Assemblée Législative de la Nouvelle-Écosse

Les travaux de la Chambre ont repris le
21 septembre 2017

Public Accounts Committee -- Wed., Apr. 2, 1997

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9:30 A.M.


Mr. John Leefe


Mrs. Francene Cosman

MR. CHAIRMAN: Ladies and gentlemen, I will call the meeting of the Standing Committee on Public Accounts to order. Today we have representatives from the Department of Finance: Mr. Robert Moody, the Deputy Minister, welcome, Bob; Mr. Rick McAloney, Executive Director Investment, Pensions and Treasury Services, Rick, welcome back to you; and Doug Stratton, Director Liability Management and Treasury Services and Doug, nice to have you back with us again. Of course, we also have Roy Salmon, our Auditor General and Claude Carter, Senior Audit Director, with us today as well.

This morning we are going to begin with a presentation by the Department of Finance and Bob, I think you are going to lead us in that presentation and then we will follow on with questions and answers. Bob.

MR. ROBERT MOODY: Mr. Chairman, ladies and gentlemen, I am very pleased to be here, back at Public Accounts. It is always a pleasure. The slide presentation that was circulated late last week is what I will go through this morning. There have been some minor modifications since that time. I will try to point them out, but nothing major.

I will be prompt in my presentation. There are 35 slides. I believe that will give a nice context in terms of the entire debt management environment within the Department of Finance and I think that will allow us to have a good, productive Q&A session after that. The comments that I will give are complementary to the slides, not meaning to duplicate the slides but to add additional information.


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Before speaking to the exact slides, I just want to say that since coming to the Department of Finance - actually a year ago yesterday, April 1st of last year - this entire area has been a very exciting one and one with a lot of opportunity. We have a small nucleus of staff in this area but highly professional and highly skilled with lots of potential to do many good things in the months and years ahead. So it has been a very pleasant experience for me to be in the Department of Finance and one of the main areas for that is really the high degree of quality of the staff.

So with these introductory remarks, Mr. Chairman, I will go through some prepared notes and move through the slides on a fairly brisk basis. I anticipate that it might take 45 minutes to go through the slides but I will cut that down, if I can.

Debt management's importance grew as debt management costs accounted for more of government's budget. In our case here in Nova Scotia, a one basis point, 0.1 per cent change, in annual interest cost frees up or preempts, depending on which way it goes, almost $1 million for program delivery purposes. Managing debt is like investing stood on its head. It is just a mirror image. It, too, seeks to avoid undue risk and to utilize opportunities and to make or save money and requires good information, appropriate strategies and above all, discipline. Throughout this presentation there are, therefore, three reoccurring themes - opportunities and risks, discipline and controls, and checks and balances.

This summary slide really, I hope, will put the presentation in perspective. Very briefly, debt management is very much a discipline process. Sound debt management is critical to and an integral part of sound, fiscal management for Nova Scotia. Debt management practices have certainly been modernized in Nova Scotia in the last three years. Foreign exchange exposure has been reduced from a high of 72 per cent to 55 per cent in the past two years. Accountability has increased with such documents as Government By Design. New processes and reports that have been put in place have enhanced accountability and transparency. Lastly - and I would like to emphasize this point - the role of each player in debt management is being carefully defined. I want to emphasize, is being carefully defined. What we have here is very much a work in progress. We have come a long way in the last couple of years. We are not where we want to be but we feel very proud of what we have done.

Opportunity occurs because in all markets different market participants can and will have different objectives. Thus, for example, in the housing market both sellers and buyers have their own reasons for their actions. Risk results in part from factors beyond the market participant's control such as interest rate changes or fluctuations in currency values and apart from more controllable factors such as credit risks. Successful debt management requires the ongoing careful and disciplined balancing of the potential benefits and costs of reconfiguring the risk profile of a debt portfolio.

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In terms of an overview of our presentation this morning, the first few slides will illustrate the fiscal background that we have here in Nova Scotia today. This is relevant because the presence and size of a deficit or surplus impacts the size of the debt portfolio and on the way it can be managed. Next, we will have some slides that illustrate the framework for the province's debt management, namely our organizational structure and the mission statement of this particular area within finance. The balance of the presentation is devoted to some specific aspects of the debt management activity, including the very important question of control and of the checks and balances that are now in place.

I am sure all members of this committee are very much aware that for the first time in over a decade, in the year ending 1995-96, the province paid its own way with respect to the day-to-day running of the business of government.

Overall, in terms of total budgetary balance, the incoming and outgoing cash flows that relate to the province's day-to-day operations and long-term capital investments are now in better balance than they have been for some time, one of the critical factors in terms of putting a cap on the net direct debt. Just a very brief definition of net direct debt, the summation of all deficits and all surpluses in the province's history. Debt is the accumulation of overspending. Government debt, unless offset by real assets, reflects past benefits not paid for by beneficiaries that will have to be paid for by future generations. Net direct debt is an accounting term that denotes the difference between the total assets and liabilities reported on the statement of financial position. Net direct debt is more conservative in the public sense than in the private sector. As in our case, we attach no value to capital assets such as schools and roads and hospitals.

From this chart you will see that in recent years the rate of growth of the province's net direct debt has indeed accelerated. Our debt portfolio, however, still has a lot of foreign denominated current debt that is a source of unpredictable volatility in the government's bottom line. Since a key objective of our debt management effort is to reduce such volatility, reducing our foreign exchange exposure is fundamental to this strategy long term. What that last chart shows, as members know, is that the net direct debt now, as of March 31, 1996, stands at approximately $8.7 billion.

Within the Department of Finance, the chain of command in respect to decision making in this area, delegation of duties and day-to-day responsibilities, you will see there, of course, myself as deputy, Mr. McAloney as Executive Director of the branch and within that Mr. Stratton, Director of Liability and Management Treasury Services. Under that, there are four main functional areas: Cash Management Services; Debt Servicing and Information; Derivatives and Quantitative Evaluation; and Alternative Financing. We will return to this information later when we will look at control within the department and chain of command and how the systems of checks and balances within the Department of Finance are being put into place.

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In terms of our mission statement for debt management, we must take into account the province's fiscal objectives and, of course, they are paramount in our role here. The debt management tail cannot wag the fiscal policy end of the dog. The cheaper we can borrow, whether to finance a deficit or to roll over existing debt, the greater the scope for improving the quality of government services that can be delivered in the context of a specific tax structure.

There was a chart in the presentation, this is one that was deleted, I believe it looks like this. That just defined gross and net debt but we just took that out to simplify the presentation. So if you are wondering why you missed a slide there, I just took it out of this presentation.

Less debt and/or lower debt service costs leave more money for delivering government services and also provides more flexibility in the administration of existing programs or the creation of new ones. Foreign currency exposure is a prime source of risk and must be managed once built into the debt portfolio.

The other key risk is the interest rate mix. Fixed rate is great when interest rates are going up and floating rates when they are going down. Unfortunately, since interest rates are notoriously hard to predict with consistency, getting the mix right is challenging and, of course, we are all blessed with 20/20 hindsight and that just adds to the challenge for all of us.

Now, over the last three years there have been some very positive moves in terms of the foreign currency component, the provincial debt has been reduced from approximately 72 per cent to approximately 55 per cent. Now, members will recall that last spring, less than a year ago under the Financial Measures Act, a very key improvement was promoted by the Department of Finance to ensure that the long-term reduction of that debt will get to 20 per cent and below. Reducing it further to the 20 per cent level from its current 25 per cent, however, must be done gradually and strategically. There are benefits in dollar averaging following a program rather than trying to out-guess the market. The less the need is perceived to be in terms of moving to this objective in the market the better the pricing that will likely be offered. You sort of think of it as the Tom Sawyer fence painting approach to reducing this debt. We want to do it but we have to do it smartly and strategically as opposed to trying to do it all at once.

As Nova Scotia's credit perception improves, we become a more desirable counter-party and thus will be shown better interest rates and be able to take better advantage of interest rates while at the same time reducing foreign debt exposure.

Again, members will be familiar with Government By Design and the improvements that have been made there over the last couple of years. The requirements of the Government By Design document focuses on three key parameters of debt management: the make-up of

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the portfolio, which determines what those day-to-day responsibilities for its management have to work with, what is in the portfolio; the potential downside risks from an overall fiscal policy perspective, which focuses attention on risk tolerance; and the parameters of risk factors beyond the province's and the manager's control.

