Report: Potential Dangers of Public-Sector Investment in Hub sub debt

New report by Dr Jim Cuthbert lays bare an area of potential public financing worth billions that is currently under the radar

THE Scottish Government could be tapping into billions of potential capital from secondary market sales of private finance debt, but the potential investment funds boon needs governmental monitoring and prudential analysis to ensure it is not misused, a new Common Weal report argues.

‘Potential dangers of public sector investment in hub sub debt’ is authored by Dr Jim Cuthbert, statistician and expert in Scottish Government finance, and can be accessed in full here.

Public-Private Partnerships (PPP) use private finance to fund the building of public projects now, which is then paid back based on future revenue payments. Hub is one of the main forms of Scottish Government PPP’s, with over £2bn of investment projects currently ‘live’.

90% of Hub capital is raised from senior debt – commonly bank loans. 10% comes from subordinate debt, which is the risk capital of the project and therefore raises a higher rate of return than senior debt (currently 10-11%). 40% of this sub-debt can be invested in by the public-sector or bodies allied to the public sector.

The likely purpose of investing in the Scottish Government’s own debt is the potential to sell the sub-debt holdings on the secondary market. This offers attractive possibilities for the public-sector, but also potential dangers.

Attractions and dangers

The attraction of this is that it can act as a ‘concealed’ form of borrowing, as the secondary market investment can create a cash flow that can be used now. Additionally, the capital sum received by the public sector bodies from the secondary market could total somewhere in the region of 2 to 2.7 times the original investment.

However, there are also potential dangers in this approach. First, a perverse incentive could arise since the greater the difference between the original interest rate on sub debt, and the secondary market rate, the greater the capital return on a secondary market sale. This might mean the public sector may not adequately scrutinise the original rate of interest on sub debt, resulting in it being set too high. Private financiers on the original investment would therefore be making excessive, unearned profits.

Second, the ‘concealed’ borrowing rate from the secondary market may be higher than what it would cost the government to borrow from elsewhere.

Finally, this form of borrowing could operate outside of the normal prudential scrutiny on government borrowing, raising potential dangers in how the money is used and whether the public interest is being served.

Recommendations

In order to address this, mechanisms should be established for monitoring:

           - The internal rates of return and the phasing of payments on Hub subdebt should be published.

           - There should be mechanisms for evaluating whether sub-debt interest rates are too high.

           - Any sales of Hub sub-debt on the secondary market from any public-sector (or public-sector allied) bodies should be made open, including both the capital value realised and the implicit internal rate of return.

There should also be active arrangements for assessing the results of such monitoring, including the potential for active government intervention to change course if necessary. This requires ministerial responsibility and Scottish Parliamentary oversight, through the Finance Committee. There should also be an active debate now about what sort of performance the public-sector should expect from Hub sub-debt, in order to assess success criteria.

Comments

Commenting on the report, Head of Policy for Common Weal Ben Wray stated: “This report uncovers an as yet unexamined area of potential public financing that could amount to billions of pounds and begins to put a spotlight on it. We have to be very wary when it comes to government dabbling in complex financial innovations without proper monitoring and government over-sight. Dr Jim Cuthbert’s proposals to ensure the necessary safeguards are put in place should be implemented by the Scottish Government as soon as possible.”

Author of the report, Dr Jim Cuthbert, said: “The potential dangers highlighted in this paper point to the urgent need both for greater openness about the financing of SFT hub projects: and for a public debate about what we should be expecting from the hub programme.”

Common Weal published a report outlining an alternative to PPP for funding public investment earlier this year.

To access the full library of work by Jim and Margaret Cuthbert click here.

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