31 October 2008
The government has favoured the Private Finance Initiative, partly to keep debt off the national accounts. But, Mark Hellowell argues, with the financial crisis hitting providers, the schemes will prove more expensive in the long term
Alistair Darling confirmed in his Mais lecture this week that the government's fiscal rules are to be rewritten. More fiscal flexibility is required if the chancellor is to meet his aim of accelerating public investment to buttress the economy and protect jobs, and new borrowing targets will be detailed in the Pre-Budget Report.
As currently formulated, the Treasury's sustainable investment rule makes impossible any increase in direct capital spending. Even if recent bank acquisitions and guarantees are left out, public borrowing as a percentage of national income is close to the 40% cap and this figure will rise as the recession hits tax receipts.
But, at the same time, using the Private Finance Initiative to remove debt from the national accounts is becoming less viable.
Private finance investors have been hit by the credit crunch in much the same way as homebuyers and businesses, with debt in short supply and margins increasing. While the government has pledged to increase the availability of lending through its three new part-nationalised banks – Royal Bank of Scotland, HBOS and Lloyds TSB – it seems this will not include lending to PFI projects. These banks are three of the biggest project financiers in the world (in fact, the RBS is the biggest, in terms of the amount of debt underwritten).
But pressure to increase lending to public projects would underline the basic conflict of interest that is generated by the Treasury being both the lender and ultimate borrower of any debt raised. Meanwhile, bonds, the traditional alternative to bank debt, are simply no longer available. US monoline bond insurers such as Ambac and MBIA were hit by the sub-prime crisis and have lost their triple-A investment grade, which has effectively put an end to this kind of lending. The monolines played an essential role in the PFI market, guaranteeing repayments to bond holders in return for a fee, reducing overall financing costs for many of the larger projects.
Bonds have financed some of the most eye-catching PFI contracts ever signed, including the £1bn refurbishment of the Barts and the Royal London hospitals, which is currently under way. The viability of some large planned hospital schemes, such as those in Liverpool, Birmingham and northwest London (each of which has a projected value of between £300m and £500m) is now in doubt.
Indeed, across the public services, PFI investors are having to finance their projects in more expensive ways than in the pre-credit crunch era. Traditionally, PFI deals involve one or two 'lead' banks that lend upfront and then 'syndicate' the loan across other banks after contracts are signed. But in the midst of the credit crunch, banks are no longer willing to risk getting into difficulties with syndication after deals are closed.
Credit committees now want much more comfort that they will be able to sell down the debt through the syndication markets, to avoid holding significant amounts on their balance sheets.
Some borrowers are responding by asking banks to 'club' together during the final stage of project negotiations. This means that the syndication, in effect, takes place upfront, instead of after a contract is signed. It also means that the degree of competition in the PFI finance market is materially curtailed. The impact has been stark. In the UK, the credit margins and fees charged by banks have increased from 60–80 basis points to 100–150 basis points – that is, up to 1.5% over the banks' own cost of capital.
Some banking executives are describing this as a welcome 'correction' in the PFI debt market. But a correction based on limited, if any, competition raises clear concerns for investors that they are getting finance on reasonable terms. In turn, this is a major headache for the public authorities involved in procuring projects. Despite a general market feeling that the PFI is 'on the way out' in the UK, it is still the principal means of financing large-scale infrastructure in most areas of the public sector.
Some £23.3bn worth of projects are due to be signed over the next five years, according to papers issued by the Treasury alongside the 2008 Budget. For projects such as community hospitals, secondary schools, new-build social housing and waste management facilities, private finance is becoming more, not less, important.
Unless market conditions improve in the coming years, investors on these schemes will have an historically high cost of debt – and this will be passed on to their public sector partners. There is now a real possibility that finance costs for PFI projects will return to the level of ten years ago, when huge risk premiums were being paid because of the programme's 'immaturity'.
As the Treasury acknowledged in 2003, these schemes often involved significant 'excess costs' – a fact reflected by some of the huge windfall gains made on PFI schemes as project debts were refinanced or equities sold on the 'secondary market'.
It is therefore embarrassing for the government that the market is inching back up to those levels. This is storing up huge potential for refinancing – and huge windfalls for PFI investors – in years to come when credit conditions ease.
The Treasury appears alive to the significant political risks this presents. Officials have announced that future contracts will stipulate a higher share of the gains for the public sector. Since 2001, a 50:50 split has been in place, and will continue to apply for amounts under £1m. But for amounts between £1m and £3m this will be raised to 60%, and 70% for larger sums. The public sector will also have the right to demand a refinancing if authorities believe it will lead to better terms for the taxpayer.
It is unclear whether the government's new 'get tough' attitude on refinancing signals a less obsequious attitude to the financial community than has been evident in recent years. Academics and others have long argued that the PFI is an expensive route for investment in public facilities and is popular with the government only because it gets borrowing away from the national accounts.
Currently, as long as borrowing relates to a PFI scheme that is 'off-balance sheet' (ie, is recorded by authorities as a service contract rather than a finance lease), it does not score in the public sector debt figure. This is the source of what is sometimes called the 'fiscal advantage' of PFI over public borrowing.
But, as economists have pointed out, this is simply an accounting anomaly, and one that distorts public decision-making. After all, however money is borrowed – whether directly or through a PFI intermediary – it has to be repaid from public resources, and that usually means from taxation.
As of April 2008 there were 628 PFI projects in the UK with a combined capital cost of £59bn. However, only about £12bn of this was recorded in the national accounts for 2007 because the vast bulk of PFI schemes remain off the public sector's books under the outgoing accounting system of Generally Accepted Accounting Practice. With private finance costs increasing, it is therefore inconvenient for the government that the 'fiscal advantage' might be eroded in the next few years.
The move to International Financial Reporting Standards from 2009 will place the bulk of PFI finance on the balance sheet of the public authorities involved. This implies that at least some of the borrowing will move on to the national accounts, although how much is uncertain. The public sector debt is derived from the national accounts framework and not from IFRS.
National accounts concentrate on an evaluation of risks, while IFRS focuses on control of the asset. The Office for National Statistics has stated that any impact from IFRS in the financial statements of public sector entities will not automatically transfer into public sector debt. In any case, government departments have an incentive to try to keep projects off the balance sheet (and therefore invisible to public debt) because they must pay 'capital charges' on any estate that appears in their accounts. They appear to be acting on this. Some NHS trusts, for example, are planning to hand over their land and buildings to specially created charities, effectively divesting themselves of their physical assets.
Other public authorities are considering transferring actual ownership of their PFI assets to the private sector – undermining the long-established principle that privately financed facilities should pass back to the public sector at the end of the contract.
Such activity is likely to incur the ire of unions and other critics of the PFI. However, it is emblematic of the kind of distortionary decision-making that can occur when accounting considerations take precedence over value for money.
The November Pre-Budget Report provides a good opportunity to formally rewrite the fiscal rules so that there is, for the first time since 1992, a real choice between different types of finance for large projects.
Despite the apparent conversion to Keynesianism, the Treasury will continue to be keen to keep public debt as low as possible, for both legitimate economic and less legitimate political reasons. But the temptation to rely on the PFI at this time should be resisted as its costs increase relative to the public finance alternative.
A new fiscal target might take into account the possibility that economic circumstances now require public borrowing for the investment plans currently going forward under private finance. With the Conservatives increasingly focused on attacking the government's alleged fiscal recklessness, the move would not be without its political costs. But then, that is the nature of being decisive – a quality that government ministers have often laid claim to in recent weeks.
Mark Hellowell is research fellow at the Centre for International Public Health Policy at the University of Edinburgh
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