So, for example, one of the areas as published in Government By Design is sensitivity analysis in terms of debt-servicing costs so that people understand some of the risks involved. This quantifies the risk to the government's bottom line that debt management seeks to mitigate. If I could just have members' attention for one example, along this line here, just to give an illustration, what that means is that a one cent change in the Canadian dollar versus the U.S. dollar will mean that, if it is done on the whole year, a change of $4 million plus or minus depending upon whether the change was favourable or unfavourable. So, obviously, when you are debt servicing, costs can fluctuate quite dramatically aggravated by the rate of foreign exchange exposure. Of course, fluctuations can be both in the province's favour or not in the province's favour.

In terms of managing the debt portfolio for the province there are a number of different types of financial transactions that are used and have been used by the Department of Finance. This slide gives title to some of the more generic financial transactions that are utilized. Bonds and money market instruments are the raw material of the debt portfolio. Derivatives are useful to reposition risk and take advantage of market inefficiencies. Hybrid securities can serve a number of purposes including the matching of unusual funding needs and the hedging of specific risks.

MR. RONALD RUSSELL: Excuse me, what is a puttable bond, for those of us who don't know?

MR. DOUGLAS STRATTON: A puttable bond in this case is when the investor who bought our bond has the right to at a certain date return it to the province for full repayment. I think we have one puttable bond in our portfolio, a Yankee bond, that is, if you will, the opposite of a callable one where the province has the right to call back the obligation from the investor.

MR. RUSSELL: So it is just the opposite?

MR. STRATTON: Yes. In the puttable, the investor has the option.

MR. ROBERT MOODY: Mr. Chairman, this slide just gives a very straightforward definition of a derivative and through the next few slides we will take you through some examples of derivatives. I would also point out to members that the material circulated to you late last week, if you haven't had the opportunity, we did a backgrounder in there, I believe a three page document on derivatives.

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MR. CHAIRMAN: Yes, we have that.

MR. ROBERT MOODY: I would highly recommend for those who haven't had the opportunity to read it to go through that, because it places, I think, a nice context about derivatives and tries to remove, if managed prudently as an appropriate tool, tries to take the dirty d out of the word derivative.

So, very succinctly, a derivative is a financial contract that changes in value based upon price movements of related underlying security, future or other instrument or index. Some unfortunate instances have given derivatives a bad name. Fort William Ukrainian Credit Union, Proctor and Gamble, but as demonstrated by the Orange County example, one doesn't need to use derivatives to get into trouble if you don't have the right people, the right processes and the right checks and balances in place. Derivatives are tools that can be used for good and prudent purposes.

Repositioning risk or benefitting from market inefficiencies in a rational manner is good, speculation is not. The most important part is to fully understand what you are getting into. To counter black box talk by his derivatives people the chairman of a major U.S. bank has a simple rule, and I kind of like this simple rule, I can identify with it: if you cannot explain it to me in plain English in the first three opportunities, then it is too complicated and we won't do it. That's not a bad rule of thumb to follow in terms of looking at particular transactions that the market may open.

Again, sticking with derivatives in a generic sense, commodity future, here on this particular slide, just to give you an example, two differing objectives create needs that a commodity future - derivative - transaction can address in a mutually beneficial way. A farmer wants to fix the profit margin of a wheat crop about to be planted and therefore sells the wheat forward for delivery in the fall. A baker wants to fix the profit margin of bread to be delivered in the fall and therefore buys the necessary wheat and flour forward for delivery in the fall. A futures contract protects the farmer from a decline in wheat prices and the baker from an increase in wheat prices. Whereas at one time both would have had to find each other, an expensive and time-consuming undertaking with no guarantee of success, the modern market mechanisms available today have made this process more efficient. Neither, however, hedge their entire risk exposure, the farmer still depends on weather conditions, so there is risk there and the baker may be vulnerable to other input costs.

In terms of why we use various instruments within the province, the three basic reasons out on the slide there, in terms of funding and shortfall, investing the surplus, managing risk and to save money. People borrow or invest every day. The size and volatility of its cash flows gives the province that many more reasons to do so than the average citizen but the principles are the same. We all manage risk every day when we buy insurance, when we cross the street or more generally speaking, when we choose between the alternatives open to us at particular points. We also intuitively practice arbitrage or savings when we

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travel across town to save money on gas or merchants would do this when pricing their goods differently. Managing risk and utilizing arbitrage and debt management is different only in its scale in terms of the province and in that it is done in a more disciplined rather than intuitive way; again, emphasizing the point of discipline.

[10:00 a.m.]

The next couple of slides actually trace a transaction through the Department of Finance in a couple of ways that different things were done over time. This is a real life example of a series of funding, hedging and arbitrage transactions done by Finance. The original need was to find approximately $700 million Canadian. We borrowed, in U.S. currency, $500 million because it was the most readily available and most attractive on a global basis and we knew it would be readily convertible to Canadian dollars. Later, we initiated a swap to eliminate the foreign exchange risk inherent in the original transaction and, in the process, reduce debt servicing costs over the remaining life of the loan by $17 million. We were able to do this because, at the time of that swap, there had been a currency gain and that $7 million saving was realized over approximately three and one-half years left in that loan. Later still, we found someone willing to pay us in U.S. funds, $2.7 million to enter into a series of transactions that repositioned that person's risk but left the province's unchanged.

Just to come at that a different way, same series of transactions, first we met our immediate funding requirement in the way that was most cost-effective on a Canadian dollar equivalent basis. Secondly, we eliminated the foreign exchange risk and, at the same time, took advantage of currency changes and reduced our total funding cost. Finally, we were paid cash upfront to let another issuer change their risk profile without affecting ours. When all was said and done, the province had raised the $700 million it needed at a below market floating rate cost and had an extra $2.7 million U.S. in the cash register at the end of the day. That last transaction was the one that was highlighted in an interesting article in the Chronicle-Herald back in the fall. I think that was when Mr. Stratton got the nickname of the midnight man and cowboy, the man who never sleeps.

In terms of managing financial risk and optimizing risk, there is no such thing as risk-free debt management. Whatever financial engineering we do in whatever disciplined way, we cannot totally eliminate risk. The province's obligation to make payments on the debt instruments as it issued and the presence of some degree of risk. Thus, in the FRN swap, the province had not terminated its obligation to its FRN holders. Instead, it had created a U.S. dollar receivables to its U.S. dollar payables and created a new Canadian dollar payable stream. In so doing, it had exchanged a foreign exchange risk of which we had too much and still have too much, and which was too concentrated for a counter party risk of which it had less and which it could diversify.

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In terms of moving to a debt management statement and process and checks and balances, this slide just denotes some key elements here in terms of risk. As noted earlier, debt management involves a disciplined approach to the management of risk and the utilization of opportunities. This, in turn, requires knowing what the risks are, how the risk is measured, what the risk reward trade-offs are, what degree of risk is acceptable, how risk can be monitored, and how it can be reported. Transparency and openness in what we do and the assumptions we make are very much a part of reducing risk in this area.

Financial market risk in an overview and broad categories here and we could probably list, Mr. Chairman and members, almost an endless variety of risk, but these are main risk categories that are encountered day to day and week to week in debt management. In market risk, even minor changes in interest rates and/or currency values can have a major impact on the government's bottom line. In times of downward-turning interest rates, there is even risk, obviously, associated with interest rates that are fixed at a higher rate long term.

Credit risk, a counter party cannot meet its obligation to us when it falls due, the province, nevertheless, must meet its obligations to others. There might be operational risks, often the result of human factors, and that is controllable by good management practices, good people and checks and balances. Then, of course, there is legal risk. Experience, precedent and more standardized language are reducing the potential for this risk.

In terms of within the Department of Finance, this slide just summarizes key players within the department in terms of the control function. Some recent incidents involving, for example, misuse of derivatives occurred in environments where the transaction and the supervision of the control functions were not sufficiently separated. Finance has in place, and is putting in place, a system of checks and balances featuring two sources of input: one involves operations and the other involves control. The latter applies before and after the fact. First, it established the parameters for the hands-on managers to conform with and after the fact, it monitors that the parameters were, in fact, observed at all times. This particular slide, again, just shows the chain of control of command within the department and the key people who are involved in these processes.

MR. CHAIRMAN: Bob, just before we leave that slide, Finance's external auditor, nomenclature is important here with respect to us understanding precisely of what we speak. You are aware that the view of several members of this committee is that the auditor who is hired by the minister to do the province's Public Accounts is deemed by us to be an internal auditor, in that the audit is reported directly to the minister in contrast to an external audit which would be conducted by the Auditor General as an external auditor who would report to the House of Assembly. Is your definition of external auditor consistent with the past definitions provided by Finance that is referencing the auditor who is hired by the Minister of Finance?

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MR. ROBERT MOODY: Yes, sorry if there is confusion there, Mr. Chairman. Perhaps a different word could be Finance's contract auditor.

MR. CHAIRMAN: Yes, I think that would be more helpful.

