Friday, December 03, 2010

Problems with public-private partnerships

I am a naturally curious person. Yes, I guess that can be read in two ways. Still, I like to know how things tick.

This curiosity has sometimes led me in strange directions, picking up interests and then putting them down to follow other trails. This has made for a sometimes varied life, if not always the variation I would have liked.

At one point I became fascinated with the workings of the capital markets. I was in my economist phase then, and indeed started a masters thesis on interest rates. It was all just so interesting. During this quite long phase, I organised an exchange that saw me working as Manager, Corporate Finance for a small merchant bank. I did their first leveraged lease and was then offered a new position as Manager, Project Finance.

I turned the position down because I had already enrolled in a PhD in history and wanted to return to full time study for a period to complete the thesis. Futures turn on such decisions. The PhD re-ignited my interest in New England history and the history of the country movements, and I put the world of corporate finance aside for several years.

One of my difficulties in the corporate finance arena lay in my poor maths. I lacked the mathematical tool kit required to develop new financial products without technical support.

This weakness was offset by a very real strength, my ability to drill down to the underlying principles, to see how things worked or might work, to understand relationships. This was quite useful.

Some of the work that I did then, and again later, involved what are now called public-private partnerships.

Excluding fees, something that is very important in merchant banking, financial institutions sell debt. The return comes from the difference between interest rates received and interest paid, adjusted for risk. The challenge is to find new ways of selling the debt while increasing the spread received, the difference between interest received and paid.

I recognise that I am simplifying, but I am sorting things out in my own mind.

From a client perspective, they would be interested if your offering allowed them to access more funds, at a better rate, or on better terms.

  I mention all this because it bears upon something that I have never fully understood, the obsession with private-public (or public-private) partnerships.

One of the things that I looked at in a preliminary way during this period involved Government cars in an Australian state.

Each agency leased cars for its own purposes. As I remember it, the proposal under consideration involved combining all those leases into a single package. The Government would benefit because consolidation would lower lease costs, we would benefit if we got the mandate through fees and spread on funding.

A little later, I did some work for a client who had completed one of the first really big private-public partnerships in Australia.

This was a jewel in the crown deal, one that was highly profitable to the client. In this case, the Government benefited because it got a long term asset without putting up cash, while the costs of the project were covered by tolls paid.

Whether the citizens in the state benefited was a different issue.

The actual financial maths in this case meant that there was little difference in financial terms between Government borrowing and then charging tolls and private sector borrowing and then charging tolls. If anything, the private sector option was more expensive because of the added fees and charges. However, from a Government perspective, it got the project off-balance sheet.

Much later, I was involved for a short period in project managing a social housing project.

The idea was a simple one. Instead of the Government building certain social houses, it would fund community housing organisations to build them. The Government would give the housing organisations a very long term lease, thus allowing them to borrow against the rental streams to build new housing.

I am sure that this sounds very reasonable and at one level it was. However, the financial viability of the project rested, as it had done in my first leverage lease all those years before, on taxation treatment.

Community housing organisations receive certain tax benefits not available to Government agencies. In particular, but subject to certain very complicated conditions, they can claim back GST on construction costs. Other things being equal, this meant that the GST savings could be spent on more social or affordable housing.

From an agency perspective, this was a good thing. Strapped for cash because of real Federal Government cut-backs to social housing over an extended period, it meant more houses. However, from a national perspective it was a transfer payment. GST revenue was lost, but the amount lost was then spent on more housing.

I may seem to be meandering, so let me cut to the chase.

Public-private partnerships are simply a funding mechanism, one actually based on a small number of variables. Whether they make sense or not depends upon the circumstances of the individual case.

Further, just because they make sense for an agency or Government does not mean that they make sense in broader national terms. A transfer payment is a transfer payment.

It should not therefore come as a surprise that Nick Gruen's analysis should conclude, Me on debt and infrastructure, that the actual return from the arrangements has been negative.

There is, after all, no such thing as a free lunch. 

5 comments:

Miss Eagle said...

Appreciate this comment. Here in Melbourne the only person I know who analyses PPPs and speaks out on them is Kenneth Davidson. I have an additional query and ask - in doing these sorts of deals is there present a context for corruption between private corporation/s and government - either political or bureaucratic. With some deals one sees done in Victoria, one can't help but wonder.

Jim Belshaw said...

Thanks, Miss E.

There is always potential for corruption where big sums of money are involved. I don't know the detail of the Victorian deals, so I can't comment.

I probably have a different perspective, too, on the corruption issue. In the days when I was most directly involved in some of these things, we saw things like lunches as part of the way of doing business. Now those lunches would be classified as corrupt conduct.

Too a degree at least, or so it seems to me, we have confused rules based approaches with morality. This may seem some distance from your point, perhaps it is, but one of the reasons why PPs fail lies in the way we do them.

Perhaps another post?

Miss Eagle said...

Thank you for the insight.

Winton Bates said...

Hi Jim
Nick Gruen seems to base his argument for public investment rather than PPPs on the grounds that governments can usually borrow at a lower interest rate than private firms.
We need to think about why this is so. The main reason is that governments have taxing powers ie when their risky investments go 'belly up' they can twist the arms of taxpayers to get them to pay the interest bill.
I think we should be mindful of how quickly public finances can turn around in a country like Australia. As you know better than I do, Australia has plenty of history of public investment booms followed by periods of difficulty in paying public interest bills.
It seems to me to make a lot more sense for private investors to take the risks associated with building toll roads.

Jim Belshaw said...

Your point about the cycle in public borrowing is, of course, correct Winton. When the London markets closed in 29, NSW went down quite badly.

What I'm not sure about is whether this affects the argument at all.

Between the depression and the 1980s, all the states borrowed without a problem. In NSW state guarantees were used for authorities so they got the benefit of lower rates. Semi-government bonds were a key part of the capital market. That's a long time to get the benefit of a lower interest rate.

The risk with toll roads comes about because they are just that, toll roads. Prior to the idea of user pays, roads were seen as basic infrastructure. There was no financial risk associated with the road as such, just a general risk associated with the level of borrowing.

Now we have a new game. In a sense, the argument goes this way.

In theory, the Government can now invest more because it has, in privat sector terms, shifted the funding off balance sheet. In theory, it can borrow more. The extra costs of the now riskier private sector activities are carried by users on one side, the investors on the other.

In practice, it doesn't quite work that way. Governments have substituted specific borrowings to which an income stream can be attached for general borrowings that have to be justified on broader policy grounds. This skews borrowings to particular fundable activities.

The skew is worse because the markets don't, in fact, treat the borrowings as fully off-balance sheet. They still affect credit ratings.

Nor has the Government in fact removed risk. Too many PPPs end up costing Governments money when they get into trouble. PPPs actually increase risk because they substitute a project specific risk for a more generalised risk based on the state's financial solvency.