On April 14, the $50 million the Waipa District Council (WDC) borrowed from the Local Government Funding Agency (LGFA) last August and placed on deposit in two New Zealand commercial banks will mature.
Peter Nicholl with a caricature of him as Bosnian Central Bank governor. Photo: Mary Anne Gill
The council will use this $50 million to repay an earlier loan. Last August, the WDC issued a press statement under the heading ‘financial deal set to net nearly $400,000 profit over the next eight months’.
They described it as a ‘low risk arbitrage deal’ because the interest rate was locked in on both sides of the transaction. What was not disclosed was that they had locked the interest rate on the deposits in for eight months but had locked the interest rate on the loan in for five.
WDC didn’t need these borrowed funds until April 2025. If they had waited to borrow the funds they could have borrowed from the LGFA for four years at an interest rate of 4.41 per cent today. They choose to borrow the funds early will continue to pay the fixed interest rate of 4.67 per cent they signed up to last August for another four years. WDC will pay an additional $520,000 in interest because of this so-called ‘low-risk deal’.
Arbitrage deal, a good deal?
This is more than the additional $400,000 they earned on the deal in its first phase.
It is likely that LGFA lending rates will fall further as the Reserve Bank’s Official Cash Rate has been reduced by 1.5 per cent between last August and today and may fall a little further. If the WDC could borrow for a term of less than four years now and roll the loan over during the next four years they would be likely to save ratepayers even more money. But they are locked into a five year fixed-rate loan.
It is often easy to see that a deal is poor with hindsight. But this doesn’t apply in this case. It was predictable. Last August, households with mortgages were facing the same dilemma – when to borrow and how long to fix the interest rate for? Most borrowed short or on floating interest rates – and made the correct decision.
Everybody, including the Reserve Bank, was forecasting that interest rates would fall. The only uncertainties were how fast and how far they would fall.
Despite this, the council, apparently on the advice of their ‘financial advisor’, Bancorp, decided to lock in a fixed interest rate on their borrowing for five years. This was not a ‘low risk arbitrage deal’. In fact, it wasn’t an arbitrage deal at all.
A financial arbitrage deal involves simultaneously buying and selling the same or similar asset in different markets to profit from temporary price differences thus making a guaranteed profit. The two sides of this deal were not ‘simultaneous’ and the two sides of the deal were not ‘the same or similar assets’ either.
An interest rate fixed for eight months is a very different asset to an interest rate fixed for five years.
What the WDC did was speculate on interest rate trends. This speculative deal has backfired.
See: Too good to be true?
See: Council defends ‘low risk’ investment
See: Financial deal set to net
- Peter Nicholl worked at the Reserve Bank of New Zealand for 22 years, as chief economist for five and deputy governor and deputy chief executive from 1990 to 1995. In 1995, he became an executive director on the World Bank board representing New Zealand, Australia, Korea, Cambodia, Mongolia and seven Pacific island nations. He was governor at the Central Bank of Bosnia and Herzegovina from 1997 to 2004. In 2006, he was appointed a companion of the Queen’s Service Order for public services. Nicholl lives in Cambridge.