MR. ROBERT MOODY: My intent for using the phraseology there was to differentiate from the next line down in terms of Director of Internal Audit because within the Department of Finance, we do have our own internal audit section. Both of these auditors would be represented within this process.

In terms of the operations functions, key planners in managing risk are listed here: the Minister of Finance; the deputy minister; the internal counsel to Finance, in other words our senior lawyer; the Executive Director of Pensions, Investment and Treasury Services; the Director of Liability Management and Treasury Services; and the Director of Investments.

Operational responsibility, generally speaking, is delegated from the minister down via the deputy minister and the executive director to the Director of Liability Management and Treasury Services. The information flows from the Director of Liability Management and Treasury Services and his staff up through the executive director, and the deputy minister to the minister. The degree of delegation depends, in part, on the size of the transaction; prior approval in principle obtained before major initiatives are launched. Internal counsel, our senior lawyer, and the Director of Investments provide support in their respective areas of expertise.

Mr. Chairman and members, I would like to spend a few extra seconds on this slide because this is a very critical thing in terms of where we have been, where we are today and where we are going. Let me allow a few comments that won't become obvious from this slide. Approximately two years ago, the structure that you see up here, in terms of the risk management process and the controls and checks and balances, approximately two years ago you wouldn't have found this in place in the Department of Finance. By the end of this current fiscal year, you will see 100 per cent of this in place in a formal way. Today, if I had to estimate, I would suggest that more than 50 per cent of this structure and related process is in place in a formal way, so we have come a long way over the last couple of years. We have good work to do over the next year, so I would ask, Mr. Chairman, that members consider this work in progress in terms of putting in the appropriate checks and balances.

I am going to go through each of these in the final portion of my presentation to talk about the work that is being done and to point out the formal nature, to give you a good sense for the checks and balances that are in place today and the ones that will be coming downstream very quickly.

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The top of the screen, the Debt Management Committee, is where, in fact, the buck stops: at the officials level. That particular overall committee is there on an ad hoc basis and will soon be quite formal. The Cash Forecasting group is a key tactical decision-making forum, whereas the Credit Sub-Committee targets longer term credit exposures. The Investor Relations Sub-Committee seeks to optimize the province's image in global markets so as to improve their receptiveness to provincial debt. The Working Group on ISDA Master Agreements - and I will come back to this - will pay off in terms of fewer legal complications. External monitoring is provided, first by an audit committee and subsequently by reviews of the Auditor General.

Again, Mr. Chairman, as I go through these, I will give you a status of where they are.

The Debt Management Committee, once formalized, will be chaired by myself, as Deputy Minister; the Executive Director, Mr. McAloney, will be there and will be the alternate Chairman; the Director of Liability Management and Treasury Services; Internal Legal Counsel; Director of Investments; Manager of Derivatives and Quantitative Evaluation; a Controller from the Department of Finance; and others as required.

The objectives are set out there on the slide. If I could draw your attention to the first one, it is really setting the strategic objectives and approving the debt management initiatives, so it will set the overall parameters of what we are doing month to month, year to year and medium term in terms of debt management. We will evolve into monthly meetings and there will be formal minutes that will be available and submitted directly to the minister.

Again, this slide shows one of the sub-groups, the Cash Forecasting model. The objectives are there. The first one, "To review and coordinate the short term borrowing needs and investment profile of the Province and related funds.", is very active; quite new, but very active. It is chaired by the Director of Liability Management. It would involve the Manager of Cash Management - that person would be the alternate chairman - the Manager of Debt Servicing, the Manager of Derivatives and others as required. Now, here, the meetings are held not less than twice a month; they are usually held on a weekly basis. Minutes are forwarded in a formal way, both to myself and to the Executive Director.

This particular committee has been going less than one year and there is very formal documentation available. I'm sorry, this one has been going for approximately two years. Just by way of an example, there is a very formal audit trail kept after every meeting about what is done and why in terms of records and rationale. It is that type of audit trail and rationale that will exist for every one of these groups before this fiscal year is over.

There is also a Working Group on International Dealers Association to develop Master Agreements. The objective here is, "To ensure consistent and rigorous application of the Province's legal standards when documenting ISDA Master Agreements between industry counter parties and the Nova Scotia Public Service Superannuation Fund, the Nova Scotia

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Teachers' Pension Fund, the Province and all its controlled entities including Crown corporations, agencies, boards and commissions.".

Sitting on this group is the chairman, the Director of Liability Management Services; the Director of Investments is the alternate chairman; the Manager of Derivatives; our senior solicitor; as well as the legal assistant to our senior solicitor. Meetings have been held here as frequently as twice a week in order to document this. Again, minutes are forwarded in a formal sense, currently, to both the Executive Director and the Deputy Minister. Here, again, a very formal audit trail is provided; minutes are produced within a day or two of those meetings. As we mentioned, it can be held as much as on a weekly basis, and this particular group has been going now for just about one year.

Another sub-group is the Credit Sub-Committee. Its objective is, "To recommend derivative counterparties, bond and money market Eligible Lists and criteria for inclusion on such Lists, and dealer trading lists for money market, bonds and foreign exchange.", again, much similar to the last group. There is the Director of Liability Management; the Director of Investments is the alternate chairman; the Manager of Derivatives; the Manager of Cash Management; the Manager of Bond Investment; and others as required. To date this particular activity has been carried out but handled by the Cash Management group. It is, however, sufficiently important to be dealt with in its own right by a new group, and that will be fully enforced during the upcoming months. This group, we anticipate, will meet formally monthly, and again its minutes will go directly to the Executive Director.

Another sub-group is the Investor Relations Committee, and members will see there that the main objective is, "To ensure that investors and rating agencies are receiving accurate and timely data on the financial condition of the Province.". The group will be chaired by the Director of Liability Management; the Manager of Debt Service; the Director of Statistics; another branch will be involved with Director of the Fiscal Policy Division; our senior communications person; and others as required from the department. This group is up and running now. It is more or less done on an ad hoc basis in terms of when it is felt appropriate to update the financial markets and the outputs are formal in terms of formal minutes and formal communications to the money markets.

Internal Audit group. This group will be new and it will be set up very soon. We believe it will provide a very important check and balance. The objective here will be to provide, "An objective and independent process to identify, measure and report risks.". It will be, "Charged with the authority to monitor any and all transactions on an ongoing basis.".

This group will be chaired by our Director of Internal Audit and, as I mentioned through the Chairman a few minutes ago, within the Department of Finance we have our own internal audit group with its own director and that person would be the chair of this group. The contract auditor, or as we have termed the external auditor of the Department of Finance, will be invited to sit on that group; we plan to invite the Auditor General to sit on that group

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as an observer on an ongoing basis; and then others as required. The direction that will be given this group will be to meet monthly and, typically, just prior to a meeting of the Debt Management Committee. The minutes here will be reported by the Director of Internal Audit and will be forwarded to the Deputy Minister.

Also in that process, we are perhaps suggesting a more formalized approach with the review with the Auditor General. This is happening now on an ad hoc basis, which isn't appropriate, but the Auditor General initiates visits to discuss debt management, as is certainly his privilege and prerogative to do. What we would like to do, when we have all of these processes in place this year, is to perhaps have that on a more formal basis. We are suggesting to at least try it for the first year.

We might even want on a quarterly basis, with myself in the chair, to invite the Auditor General and other key staff in the Department of Finance, which would include the Executive Director of the Branch, the Director of Liability Management, our senior solicitor, the Director of Investments, and perhaps others as required. This would provide an opportunity, again, on a more regular, more formal basis which I think is particularly critical as we improve our checks and balances and risk management that we receive ongoing input from as many independent sources as we can. So that is something that is in the proposal stage and we will formalize an invitation with that with the Auditor General in the very near term.

One of the original requests for this session came out, I understand, from members looking specifically at derivatives and draft derivatives, encouraging the Department of Finance to have a derivative policy. This is obviously a very specific area. We have spent much of the presentation this morning talking in a very general way, giving the overview of processes and risks and balancing opportunities and risks. The derivative policy which we now have in a working draft form is an important part of that as are other policies and processes that we are putting in place.

I will just mention I have one slide after this, Mr. Chairman. This particular slide really summarizes the draft policy statement in terms of what it is intended to do. Again I would refer members to the backgrounder in the documents that were provided late last week for a good walk-through of that particular draft policy. Basic parameters are provided by legislation and by Government By Design in terms of the use of derivatives. Cash management and the credit subcommittee meetings are key to policy implementation. The minutes of these meetings are sent to the deputy minister and the executive director.

