WEEKLY COMMENT 24-11-2016
By Barry Edwards
Almost every detail in the autumn statement was previously announced or predicted accurately by the media. Consequently, there were no surprises and it was a mundane affair which did not generate much inspiration or excitement. The really interesting plan in the statement is the revelation of the Industrial Strategy that will be published in a green paper early next year which will be the first time for ages that a British government has set out its long-term objectives to grow the economy. If you would like to read the full details of the autumn statement click on the link below;
The main criticism of current government policy is that austerity has not worked and insufficient infrastructure investment has been made since the financial crisis. The statement addresses the infrastructure complaint but it is simply far too small a sum (£23 billion over five years) to make much difference. There is a lot of debate about the method and amount of investment required to counteract the effects of Brexit, the great recession and the lack of investment since the World War 2. It takes at least 50 years to recover from a war of that magnitude but most commentators agree that during the last 25 years there has been serious underinvestment in most developed countries.
To respond to this criticism the EU announced the Juncker Plan in 2014 which is underway now and the European parliament is planning to increase the size from €315 billion around €750 billion. This should have a real impact on growth although so far most projects funded with the guarantees this plan utilises would have gone ahead anyway according to EY consultants. Donald Trump was elected partly because he is prepared to invest $1000 billion to improve infrastructure in the America which is desperately in need of repair. The UK needs to follow suit and hopefully the Industrial Strategy will include further investment when it is published.
In Asia, those countries that can afford it have been investing vast sums into infrastructure which has completely transformed their economies achieving substantial growth benefitting all people that participate. It is fair to say that previously in Asia there was no modern infrastructure in these countries but despite that it is clear how this kind of investment does create enormous commercial opportunity. The effects are demonstrated conclusively and there is no doubt that similar investment will have the same reaction in developed countries.
It should be pointed out that in Asia the investment made was part of long-term economic plans which have been successfully implemented. It is a surprise that it has taken so long for developed country governments to learn from the emerging markets that this policy works so well. In most developed countries, economic plans tend to refer solely to government budgets which only represent roughly 40% of Gross Domestic Product (GDP) ignoring the other 60% commercial activity. That is why talk of an industrial strategy makes such welcome news to commentators and economists who have been asking for something like this for ages.
The big problem with substantial infrastructure investment is that it increases government borrowing substantially which makes politicians nervous because it might frighten away investors. Most economists believe this would not happen providing the preparations and selection of projects are carefully analysed as part of an overall economic growth plan. It has worked perfectly well in Asia so why not in Europe and America?
If it was possible to make this kind of investment without increasing government debt as a percentage of GDP which is the figure careful investors concentrate upon then there would be no reason not to proceed. Recently, I wrote a paper which explains how this could be done and I thought I would share this with you to get your comments and ideas. There is a one and a half page summary at the front of the document that outlines the proposal so there is no need to describe it here.
The ten page paper is reproduced below following this weekly comment and I would be very interested to hear your views.
That’s all for this week, more observations next week.
PROPOSAL FOR A “COLLATERAL GUARANTEE SYSTEM”
By Barry Edwards
SUMMARY – JUNE 2016
It is proposed that the Bank of England should establish a “Collateral Guarantee System” (CGS) – a method of utilising the assets on its balance sheet through the issuance of guarantees for the purpose of financing infrastructure and approved commercial projects that would not otherwise achieve support or are limited by government budget commitments.
Governments in developed countries are limited by budget constraints to commit to infrastructure projects while commercial capital available for investment projects is severely limited in the current environment, restricting potential development opportunities and future economic growth.
At the same time, central banks including the Bank of England have greatly expanded their balance sheets through asset purchase programmes aimed at lowering longer term interest rates and increasing the liquidity profile of the commercial banking system. However, economic growth remains anaemic and investors lack the confidence to provide the capital investment needed to spur recovery.
There is a need to unblock these constraints without incurring more expense on government budgets, by unleashing the potential of commercial capital expenditure that has been unavailable to all but a few projects.
Proposed Collateral Guarantee System explained
Under this proposal gilts acquired by the Bank of England (BofE) under the Quantitative Easing programme would be made available as collateral for infrastructure and related commercial projects to the CGS. All projects take time to be constructed and completed which are usually funded by bank borrowing during the investment period. The CGS would issue guarantees to fund all kinds of projects for a fee to compensate for the risks while construction takes place. As the loans would be collateralised with UK gilts, banks would be able to lend at competitive rates and at a better rate than they can achieve by depositing funds with the BofE.
