report to parliament.
One of the problems we face when making judgements about a councils’ use of debt is the fact that councils use a variety of benchmarks, making comparison complex, for example, councils use:
- interest as a proportion of revenue;
- debt in relation to assets or equity;
- debt as a proportion of income;
- liquidity ratios;
- debt caps;
- interest as a proportion of rates.
To accurately assess whether councils have too much debt we need to agree on appropriate measures and benchmarks, which may vary according to the type of council. For example, councils experiencing considerable population growth are able to sustain higher levels of debt. These are councils which need to borrow to put in place the necessary infrastructure before new citizens arrive. Space does not allow a full discussion on different benchmarks so this paper is limited to the use of a single measure, with the result that some councils may exceed the measure and still be acting prudently.
In recent years there have been four published studies of local government debt, all have applied a measure which uses the cost of debt (interest) as a proportion of total rates income.[1] This is an appropriate measure for councils that rely on rates for almost all their discretionary income but overstates debt levels in those councils with significant levels of non-rates income.
Councils receive revenue from a variety of sources, for example, most councils would set charges for facilities, such as refuse stations, to meet all or part of the facility’s running costs, including the cost of capital. (When reviewing central government debt international agencies don’t just consider debt against income tax, they review debt against all government income, including dividends.) So, what are the appropriate measures and benchmarks?
Proposed benchmark
A commonly used measure in the international literature for assessing debt levels uses interest payments as a proportion of revenue and sets the benchmark at less than 10 per cent of revenue. Interest expenditure beyond the 10 per cent is deemed to ‘crowd out’ or limit the ability of organisations to allocate expenditure to other services or respond to emergencies. Ultimately the more spent on servicing debt the less discretion councils will have in the allocation of future resources and may have to reduce service levels.
Figure 1 Total interest payments as % of total revenue
Source: Statistics New Zealand
One advantage of using interest payments as a measure is its sensitivity to the terms on which debt might have been raised. Councils with a strong credit rating should be able to sustain higher levels of debt due to their ability to get loans on better terms than councils with poorer ratings. Figure 1 shows the total level of interest payments as a proportion of total revenue. Although increasing over recent years the figure is still less than the equivalent amount in 1995 and well below the 10 per cent benchmark, even though the full amount of debt was considerably lower than today, reflecting the ability of councils to borrow more cheaply since de-regulation in 1996.[2]
While interest is approximately 5.5 per cent of total revenue, the average level of interest paid by councils was less than 2.5 per cent (2009) indicating the degree to which debt is unevenly distributed across councils.[3]
Although the figures for the sector as a whole are low, seven councils have interest payments above the 10 per cent threshold, and four further councils are close. Of those seven councils at least five are high-growth councils allowing them to sustain higher levels of debt than councils not facing the pressures of population growth. As the Department of Internal Affairs notes (DIA 2010), high levels of debt, and therefore interest payments, tend to be found in councils experiencing rapid population growth. Councils which may also have other funding tools, such as development and financial contributions, to assist with the cost.
Conclusion
Good governance requires prudent management of the community’s financial and non-financial assets. New Zealand councils are more fortunate than councils in many other countries in having the freedom to set their own debt ceilings and to borrow directly from banks and other providers, including raising their own bonds. This has had the effect of reducing the cost of debt even as the total amount has been increasing (see Figure 1). In addition, the local government system operates in accordance with a number of checks and balances intended to ensure financial decisions are prudent.
Councils have responded to the Rating Inquiry’s criticism that the sector should make more use of debt to fund assets and infrastructure, and they have done so responsibly. With the total interest payment figure sitting at 5.5 per cent of total income in 2010 and more importantly the average figure sitting at less than 2.5 per cent (central government spends 4.7 per cent on debt servicing) any suggestion there is a or systemic issue with debt should be seriously questioned.[4] However, as Figure 1 reveals, debt is increasing and 15% of territorial local authorities sit at or above the 10 per cent threshold of interest payments to income.
While the majority of these councils use debt to invest in infrastructure to cater for growing populations they will also be acutely aware of the challenge of meeting both community expectations and the cost of finance from budgets always under pressure. Being above the 10 per cent threshold does not in itself reflect a problem with financial sustainability and perhaps the best indication of this is the fact that one of the eleven councils sitting above the 10 per cent threshold has recently received an AA- rating from Standard and Poors, which noted its sound financial management practices (while also noting the importance of managing its forecast debt) – surely an indication of confidence (Kapiti News 31/8/2011). So the debt issue is a complex one and a single measure cannot fully do the subject justice, but with councils with relatively high debt being endorsed for the quality of their financial management by international agencies, debt is not a systemic problem.
Councils use debt to invest in essential infrastructure in accordance with the principle of inter-generational equity. It is the principle that ensures that all generations contribute to the costs of long life assets. However, we are yet to come up with an established benchmark with regard to how much debt a council should carry in order to be consistent with the inter-generational principle (and the degree to which that benchmark should vary according to the rate of population growth, for example). Greater clarification of the implications of the inter-generational equity principle is necessary in order to fully understand the picture of local government debt.
For further information see ‘Trends in the use of debt by local government’ (DIA 2010) available form www.localcouncils.govt.nz
[1] See Larry Mitchell’s Local Government Index at www.kauriglenn.co.nz, the Department of Internal Affairs report “Trends in the use of debt by local government” available from www.localcouncils.govt.nz; Funding Local Government, the Report of the Local Government Rates Inquiry, 2007, see www.ratesinquiry.govt.nz, and Local Authority Funding Issues, prepared by the joint central government local authority funding project team, available from Local Government New Zealand.
[2] The establishment of the Local Government Funding Agency will further reduce the cost of debt.
[3] Data does not include income from development and financial contributions which arguably should be included as contributions are used to repay debt raised to develop infrastructure for new communities.
[4] Due to availability of data the average figure is calculated on 2009 returns.