Coming to the crunch: Public Finance

Posted on October 17, 2008 · Posted in Public Finance

The crisis in the markets has left a trail of financial giants in tatters. Public services, especially those with Icelandic investments, are feeling the strain. Paul Gosling reports on how the sector is preparing for the worst

‘Never send to find for whom the bell tolls, it tolls for thee.’ John Donne’s lament for the passing of others is a metaphor for our times of global interconnectedness. Just as a crisis for one bank is a crisis for all, so the meltdown of the world’s financial markets is a disaster for the public sector. Budgets are turning into fiction and investment plans might become pipedreams.

The government’s £400bn rescue package for the major banks is staggeringly large – and with even more enormous implications for public finances. The £37bn injection of capital into the Royal Bank of Scotland, HBOS and Lloyds TSB will be financed by borrowing, increasing the public sector net debt. But more significantly for the PSND figure, RBS’s commercial liabilities of £1,800bn are also likely to be included in PSND, believes the Institute for Fiscal Studies.

‘The Office for National Statistics will have to make a decision based on international accounting rules,’ says the IFS deputy director, Carl Emmerson. But the institute believes that, based on previous ONS decisions, the RBS liabilities will be taken into PSND. ‘With RBS it’s the case that the government will own 60% of shares and it seems it will have a say in the direction of policy, for example, giving certain directions on lending,’ explains Emmerson. ‘So it is likely that the ONS will say it needs to be included. It may also say the same with the other banks [HBOS and Lloyds TSB], but with those the government is a minority shareholder.’

With the IFS’s interpretations of the rules, PSND will escalate to about 179% of national income. And it could rise still further. The government may yet inject capital into Barclays and possibly other banks and building societies, and the IFS has not included the £100bn of short-term lending and £250bn of loan guarantees which it believes are unlikely to be counted into PSND. Either way, PSND is heading way over the 40% of national income limit imposed by the Treasury’s sustainable investment rule – which Emmerson believes would have been broken next year anyway, when tax receipts fall as the recession bites.

Councils have lost out severely from the collapse of Icelandic banks, especially Landsbanki, which offered local authorities attractive rates on deposits. Over a hundred councils had loaned money to Landsbanki, its UK subsidiary Heritage, Glitnir and Kaupthing Singer & Friedlander. Between them, the authorities have more than £800m at risk – with police authorities, NHS trusts and other public bodies also holding deposits with the banks. The biggest potential losers include Kent County Council, which had £50m in Icelandic banks; Nottingham City Council, £42m; Transport for London, £40m; Norfolk County Council, £32.5m; the Metropolitan Police Authority, £30m; and Hertfordshire County Council, £28m.

The LGA is calling on the government to reimburse councils for any losses arising from the Icelandic bank failures. Chancellor Alistair Darling said that no decision had yet been taken, but that he regarded councils as ‘informed investors’, whose situation was different from that of individual depositors – whose losses will be fully reimbursed. A spokesman for the Treasury adds: ‘Local authorities have the prime responsibility for assessing their financial situation and revising their financial plans and strategies to address problems caused by the failure of financial institutions.’ But, he says, Landsbanki’s UK assets have been frozen to assist all investors in recovering their losses.

Some 13 councils are particularly seriously affected by their potential investment losses, though this will not affect their ability to pay wages or meet other immediate obligations, say the LGA and DCLG. Financial experts have been appointed to work closely with three of these to help them with their immediate crisis, with the other ten having their situation monitored closely. But, as yet, the government has not agreed to cover the losses of any of the councils affected.

The government should go much further in supporting local authorities, suggests Labour backbench MP for Hayes and Harlington John McDonnell. ‘I have been arguing since this came to light that local authorities abided by the rules, they acted on the credit ratings, they have acted appropriately on the basis of advice,’ he says. ‘On that basis it behoves the government to intervene. If they are supporting banks they should be supporting the local authorities. Some package of support needs to be undertaken.’

Local authorities already had their own ‘double whammy’ of increased costs for energy and food, coupled with the onset of reduced income and capital receipts. This is not to mention union calls for higher pay and probably increased demand for adult care and other welfare services as the recession hits. According to the LGA, even without the loss of the Icelandic investments, councils will have to find savings of £500m to avoid cuts in services because the funding award in last year’s Comprehensive Spending Review has failed to match increased overheads.

The LGA says that fuel bills have escalated by £374m annually in the past four years, the cost of school dinners and meals-on-wheels for elderly people has risen by 15% in the past 12 months and subsidies to public and community transport schemes have had to increase significantly. Meanwhile, income has fallen, with lower capital receipts from land and building sales, reduced Section 106 ‘planning gain’ contributions from developers and less income from leisure centres, car parking and other commercial services.

Local government minister John Healey responded that councils should find ways of managing budgets without cutting services. ‘We have introduced a three-year funding settlement for local government, precisely to give councils the certainty and flexibility they need to plan ahead and manage their budgets over the longer term,’ he says. ‘So there is no need for service cuts or excessive council tax rises. In this difficult economic climate, everyone is feeling the pinch. Local government and national government are in the same position. Councils will face tough decisions, but this is what local leadership is about.’

