New Zealand's councils are playing the long game as they borrow for long-term infrastructure. Rising debt is weighing on local government finances, but credit quality remains very strong.

A weakening trend in institutional settings doesn't signal missteps by the councils; it means credit risk is rising from low levels. Councils are simply delivering their obligations under law to provide essential services and infrastructure to residents and future generations. New Zealand councils' substantial obligations relative to their revenue sources require them to rely on debt more heavily than their international peers (see "New Zealand Councils' Extremely Predictable And Supportive Institutional Settings Are At Risk," published on RatingsDirect on Feb. 19, 2024).

Credit quality remains very strong for New Zealand local councils despite the rising financial risks. The average credit rating in the sector is 'AA', equivalent to our sovereign ratings on the U.K., France, and the resource-rich Abu Dhabi and Qatar.

Credit Risk Differs Between Councils And Countries

The needs of councils vary greatly and so do their resources. The wealth of the local economy, the average household income, the proportion of residents on fixed incomes (such as retirees), the number of residents that are unemployed, and growth pressures mean each council faces a unique set of requirements and tradeoffs, particularly with their infrastructure.

Growth councils, for example, are facing pressing infrastructure needs that are resulting in large deficits, and rising borrowing and credit risk. These councils need significant investment in underground assets to allow growth to occur. They may also need to build new community infrastructure to accommodate larger populations. Other councils, with slower growth, are still facing issues such as large investments for water services.

The ability to pay for this infrastructure and the related debt differs by council. Councils with wealthier residents, for example, can afford to raise property rates more than councils that have residents on lower incomes. While residents may not like it, this means councils with wealthier residents should be able to pass on higher property rate increases than others without breaching their affordability benchmarks.

As Debt Rises, Credit Risk Rises

Our ratings on most councils are under pressure. Rising deficits and debt are increasingly weighing on industry settings. Large deficits and high debt levels don't mean councils are doing the wrong thing. It depends on why debt is rising. In New Zealand's case, debt is generally rising to fund long-term, productive infrastructure to address growth. New Zealand councils aren't borrowing to pay ongoing costs such as wages or utility bills.

New Zealand councils are required to borrow more than other highly rated local government systems such as in Scandinavia, Canada, or Australia. This is because of how the system was set up. New Zealand councils have limited taxation powers; they can't impose personal income, corporate, or consumption taxes. They also have greater infrastructure responsibilities relative to many peers. This means they must run larger deficits and borrow more heavily to fund infrastructure.

New Zealand Councils' Infrastructure Responsibilities Mirror Those Of Australian States And Canadian Provincial Governments

New Zealand councils punch above their weight. The deficits that New Zealand councils run are closer to those of the Australian states and territories (hereby "states") and Canadian provincial governments than Australian and Canadian local governments (see chart 1). This is because Australia and Canada have three-tiered government systems, whereby states and provincial governments are responsible for the bulk of infrastructure spending, not councils. In addition, Canadian provincial governments' institutional settings are weaker than those in which New Zealand councils currently operate.

Chart 1

Intergovernmental Transfers Are Low In New Zealand

New Zealand councils also receive a lower proportion of transfers from the central government than peers (see table 1). These transfers don't include the goods and services taxes (GST) raised by the Australian central government and passed onto the States. GST contributes about 20% of states revenues.

Table 1

New Zealand's Population Growth Is A Clear Differentiation From European Peers

New Zealand, like Australia and Canada, is also facing far greater population strains than Scandinavian peers (see chart 2). This means governments must build infrastructure to accommodate growth. While these pressures have existed for many years, they have grown over the past decade. For the seven years leading into the pandemic, New Zealand's population growth of 2% a year outpaced many, if not all, peers. New Zealand, Australia, and Canada accept many more migrants than other countries. Consequently, border closures during the pandemic hit their population growth. Since reopening, the growth has soared.

Chart 2

Policy Uncertainty Is Weighing On Credit Risk

Further escalating credit risk is the policy uncertainty the sector faces. In February, the National Party-led government repealed the previous labor government's water legislation, which was more than five years in the making. We do not know the structure, timing, or implications for the local government sector of the National government's policies. Will water services remain a council responsibility under the "Local Water Done Well" reforms? When will any change happen? These questions may change the fundamental makeup of the sector. It means financial forecasts for some of the highest rated local governments in the world could be materially wrong--this is no fault of the councils, but it is escalating credit risks.

Ratings Fluctuate As Risks Rise And Fall

It is worth remembering that credit ratings are dynamic, not static. They are designed to reflect rising and falling credit risk. Ratings reflect our expectations of future outcomes based on what we know now. If things change, then our ratings may also change. If credit risk falls (for example, via smaller deficits, lower debt levels, and a stable policy environment) as a result of the government's Local Water Done Well reforms, then our credit ratings may well improve.

Credit Ratings Could Fall Within 12 Months

If uncertainty persists or deficits and debt rise, we may lower the institutional assessment and credit ratings on many councils as early as next year. We may also choose to wait longer to see where things are headed.

We could consider the trend for the institutional settings to be stable if we see greater policy certainty for local councils, particularly regarding water, and a narrowing of deficits and a reduction in debt levels relative to operating revenues.

Credit Risk Of New Zealand Local Councils Is Very Low

If we do end up lowering our ratings on New Zealand councils to reflect higher risks in the institutional settings, the average New Zealand local council credit rating is likely to be 'AA-'. This would still be very high in a global context. According to our empirical studies, the observed default of subnational governments in the 'AA' category (that is, 'AA+' to 'AA-') within the next 10 years has been zero. In the next 15 years, it is about 0.2%. In other words, historically about two local governments out of 1,000 may default 15 years after being rated in the 'AA' category.

We believe that a one-notch downgrade of a council should have a relatively small effect on its borrowing costs. Considering the Local Government Funding Agency's pricing of its loans to councils, on average, marginal interest rates could rise by between 0.05% and 0.10% for some councils; many others could see no change in interest rates.

Council Have Limited Avenues To Counter Risks

Under current policy settings, councils have limited avenues available to counter growing credit risk. To do so they would need to significantly increase property rates over many years or cut essential services and infrastructure budgets. The difficulty councils face is that increasing property rates significantly or cutting services are unpopular with residents. Cutting infrastructure budgets just kicks the can down the road.

The alternative is that councils incur slightly higher credit risk and, at 'AA-', remain highly rated on a global scale.

Editor: Kai Ruthrof

Related Research

• New Zealand Councils' Extremely Predictable And Supportive Institutional Settings Are At Risk, Feb. 19, 2024