Now the Internal Audit Committee and the Auditor General's ongoing reviews, whether they be ad hoc or more structured, will act certainly as second and third lines of defence in ensuring that the policy parameters are observed at all times. What we have done with this draft policy statement is we have sent it out to various people in the private sector for their comments, looking for constructive input back and very late last week we submitted

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it to the Auditor General, asking for his input on this draft policy also. I say very late last week - in all fairness to the Auditor General, that may not have arrived until Tuesday of this week but we have asked for comment there.

This slide, Mr. Chairman and members, is the last slide in terms of the formal presentation. It is one - it was, I believe, the second slide that I started with this morning - really to summarize. In terms of debt management, it very much has to be a discipline process. Sound debt management is critical, too, and an integral part of sound fiscal management. Debt management practices have been quite significantly modernized within the Department of Finance over the last three years. Foreign exchange exposure has been reduced from 72 per cent to 55 per cent in the last two years. Accountability has increased with such documents as Government By Design, new processes and reports have been put in place and enhanced accountability and transparency. I will come back to that last bullet point.

Our objective this morning in terms of the formal part of the process was to attempt to demystify the practice of debt management, to demonstrate - as I am sure members are well aware - its importance to the province and to show that the province's debt management portfolio is being managed in an orderly, disciplined and controlled manner.

The last point on this particular slide here - and I will end on this point, Mr. Chairman - is that the role of each player in debt management is being carefully defined. I mentioned earlier this morning that this is very much a work in progress. We are very pleased with the significant progress that has been made over the last two years. We are not quite where we want to be. We have a year's hard work ahead of us but we feel very positive about what has been done over the last two years.

I want to thank you for the opportunity of being here this morning and I will invite both Mr. McAloney and Mr. Stratton to join me in responding to your questions. Thank you, Mr. Chairman.

MR. CHAIRMAN: Thank you, Mr. Moody, for a most comprehensive presentation. The floor is now open for questions. Mr. Russell.

MR. RUSSELL: Mr. Moody, I appreciate the effort you have put forward in bringing debt management to the committee. I think it is the best briefing we have had on debt management, to my knowledge, within this committee.

There are, I think, a lot of questions remaining as to where we are actually going with our debt management. You speak, for instance, of reducing our foreign exposure and returning the majority of the debt to Canadian dollars. In reality, is it not better to keep a fairly significant percentage of our debt within foreign currencies?

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MR. ROBERT MOODY: Let me answer that in a general way. The bottom line becomes a judgment call as to the balance between risk and opportunity. Approximately a year ago, in leading up to advising the then Minister of Finance about where we should be, long term and the 20 per cent goal, we did consultations in terms of the money markets. Certainly, without question, there was overwhelming consensus that where we were at that time was much too high. We kept on asking the question, what's right? What's the right balance? Through consultation, we really felt that, well, if we could get down to 20 per cent or lower that that would be an acceptable risk for the province. Because as you know, as members would appreciate, there are opportunities when you have investments or carry debt in a foreign currency you could work that to your advantage, depending upon how the market works, but the market goes both ways. So, again, it is a matter of balancing opportunity and risk.

So, just to summarize on your question, Mr. Russell. We felt that long term an acceptable risk level was to have the amount of debt in foreign currency at no higher than 20 per cent.

MR. RUSSELL: Let me put the question another way then. In view of the fact that no matter where we go in the Canadian market, it is going to be more expensive to borrow in general terms and, secondly, if we try to borrow when we have to borrow on the Canadian market we are always probably going to have to borrow at a higher rate than we could at that particular time in a foreign market.

MR. RICK MCALONEY: First of all, your observation would have been perfectly accurate approximately a year or two ago but since then the significant progress by virtually all governments in Canada has been recognized in a very significant way by investors in the market place. Actually, Canadian interest rates, as you probably are aware, at least for shorter term, you know, three months, six months, one, two, three and five years and so on, are now lower in the short end, three months, six months, significantly lower than U.S. borrowing. First of all, the market has changed significantly in approximately the last year or so. It is no longer necessarily true that all borrowings are more expensive in Canada.

Also, there are many things you have to consider. It is the actual currency at the time as well as your outlook for the currency, which is dependent upon the forecast for the economy, both domestically and whatever foreign currency you are considering as well as the interest rate differential.

So what we try to do when we look at borrowing opportunities is we internally prepare what we call an arbitrage matrix, that's simply a way of bringing all borrowing opportunities back to a common basis to evaluate them all to first of all make sure that we have the most efficient opportunity. Then the second part, once we have identified what we think is the most cost-effective opportunity is then to determine what risk profile we want in our total debt portfolio so we don't just look at the new transaction in isolation. We look at

[Page 15]

what that would do to our total debt portfolio and make sure any change in our risk profile - when I talk about risk profile, the big measures are basically, do you want a floating interest rate risk or do you want to have fixed interest rates for a long period of time and also do you want to have currency risk. So we look at all of those. At the end of the day, you are right, it is a judgment, some judgment is required. It is part art and part science. But it is not a given that all borrowing opportunities in Canada are more expensive.

[10:30 a.m.]

MR. RUSSELL: You mentioned that our interest rates are lower than the U.S. at the present time, that's very, very true, and it is most unusual. But I was thinking about, for instance, the Japanese market where there are significant differences are there not between borrowing opportunities in Canada and on the end market at the present time? What is the spread there, about 2 per cent or 3 per cent?

MR. MCALONEY: In the short end it is almost 3 per cent. I think short rates in Japan are approximately 0.5 per cent and in Canada they are approximately 3.25 per cent.

MR. RUSSELL: But you have some idea of where the Canadian dollar is going vis-à-vis the yen. Is it not to our advantage, for instance, today, if we wanted to borrow a certain sum to borrow on that market rather than borrowing on the Canadian dollar market?

MR. MCALONEY: Well, again, we always try to take a portfolio view in making these decisions, so we try to stand back and say, what is the risk profile we want to maintain for the overall province's debt portfolio? So we consider how much exposure we have to floating interest rates in Japan as well as to the currency, the yen. Prior to the recent legislative changes, if we felt that the province could have accepted more risk and we felt that was a good decision to make, we would have done that as we did back in August 1994, there were two issues then that we profited big time, I have actual numbers here if you are interested I can quote, but I wish all my decisions could go that well, obviously they didn't. So then we did but after having done that the feedback from the marketplace was that most observers felt that Nova Scotia had more risk than they felt it should have in the long term, so then a policy decision was made and that was supported by legislative changes that prohibited us, on a global basis, on what I call a portfolio-wide basis from increasing our foreign currency exposure. So we have to either maintain it or reduce it until we get to 20 per cent and then once you get below 20 per cent you can increase it again but not beyond the ceiling of 20 per cent.

MR. RUSSELL: The performance of the department insofar as debt servicing costs has been nothing short of phenomenal over the past and the balancing of the current account I think is in large measure due to the fact that that debt servicing costs have come down so dramatically. Is that because of the reduction in interest rates or is that because of more astute borrowing?

[Page 16]

MR. MCALONEY: It is a combination. Clearly, we can't control the markets. We benefit from the positive changes and obviously are at risk to the negative changes. But clearly there have been some transactions - for example, the one that was written up in the newspaper around Thanksgiving, clearly that saving of the $2.7 million U.S. was what I refer to as a pure arbitrage. That is, there was absolutely no change in the province's risk portfolio, that was pure profit. Our risk exposure in terms of how much we had in debt, the quantity of debt, the term of the debt, the currency of the debt, whether or not it was exposed to a floating interest rate risk, was exactly the same at the end of that series of transactions as it was before and the net result is we had a profit of $2.7 million. So it is a combination of those two factors.

MR. RUSSELL: Is it policy at the present time that any foreign exchange transaction that takes place is hedged in some way against a dramatic drop in the value of the Canadian dollar?

MR. MCALONEY: The legislation actually reads, a series of transactions. So that transaction along with any related transactions cannot increase foreign currency exposure.

MR. RUSSELL: No, that wasn't where I was coming from really. What I am saying is, is the present debt that we have out there, the present bond issues that we have out there, are they fully hedged at the present time?

MR. MCALONEY: No, they are not.

MR. RUSSELL: What percentage would be?

MR. MCALONEY: Of the total debt about 55 per cent of that is not hedged.

MR. RUSSELL: Is that a satisfactory figure? Is that normal?

MR. MCALONEY: It is higher than most other provinces. Some observers have told us that in their opinion, in terms of long-term strategy, it is higher than it should be. That is part of the reason why we have set the policy to reduce that over time.

MR. JOHN HOLM: I would also like to echo Mr. Russell's comments of appreciation for your presentation this morning. There are a few things I would like to ask about. First of all, you indicated that the amount that is unhedged, 55 per cent, certainly coincides with the exact amount that, according to the slides, we had in foreign borrowing. Are the two exactly the same, not only in percentage, but what is the correlation between the two?