Once the projects are completed they can be refinanced through the issuance of long-term bonds (30 to 50 years) underpinned by government payments for infrastructure projects while the commercial portion of the portfolio would be refinanced by the issuance of private corporate bonds. The commercial funding could also involve some equity participation part of which could accrue to the CGS as the guarantee provider to be held on behalf of the BofE or a sovereign wealth fund which could be established.
Benefits of the CGS
While demand and interest rates are low there is a need to stimulate growth through investment which can be funded at current very attractive interest rates. The CGS would clearly add to the potency of quantitative easing by utilising the BofE’s gilt portfolio with a more direct stimulation of investment activity. The CGS would reduce the cost of private capital funding infrastructure projects. This ultimately reduces the cost burden on government finances and, by allowing projects to be initiated that would not otherwise be started, provides substantial additional tax revenues.
THE DETAILED DESCRIPTION OF THE CGS
Anatole Kaletsky in his article (May 2016) in the Project Syndicate website headed ‘Central banking’s final frontier’ stated;
“As central bankers worldwide continue to struggle to boost growth, inflation, and unemployment, the real issue is not whether more powerful monetary instruments are still available. The question is whether using them is necessary – or even threatens to do more harm than good.
There are, in principle, four broad ways to add more stimulus to the world economy. The obvious course is to keep cutting interest rates, if necessary deeper into negative territory, as suggested by Koichi Hamada, economic adviser to Japanese Prime Minister Shinzo Abe. In Hamada’s view, interest-rate cuts work mainly by weakening currencies and so boosting exports. Likewise, Raghuram Rajan, Governor of the Reserve Bank of India, believes that “exchange rates may be the primary channel of transmission” for monetary easing, but worries that currency depreciation is a zero-sum game for the world as a whole.
A bigger problem is that rate cuts may not weaken currencies at all. As I noted six months ago, the fact is that the “widely assumed correlation between monetary policy and currency values does not stand up to empirical examination.” Indeed, Hamada admits that Japan’s recent rate cuts perversely strengthened the yen: “The effects on the yen and the stock market have been an unpleasant surprise.”
A second option, implemented in March by the European Central Bank and supported by Hans-Helmut Kotz, a former chief economist of the Bundesbank, is to expand so-called quantitative easing (QE). Emulating the approach adopted in 2010 by the US, the ECB is boosting liquidity by purchasing long-term government bonds and other financial assets.
A third standard response is fiscal expansion – cutting taxes and increasing public spending. This is the course recommended by the International Monetary Fund and the OECD. Yale’s Stephen S. Roach, a former chairman of Morgan Stanley Asia, calls over-reliance on monetary policies “a final act of desperation,” one that is “effectively closing off the only realistic escape route from a liquidity trap. Lacking fiscal stimulus, central bankers keep upping the ante by injecting more liquidity into bubble-prone financial markets – failing to recognize that they are doing nothing more than ‘pushing on a string,’ as they did in the 1930s.”
The problem is political, not economic. Fiscal expansion conflicts with what Kotz calls the German “fetish” of balancing budgets “come hell or high water.” The same irrational opposition to fiscal stimulus prevails among American conservatives, who, according to Berkeley economic historian Barry Eichengreen, “have been antagonistic to all exercise of federal government power for the best part of two centuries.”
This leaves the fourth possibility: “Helicopter drops,” the term coined by Milton Friedman for central bankers’ infinite capacity to generate inflation by printing money and distributing it directly to citizens. Rajan describes the idea succinctly: “The central bank prints money and sprays it on the streets to create inflation (more prosaically, it sends a check to every citizen, perhaps more to the poor, who are likelier to spend it).” And today, nearly a half-century after Friedman mooted the possibility of such a policy, there are growing calls to implement it.”
The CGS proposes a fifth possibility that does not cause the problems outlined in the four methods described above and utilises resources that are already available within central banks’ balance sheets. This plan is based on the UK’s Bank of England but it could be adopted in any country with a functional financial system.
Quantitative easing has accumulated £375 billion of government bonds (now increasing to £435 billion) which are held on the balance sheet of the Bank of England (BofE) and the policy is to maintain this amount when any short term bonds are redeemed. Since ‘Brexit’ the BofE has declared it will purchase a further £60 billion of government bonds and £10 billion of corporate bonds. It is assumed that the policy will remain the same and these assets will remain on the balance earning interest which is currently repaid back to the Treasury annually.
