Like the U.S., the UK needs infrastructure capital
The U.S. has long been in dire need for an infrastructure rehaul. An estimated $3.6 trillion is needed by 2020 for infrastructure updates, according to the American Society of Civil Engineers (ACSE). But the U.S. isn’t the only developed country with infrastructure problems. The UK is one example.
Last month, the Irish government issued a 100-year bond and raised €100 million ($113 million). Relative to Ireland’s fiscal position, which has a national debt of €183 billion ($207 billion), the amount is small. But the fact that there was investor appetite may provide a timely reminder to the UK government that now is a good time to raise the long-term money needed to invest in much-needed national and regional infrastructure projects.
The Irish government got its bond issue away at 2.35%, which is relatively cheap for a country that has recently flirted with financial ruin and as with all other nations, is dependent on a global economy that isn’t currently in the rudest of health.
Fortunately for the Irish, and many governments and corporates, ultra-low interest rates around the world mean there is demand for anything offering a yield.
Four years ago, the UK Treasury toyed with the idea of issuing a 100-year gilt, but investor demand wasn’t there. Pension funds, natural buyers of long-dated paper, didn’t step up to the plate. This was partly because they prefer inflation-linked products with maturities between 30-50 years, and partly because the pricing (the yield being offered) was unattractive.
But this should not stop the Treasury from revisiting the idea of issuing long-dated paper. Maybe 100 years is too long to appeal to a large enough number of investors. This could explain why Ireland was only able to raise €100 million ($113 million). However, 30-50 year dated paper may attract attention.
As years go, the end of the decade seems to be a deadline for many countries. Whereas the U.S. government will be on the quest to raise funds for new and improved infrastructure, the UK will be working to get its finances in order. UK Chancellor George Osborne has given his focus on balancing the books by 2020.
I suspect he may be reluctant to consider issuing more debt because of this proposal. The UK Chancellor’s aim of reducing the deficit may be understandable, given where the UK economy has come from. Still, I think we need to move away from lumping current spending and capital expenditure into one pot.
Whether the Government ends the decade £10 billion ($14 billion) in surplus or £10 billion ($14 billion) in deficit is immaterial in the grand scheme of revenues and spending that amount to hundreds of billions of pounds each year. The more important gauge of the UK economy’s long-term health is the size of the country’s debt relative to national income, in other words, gross domestic product (GDP).
This debt currently stands at £1.5 trillion ($2.1 trillion), or 83% of national income. Before the financial crisis, the UK’s debt burden was below 40% of GDP. To bring debt’s share in the economy back down towards these levels, we could continue to focus on the debt side of the equation and reduce our borrowings over time. But another route, one that may seem counterintuitive, could be to borrow more money. If done cheaply and invested effectively, this could have a positive impact on GDP.
One hundred billion pounds ($142 billion) raised via the issuing of long-dated government bonds and used specifically to finance infrastructure projects could be transformational in terms of job creation. Not to mention, it would help upgrade transport networks and may boost the energy sector.
This would be the multiplier effect at work, which students of economics learn from an early age: the rise in national income that follows from a rise in government spending or investment. Recent International Monetary Fund (IMF) research points to an average government spending multiplier, across a range of countries and time periods, of between 1.4 and 1.6.1
In other words, for every £100 ($142) spent by the government, national income could expand by an additional £40 ($57) or so. Not only would this be good news in terms of the extra activity and jobs created, but it could also potentially lower the UK’s debt burden as measured by the ratio of government debt to national income over time.
In addition, there is widespread agreement that the multiplier tends to be larger when monetary policy is constrained. This is exactly the situation we find ourselves in at present, with the Bank of England (BoE) having left interest rates at close to zero for the past seven years.
Against this backdrop, talk of creating a Northern Powerhouse* and the new National Infrastructure Commission make sense. Boosting economic growth in northern regions of England outside London, building resilient infrastructure, supporting sustainable industry and encouraging innovation can be beneficial. But there needs to be financial firepower behind these goals.
Here, we could take a leaf out of the United States’ book. After the financial crisis, Build America Bonds (BABs) were created through the American Recovery and Reinvestment Act. BABs reduced the cost of borrowing for state and local government issuers and carried special tax credits benefiting both the issuer and bondholder. In total, around $180 billion of BABs were issued between April 2009 and the program’s end in December 2010.
Committing capital to UK infrastructure projects would also help to address the problems arising from decades of under-investment in transport networks and energy sector, especially given estimated UK infrastructure capital spending requirements to 2025 are around £300 billion ($427 billion).
Understandably, there seems to be a desire within the government for the private sector to provide up to two-thirds of this sum. But while there is a lot of talk of pension funds allocating more to infrastructure, policymakers need to take this with a pinch of salt. True, a Canadian-led consortium of pension funds recently bought London City airport for £2 billion ($2.8 billion).
A big attraction for such investment would have been the ability to draw an immediate income from these pension funds’ investment. Pension funds are typically reluctant to commit capital to infrastructure projects at the planning or building stage, particularly if completion is five years or more into the future.
Increasing the number of toll roads in the UK – albeit politically challenging – may be one to encourage more infrastructure investment from institutional investors. The roads are already built, but upgrading would take only a couple of years, after which the investment would provide an income.
Getting larger, longer-term infrastructure projects off-the-ground is likely to require government backing. This is where the issuing of a 50-year bond may be the solution.
With the gilt yield curve currently indicating the UK Treasury could issue a 50-year bond at 2.25%, we believe this is a golden opportunity for the UK Government to borrow today to build for a better future. This could then upgrade the country’s infrastructure while providing a timely capital injection to stimulate economic growth.
*The goal of the Northern Powerhouse initiative would be to rebalance the UK economy away from London by pooling the strengths of towns and cities that are north of England.
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).
A version of this article originally appeared in The Sunday Telegraph on April 10, 2016. http://www.telegraph.co.uk/business/2016/04/09/ideal-time-to-commit-capital-to-infrastructure-projects-in-brita/
1 Emmanouil Kitsios and Manasa Patnam. “Estimating Fiscal Multipliers with Correlated Heterogeneity.” International Monetary Fund 4 February 2016. Online.