A chronicle of repurchase agreements (RP) and other paradoxical property ownership contracts - www.omo.co.nz


"Good News" Macroeconomics.

By Stephen L Hulme, 16 March 2004.

Fran O'Sullivan for the NZ Herald noted in a recent article that an Australian bank (NAB) with a large New Zealand subsidiary had become enveloped in a "good news" culture in respect of its board's failure to detect loss making rogue currency transactions.

But lets be clear, events of this kind are not uncommon and there have  been many reported instances of large fraudulent losses taken by institutions on behalf of their employees. The famous nineties Volkswagen crisis crossed many borders as an intricate web was spun to enrich a few at shareholders expense. And of course there was Barings Bank's, Nick Leeson.

The point here is that these rogue trades are placed because they can be. Management on behalf of shareholders only wish to report winners and any early losses are compounded by doubling the bet until regulatory authorities or bankruptcy belatedly catch up.

It is not a lot different at sovereign level. Chris Sanders article "M For Money"- succinctly describes the current scenario. Governments pursue policies that gratify the voting majority because they can. In the case of a money production economy like New Zealand, and of course many others,  government fiscal surplus policies dictate that the private sector borrows to promote a perceived GDP growth. Subsequent real estate inflation constitutes good news for many in an environment where investment in productive assets is not tax effective.  

Inevitably that borrowing and asset inflation generates demand for consumer goods produced elsewhere beyond the income received by exports. The resultant current account deficit has to be offset by equal and opposite capital inflows. 

They can only be satisfied by national asset sales or promises to pay in the future issues to our foreign creditors.

They in turn have to buy our currency which rises in value to a point where local panic sets in and new regulations are promulgated to supposedly arrest currency gains caused by credit financed domestic growth leading to more import demand. 

The problem is that the offshore creditor has no inherent interest in this manoeuvre, as the prospect of reduced goods sales encourages further financing at reduced interest rates to keep their factories running, unless borrower default becomes a possibility.

One may ask why anyone would pursue such a merry go round existence - The answer is, simply because it is "good news" for some and one can. 

These macro economic actions can easily be encapsulated by simple basic accounting and money rules set out below from  Rob Parenteau's article 

In this case I have taken the liberty of inserting NZ's circumstances and modifying the statistics and text compared with the cited original, such is the similarity of the situation existing in most Anglo Saxon economies.

The elementary relationships of macro financial balances

For every borrower there must be a lender.

When any economic agent spends more than they earn over any given period of time, they are deficit spending.

Liabilities must be issued by deficit spending units to plug the spending/income gap they have a financing gap which is requires issuing financial claims.

For these liabilities to be voluntarily placed, there must be other economic units that are net saving, or spending less than they are earning.

The economy can be split into three sectors: private domestic (households and firms), public (combined state, local and federal government), and foreign.

The net saving or financial balance of these three sectors must sum to zero: this is simply an extension of the fundamental principle for every borrower there must be a lender. That is,

Private sector financial balance + fiscal balance + capital account balance = 0

Here, the fiscal balance is not just the surplus or deficit on current expenditures, but is government revenues minus government current expenditures minus public investment. See the graphs on this page as a good proxy

In addition, the capital account balance which measures net capital inflows, must be equal to the negative of the current account balance, which itself is the trade deficit plus net investment income plus unilateral transfers. Any trade gap is financed by an offsetting capital flow.

Therefore, by simple rules of algebra, the above identity can be rearranged in the following two steps:

Private sector financial balance + fiscal balance current account balance = 0

Private sector financial balance = current account balance fiscal balance

If, for example, as has recently been the case, the private sector is deficit spending (expenditures > income, therefore liabilities must be issued), then it must be the case that the sum of the public and foreign financial balances is equal to the private sector deficit ex post. That is, at the end of any accounting period, these two sectors must have been net saving in order that the liabilities issued by the deficit spending private sector could be placed.  

Macrofinancial dynamics in a typical recovery

We know in economic recoveries New Zealand has a high income elasticity of demand for imports, the current account balance tends to go deeper into deficit. The latest release for Q3 2003 recorded a $6.005 billion deficit, or 4.6 percent of GDP . A resurgence of the current account deficit beyond the critical 5% of GDP level is not out of the question by 2004 year end.

Similarly, because of the nature of automatic stabilizers (like unemployment compensation, progressive and regressive GST tax rates), fiscal policy tends toward surplus during economic recoveries. Given the prevailing policy bias to avoid deficit spending a significant reduction in the fiscal surplus beyond what is recorded to date in the current 2003/4 year is unlikely.