MR. MCALONEY: Yes, they are one and the same. In the past, I don't think there were any foreign currency transactions that were simultaneously hedged. Under our current structure, in the last two or three years, there have been some smaller issues that have been

[Page 17]

immediately hedged, or simultaneous with the transaction there has been a hedging. We don't actually report that, other than in the deep detail, but in our summary reporting we don't report that as a foreign borrowing, because to us there is no foreign currency risk.

MR. HOLM: I note, and it certainly looks very impressive, that the exposure has gone from 72 per cent down to 55 per cent. Then I am reminded of what I heard this morning on the way in, or last night on the news, how the Canadian dollar has dropped and how the interest rates are going back up. Now, hopefully that is only going to be in the very short term, but am I not correct in that a good portion of the reduced exposure, from 72 per cent to 55 per cent - not by any stretch all of it but a good portion of that - is as a result of increased Canadian dollar value versus some of the other currencies, and that if the Canadian dollar were, in fact, to drop, that exposure portion, as a percentage of the total portfolio, would increase?

MR. MCALONEY: The answer to the second part of your question is, yes, if the Canadian dollar drops, that percentage will rise from 55 per cent. In answer to your first question, there are actually three factors contributing to the drop in foreign currency, and you are right, one of them is the fact that our recent issues have been immediately swapped back to Canadian dollars, so the same effect as if they were domestic issues. There were two others though. There is a management-induced action that we have actually swapped some foreign currency debt back to Canadian dollars and the other is the overall increase in the value of the Canadian dollar. So, the three factors: the rising Canadian dollar, issuing domestically and the management-induced factor of swapping specific issues back.

MR. HOLM: I am certainly not suggesting that all of the reduction in foreign exposure - and I happen to be one who quite likes the idea of reducing foreign exposure - but a significant portion of the reasons why we are less exposed now, those same factors that led to that advantage, if the market trends of the very recent short term, could in fact bring that figure back up again, which is one of the issues that I am sure you are all watching extremely closely.

Following on the same thing, and you talked about the callables and the different length and terms, and so on, of the debts, and of course even now certainly the interest rates are much lower than what we had to pay 5, 10 and 15 years ago. I am interested to know what is the dollar value, for example, this coming year of issues that we can call that were at a higher rate of interest and that you anticipate you will be able to flip over into a lower borrowing rate and, also, I guess the kind of interest rate savings that, as a percentage of the spread, you anticipate between what is due this year versus what you expect to be able to get? Now, I appreciate that rates can fluctuate, so there is no absolute, but I am just trying to get a general picture on what kind of savings. They would be very significant, would be my guess.

[Page 18]

MR. ROBERT MOODY: If I may, Mr. Chairman, I would ask Mr. Stratton to respond to Mr. Holm's specific question, but I would like to make one observation that relates to your last question and to this one. One thing we feel quite optimistic about in the Department of Finance is that the economists in our department share the general outlook that the Canadian dollar today remains undervalued in an international sense, and what we have seen in terms of the weakening of the Canadian dollar over the last few weeks is generally believed to be a short-term blip. That is held quite widely across the country for the reasons that Mr. McAloney addressed.

Assuming that to be true, and we certainly hope that it is true - it is in all of our best interests if it is true - that will afford the opportunity over the next two to three years to bring back a lot of this debt to Canadian dollars, not only bring it back and reduce that risk but do it on a very favourable basis so it looks like the opportunities over the next two to three years to do that, to reduce the 55 per cent further, before the swing might go another way, it looks like the market opportunities will play into our favour; time will tell for sure. Certainly that is what we are predicting consistent with economists across the country.

Doug, if I could ask you to answer the specific question.

MR. STRATTON: We had provided an addendum to the presentation on the Standing Committee on Public Accounts, which you have in your folder, and if you go to the third page there is a schedule of debt maturities and callable issues in 1997-98, which is the fiscal year we are just entering. That is the second schedule, so that is the one that is dated 1997-98. You can see the issue is maturing; in Canadian dollars it is a total $470 million. If you run your eye down the coupon column, I think the highest coupon maturing is Cdn. $100 million issue with a 15.5 per cent coupon. The next highest appears to be 11 per cent, but that is a smaller issue, and the $150 million issue is a 9.875 per cent coupon. In U.S. dollars we have one small issue maturing, U.S. $4.4 million with an 8.875 per cent coupon. Under callable issues, we have none planned for this year.

To put that into context of today's rates, when I looked at the rates as of this morning, the 10 year Canada bond was approximately 6.8 per cent, so the province would issue in the range of - and this is a loose number because I haven't talked to the syndicate recently - 7.2 per cent; that is if we issued a 10 year Canada bond today. So that is comparable to the 15.5 per cent coupon which is the largest coupon that is coming due with a significant size of Cdn. $100 million. Does that cover your question?

MR. HOLM: Yes. If I might, Mr. Chairman, just impose on the time of the committee for another question; I will break this down into two parts. We just received late yesterday the actual package of materials that was provided by the department last week, so I haven't gone through the derivative drafts and I am not proclaiming or professing to have the knowledge or the expertise to analyze it myself and to say if it is or isn't a good policy, but the first part of my question would be, when do you anticipate that a decision will be made

[Page 19]

in terms of having the draft part removed and have it the official policy of the department, a time line for that?

I guess the second part of the question that I pose - I am very much of a novice in this world - is, what I don't understand is why governments have in the past, and I am not just laying this at this current government, entered into long-term agreements when the interest rates are in their high bleep and you end up getting stuck on, for example, the 15.5 per cent kind of rates? Most people who have borrowed money in their own personal basis, whether to pay a mortgage or whatever, know that there are times when rates are extremely high and if you lock into them long term, you are paying at a much higher rate than if you take it at a short term knowing that the markets will eventually swing down in a period of time, as they always do.

So, I am interested not only in the derivative policies, but what kind of policies the department has, where are the cutoff lines, how is it determined whether you will go for a three month or a six month or a one or two years, five year, whatever kind of thing. I look back and I think that a good proportion, and I would love to know what total percentage of our debt is tied in at those very high interest rates of, for example, the early and mid-1980's for which some people are going to be clipping very handsome coupons when the day comes.

MR. ROBERT MOODY: I will begin to answer the question on the policy side and I will start to address in terms of the longer term and then I will ask either Mr. Stratton or Mr. McAloney to talk about the longer term versus the shorter term, fixed rates versus floating rates.

In terms of the policy, effectively we are following that policy now. It is there, it is quite straightforward and what we will do in terms of a commitment is, that policy and all the other structures and checks and balances will be formally in place before the end of this fiscal year. I would say that this policy will be formally, I will give you a date, I will say in 60 days or less. We are just looking for input and once it is in place and the draft removed, we will obviously continue to improve it. So, if someone comes along on the 61st day and says, here is another section we should add in terms of the derivative policy, we will look at that and if we believe it is prudent, we will add that. Like all policies, you want to continually improve and change. Certainly that is going to be something that will be handled very quickly.

In terms of the more general question, Mr. Holm, on the locking into long term at 15.5 per cent, let me make a couple of historical observations and then I will turn it over to Mr. Stratton perhaps. At some time in the not too distant past, it pre-dates the three public servants you see in front of you today, before our time but not too much before that, virtually 100 per cent of the province's debt was in long term, fixed interest rates, because that was the way it was done and we did not have the kind of sophisticated financial transaction tools that are available to us today, and we did not have the ways of checking and balancing.

[Page 20]

So, the prudent use, for example, of derivatives was not known perhaps as sure as 10 years or 12 years ago. It was not there.

MR. HOLM: Even common sense might have dictated at that time that you do not lock in at a really extremely high interest rate which is uncharacteristic. I am not laying it at anybody's feet.

MR. ROBERT MOODY: I will ask Mr. Stratton to respond in the specific, but you recall one of my comments in one of my earlier slides is that we are all blessed with 20/20 hindsight? We three are so blessed as everyone else is and sometimes the markets take funny turns and sometimes there is no short-term money available, and perhaps the need is such or the creditors' outlook on the province was different than it is today. So, there are all kinds of circumstances that might put a different light on that type of a coupon. I will ask Mr. Stratton to respond more specifically.

MR. STRATTON: Well, as far as locking in fixed rates, I guess one has to put yourself back in the times when some of these issues were done, and I think a lot of the advice was interest rates were going higher. I think we remember the early 1980's when the bumper stickers said, have you hugged your mortgage today. At the time, as well, derivatives did not exist as they do today. This is one of the reasons, and it is an excellent question, why we have put a huge effort into the ISDA Master Agreements which is a legal agreement, that binds the province to a counter party for derivatives. Derivatives allow one to alter one's exposure to interest rates and currencies after the fact.