Conversely, there are deposits from commercial banks held as liabilities earning 0.25% which are the excess of deposits that are not utilised for lending or investment purposes by the banks. The CGS proposes that the government bonds are used as collateral to issue guarantees for a fee of 3% per annum for infrastructure and secure commercial projects to be financed by using these commercial bank deposits with the BofE and/or cash from other sources creating loans to construct the projects. When they are completed, long-term fixed interest bonds are issued for pension funds and other investors to acquire; the bonds would be priced to make sure the issue is fully subscribed.
While construction of the projects is undertaken, the loans would be held on the commercial banks’ balance sheets and earn a higher interest rate than the 0.25% paid by the BofE. Liquidity could be provided to the banks for the cash utilised by repoing the loans made in the normal course of central banking activity. The 3% annual fee payable while the projects are being constructed and completed would be held in a reserve account at the BofE to cover any calls on the guarantees until the fund is considered to be of sufficient size to cover any situation. Any excess after that amount has been achieved would become current assets for the BofE until the CGS reverts to private control (see below).
The infrastructure projects that do not generate income would be funded by semi-annual payments from government finances which should be adequately covered from the generation of tax receipts from the increased economic activity created by the investment in the projects. This should potentially generate sufficient tax receipts over the long-term to allow funds to be accumulated to manage a repayment schedule for the bonds when the government budget returns to surplus. However, it would be in the interests of government to delay repayment of the bonds as inflation will have its beneficial effect when the time comes to redeem the bonds. An alternative to this method would be that the CGS is responsible for the repayment of the bonds where government payments are required. This would include additional annual payment of 1 or 2% on top of the interest payable which would remove the debt from the government balance sheet entirely.
It is proposed that the commercial projects that the use the CGS would, on signing the agreement to proceed, issue to the UK sovereign wealth fund (to be established), a minority equity stake to be agreed to counter the extra risk taken by the CGS. The equity stake would increase at a rate to be agreed each year the guarantee is in force to encourage efficient construction and completion.
It is suggested that the sovereign wealth fund (SWF) would retain the equity holdings it is issued for the nation and receive the dividends paid by the companies when the projects are generating income. The plan is that this SWF would become a shareholder in many companies that have utilised the funding of the CGS and in time both entities could merge to take over the role initiated by the BofE. The income received by the SWF could be utilised to fund long-term research and development for the nation.
The proposal is intended to be a long-term investment and funding entity to be started by the BofE and then gradually taken over by CGS/SWF in conjunction with government strategy although managed and operated privately. Ultimately, the structure of that would involve inviting financial institutions and asset rich organisations to provide the collateral to support the guarantees to earn the fee of 3% to enhance the yield on their investments. The BofE would progressively withdraw as the government bonds are repaid and the quantitative easing programme is unwound.
Once the CGS is established and proved to be a secure method of funding infrastructure and commercial projects, the financial institutions would be confident to participate in the construction phase of projects and invest in the bonds that are eventually issued without the uncertainty and risk that is currently perceived. The guarantors will receive yield enhancement from the fees earned during the construction and completion phase and attractive rates on the bonds they may choose to buy improving the returns for savers and investors.
To give extra comfort to the guarantors’, part of the reserve built up by the BofE could be transferred to the CGS/SWF to act as first call insurance in the event that any claims are made on the guarantees achieving the risk management levels acceptable to most institutions. It would also be feasible to create a credit default swap (CDS) product specifically for the CGS to provide further reinsurance for those who wish it to completely protect the original investors and savers. The government could participate in this reinsurance to make sure there is a facility even during aggressive economic downturns to help stimulate business activity. This approach has been successfully adopted for flood damage recently and for terrorist attacks by the IRA in the past.
THE ADMINISTRATION AND MANAGEMENT OF THE PROJECTS
The CGS could establish an organisation to assess and manage the projects; however, it would make perfect sense to work closely with the organisations that have already been set up by government over the last four years.
The coalition government initiated the ‘UK Guarantee Scheme’ in 2012 to support the funding of infrastructure projects throughout the nation which was due to expire 2016. The Chancellor (George Osborne) extended this scheme until 2020 in the last budget which should allow the full amount of £40 billion to be utilised fully. In addition to the guarantee scheme, the government has set up the ‘National Infrastructure Commission’ (NIC) which is in the process of establishing itself. The official description of the commission is taken from their website and is as follows;
The National Infrastructure Commission will enable long term strategic decision making to build effective and efficient infrastructure for the UK and will be established by legislation as an independent body.
