Tuesday, 30 June 2009
Generally it's a fallacy to suggest that governments should act like ordinary people in managing their debts. Governments have a responsibility to consider the effects on the rest of the economy - whether in economic stimulus, or the effect on long-term interest rates of an increased debt burden, or the fact that they create a destination for excess desired savings.
So does this apply to the financing of aircraft carriers which Robert Peston reports today?
As Peston says, the government appears to be acting like a cash-constrained household - deferring payments now and accepting that they'll have to pay more in the future. This may be perfectly logical for households - if they need to buy a car that they can't afford, the value to them of having access to the car may exceed the extra payments, especially if it helps people get to work and earn more money.
But for governments there are different ways of borrowing money. The way Peston presents this it looks like vendor financing - where you pay the supplier of the goods an interest rate in order to not have to pay cash up front - normally an expensive way of achieving the goal because the vendor can't borrow money as cheaply as the government. The UK Treasury can borrow at present at rates of about 3.75% so shouldn't it borrow the money on the market and then just pay the contractors in the normal way? Wouldn't this also contribute to a greater fiscal stimulus?
I thought I'd investigate roughly what effective interest rate they are paying for extending the term. According to defence procurement minister Quentin Davies, the extension is two years (from an original delivery in 2014 and 2016 to new dates in 2016 and 2018). So on average an extension from 2015 to 2017.
Assuming the annual payments under the contract are equal, we were expecting to pay (from 2008) approximately £490m per annum, and we will now pay £500m. So that can't be right. The payments must be back-loaded. Let's say that (as a rough estimate) annual payments would have been £200m per year for eight years with a £2.3 billion payment on delivery (£3.9 billion total), and they'll now be £150m per year for ten years with a £3.5 billion payment on delivery (£5 billion total).
Taking out £300 million of the increase to represent changes in specifications, we are left with a relatively simple NPV calculation. And it turns out (figures available if you want them) that the government would be paying an interest rate of around 10.5% for this extension.
Admittedly that does include inflation, so the real interest rate might be more like 7.5% - but then the 3.75% rate they pay at the moment also includes inflation. So this doesn't look like a good deal.
Why are they doing it then? I believe the overriding factor is that debt is politically toxic. Any extra debt is harshly criticised - as I've written before, there's an anti-debt culture - and particularly at the end of 2008 before the government had announced its future debt path, borrowing extra money would have looked irresponsible.
We have seen this before - the desire to reduce balance sheet debt at the cost of increasing future payments was also the unfortunate driver of some PFI deals in the past, rather than the increased value that the private sector should be incentivised to deliver.
Aside from the fear of debt there may be a credibility factor. If the government can stop its departmental expenditure rising above budget, it's more likely to have credibility in sticking to future spending plans - which might help keep overall interest rates low. And it's definitely important to keep down the interest rates on the £150 billion or so of borrowing that needs to happen next year; every tenth of a percent increase in interest rates on that debt over 20 years costs £3 billion.
So it is possible to make a valid case for why this deal is in the country's financial interest - but it relies on a couple of assumptions which are politically dangerous for the government to admit. If they talk about the political dangers of debt they sound like they're making excuses for further borrowing; and if they talk about the need for financial credibility they risk damaging that very credibility by making it a political token. A tough place to be.