With the UK’s political class and media obsessed with Brexit, a big policy change went through almost unnoticed earlier this month.
Apart from specialist and local newspapers, including GlobalCapital, there was hardly any reporting of the Treasury’s decision to raise by 100bp the cost of borrowing for local authorities.
The UK is unusual, in that most of the borrowing done by municipalities is from the central government. The Public Works Loans Board, an arm of the Treasury administered by the Debt Management Office, offers four kinds of loans. All councils pay the same rate, composed of the Gilt yield curve plus a margin.
Until October 9, these margins were 100bp for Standard Rate loans, 80bp for Certainty Rate loans, 60bp for Local Infrastructure Rate loans and 11bp for debt from the National Loans Fund.
For many councils, the 80bp rate was what mattered. It effectively kept the private sector market for long-term local authority debt closed. With very few exceptions, councils have not issued bonds or debt private placements for many years.
Private investors would have been happy to lend to them — but not as cheaply as 80bp over Gilts. GlobalCapital research indicates that private placement investors would have been willing to go as tight as about 100bp over, and had hoped to tempt councils by offering them flexibility such as delayed drawdowns — but councils were not seduced.
At a stroke, Sajid Javid, the chancellor of the exchequer, has overturned this long stasis. For new loans, many councils will now face a choice between borrowing from the PWLB at 180bp over Gilts, or from private investors at 100bp-150bp, depending on the council’s perceived credit quality. That is, if they can obtain private funding at all.
Investors have told GlobalCapital they will be vigilant about credit risk. They will be eager to lend to financially secure local authorities, but weak ones need not apply.
For investment banks and institutions that invest in bonds and private debt, the change is so stark it is like opening the starting gates at a racecourse. The runners — local councils wanting to borrow — are not haring out of the gates, but they are beginning to nose forward. Council finance officers who a few months ago were not interested in borrowing from the capital markets are now getting in touch with banks saying “now you mention it…”
This is great news for those investment banks and asset managers. But it is very hard to see how it can be good for local authorities, or the UK as a whole.
Doubling the fee
The basic effect of the policy is to fatten by 100bp the fee that local authorities already pay the central government for using it as a conduit for their borrowing.
It is not clear why this fee should exist at all. Councils are democratically elected government bodies, just like the national government. That they can benefit from borrowing at the central government’s rate is a benefit to taxpayers and society as a whole.
The PWLB’s standard explanation of the spread charged, which goes back to the National Loans Act 1968, is that “The methodology is designed to ensure that the government does not on-lend at rates lower than those at which it could notionally borrow, and generally to ensure compliance with the policies of HM Treasury.”
This could be accomplished by a spread much narrower than 80bp. This reasoning certainly does not explain a sudden increase to 180bp.
Withdrawing the punch bowl
In the bald statement announcing the new policy, the Treasury gave two intertwined justifications — that councils had been borrowing a lot, and that the rates they were paying had fallen.
“Some local authorities have substantially increased their use of the PWLB in recent months, as the cost of borrowing has fallen to record lows,” it said. “HM Treasury is therefore restoring interest rates to levels available in 2018, by increasing the margin that applies to new loans from the PWLB by 100bp on top of usual lending terms.”
This appears to imply that the 100bp extra may be a temporary adjustment, to compensate for the present low Gilt yields.
The 10, 20 and 30 year Gilt yields are now 0.73%, 1.13% and 1.22%, respectively 54bp, 66bp and 63bp lower than a year ago.
The Treasury’s logic is bizarre. It smacks strongly of nannyishness — but on that basis, is inconsistent.
“Now, now, you naughty children,” it seems to be saying, “you’ve been enjoying this cheap money too much, so for your own good Mummy is going to make it more expensive.”
Mummy, of course, will carry on enjoying the low rates herself — she will just fine the children to teach them good behaviour.
As GlobalCapital reported last week, the Treasury may have some grounds for concern about financial management among local authorities. Local authorities borrowed £2bn in August and £1.6bn in September — the two highest monthly totals ever. Some authorities have been investing in commercial property, taking advantage of their cheap borrowing costs to diversify their revenues, but taking on risk. Councils’ acquisitions of land and buildings rose to £4.4bn in the financial year to March, from £1bn three years ago.
But even if the government is trying to put a lid on financial high spirits among local authorities, raising the PWLB rate does not make sense as a policy tool.
The PWLB is behaving a bit like the Bank of England, trying to control the cost of credit in this corner of the economy.
But the PWLB’s role is not that of the Bank. It is itself the lender, so it can choose which councils it lends to. If it believed a local authority had an unwise financial plan, it could say so, and withhold further funding.
Raising the rate for all borrowers, on the other hand, will not stop incautious borrowing. Councils can still borrow at the higher rate. The PWLB has also increased the cap on its total loan stock, from £85bn to £95bn. Or councils can seek private funding.
The higher rate is really a tax, levied on taxpayers and service users in local areas. And it is highly regressive. The richest areas, with the best access to private capital markets, will be able to avoid perhaps 80% of this tax — and pay the other 20%, not to the central government, but to private investors.
Poor areas with financially weaker councils are more likely to have to pay the whole tax.
Market forces ill-placed
Some economists and politicians believe local authorities should be subject to market discipline, borrowing at higher or lower rates, depending on the quality of their balance sheets and revenues.
The US system, with its $3.8tr municipal bond market, has a much stronger element of this. Debt is a much larger feature of local authority finance, with about $11,600 oustanding per capita against $1,640 in the UK, based on the old £85bn PWLB cap.
But the rights and responsibilities of local government in the US are completely different. Far more power and accountability over budgets and taxes rest at the local and state levels. Even small towns have genuine governments, with wide freedom.
Introducing market forces to the UK system, without radical increases in local autonomy, might have some disciplining effect at the margin, but would be largely meaningless.
US municipalities are also far from having to borrow at market rates, because 70% of their bonds are tax-exempt. This means even a single-A rated municipality can borrow for 10 years, this week, at about 1.8% — a few basis points tighter than the 10 year US Treasury yield.
Market discipline is real, because the cities and states borrow at different rates, but the federal government still judges it worthwhile to subsidise them, at a cost of many billions, to give them a borrowing cost comparable with the federal government.
But claims that market discipline is financially astute are highly suspect. Just ask pension savers who lost money on bonds of Detroit, which went bankrupt owing $18bn in 2013 — not to mention Greece and Argentina.
A dog in sheep’s clothing
As some UK local authorities have already realised, this could be a trap, too. If they rush out and borrow from private investors, and then this or a future government changes its mind in a year or two, they will have been guided into a bad decision in a way reminiscent of financial product mis-selling scandals.
Local authorities in the UK have borne most of the burden of the spending restraint required by Conservative governments since 2010, as they fought to bring down the Treasury’s gargantuan budget deficit, which reached 9.9% in 2010.
Many areas of the UK are economically depressed. They need investment and creative management, at the local level.
What this requires is an intelligent partnership between locally elected leaders and the central government. Councils should be able to take sensible risks and try new ideas to regenerate their areas, and need suitable sources of finance. There could be a role for private investors.
But simply hiking the rates on PWLB loans is the bluntest of instruments, applied to the wrong problem. It actually weakens Treasury control over council finances, encouraging them into the arms of private investors, who have a patchy track record for prudence.
Dress it up how you want, the rate rise is nothing better than a penalty for councils — the most financially stretched part of the UK public sector — and penalises the weakest councils most of all.
Sajid Javid should change his mind forthwith. Luckily for him, politicians and the media would be unlikely to notice.
Additional reporting by Silas Brown