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Internal Borrowing (By Any Other Name!)

The following is a letter to the "Informer" from Dal Minogue which with Dal's permission I re-publish here in full, together with Steve Baker's Reply (Below):                                                                         (My comments are in the following post) 

I recently heard a comment that there is now reluctance by Thames Coromandel District Council to use in any way the words "internal debt" when discussing its financial position. So I decided to investigate. 

I discovered that in the Council’s 21 May 2014 agenda, in the minutes of Council’s 9 April meeting, the following "key discussion point" records - 

"Council discussed that the terminology of ‘internal debt’ is misunderstood as a negative connotation and suggested staff use a different terminology going forward such as ‘internal reserves.’" 

This approach is indefensible as it allows Council a tactic to completely disregard internal debt and pretend to the public that it does not exist.

For the record, "internal reserves" and "internal debt" are two completely separate things.

Internal reserves are made up of money accumulated in accounts for such things as development contributions collected for the shared cost of future assets, depreciation collected from current ratepayers for the eventual replacement of certain assets, "carry overs" from one financial year to another, cash reserves held for a specific, limited purpose such as the money obtained from the historical sale of Council’s Power NZ shares, etc.

"Internal borrowing" occurs when the Council decides to borrow against these internal reserves instead of using external debt (bank borrowing).

When internal borrowing is used, an interest rate similar or identical to external borrowing is charged so as not to depreciate the real value of the internal reserves. So it is really the equivalent of external borrowing in terms of its impact on Council’s financial position.

Also, internal reserves may or may not be borrowed against. Most councils, in fact, do not undertake the practice. If a council does decide to borrow against these reserves, such as ours has done, then it can really only be called "internal borrowing" because that is exactly what it is.

Removing all reference to internal borrowing will not make Council’s internal borrowing go away. It will only remove the concept from the public mind and make Council’s real borrowing position appear to be 30-40 million dollars less than it actually is. "Going forward" indeed.

But I do not wish to be too critical. Councilors are obviously trying their best to avoid controversy. That of course is dangerous given usual unintelligent reporting by the media. However, in this instance their claim is a bridge too far and, like it or not, underlines a serious lack of financial comprehension or a deliberate act of misleading.

Dal Minogue

Here is the reply from Steve Baker:

When we talk about internal borrowing or internal debt, we are referring to using Council funds for a different purpose than for what they were received.

We don’t’ have surplus funds lying around, instead we have a range of reserve funds, including -

Depreciation reserves (Council assets depreciate as they are consumed and depreciation funds are collected to replace these assets).

Disaster reserves (Council collects funds each year specifically for unplanned events caused by natural disasters. These usually are used for repairs to roads after storm events).

Retained earnings, both District wide and by Community Board area.

Power NZ Reserves.

More detail about all of Council's reserves can be found in our annual Plan or Ten Year Plan documents.

When we "borrow internally" we’re referring to these reserves as another "borrowing facility."

The benefit of doing this means we don’t need external borrowing (ie from a bank). When we borrow internally, we charge ourselves (or more correctly, the activities which have borrowed the funds) interest for the use of these funds. The funds are repaid so that they can be used for their original purpose.

Why do we charge ourselves interest?

We have a policy which means that any interest earned on Council funds goes toward subsidising rates and more specifically against the Uniform Annual General Charge (UAGC). This UAGC is something that all ratepayers in the district pay equally (like a flat fixed charge), so by offsetting the cost of the UAGC, the benefits of any interest earned are distributed to all ratepayers.

When we reduce the reserve funds through internal borrowing, we are therefore removing the interest benefit to all ratepayers.

If we are using internal borrowing for a project that does not benefit everyone in the District equally (for example, something like the pool in Thames), then it is not equitable that the community of Thames has the benefit of use of the funds, whilst the District's ratepayers do not receive the benefit of the interest subsidy. That’s part of why we charge interest on internal borrowing.

Please note the same rate of interest is levied regardless of whether the debt is internal or external.

We deliver services through 28 different and unique activities. These aren’t all funded the same way and each ratepayer doesn’t fund the same activities as all other ratepayers. Eg halls, harbours and parks and reserves are funded by individual Community Board areas. As such a ratepayer in Whangamata isn’t rated for and doesn’t contribute to the parks and reserves in Mercury Bay and vice versa

For our wastewater activity, we collect rates from only those ratepayers who are connected or have the ability to connect to our wastewater infrastructure. Therefore those ratepayers who aren’t connected nor have the ability to connect don’t contribute.

If all activities were funded in same way, to the same amount, by all ratepayers, then there probably wouldn't be the same need for and use of internal borrowing. But we have a different funding structure for each activity to reflect the way each activity benefits different people in the District.

So what's with these Power NZ Reserves we hear about so often? Back in 1992, the electricity corporatisation process formed Power NZ. As part of that process it was argued that ratepayers were entitled to a share in the net worth of the power boards as the parties whose backing enabled their creation. Accordingly, 20 per cent of shares were to be given to councils to manage for the benefit of present and future generations

The Council of the day considered a number of options on how to deal with this money including -

Fund deferred maintenance.

Fund development of new capital assets.

Subsidising rates.

Creation of a new borrowing facility.

Maintain capital value of the fund.

After much deliberation they considered that in fulfilling the purpose for which the money was received, they would create an internal borrowing facility that would benefit both the ratepayers of the day and the future equitably. That is, we would invest the money (our money) in the business rather than taking on external borrowings.

This reserve does not represent an obligation of Council to pay monies to an external party and as such should not be considered nor treated in the same way as external debt.

At the end of June 2013 Council had external borrowings of $49 million. They also had a Power NZ Financial Reserve (part of its equity) of $24 million.

It would be misleading to portray that we owed an external party $73million when we do not.

Steve Baker

TCDC Chief Financial Officer



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