The commission was set up on an interim basis on 5 October 2015 and will look at the UK’s future needs for nationally significant infrastructure, help to maintain UK’s competitiveness amongst the G20 nations and provide greater certainty for investors by taking a long term approach to the major investment decisions facing the country.
The proposal is for the CGS to utilise and extend the UK Guarantee Scheme, in conjunction with the HM Treasury Infrastructure unit, and work closely with the NIC to expedite the projects they are currently promoting. For the commercial projects, a new unit would have to be established to manage the processing of applications although it would be perfectly feasible for the CGS to outsource most of this activity. However, the main function and purpose would be to form a committee to decide on the viability and acceptability of the projects.
Apart from the commercial project committee and processing unit, it would seem unnecessary to create another organisation to manage, process and decide which infrastructure projects should be supported when the mechanism is already in place to fulfil that function. Allen & Overy have prepared all the legal documentation and if you click on the link below you can read the overview of the format they have devised;
The expertise for project consultation and management is extensive and extremely professional. Since the preparation and assessment is very thorough, most commercial projects are constructed and completed on time. Technology has transformed the construction process and project finance has an excellent track record of being a secure and long-term investment with very few repayment problems.
Institutional investors are keen to purchase project bonds for the yields they offer compared to government bonds making them a perfect investment to produce the returns they wish to achieve for their pensioners and savers.
OTHER ORGANISATIONS THAT COULD BE CREATED WITHIN THE CGS CONCEPT
The CGS is designed to activate much delayed infrastructure investment and related commercial projects that would stimulate the economy without the need to increase government debt. The effect on the wider economy would be substantial and utilise products and services from companies of all sizes. This would almost certainly create an imbalance where large investment was supported adequately by the CGS but small and medium sized enterprises (SME’s) that would inevitably be involved in supplying a significant proportion of products and services for this major investment programme would be left unable to finance their working capital and investment requirements.
To correct this imbalance, the CGS would need to establish a specific SME funding project to provide access to finance for those businesses that could not obtain suitable bank finance or issue bonds in their own right. It would be counterproductive if the supply chain involved importing many products and materials for the simple lack of adequate funding opportunities for those companies that could supply nationally.
Therefore, it is proposed that Enterprise Managers are established to fulfil this objective as well as improving the overall financing process for SME’s.
SME’s are the core of business in all countries and employ more people than any other sector. It has always been government policy to help these companies for that reason and the methods used to make this happen have been very varied and usually not very effective. The Internet has transformed this approach and has had a big impact on the accessibility of finance for those businesses that can meet the lending criteria. At the moment, it is still a tiny percentage of all lending to SME’s but is growing at a steady rate and is changing the attitude of the banks who are now beginning to work with these alternative lenders to manage their own small business customers much more efficiently.
Many of these loans are being securitised and placed with financial institutions who have been content to accept the extra risk involved for the higher yields available especially in this low interest environment. This new style of lending has evolved since the financial crisis and has not yet experienced a serious downturn in business activity to test the overall viability of the concept. This makes it untested for many institutions that prefer to wait and see how it does perform when that inevitable recession does occur again.
The main problem with these new lenders is that they rely on financial information that may be quite old and the clever algorithms used to analyse all available data do not replace adequately traditional person to person analysis and careful due diligence. The other major flaw in all SME lending is that once lending has occurred there is little or no monitoring and support provided in a format that can be relied upon as full proof. The main reason for this is that it is expensive to carry out and most SME’s would not accept the close analysis unless it involved managerial advice and strategic support both for accounting and the future development of the business with the finance to make it happen including the provision of equity as the company grows.
At the moment, a service such as that described above does not exist as one entity and therefore when the CGS arranges finance for a project, there would need to be an organisation to work closely with the main contractor to help smaller suppliers with the funding of their contract and provide the support needed. It would be part of the agreement with CGS that all project contractors do their best to seek supplies nationally and refer any business that may need assistance to the Enterprise Managers. This would help to develop smaller businesses in a way that has not been encouraged before and provide much increased turnover to help them grow more quickly.