One of the facts of running a debt portfolio is when we issue a 10 year, $250 million domestic bond, like we did this year in the fall of 1996, the province has a contractual obligation to pay that coupon for the next 10 years. So, to reverse that trade, if you decide that the interest rates are going to come down or for whatever reason one has to use derivatives, actually, one could use derivatives, one could use sinking funds, one could buy back the issue. The latter two are actually rather limited. It is difficult to do. So, it really ends up that derivatives are very important in managing a portfolio. So, that is why one, in the past, has ended up in these fixed rate issues.

We are also trying to be more balanced in our portfolio in having a floating rate exposure that we think has a more balanced approach, and we also will be putting in ranges where the floating rate exposure should remain in the range. The same with foreign exchange exposure; it is a question of balance because the debt portfolio has to be dealt with in the context of the fiscal policy of the province. Robert Moody made a comment earlier, the tail does not wag the dog. So, the debt portfolio has to be within the context of the fiscal policy. That is why we take a more balanced approach, but it is an excellent question and I do not think there is a right answer.

[Page 21]

MR. ROBERT CARRUTHERS: Madam Chairman, the trend that we are on, I would just like to continue for a moment. I have always said that a little bit of knowledge makes the worst type of thinking and I have a little bit of knowledge in this field and, therefore, you have lost me on a couple of occasions. It makes me dangerous.

I am just going to kind of keep it simple. When I look at the information that you provided us, it appears to me that there seems to be a correlation between long-term fixed rate indebtedness at high interest rates and short-term floating rate investments at low interest rates. That is what the numbers appear to me. When I look at the fixed interest rates, they were at high interest rate times. When I look down the list and see those monies that we have invested at a floating rate, they are at low interest rate times. Obviously, I am not capable of grasping this because to me when I go to the bank to borrow money, if the interest rates are high, I do not fix them for long terms; if the interest rates are low, I try to. It does not seem that it takes a rocket scientist to follow it, but these numbers show the exact opposite.

We can say hindsight is a wonderful thing, but I do not think you would have to be relying on hindsight to know that an investment at 15.5 per cent, locked in for a long term, what kind of hindsight do you need to note that it had to be just about the highest interest rates this country has seen in all its history? So, to me it just seems absolutely - and we seem to be doing it again. We have low interest rates now, some of the lowest rates that we have seen certainly in the last decade or two, and now we are floating them, which means they are probably going to rise. It is obviously too simple. You people are a lot more knowledgeable than me, but explain why that does not make sense.

MR. MCALONEY: Again, a great common sense observation. With regard to the portion of your question as to why would people have locked into high interest rates for long periods of time, again, I cannot answer for those people. I certainly want to give them the benefit of the doubt and have reason to believe they were rational people but I do not know what pressures were upon them then, what the experts were predicting, what their needs were and, as someone mentioned earlier, what the investors were looking for. There has to be two sides to this coin, they have to match up. We have to want to issue in a certain term and investors have to want to invest in that term, especially years ago when derivatives were less prevalent.

With regard to the portion of your observation, I guess, about why are we issuing floating rate debt now when rates are low, if we were transactional thinkers, as I think was maybe the general way of managing years and years ago, not just here but in general, we may have come to the same conclusion as you but we very much try to always maintain a portfolio-wide view and when we looked at our portfolio where we already had virtually all long-term, fixed rate debt, I am not smart enough to know what the exact mix is but I try to be approximately right than exactly wrong. I am very confident in saying 100 per cent fixed and no floating was wrong. I am not smart enough to know what the exact ratio should have been but we wanted to try to get it approximately right and hence in the early policy

[Page 22]

formulation stage we had set a range of 15 per cent to 35 per cent on our floating rate debt. So we wanted to bring more diversification to the risks in our portfolio. Obviously not because we wanted to take on more risk but because we felt there was opportunity in doing that and so far there has been tremendous opportunity enjoyed but obviously there is more volatility ahead.

MR. CARRUTHERS: So I guess then it is a transitional thing. It will be a short-term thing until we get that approximate balance that we are looking for.


MR. CARRUTHERS: I see. Just switching a bit to the question of derivatives and the purpose of a derivative. It seems to me, with the exception of the purpose that you outline of the use of a derivative to allow you to change your mind after you have made an investment or an issue, that perhaps things are going differently than you anticipated and therefore you use the derivative to offset the negative, that makes good sense but the basic purpose, other than that, of a derivative, that being to lower your risk to offset a possible calamity, falling currencies and such as that, it seems to me that if you don't want to have a risk situation, if that is what you are trying to accomplish, that your exposure is reduced, then instead of investing in a high exposure investment and then using a derivative as a counter balance, why don't you just not invest in a high risk? You will still get the balance in the end. I mean, why do you invest in a high risk or a high exposure thing, then use a derivative to balance off the risk? If you don't want the risk, don't invest in the risky thing in the first place.

MR. MCALONEY: Because we do have significant capital market requirements. We do have an $11 billion debt portfolio that we have to manage. Prior to this year there was also a deficit so we had to raise new debt. In addition to that, each year a certain amount of that debt matures and we have to do a certain amount of refinancing. So we have to transact. It is not a question of we go out and take on risks because we want to take on more risk. If we had the choice of avoiding that, you are right, we would but actually, whenever we use the word risk, you can also substitute the word opportunity. It is always risk/opportunity. We could have gone to all fixed rate debt. There would have been no risk on floating interest rates. There would have been no risk of interest rates going up but at the time we made those decisions, a yield curve was extremely steep in Canada, probably as steep as it has ever been and our interest cost would have been significantly higher to issue long term fixed rate debt and that is why we also issued a significant amount of floating rate debt. It is because of the opportunity that goes along with that risk but you always have to manage your risk to make sure an aggregate or on a portfolio-wide basis, your risks don't get beyond what is manageable with the province-wide entity.

MR. CHAIRMAN: Mr. Stratton, do you want to add to that?

[Page 23]

MR. STRATTON: You have been talking a lot about foreign exchange risk and interest rate risk. There are also other risks and one of them is refunding risk and we don't want too much debt maturing in the same fiscal year. For example, if you had a whole $11 billion maturing this year, that would be risky because we don't know exactly what interest rates, we don't know if the capital markets will absorb that much of Nova Scotia paper, et cetera. So we also have to strike a balance on how much refunding do we want to occur each fiscal year. So hence, it is important to do a 10 year issue, a 5 year issue and those are the type of issues we do. That also provides a balance in terms of your maturity schedule.

[11:00 a.m.]

MR. CARRUTHERS: And that makes good sense. Of course when you are talking about the term of the issue, that doesn't reflect on whether the rate should float or fix. The other thing is, a derivative would not be used in that sense, that would be the issue itself and that makes good sense. The comment that was made earlier, I also agree. Personally, I am not much of a risk taker so I don't like being exposed as a government representative but I think that is true. Every time you use the word exposure or risk, you also have a possible advantage or an opportunity and that is the nature of the animal. I think that is important. We always speak in terms of negative but as we have seen in the last year, a lot of this stuff worked out very nicely for us. So I agree. I don't think we should always look at this in the negative. One of the terms you said of the rules in the future or the outline of the policy in the future, that we will not speculate. One of the slides indicated no speculation. To me, I don't understand how that can be. It is all speculative. Any time you are dealing with interest rates, any time you are dealing with foreign currency, what length of investment or maturity, it is all speculation, is it not? Is it not just a question of how wide or to what extent you are speculating? It is all speculation isn't it? Isn't that what it all is?

MR. MCALONEY: Yes, we are into semantics and I would actually answer it in this way and say there is no way to avoid risk. You can merely substitute one risk for another and it is important that you understand your risks, measure them and if your circumstances change or your outlook changes, for the economy or interest rates or currencies or whatever, then you modify those risks to ensure your portfolio-wide risk is a set that you can live with. Does that answer your question?

MR. CARRUTHERS: Yes it does. Thank you, Mr. Chairman.

MR. CHAIRMAN: Thank you, Mr. Carruthers. Mrs. Cosman.

MRS. FRANCENE COSMAN: I wonder if it would be possible to bring up on the screen the net direct debt slide once more. That was early on in the presentation. The pages in the books are not numbered but it was very quickly into the presentation.

[Page 24]

What percentage does that represent in terms of the graph between 1978 and 1993 in terms of the growth of the net direct debt? It looks like it started somewhere around $300 million and went upwards in the range of $6.5 billion or $7 billion? Does anyone know the percentage that represents?

MR. ROBERT MOODY: Percentage growth?


MR. ROBERT MOODY: I don't have that on my fingertips. If you give us a minute or two, we would work that out.

