The government is planning to underwrite £50bn of infrastructure and housing projects, but it must be careful to not burden the taxpayer with liabilities that could prove catastrophically expensive
David Cameron will this week give details of new legislation that will allow the government to guarantee up to £40bn in infrastructure projects and £10bn for new housing. Ministers are presenting the bill, which should be on the statute books by the end of October, as a key part of his administration’s renewed focus on growth.
In fact, the plan to establish a ‘UK Guarantees’ scheme to accelerate investment in economic infrastructure was announced by the Chancellor George Osborne in July.
To qualify for a government guarantee, projects must be ‘nationally significant’ and ready to start in the 12 months following a guarantee being confirmed. They must also have equity finance in place – and sponsors will need to persuade officials that they are unable to secure financing from commercial sources without state support.
So, what to make of this plan? As the focus on ‘shovel ready’ projects indicates, the scheme is as much about stimulating growth and employment as it is about addressing Britain’s need to update its energy, transport and communications infrastructure.
Four years after the collapse of Lehman Brothers, banks still face capital and liquidity constraints that undermine their ability to lend to long-term projects. This is damaging the economy, which needs greater spending by the water, power and network industries to offset the collapse in public and private sector investment.
Instead of the government borrowing directly, the idea is to use the current administration’s ‘hard won’ credit-worthiness to guarantee payments to creditors and thus enable risk-averse banks and institutional investors to lend into projects.
The logic is that, because of the ‘safe haven’ status of gilts, the government can take on contingent liabilities without its low interest rates being threatened. Transferring project risk to the public sector will make lending less expensive for banks in terms of their capital reserve requirements, and should therefore boost lending. In addition, enhancing credit in this way might enable projects to be financed by bonds, to be purchased by pension funds and insurance companies.
The key to institutional investor involvement is to improve the rating of bonds from BBB to ‘single A’, for which the market is deeper for a variety of reasons – partly the culture of institutional investors, and partly the fact that forthcoming international regulations will limit the capacity of such investors to buy assets without an A-rating.
But there are risks here for the government. Economists – perhaps reflecting on the origin of the financial crisis in processes of credit risk transfer by banks – would point to two key issues.
First, there is the problem of adverse selection – the fact that projects seeking guarantees are those that have been unable to secure financing in the private sector, and therefore present a relatively unfavourable balance between risk and return.
Second, there is the problem of moral hazard – the fact that a guarantee will insure lenders against the costs of default, which may result in a lack of attention to the risks presented by projects or their sponsors. A bank that has transferred credit risk to the government in this way has less incentive to carry our proper due diligence on a loan – or monitor the performance of the borrower after the loan is provided.
Removing or weakening that due diligence function could generate unacceptable fiscal and economic risks for the government if the process is not well-managed.
In terms of the commitment to boost investment in residential developments, it appears the government wants to give housing associations a new role. Though the details of the plans was not available at the time of writing, the idea seems to be that associations will issue bonds – again, underwritten by government – to sell to institutional investors who want long-term secure assets and fixed rates of interest.
Housing associations would then contract with developers to build houses and flats, which the association would sell or rent in the open market. Of the two elements of the government’s guarantee plans, this looks like the less risky. As the private rental market is relatively buoyant, the revenue stream associated with the new properties should be relatively stable, though development costs will need to be well-managed.
Britain remains in a deep recession of uncertain duration, and the seriousness of the situation is underlined by a government – especially this government – introducing such unconventional measures.
As conventional public capital spending is reined in and big corporates hoard cash until they see signs of growth, the country undoubtedly needs more infrastructure investment and the high impact multiplier it can provide. Well-conceived projects can also be of huge benefit for economies in the long-run, especially in an era of rapid technological progress, climate change, urbanisation and growing congestion.
And if the housing plan can contribute to employment and growth while allowing more people to be housed decently than are now, that is obviously very desirable.
The risk is that, as the government scrabbles around for growth in the context of the all-encompassing priority afforded to deficit reduction and the political need to avoid further ‘dithering’, it will burden the taxpayer with contingent liabilities that, as countries such as Portugal have recently found, can prove catastrophically expensive when they crystalise.