Back in the dim and distant days when I was starting work as a graduate in the City of London I found myself helping with deals with Hammersmith and Fulham council. It was entering into various swap contracts which later hit trouble. Assumptions that the government would stand behind it proved unfounded and the council was in the end rescued by the courts declaring much of the business as Ultra Vires. So I note some of the recent movements in local public finance with some disquiet. Let me start to explain with this from The Guardian.
Aberdeen city council has taken the unusual step of appointing economic advisers to assess its prospects for the bond market, as a growing number of local authorities turn to the world of high finance amid central government cuts.
Let us now look at the trend driving this development.
The move comes amid the increasing financialisation of local authorities. Whitehall cuts are pushing councils to either scrap services or borrow to invest in profit-making schemes. Although devolution means Scottish councils are funded differently to the rest of the UK, Holyrood has also come under criticism for squeezing local authorities,
Let us now move to a more general view of UK council finance.
As well as using the bond markets, authorities are taking out cheap loans from the Public Works Loan Board, a Treasury agency, as they plough money into property developments and other investments.
If this was the USS Enterprise in Star Trek Captain Kirk would be declaring a yellow alert as he read this from the Financial Times last April.
UK local councils are engaging in what is known in the financial jargon familiar to hedge fund managers as a carry trade — a form of arbitrage whereby they borrow at rates much lower than private sector borrowers can obtain in order to invest in property that shows a much higher yield. Money borrowed at 2.5 per cent or so is typically going into property yielding 6-8 per cent or more.
Regular readers will be very aware of carry trades and are perhaps already thinking, what could go wrong? The problem with the Swiss Franc carry trade was of course a higher Swiss Franc which caused capital losses for the borrowers and the equivalent here would be falls in commercial property prices. At this point I am reminded of the freezing of some commercial property funds after the EU leave vote which must have sent a shiver down the spine of some council’s. I hope that they factored into their calculations the issue of property investment’s being a very illiquid form of investing especially in falling markets.
How do they get cheap money?
The Financial Times explains.
Where Britain differs from bubble-period Japan is in the financing of the property binge, which comes mainly from the public sector. If local authorities can outbid almost all other participants in the commercial property market, it is because they have access to cheap and flexible funding from the Public Works Loan Board, an arm of the Treasury that has been helping finance capital spending by local government since 1793. Its interest rates are linked to those in the gilt-edged market which have been at exceptionally low levels since the financial crisis of 2007-08.
The Public Works Loan Board or PWLB updates its fixed interest rates twice a day and this morning’s varied between 1.1% for a year or two to 2.77% for long-dated funds. So as the band Middle of the Road put it.
Chirpy Chirpy, Cheep Cheep
It also provides data on borrowing in July where for example Kingston Borough Council took out several loans totalling £40 million and Torbay Borough Council £19 million.
The Financial Time summarised the dealings as follows.
The spending spree has been at its fiercest for shopping centres. Surrey Heath borough council last year spent £86m on The Mall, Camberley; Canterbury city council bought half of the £79m Whitefriars centre in the cathedral city, Stockport borough council bought the Merseyway centre in the town for £75m, while Mid Sussex district council spent £23m on another in Haywards Heath. They have also been busy buying offices, retail warehouses, industrial parks, solar farms, hotels, garages and country clubs. Increasingly this speculative investment activity is taking place beyond council boundaries.
The Private Finance Initiative
If we look at PFI the concept of cheap finance due to the UK’s ability to borrow cheaply vanishes like a Klingon Warbird with a cloaking device. From the Centre for Health and the Public Interest.
There are currently 125 PFI contracts with private companies overseen by the Department of Health. The capital value of the assets which have been built is £12.4bn. However, over the course of the life of the contracts, the NHS will pay in the region of £80.8bn to PFI companies for the use of these assets.
It also points out this.
In 2011 the Treasury Committee found that the cost of financing a PFI scheme through loans and equity stakes was double the cost of government borrowing.
Parliament looked at the numbers in 2015 and concluded this.
The implied interest rate for government borrowing was around 3% in 2013/14, whilst the implied interest rate for private finance was around 7%.
Things have got cheaper since in bond markets but if the margins remain the same for PFI deals then relatively they may look even worse. Exact numbers are not always easy to calculate which is another worrying sign. Back to the CHPI.
With a PFI contract, a public body such as an NHS hospital trust contracts with a private company set up for the purpose known as a Special Purpose Vehicle (SPV).
Sadly the positive thoughts generated by thoughts of Captain Scarlet and indeed Captain Blue driving a SPV which seemed a marvel when I was a child soon disappear. The SPVs of the finance world are there to hide things and lay a smoke screen especially if combined with use of the word “innovative”.
The main purpose of the PFI era was essentially to allow government’s to borrow without the numbers raising the national debt. The downside of that is that taxpayers have to pay higher deficits in the future as the annual cost was as we have seen earlier around double the alternative of outright government borrowing. As the NHS has been particularly afflicted by this there is a particular irony in politicians pumping in money which then goes towards paying for poor value deals. But it is not only the NHS as the Airtanker deal to provide 14 Airbus tankers for the RAF poses all sorts of questions.
Now we see that we are letting council’s borrow much more cheaply to “invest” in commercial property. So this is more of a priority than national health or defence? For a start should they not be using such funds for social housing which might help quite a few problems in one go? Also if the example of Aberdeen Council is any guide there may be another worrying trend. From the Guardian.
Stephen Boyle, RBS’s chief economist, Hanan Morsy, an economist at the European Bank for Reconstruction and Development, and Douglas Peedle, chief economic adviser to Jersey, will sit on the panel of experts. They will be paid as much as £17,000 a year for working one day a month, for a term of up to three years.
The idea that the higher echelons of RBS are “experts” in anything other than losing large sums of money is bizarre. Or perhaps they will have their excuses for failure ready.
But the system where we pay over the odds for what seems vital projects whilst allowing councils to take a punt with cheap funds requires the Nutty Boys.
Madness, madness, they call it madness
But if this is madness
Man, I know I’m filled with gladness
It’s gonna be rougher, rough, it’s gonna be tougher, tough
And I won’t be the one oh, no, no who’s gonna suffer