However, the crisis for local government finances will probably worsen in the coming period, unless the stock markets rebound strongly and unexpectedly. Share prices were already depressed before the crisis worsened – the FTSE 100 was pulled down to below the 4,000 mark, against the 5,900 level it reached a decade ago. Local government pension schemes have relied on income from share dividends, which will probably fall badly in the coming recession. Other asset classes are likely to be affected, including property, which has suffered badly, and hedge funds, which have just had their worst trading year since 1990. There are now growing expectations that deficits will have to be plugged from councils’ revenue.

Some council pension schemes’ investments have turned bad. The Lothian and Northern Ireland local government pension schemes are leading class action suits against former executives of Lehman Brothers over losses the funds incurred from their purchase of shares in the years before the collapse of the bank.

Other financial institutions currently in crisis have close relationships with the UK public sector. HBOS, Dexia, Fortis and Royal Bank of Scotland are all major players in the Private Finance Initiative market in the UK. HBOS is reportedly seeking to sell half its PFI portfolio as part of its Lloyds TSB rescue, though HBOS did not return calls seeking confirmation of this. Both Dexia and Fortis are being rescued by groups of European governments.

But PFI advisors believe that the market will not collapse despite these troubles – though finance is becoming more expensive. Dougald Middleton, a partner at Ernst & Young, says that, although the PFI market has been hit, it is only back to where it was four or five years ago, before the sector grew substantially. Even before the latest escalation of the crisis, banks were limiting their exposure. ‘For the last few months, no one was willing to do more than £25m anyway,’ he says. He predicts that market conditions will rebound in the next three years or so, given the level of demand from the public sector.

Kevin Magner, director of Deloitte’s government and infrastructure team, agrees that the PFI is still regarded favourably by the banking sector. ‘The PFI market is fortunate in a sense, as it is seen as a very stable one,’ he says. ‘But that does not mean it will be immune from the problems affecting the banking market more generally. It would be too sanguine to say that the market has not become more difficult.’

Magner adds that given the speed of events it is too early to assess the full impact on the PFI and infrastructure from the financial market turmoil and the public sector’s likely response.

Chris Wilson, chief executive of the 4Ps – the agency advising councils on project delivery – remains upbeat about the PFI situation. He points out that £11bn of PFI credits awarded in the last Comprehensive Spending Review remains in place, with £2bn worth of waste management schemes, the same for highways improvement, and more than £1.8bn worth of projects for social housing. Other schemes, including Building Schools for the Future, are also progressing.

‘In the waste sector, there are a lot of programmes going forward,’ stresses Wilson. ‘In housing, more councils are putting forward schemes – 26, which is more than in other rounds.’

But Wilson accepts that conditions are tighter. Banks are less willing to lend such large amounts, there is more need to group banks together to provide necessary levels of funding, banks are focusing on existing clients and margins are increasing. In practice, this means that local authorities might have to pay half a per cent or more above previous prices. The advice from the 4Ps is that, in these circumstances, councils must ensure that – if conditions improve in coming years – they get the benefit from any subsequent refinancing that reduces contractors’ costs.

Despite Wilson’s confidence, there are particular concerns about investment in social housing schemes. The latest figures from the Royal Institution of Chartered Surveyors show a big fall in new house building, casting doubt, it suggests, on the government’s ability to meet its target of building 2 million new homes by 2016.

Indeed, the National Housing Federation believes that, on current trends, the government’s target of 3 million new homes by 2020 could be missed by nine years.

Richard Parker of PricewaterhouseCoopers is author of a newly published discussion paper on how to fund affordable housing. He points out that about half of the affordable housing supply in recent years has been provided under Section 106 agreements. With the private sector unable to proceed with new-build schemes, the supply of affordable homes has also stalled. ‘If private house builders aren’t building, then the impact on affordable housing supply is quite profound,’ he says. ‘That is potentially bleak.’ And with PFI margins going up, more schemes that would have gone ahead are no longer viable, Parker says.

‘I am having conversations with several local authorities about steps that are equivalent with the government’s action in recapitalising markets,’ says Parker. He suggests that councils could release some of their own land for housing immediately, but delay the capital receipts until homes are sold – despite the potential damage to their capital programmes.

The extent of the financial injury to the public sector could go far beyond this. In recent years, many public services that have been privatised are now owned by private equity firms – particularly in the waste management, health care and social care sectors. Typically private equity operates by borrowing heavily – and some chains of social care homes nearly collapsed in recent months as they hit difficulty in refinancing debt. If private equity-owned public service businesses do collapse in the coming months, there could be pressure on the Treasury to bail these out, as it has done with banks.

‘There are going to be problems with some of the highly leveraged transactions, when the debt facilities come up for refinancing,’ agrees Ernst & Young’s Middleton. ‘Some of those problems will be two, or three, or five years out. We won’t expect them [the debt facilities] to be on the same terms as before. Some of those [private equity firms] will take a hair cut and some of the lenders will take a hair cut as well.’ Clearly, the public sector will need to consider how it would respond to the collapse of key contractors.

There is now a need for a bail-out of the public sector, in the same way there has been of the banks, believes Labour’s John McDonnell. ‘This is going to run on,’ he says. ‘This is capitalism for you. This is the economic system. The government is going to have to stand ready to deal with the ramifications of all this. At the moment my biggest concern is that so much money is going into banks, that it is putting public services at risk, because the public borrowing has gone so high. The government has to think about tax policy.’

It will also have to rethink its investment approach, says McDonnell. ‘The PFI is finished. It’s dead in the water now. We need get back to responsible banking and responsible public investment. The traditional routes will stand us in good stead for the future. You can’t get something for nothing.’ l