Councils rely heavily on the income generated by their investments, but a fall in the interest rate has stemmed this revenue stream. Now they need to focus on managing the other side of the balance sheet
There has been a fundamental shift in most local authorities’ financial prospects in the past 12 months. Not only is the deepening recession increasing demand for their services, but their investment earnings projections have been much reduced.
The rapid cuts in interest rates by the Bank of England have completely altered the investment environment. The era of achieving interest rates of 5% or even 6% is over, at least for the medium term. In fact, in the short term, it is likely that real and nominal interest rates will continue to fall.
The response to the crisis in the banking sector, which is the principal home for local authority investments, means that marginal rates of income are now much more widely accepted in return for capital security.
Many local authorities have built investment returns projections into their financial plans, which they are now not able to achieve. The increasingly risky environment has persuaded many to invest a higher proportion of their assets with the Debt Management Office.
This is an understandable response to the recent banking failures but this yields significantly less than 1% and creates additional pressures on revenue budgets. Against a backdrop of declining interest rates, normal treasury strategy would be to lengthen investments to provide protection against lower interest rates.
The problem is that heightened credit risk has understandably quashed councils’ appetite for longer-term deposits. But they need to challenge normal practice. Longer-term returns are available with appropriate risk characteristics, but they must look beyond term deposits and into appropriate bonds.
It is clear that local authorities are not going to achieve their projected investment returns, even if they were willing to take on the levels of risk that would be necessary to do so. Therefore, they should look at the other side of the balance sheet and see if they can reduce the interest they pay on their debt and minimise the disparity between the rate at which they are borrowing and the returns they are achieving on their investments. Increasingly, the debt costs and interest earnings of local authorities are now largely administered by two sections of the same government agency, the DMO.
There is often an assumption that the Public Works Loan Board’s dual interest rate structure, introduced in October 2007, has effectively removed debt restructuring from the local authority treasury manager’s toolbox. This is not the case. But the evaluation of options has to be set against realistic criteria that reflect today’s interest rate environment.
While local authorities are reasonably happy to have investment returns based largely on a short fixed rate of interest, these are not often widely reflected — on either a strategic or tactical basis — in debt portfolios. The latest CIPFA Capital expenditure and treasury management statistics 2006/07 report indicates that, nationally, around 5% of external debt portfolios operate on a variable rate basis. But this could include fixed-rate loans classified as variable, such as money market loans.
Councils are also in a reasonably strong position to renegotiate existing debt. Lenders might not want to risk losing the income stream they provide and will be willing to consider negotiation of terms.
What this strategy does require is a more active approach to managing debt. Authorities have become used to constantly moving around their cash assets to benefit from higher interest rates, but traditionally they have been a lot less nimble in relation to debt. However, the principles of actively managing debt are identical to those for managing assets and there is no reason why local authorities should not be able to do this effectively.
Another option that authorities might want to consider is using some of their reserves (where they exist) to pay off some existing debt. This is one of the legacies of the increased scrutiny of local authorities in the post-Iceland era. Councils are understandably often reluctant to use their reserves but it might be the most prudent use of funds.
Among the potential issues warranting strategic consideration during these tough times must be a period of extended recession and deflation, leading to lower interest rates for much longer.
At the other end of the scale, we have the authorities desperately seeking ways of initiating a burst of inflation and growth into economies, leading to a sharp upward revision in interest rates. It is against this challenging backdrop that local authorities must set their treasury management strategy. Caution is appropriate, but not inaction.
There are things that authorities can do to improve their situation and, ultimately, their long-term financial health. What is clear is that they must act now to ensure that treasury management strategies truly reflect reality and are robust enough to face future potential periods of stress.
Mark Horsfield is director of Arlingclose, independent treasury management advisors to the public sector