I can only surmise as house prices declined in the later part of Q4 2003 spending was diverted to consumer consumption in January with borrowed funds as supplied by the Government to the banking system via the Central bank's open market operations.There was a significant up move in the level of outstanding Government deposits available for this purpose in this early 2004 period.     

Returning to our fundamental financial balance equation:

Private sector financial balance = current account balance fiscal balance, or


we can see if the current account balance is going deeper into deficit, even with no change in the fiscal balance, the private sector financing gap will rise. If the current account deteriorates, and the fiscal balance remains in surplus, private sector deficit spending must deepen even further. The private financing gap must widen as we subtract less of a negative number (fiscal deficit) and then more of a positive number (fiscal surplus) from a widening current account deficit (which is chronically in NZ a negative number). This is elementary algebra, and it is irrefutable.

A contemporary example and a pro forma forecast of NZ macro financial balances

By way of illustration, here is how the financial balance equation looks at different points in time, as a share of GDP (to give a relevant scale):

In Q3 2003, we had a large current account deficit and a large fiscal surplus:

PSFB = CUB FB (FB estimated from outstanding omo surplus on 30 Sept 2003)

-7.1% = -4.6% - (2.5%)  This is equivalent to net borrowing of approximately $9.20bn

Based on preliminary Q1 2004 data, I estimate the following composition:


-8.6% = -4.8% - (3.8%)  This is equivalent to net borrowing of approximately $11.22 bn  

Is it any wonder NZ retail sales rose exceptionally in January 2004 when one checks the first graph on this page again.

The relation between deficit spending and debt loads

 Keep in mind that when the private sector is deficit spending, they are adding to their outstanding debt load. Any rise in the private deficit spending to GDP ratio therefore equally implies a rise in the private debt to income ratio. Unless interest rates fall in an offsetting fashion, debt servicing loads must also rise in a period when the private sector balance is growing faster than GDP. Inevitably as described above the import demands caused by these debts puts upward strain on the current account deficit and thus the currency as positive capital inflows offset the negative position. And yet the Government persists with running a surplus in the vain hope that the consequent  lower interest rate costs will lessen the burden of servicing decades of accumulated liabilities.

These relationships are simple but deeply obscured in modern macroeconomic or financial theory. They were well understood by some of the original explorers of macrofinancial dynamics in the first part of the 20 th century. For most economists and strategists, they are unknown, even though they lie at the heart of the bubble dynamics that have so clearly driven macro and market outcomes in recent years. If we take the time to recognise, think through, and apply these simple relationships relationships really no more complicated than analysing the cash flow from operations and investment segments of the cash flow statements put together by individual firms we will have access to some unconventional yet irrefutable conclusions that can give us a decisive edge in our portfolio strategy decision making over those who find these relationships unknown or obscure. It is possible to extend this analysis by splitting up the private sector into the household and corporate sectors and making assumptions about changes in their saving or investment behaviours. It is also possible to extend this analysis by building debt trap equations for both the household and corporate sectors. 


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OMO Matters

US Federal Reserve Reference Publications

"The market for repurchase agreements on US government securities is of vital importance to the New York Fed, and the whole Federal Reserve System, because it is where virtually all of our monetary policy operations are conducted."- Peter Fisher, Manager, System Open Market Account - 15 January 1997.

"Open market operations are not another weapon in the Fed's arsenal, but the only weapon in its arsenal." - Monetary Trends, St Louis Federal Reserve, August 2003.

Repurchase Agreements with Negative Interest Rates - FRBNY - A primer detailing how short sales of Treasury securities can lead to protracted RP fails and consequently negative rates to address capital requirement issues.

Reserve Bank of Australia repo eligible, basis swapped, foreign issued AUD debt - read here.

"Good News" Macroeconomics

OMO-Repo Misuse - Letters to Hon. Dr. Michael Cullen, N.Z. Minister of Finance.

Repo Transaction Accounting. Letter to Mr A Orr, RBNZ.

IMF Repo Accounting Examples, Full Article

Credit Creation, Letter to Iris Claus and Arthur Grimes.

NZ Debt Management Office Uridashi issue and associated EuroKiwi letters to Hon. Dr. Michael Cullen, N.Z. Minister of Finance.

Record Uridashi Issuance.

NZD Mortgage War