Disappearing Financial Reserves … Sinking without a trace.

Remember the Sinking Funds?

For those of us who have been in the game long enough to remember the (now unfashionable) use of local government financial Sinking Funds, their demise coincided with an explosion of Council debt.

This huge accumulation of Council debt has arisen over the last decade or more and should come as no surprise given the growing New Zealand economy’s dire need of long life asset creation.

New Zealand Council sector debt has increased over threefold since 2010, admittedly with much of the increase being for sound asset creation and financial management reasons … but not for all of it. 

A good proportion of this large increase the exact total of which can only be guessed at, has been brought about by insidious means which have had a great deal to do with the loss of accountability arising from the demise of sinking fund accounting. Previously earmarked funds held in something approximating an escrow have been plundered for purposes well beyond their usual intended even permissible disbursement. 

 With long predicted interest rate rises imminent, post a very long period of international quantitative easing, debt retirement will again be ushered back into the spotlight. At issue are the questions of … Are we able to learn from the lessons of history? And can we afford to ignore them?

Discussion of Sinking Fund history may seem to reflect only reminiscences, a little more relevant to war stories of the good ol days than to serious debate. Far from it … for we seem to have forgotten the basic sound thinking that lay behind the design of a Sinking Fund.

Consider this: It is difficult to recall any Council in the modern era (the last 20 years) that has done anything but increase its debt total. Is this not a trifle strange? Is it, as well, a result of the inexorable (and irrepressible?) pressures on Councils to provide additional  and/or better services? Or does it just reflect a denial to allow even for the possibility of debt reductions? A chocolate fish for the best answer.

This wave of debt expansion has by and large been achieved within normal prudential borrowing limits, fair enough … particularly for an expanding population and economy.

But there will surely come a time when debt reductions will be necessary, possibly even mandated and most probably due to changes to the prevailing low interest rate banking environment. There will inevitably be pressures to engineer repayment of Council debt. After a long absence repayment as a subject will again become topical. The means of achieving debt reduction will become pressing as will the means by which reductions can be achieved.  

For as unfashionable as it may first appear, the philosophy (if not the reintroduction of the practice), lying behind Sinking Funds and the notion of saving for a rainy day, may soon see its own pigeons returning to roost. If repayment of Council sector debt, having reached maximum ceilings at historically low interest rates in many cases, do not soon become a more  pressing issue … then interest rates will miraculously have dodged forces akin to those of gravity. 

Major amendments to local government financial management legislation played their part in this disappearing Sinking Funds saga. These amendments of the law occurred at three major points. The first happened in 1989 … accrual accounting was introduced, again in 2002 with a totally revised Local Government Act … its introduction of comprehensive Treasury Management policies and finally in 2009 …  policies derived from the Better Local Government movement’s introduction of extensive new debt control (debt ratio) mechanisms.

As far as can be determined, while none of this legislation specifically outlawed a continuation of sinking funds, collectively they soon became a collateral casualty of this flurry of new law. What appears to have happened is that they simply became “outmoded”. Given the advent of a new kid on the block, in the form of circulating fund’s management* accompanied by rollover refinancing of Council debenture deed and other credit facilities, these new methods were seen as being more simpatico with the new whizzy treasury management policies. Banks and other financiers of Council credit happily facilitated these trends within an already more permissive and more creative-open banking environment.

*[Referred to often as the “Slush Fund”  approach … where available credit at any time could be utilised without the need to account for fund movements individually by loan and through real reserve accounting mechanisms such as Sinking Funds].

Sinking funds had been set up for the sole purpose of ensuring that funds were gradually and consistently put aside … steadily accumulated over the term of the loan to thereby ensure that when the loan repayment term became due, these funds would be available for their repayment.

Previous Sinking Fund’s orthodoxy, used to ensure that debt repayment funds were available, in a timely fashion, gradually disappeared. Historical, established sinking funds that had accumulated on the books, were subsumed into the maw along with all Council bank-treasury funds of all sorts.

The traceability of individual funds held for repayment vanished to be replaced by treasury wide debt control mechanisms which included the overall debt ratios and parameters of “modern” methods of debt management. And after all, the term “sinking fund” did sound a little like some quaint artefact of a bygone era. What is more, the discipline of keeping track of debt repayment funding, at such a detailed level was both onerous and often placed pesky constraints on further debt increases. No doubt, better banking IT with hard wired treasury management packages (that did not buy into sinking fund accounting) played a hand here as well.

A pernicious outcome results from the demise of Sinking Funds. Its full explanation is too convoluted and pointy headed in accounting technical terms for this layman’s piece. In summary though, the upshot of a failure to run a sinking fund or equivalent philosophy of debt repayment reserve fund accounting, can often result in the need to borrow more, just to find funding for debt repayments as scheduled.

Current practice provides examples occurring, where the robbing Peter to pay Paul technique (hardly an acceptable default position) is used to cover for an increasing number of cases where funds have not been set aside to meet repayments.   

And lookout! if that further loan repayment-related borrowing puts a Council in breach of its mandated debt ceiling. A certain Micawber credit management adage comes to mind as does “a rock and a hard place”.

Provisions for depreciation of long-life assets build paper reserves over time and are accumulated with the funding of asset replacements in mind. They are correctly called paper reserves, book entries only as once again they invariably are not backed by any actual that is real-physical funding a la Sinking Funds. In some cases of over borrowing and maximum debt ceiling limits, sources of funds have dried up with nothing to hand even those in the form of unused bank facilities.

Ratepayers, they are told, are levied as asset depreciation for the funding of reserves intended for use as future asset replacement expenditure. In practice though, aided by  the slush funds of circulating treasury funds management these paper reserve “funds” are  often used for expenditures far removed from their stated asset replacement purpose. 

But the fact that depreciation reserves have not been earmarked for scheduled repayments or have been raided for other purposes directly contributes to  further borrowing for repayment when often and at times when the cupboard (of funds held and to hand) …  been found to be bare.

If this edition of I’ve been thinking appears too foreboding, then at least the next edition throws out a lifeline. Councils do not (often) go broke, their huge backing of infrastructural asset values usually sees to this. The solutions though, to the reduction of unsustainable or excessive debt, (consider privatisation and or discontinuation of services), though unpalatable to some, may have to be contemplated.

For if in future we neglect the dreaded subject, (don’t mention the repayment word) as effectively as we have over the last two decades particularly when economic growth falters, possibly due to climate change or other global economic factors, we will have failed  to consider the lessons and the essence of the rational justification for the good ol Sinking Fund.