MRS. COSMAN: I guess I was intrigued by the start up of the presentation that talked about discipline and the requirement to have discipline to deal with this whole subject of debt. I am assuming, when you are talking about discipline, that you are talking political discipline because if there is no political will there to manage this indebtedness of the province to do the difficult and the painful things that have to be done, then it doesn't happen. So threading through the presentation is the word discipline and I was curious about the percentage change in the debt from that graph and I also want to ask the question about the change in the current debt picture. What portion of the change in that debt is directly attributable to the change in the Canadian dollar?

MR. CHAIRMAN: Any takers? Mr. Moody.

MR. ROBERT MOODY: A couple of those are difficult questions but I will attempt to answer them as best I can. Your latter question, we don't have that data here today, Mrs. Cosman, but we will get that data in terms of the percentage attributable to the Canadian dollar in terms of foreign currency exposure. We just don't have that figure physically here but we will get that and get it back to you tomorrow at the latest.

MRS. COSMAN: It seems to me that in one of the presentations we had that there was a significant impact in the fluctuations in the Canadian dollar in terms of the changes in the debt ratio, that it wasn't something that we could control at any given moment, that we were not adding to the debt ourselves by any actions we were taking, rather those changes were being imposed upon us by virtue of the fluctuations and the rate?

MR. ROBERT MOODY: Well, certainly, as was pointed out earlier, that is a factor and that is one of the reasons why over time we want to reduce that foreign currency exposure to 20 per cent or less to reduce that type of risk to what we feel is in a manageable range. So certainly that is a factor. But in terms of the exact dollar amounts, we do have that data, we just don't have it here today. So I will make the commitment through you, Mr. Chairman, to get that to you no later than tomorrow.

[Page 25]

MR. CHAIRMAN: Thank you.

MR. ROBERT MOODY: In terms of the discipline, I will avoid the use of that word, political discipline, if I may in answering your question. But let me say that in answering the question, I think over the last number of years within the province we have gone through a very important period, all of us in the Public Service - and I would not exclude any group in that - and I certainly include myself, as a career public servant, having a growing awareness of discipline required in various processes. Discipline doesn't mean rigidity, it doesn't mean not being open to new ideas, but it means going through a certain series of checks and balances and being accountable for what we do.

So if I could answer your question from the perspective as a non-elected public servant, I think that one of the things that we have done well in the last few years that we didn't do too well in the years before that - and I count myself among those who would be counted - one area where we have greatly improved is in the whole area of general accountability and transparency in what we do and why we do it. We talked earlier in the presentation about putting in, for example, the assumptions on which we are making our projections in terms of debt servicing costs in the years ahead. We put in there about the sensitivity analysis in terms of how changes in foreign currency can impact positively or negatively.

What we have done well in the last few years, I believe, as a Public Service in Nova Scotia, is being accountable and putting into writing in printed documents published by the government and tabling in this Legislative Assembly, here is what we are doing, here is why we are doing it and here is the expected outcome that we achieve. That general parameter of accountability reinforces, I think, all of us to take a much more "disciplined" approach to the way we do our business. I don't believe there is a more important area to have that disciplined approach than in debt management.

Just a final comment, Mrs. Cosman, in my opening remarks I said how very proud I was to be able to work with such a great group of professionals in the Department of Finance. I think that this type of environment today, where we are encouraged as public servants to be open, to be forthright, to be accountable, encourages us to ask the questions and be creative and come up with good solutions.

In the long term, getting back to the topic at hand, I think that will lend us very well in terms of being able to manage this debt. It is there, it is a reality, it has to be managed in a more assertive way than has been the case in the past, but with a measured amount of discipline. I hope I have answered it without skirting the question.

MRS. COSMAN: I think that you probably have but it is an observation that the career public servant really has a requirement to manage the political decisions, i.e., where we spend our capital dollars, et cetera, that are handed to the public servant. If political decisions

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are made to drive the debt up by virtue of constructing 10 new hospitals, for example, all you are put in the position of is doing the best you can to manage the risk that that represents in terms of where we go to the market and how we manage the long-term debt portfolio.

Coming back to the question of discipline, had we started with a balanced budget in 1988, for example, where do you think we would be now in terms of our debt retirement and where would we be in terms of our ability not to be paying $3 million a day just on the interest of the debt alone? Do you have any ability to respond to a hypothetical scenario, because we weren't managing the debt in 1988, we weren't balancing it in 1988?

MR. CHAIRMAN: Anyone care to speculate?

MR. MCALONEY: Well, certainly, I cannot put absolute numbers on that, but it is intuitive that the debt would be significantly lower if we had not incurred the deficits. Again, I don't know the ratio of the current debt, how much of that is attributable to currency losses over the years and how much is attributable to deficits but certainly a significant portion of that would have been deficits.

The other thing, we have to be careful when we evaluate whether currency exposure is good or bad, there are two parts and they get reported in different ways in the financial statements. One is the actual currency, gain or loss, but the other is the interest rate differential, which shows up in either higher or lower interest costs. I am not sure we will be able to reconstruct that when we go back through our records to come back with a more complete answer to your question, but we will certainly do our best.

MRS. COSMAN: I would like just briefly to touch on the credit ratings. One of the questions that many of us were curious about is what even a small movement downward in the credit rating does to affect our ability to borrow, what is the impact of a downward credit rating on the province's debts? Would somebody like to talk to us about credit ratings?

MR. CHAIRMAN: Mr. Stratton, are you the lucky winner?

MR. STRATTON: Okay. Again, on the addendum that we provided, towards the back of that addendum you will find three pages and what I can do is I will walk you through the three pages and then we will focus on your particular question. What we have provided came from CIBC Wood Gundy Securities Inc. The first page simply shows as of March 24th the spreads of all the provincial sectors in the domestic Canadian market for term debt issues. So that is for large syndicated deals in the Domestic Canadian market. For example, if you were interested in knowing the Nova Scotia spread in the five year term, you would simply go to the five year column and follow your eye down to Nova Scotia and you would get 0.155 and that is our credit spread above the Government of Canada bonds in the five year sector. So that just gives you an idea of what the credit spread is for the different provinces in different terms.

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The second chart is a chart that plots the credit spreads, that is the provincial spreads above the Canada bonds, for 10 years . . .

MRS. COSMAN: Sorry, which chart are you looking at?

MR. STRATTON: I am going to hold it up. I am looking at this chart now. We will put this up on the screen, I think we have . . .

MRS. COSMAN: Do you mind just backing up to the first page that you talked about and just run us by the explanation again. Those of us who can't balance their chequebooks need a little help.

MR. STRATTON: Let me take a step back and just explain to you how we determine the coupon on a bond when we issue it in the market, again, using the five year Nova Scotia example. What we do as market practice in Canada, it takes the Government of Canada benchmark bonds and as you know they have quite a large liquid bond in the five year sector that is actively traded every single day by the financial markets, so that is used as a benchmark and then the provincial spreads, the so-called credit spreads, are added to that. Your question relates to Nova Scotia in particular. So if we look at the five year column we see 0.155 for Nova Scotia. That means you take the five year Government of Canada benchmark bond, whatever its yield is on that day, and add 0.155. So actually it is a fairly small spread I would say over the Government of Canada bond. For example, if the Government of Canada five year bond was at 6 per cent, which is approximately where it is, then we would issue at 6.155 plus fees, fees are usually about 0.1, so that would make it 6.255. So the higher those numbers are the more it costs us to borrow on a particular issue on that particular day. So this is the matrix of spreads that are used by the capital markets practitioners to help us determine how to price an issue. You can see it is a large matrix of numbers and it is difficult at times to make rhyme or reason out of these.

I think your question is, do these numbers relate to what the credit agencies' view of the provinces are. That is what the second chart, which we have on the board, tries to explain. So, does that help you on the first try?

MRS. COSMAN: It does but I was getting more specifically into if there was a downward switch by a very small amount in our credit rating, how much more would it cost us to borrow money?

MR. STRATTON: Well, if we look at the second chart, what we have done here is we plotted, for the different provinces, the credit rating and also the spread in a 10 year sector. So, you can see Nova Scotia and its spread would be about 28. We are an A3/A-, S&P and Moody's, which is the very bottom of the A section. If we were downgraded, we would go into so-called BBB.

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MRS. COSMAN: If that happened, if we were not trying to manage our debt with discipline, what would that impact be?

MR. STRATTON: It is a complex question but let's take a look at Newfoundland. Now, of course, their situation is different from ours, but they have a BBB+ rating, and you can see them at the top of the screen here, and if we come across, they pay 0.4 per cent or 40 basis points, where we are currently paying approximately 28 basis points. So, that is the increase if we were according to this chart.

