Published in Business Spectator (Melbourne), 5 March 2015
It is fair to say that New Zealand and Portugal are not particularly close nations.
Yes, there were a few Portuguese whalers in 19th century New Zealand but according to the latest census the NZ Portuguese population is estimated to be just under 1,000 people — or roughly 0.02 per cent of the total population. There are even more Ethiopians, Sinhalese and Tokelauans in New Zealand than there are Portuguese.
The confrontation between the New Zealand government’s super fund and Portugal will ensure that the countries are unlikely to develop any greater affection for each other in the near future. In an action highly unusual for sovereign wealth funds, the New Zealand Superannuation Fund is suing Portugal’s central bank over an investment it had in Portugal’s failed Banco Espírito Santo.
What has happened to the NZ Super Fund’s investment in Portugal is at once highly complex and quite simple. And it highlights the problem of political risk in the eurozone.
The complex bit of the fund’s Portuguese engagement is the way it chose to invest in Banco Espírito Santo. It was arranged through a vehicle called Oak Finance, created by Goldman Sachs, which bundled the loans of a number of investors. At the same time, the fund also took out a credit default swap against the risk of the Portuguese bank’s collapse.
Sounds complicated but according to Adrian Orr, the fund’s chief executive, all these transactions were really just “plain vanilla” in the world of global finance. Altogether, it allowed the Kiwis to invest $US150 million with the Portuguese bank, supposedly risk free.
Even when Espírito Santo collapsed in August last year, this did not look like a problem for the super fund. After all, it was protected against default through its credit default swap. Besides, Espírito Santo was split into two banks — a new good bank called ‘Novo Banco’ and a bad bank. The fund’s loan was initially placed in the good bank, and so looked likely to be repaid. It was supposed to be a senior debt obligation in any case.
All of that changed when the Portuguese central bank, out of the blue, decided to put the fund’s loan into the bad bank and thus separate it from the credit default swap that was supposed to insure it. With one administrative decision by Portugal’s central bank, the New Zealand Super Fund lost $US150m. No wonder the fund’s CEO is fuming. “It’s just like theft,” Orr said at a business lunch in Wellington on Tuesday. He probably does not use these words lightly. As a former deputy governor of the Reserve Bank of New Zealand, he is an ex-central banker himself.
Portugal’s central bank, in a clumsy way to target some big lenders to Espírito Santo, had decided that anyone above a 2 per cent shareholding should be repaid only after other creditors. The problem with this provision was not only that it was applied retrospectively. It was also bundling up all lending in the Goldman Sachs created vehicle as if it was originating only from Goldman Sachs itself. In fact, Goldman Sachs had only arranged the vehicle.
The New Zealand Super Fund is now taking legal action against Portugal and its central bank, and prima facie it seems to have a good case. There just is no good or reasonable explanation why the Bank of Portugal would place the New Zealand Super Fund’s loan in the bad bank (despite previous assurances to the contrary).
However, the Kiwi super fund’s case also highlights the political risk involved in eurozone transactions.
Europe’s banking system, especially in periphery countries, is fragile. For years we have been seeing various stop-gap measures implemented by the European Central Bank to shore up banks in these countries. They remain fragile regardless and find it difficult to access capital.
If under these circumstances a central bank like Portugal’s can seemingly at will change the nature of lending to these banks, it will only make it harder for Europe’s periphery banks to access international capital markets. Other investors, not just sovereign wealth funds, will think twice before committing themselves to “plain vanilla” lending if these later turn out to be not so plain after all.
If the Bank of Portugal’s decision became a precedent, it would also put question marks over the market for credit default swaps. If it was that easy to effectively invalidate a credit default swap by separating it from the loan it was meant to protect, then why would anyone even consider taking out such worthless insurance policies? It would only make investors even more risk-averse.
At a time that periphery European financial institutions find it hard to borrow internationally, as evidenced in the ECB’s Target 2 balances, the signal from the New Zealand Super Fund’s troubled Portuguese engagement could not be worse. It will send a strong warning to anyone contemplating a loan to a bank around the Mediterranean.
For investors already concerned about the eurozone’s inherent fiscal instability, its lacklustre economy and its monetary challenges, this extra bit of political risk may be the last straw. If you cannot even invest in major financial institutions under the protection of a credit default swap, you might just ask yourself whether Europe really is the place you would like to take your money to.
The New Zealand Super Fund’s battle with Portugal is the first major clash in the two countries’ history. Fortunately, we do not have to expect any kind of retaliation, nor will the two sole frigates in the Royal New Zealand Navy set sail for Lisbon anytime soon.
Instead, the Kiwi Fund has written off its $US150m loan to Banco Espírito as a conservative and precautionary measure (while still taking court action). It certainly can afford to be a bit more relaxed about the potential Portuguese loss, annoying and concerning as it is. Over the past year, the super fund delivered a profit exceeding $NZ3 billion — and its Portuguese loss is well within its daily fluctuations.
Having said that, the loss of confidence in European banking regulation weighs more than any loss the Kiwi super fund may have to bear.
