Weekly Comment 23-11-2012

 

 

WEEKLY COMMENT 23-11-2012

By Barry Edwards

 

It is surprising that financial markets have been virtually unaffected by the Israeli/Palestinian conflict. Although we now have a ceasefire, it is beyond most people’s belief that this will be the end of the troubles.

It is clear both sides are at fault and the failure to recognise their own shortcomings seems to be the real problem behind the unending antagonism.  It does not help that outside influence plays a big role in the actions of the Palestinians but ultimately the cause of the reaction by the people is simple poverty and the lack of opportunity to make a better life for themselves without unwelcome interference.

It is unlikely families will threaten the environment where they live if their economic circumstances are giving them a satisfactory living to enjoy the fruits of life. It is easy for someone living in a developed country commenting on the situation there to make these statements without experiencing the horror of it first-hand but where people have the freedom and the chance to make a proper life for themselves you do not usually see this kind of conflict.

Ultimately, this will mean an international agreement to support Palestine and fund its development to prevent continuous aggression. That seems to be something that never gets discussed and until it is on the UN agenda to make it happen, the problem will continue.

 

In the UK this week, the interesting discussion is about encouraging infrastructure projects as the preferred method of stimulating the UK economy. The Government is attempting to entice pension funds to provide the funding but so far without much success.

In case you have not been following this discussion, government has announced various support programmes such as £40 billion of guarantees and a restructuring of the Private finance Initiative (PFI) to get the ball rolling. The problems are that many banks are withdrawing from long term lending and the pension funds themselves lack the expertise to assess projects for investment.

Finding equity capital for projects has always been very difficult, even in the good times, so that the only real method of funding projects is by loans until they are constructed and the financial returns can be properly evaluated. At this stage it is possible to raise equity and refinance the loans by issuing bonds which would be of great interest to pension funds.

The income from the bonds would provide a better match for their pension commitments and since most infrastructure investment involves government payments in one form or another, they are considered very safe. Therefore, all that has to be done is to devise a method of funding projects to completion and refinancing them at that time, hence the government initiatives mentioned above.

Yes, you’ve guessed it; it is not as simple as that!!

Most projects are completed on time and on or below budget. A few, usually infrastructure projects, encounter cost overruns that can substantially increase the initial cost which is why pension fund trustees are not willing to commit to funding prior to completion. This is why the European Investment Bank (EIB) has established a 20% cost overrun guarantee scheme by allowing infrastructure projects that apply to them to draw on further subordinated loans to meet that cost if it occurs. This has helped with funding in Europe and projects are underway using this facility.

It is very rare for an overrun to occur above that amount (20%) but it is still not good enough for most trustees of pension funds to take the risk since they have to pick a few investments out of the many available and it might be one of the projects they select. That is why it is not easy to get pension funds to commit prior to construction which undermines the government initiative.

How you get round this problem is explained in the Collateral Guarantee System (CGS); the second part of The Economic Growth Plan in the right hand column of this page in Business and Support. A brief summary of how this works is explained below.

The proposed Collateral Guarantee System (CGS) borrows prime assets of any kind, such as securities or property, to support the issuing of guarantees for projects of all types for 5 years at a fee of 3% per annum. The funding is provided by banks and if they do not wish to take up the lending opportunities then the Bank of England could utilise the Quantitive Easing programme (printing money) and buy the bonds to fill the gap while the economy improves.

While construction is taking place, pension funds do not commit to specific projects and still earn 3% on the value of the assets pledged. When the projects are completed, which is usually after 2 to 3 years only, the refinancing by issuing new bonds is arranged and pension funds can purchase them in the full knowledge of the exact return they can achieve without any construction risk. The refinancing cancels the guarantee and a new one is issued for another project and so forth. The new bonds could be used as collateral for the CGS improving the yield even more, helping to increase the returns of the pension funds.

In effect, the CGS is a pooling mechanism earning a respectable 3% per annum for pension funds, helping to improve their income in the process. Any cost overruns are paid for out of the retentions the CGS makes on all guarantees issued and the expertise within the CGS network of specialist project advisors makes sure all pre-planning and preparation is properly carried out.

The pension funds have removed their construction risk, the government has a mechanism to stimulate the economy and assist many commercial projects to get funded as well, many construction workers are employed and all the materials are sourced in the UK. It will not take long before the funding of these projects filters through to the wider economy including the services sector.

The CGS could be set up in a few months since all the components to make it work are already in place. It does not cost the taxpayer anything and all the government has to do is say ’yes’. It is as simple as that.

 

That’s all for this week, more observations next week.

 

 

 

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