MRS. COSMAN: That is quite significant.

MR. STRATTON: Yes, but I am going to now complicate the matter. If we take a look at Quebec which has a higher rating than the Province of Nova Scotia, they have a similar spread as Newfoundland. So, it is not just credit rating. There is obviously other factors and I think it makes it a very complex question. In fact, I think the academic community, when many try to determine why spreads are where they are, they do not come up with a very good answer.

MR. MCALONEY: May I add to that?

MR. CHAIRMAN: Very quickly because we have other people, including myself, who have questions to raise and we only have until 11:30 a.m.

MRS. COSMAN: I had one last question I did want to ask afterwards.

MR. MCALONEY: I will just add an observation to your question. An excellent question and I assume it is based on the premise that credit rating is important and are the ramifications of a reduction in that credit rating significant. You have hit on certainly a key outcome of that event would be higher interest costs. There are also a couple of other things that we should keep in mind, and credit rating is extremely important to maintain and hopefully improve, and that is the quantity of investors that are willing to invest in us. The higher your credit rating, the longer that list is. The third one is our ability to manage our debt portfolio. When we talked about derivatives and the ability to manage or substitute risks, as either our own circumstances change or as our outlook for markets, currencies, interest rates and so on change, that, again, the higher your credit rating, the more counter parties you can do swaps with, and there is a point that if you drop below that, you cannot do swaps and you are unable to manage your risks. Then you are a bit like a huge ship adrift.

MRS. COSMAN: Just one final question and it has to do, again, with the discipline of what we are trying to accomplish and the targets that we set for ourselves and that we are achieving. It has to do with the fact that we have tasked certain managers in the Department of Finance with very specific and strategic areas of management, and some of us have a concern that, how are we bringing on the aspect of replacements for those very specifically

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tasked managers if they suddenly decided to leave for a $300,000 private sector job. What are we doing to train up in those areas of responsibility with which those managers are tasked, because we certainly cannot afford to have a big hole in the management structure at any given time?

MR. ROBERT MOODY: That is a difficult question to answer. I think it is fair to say that when I first came to the Department of Finance last spring, one of the areas that I noted that we were vulnerable was in this specific area. We have a small highly skilled team but it is just that, it is small. So we are, in fact, subject to some degree of risk there. We, the Department of Finance, have been working quite aggressively with the provincial Department of Human Resources to come up with strategies over both the short and medium term that will minimize risk in this particular area in the areas of recruitment and retention because there are two parts to this. There is getting the good people in the door and then keeping them. So it is both issues, recruitment and retention.

We have made some very significant progress in the last couple of months. I don't have a full solution that I want to share with you today. I do want to acknowledge that it is certainly a risk area, and because it is such an area of opportunity, we have to do everything we can as a provincial government to minimize that risk. We are looking at all kinds of different options in terms of formalized career planning, working with provincial people who are experts in this area, private sector people, perhaps people from the university community, taking advantage of training programs not only locally but nationally, cross-training.

We are instituting in this fiscal year, the Department of Finance, what we will call our trading desk. We are actually bringing a number of people together physically in an environment that will allow them to learn from each other on a daily basis, again to minimize risk. So there is a whole host of different strategies that we are following and it is something that we hope that we will bring to a positive conclusion again during this fiscal year. But I do acknowledge your comment that it is an area of risk and what we have to do is minimize that so we can maximize the opportunities.

MRS. COSMAN: Thank you.

MR. CHAIRMAN: Well, I had much the same question in my mind that Mrs. Cosman has just raised and I would like to pursue it a little further. I would like to pursue it with respect to derivatives which seem to be one of the more complicated aspects of the business that you carry out on a day-to-day basis. With respect to your capacity to manage debt, Mr. Moody, would you define derivatives with respect to the role that they play in that debt management as somewhat important, important or very important?

MR. ROBERT MOODY: The importance of derivatives as a tool?


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MR. ROBERT MOODY: Very important.

MR. CHAIRMAN: Okay, and you said that - and you referenced Orange County, California, as an example - you have to have the right people in place in order to ensure that the public interest is well protected. I think it is quite evident from the response of this all-Party committee that we have confidence in those who are currently managing that aspect of the department's work as well as other aspects. Mr. Stratton, I think, is the most directly responsible person with respect to derivative management?


MR. CHAIRMAN: And Mr. McAloney would play an important supporting role in that respect and you, of course, would be directing them in your capacity as Deputy Minister.

Mrs. Cosman has raised a very important question and the question really revolves around bench strength. You have clearly indicated to us that you really don't have a second line to put on the floor if your first line has to be taken off or, indeed, you may not have a good substitute if you lose one of your first line. That causes me, and I am sure other members of the committee, some significant concern. Now you have mentioned that you are endeavouring to put in place a strategic policy which will address this situation. I think it is important for us to understand time-frames in this respect. How long did it take the department from the time it decided to recruit a person to undertake Mr. Stratton's job until Mr. Stratton was employed as a consequence to the competition? How many months?

MR. ROBERT MOODY: Approximately six months, sir.

MR. CHAIRMAN: And Mr. McAloney, who also is new to the department?

MR. MCALONEY: I was already in the Department of Finance in a different role. So I was transferred.

MR. CHAIRMAN: You were transferred in.


MR. CHAIRMAN: Was there a competition or was it simply a transfer?

MR. MCALONEY: No. A competition was advertised in the Globe and Mail as well as the local papers and so on.

MR. CHAIRMAN: So how long did that competition take?

MR. MCALONEY: Three or four months, approximately.

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MR. CHAIRMAN: So we are looking at, for an inside promotion or change, four months, and for an outside acquisition of staff, six months. What would happen if you had to go four to six months without either of these people available to you? What would happen to your debt management strategy?

MR. ROBERT MOODY: Certainly, Mr. Chairman, we are vulnerable here. If that were to happen it would have to be, obviously, a priority of the department to recruit. I would suggest we would probably recruit in two ways. We would go to the market place and look for short-term assistance from the market place and then you would embark upon the longer term competitive process. In an ideal situation, you would have that kind of bench strength built in and you would be able to have people substitute. I believe we can do that on a short-term basis today so if you know something is going to happen in the short term, you can do that. But it is a small team and I don't want to leave you with any other conclusion other than the fact it is a small team and we have to lessen the risk here. There is no doubt about that.

MR. CHAIRMAN: Very clearly, people who exercise the skills that these two gentlemen exercise and their peers would exercise are not a dime a dozen. In fact, one would gather, probably, with much of this being relatively new with respect to the debt management landscape, that there are relatively few people across the country who would be able to step into these kinds of positions. I am concerned, and I suspect others are and I think Mrs. Cosman, again, alluded to this, that the constraints with respect to salaries imposed on a Public Service - not necessarily this one - are such that it may be more difficult rather than less difficult for us (a) to be able to attract good people and (b) equally importantly to be able to hold them. Is that a reasonable fear and if so, how do we go about resolving it?

MR. ROBERT MOODY: Well, certainly a part of any recruitment and retention strategy has to be able to address compensation in a general sense. A very large part of a compensation package is, of course, salary. Then there are other things, benefits, working environment, et cetera. We would like to think that we have the best working environment in the country and we all know we have the best province in the country. So those are a couple of things going to our advantage. Compensation, methods of compensation, is certainly one of the areas that we have to look at, that we are looking at in terms of how to do that. Again, I would be misleading you, Mr. Chairman, if I were to say we have the answer today but we know very clearly what the issues are and we are addressing them assertively.

MR. CHAIRMAN: Now we started a few moments late and with the agreement of the committee, the Chairman would be prepared to have us go until about 11:40 a.m. (Interruption) We can't? All right. There are members who have other commitments so we are not going to be able to do that. That being the case, it is now 11:29 a.m. and I do have one small piece of business that I want to bring to the committee before we disperse, so I want to thank the three of you for being with us today. It was very interesting and informative and we wish you good luck as you pursue the absolutely essential task of assisting the government of the day in managing the province's debt and finances. Thank you very much.

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MR. ROBERT MOODY: Thank you, Mr. Chairman.

MR. CHAIRMAN: Prior to adjourning, I would like to point out to all members that as a consequence of Mr. Mitchell's elevation to the Executive Council by His Honour the Lieutenant Governor this morning, we now have a vacancy on the committee and I am sure that that will be filled quickly by government caucus. I want to take this as an opportunity on behalf of all of us, as a matter of record, to congratulate Mr. Mitchell on his appointment and to note that he has been a very effective member of this committee and we certainly will miss him as a member of it and we wish him well as he pursues the new challenges which will be facing him as a Minister of the Crown.

Any further business?

We stand adjourned.

[The committee adjourned at 11:30 a.m.]