The main purpose of the Enterprise Managers (EM’s) is to allow all businesses that have the capability to work with and supply CGS projects to become involved and not be forced out of participation because funding is not available. The EM’s would raise funds by issuing zero coupon bonds into the market to provide equity funding where it was deemed necessary and issue guarantees similar to CGS for lending in conjunction with projects that are also supported by CGS. Other SME’s may approach the EM’s but initially most of the activity is expected to be generated by CGS supported projects.
The five year zero coupon bonds would be issued at about 60 to give a yield of around 10% per annum to investors when the bonds are redeemed at 100 to make them an attractive investment and it is suggested that they are given tax free status for income a and capital gains. It is intended that they would be issued in minimum tranches of £100 million as the demand for equity investment in SME’s increases as the CGS grows. The bonds are repaid from the sale of the equity to later stage investors or securitised into venture capital funds and resold in the market.
The guarantees for lending where necessary would follow a similar pattern to CGS and a fee of 3% would be charged per annum. Every company using the facilities of the EM’s would be allocated a coordinator who would be a non-executive director of the company and manage all the support and advice that would be available from the professional people who would associate with the EM’s and deliver the full range of services that are required to support the SME’s. The coordinators would work closely with the SME’s and produce a monthly report and confirm the accounting monitoring is up to standard. This information would be available to all businesses supporting the SME while they are involved.
Every SME that agrees to access the facilities of the EM’s would be charged a monthly fee relative to the size of the company which would cover the cost of the coordinator and most initial advice. All other services the SME may use would be charged as normal for any support given although the cost would be priced to make sure it is affordable to suit each business since the volume would allow for contract deals to be negotiated by the EM’s. It should be stressed that these SME’s are expected to grow rapidly and naturally will require much more advice than is normal for the sector. The EM’s would be able to cover their costs from the fees charged.
The details of how the EM’s would function and operate are available in a separate document.
THE FILM AND TELEVISION INDUSTRY
The film and television industry is a natural for the CGS. All films and some TV are financed by bank borrowing in some form or another and most are guaranteed by the big film production companies who retain a majority stake. Europeans have been big film makers at various times in the past but most countries now produce films in their own language for the national market usually with government support. There is an enormous opportunity for the UK to become a big film production centre since the expertise and acting skills are in abundance throughout Europe and the only thing missing is a reliable source of finance to make a wide range of films and TV specials for the world market.
The film and television industry employs a lot of people and indirectly it creates further employment for sub-contractors and technology specialists which is now a vital part of the business. A lot of this expertise is based in the UK and Europe and is employed all around the world. The demand for English language content from cinemas, television channels and home viewing is enormous and is only likely to increase as more ways of seeing this content is promoted. All the ingredients are available on the doorstep eager to participate in a revitalised UK film and TV production sector that could become a world centre in this industry.
The CGS would be a perfect system to support the funding of this industry and building a library of content for sale over the years to all the media outlets around the world. The procedure would be exactly the same as financing commercial projects except a bigger equity stake would be available; this is current practice for most film production everywhere. The key to making this business a success is to make enough films every year to allow for those that do not meet with public approval; ultimately that will mean making 300-400 films and TV productions a year. If the CGS does get underway this is one of those opportunities that could be extremely beneficial for the nation since the GCS format is a perfect fit for this industry.
The most important point about industrial strategy is that you are not trying to pick individual businesses to support but setting the parameters for commerce to flourish and funding the specific research that is demonstrating substantial potential. It must be accepted that mistakes will be made and changes of direction will occur as technology and commercial experience show that a new direction must be taken. Whatever is decided it is very likely that an organisation such as the CGS would play a major role and help to steer companies to take on the challenges that are presented.
The UK has a history of not taking advantage of inventions and innovations that have been initially developed but left for other countries to exploit further. The main reasons for this were that funding was extremely scarce after World War 2 and an effective industrial strategy has never been a major policy directive for any government. There have been industrial support schemes which focused on funding companies that were considered vital to the economy, many of which eventually failed.
The time has come for this to change and the new Conservative government under the leadership of Theresa May has indicated that this matter will be addressed. It is expected that the main concept of an industrial strategy will be revealed in the autumn budget together with fiscal incentives to counteract the effects of Brexit. Whatever is decided having an organisation like the CGS as a key player could only enhance the effectiveness of any government policy if only for it to be there when any opportunity has been fully developed and needs funds to exploit the commercial advantages that it offers.
The CGS can play an important role in supporting government and commerce in many ways which would help the nation to recover and benefit from the Brexit decision and flourish in the long-term.