Magazine article Public Finance

Balancing Act

Magazine article Public Finance

Balancing Act

Article excerpt

There has been a fundamental shift in most local authorities' financial prospects in the past 12 months. Not only is the deepening recession increasing demand for their services, but their investment earnings projections have been much reduced.

The rapid cuts in interest rates by the Bank of England have completely altered the investment environment. The era of achieving interest rates of 5% or even 6% is over, at least for the medium term. In fact, in the short term, it is likely that real and nominal interest rates will continue to fall.

The response to the crisis in the banking sector, which is the principal home for local authority investments, means that marginal rates of income are now much more widely accepted in return for capital security.

Many local authorities have built investment returns projections into their financial plans, which they are now not able to achieve. The increasingly risky environment has persuaded many to invest a higher proportion of their assets with the Debt Management Office.

This is an understandable response to the recent banking failures but this yields significantly less than 1% and creates additional pressures on revenue budgets. Against a backdrop of declining interest rates, normal treasury strategy would be to lengthen investments to provide protection against lower interest rates.

The problem is that heightened credit risk has understandably guashed councils' appetite for longer-term deposits. But they need to challenge normal practice. Longerterm returns are available with appropriate risk characteristics, but they must look beyond term deposits and into appropriate bonds.

It is clear that local authorities are not going to achieve their projected investment returns, even if they were willing to take on the levels of risk that would be necessary to do so. Therefore, they should look at the other side of the balance sheet and see if they can reduce the interest they pay on their debt and minimise the disparity between the rate at which they are borrowing and the returns they are achieving on their investments. Increasingly, the debt costs and interest earnings of local authorities are now largely administered by two sections of the same government agency, the DMO.

There is often an assumption that the Public Works Loan Board's dual interest rate structure, introduced in October 2007, has effectively removed debt restructuring from the local authority treasury manager's toolbox. This is not the case. But the evaluation of options has to be set against realistic criteria that reflect today's interest rate environment. …

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