Dear Prudence

According to their website this week, CIPFA has amended the prudential indicator for prudence in the Prudential Code.  I’m not joking – apparently it will now be even more prudent than ever!  When the Code was first issued in 2003, the indicator for prudence used to state that a Council’s net borrowing should not exceed its highest projected capital financing requirement (CFR) for the next three years, except in the short term.

For those not initiated into the arcane world of local authority capital finance, the CFR is an accounting concept that measures the extent to which a Council’s fixed assets, like property, vehicles and equipment have not yet been paid for by the taxpayer.  Because cash has been spent on buying the asset, but no money has been received to pay for it, the CFR represents capital expenditure financed by borrowing.  However, since loans always need to be repaid, borrowing is only ever a temporary way of financing expenditure.  So I like to look at the CFR as a measure of expenditure that has yet to be permanently financed.

Now, because the CFR creates an underlying need to borrow for capital purposes, keeping your net borrowing below the CFR seems at first glance to be a decent indicator of prudence, and indeed CIPFA ran with that definition until 2011.  However, a CFR can also arise from leasing assets or, since April 2009, by signing PFI contracts. So prudence was redefined last year as not having net debt exceeding the highest projected CFR for the next three years, where debt is defined as borrowing plus finance leases and PFI liabilities.

CIPFA consulted quite widely on that change, and it made good sense (the Code should always have been written that way), so its inclusion in the 2011 version was always expected.  But the Panel also slipped in a surprise new indicator on “gross and net debt”, supposedly to measure whether an authority is borrowing in advance of need.  Net debt, by the way, is debt less cash investments, the same measure as used by HM Treasury for public sector net debt.  The government has had a bee in its bonnet about local authorities borrowing “in advance of need” since the Icelandic bank crisis, when they finally noticed that councils were stocking up on cheap PWLB loans and investing the cash in banks of various credit quality until they needed to spend it.  But borrowing money and immediately investing it doesn’t affect your net debt, so comparing net debt to the CFR was never going to be a brilliant measure of prudence.

This week’s official definition of prudence is not having gross debt above the highest projected CFR for the next three years, except in the short-term, which I think is a small improvement on the previous indicators.  It will highlight authorities that are borrowing to invest, as well as those borrowing to fund revenue expenditure, for example.  But it’s by no means perfect, and a number of authorities will fall foul of the indicator without acting imprudently.

There are a number of good reasons why a local authority’s debt might be higher than its CFR.  Firstly, some councils have a negative CFR; even if their gross debt is as low as numerically possible, zero, it will still be higher than their CFR.  Other authorities are seeing their CFR but not their debt fall for various reasons including housing finance reform and the cessation of supported borrowing credits.  Then there’s shared investment schemes where councils pool their cash together, which can count as borrowing for the lead authority – if that takes their debt above the CFR does it make the shared service imprudent?

Local authorities are also required by law to be prudent when calculating their minimum revenue provision (MRP), which is the amount charged to the taxpayer each year to pay for capital expenditure and reduce the CFR.  If you follow government guidance on what counts as a prudent level of MRP and reduce your CFR, it can make you fail CIPFA’s debt to CFR test of prudence!  If you can’t comply with both sets of statutory guidance, which one is it more prudent to fail?

In the extreme, an authority in one of the above situations that felt the need to rigidly comply with the Code would be forced to either incur extra unfinanced capital expenditure (to increase their CFR), to swap their bank deposits for equity investments (which also increases the CFR) or to incur large penalties on repaying their loans prematurely (reducing gross debt).  I’m pretty sure CIPFA isn’t recommending authorities to rush ahead into one of those options, but you can see why someone focused on ticking boxes would be tempted to.  Maybe it’s already time to think about yet another definition of prudence.

David Green is Client Director at Arlingclose Limited.  This is the writer’s personal opinion and does not constitute investment advice.