Gross or Net?

Some things in life are gross. I’ve heard it said that a bailed-out banker or a Premiership footballer getting a £1 million bonus for just doing his job is pretty gross. But as any striker knows, it’s the net that counts. After income tax and national insurance, a gross £1 million is “only” £480,000 in net pay. That’s the difference between buying four new Ferraris and managing with just two.

When we were all wondering if Greece would officially default on its debts, some uninformed politicians spread scare stories about the impact on the banks that had written $70 billion in credit default swaps. Surely losses of that size would cause another European banking crisis? But once again, it’s the net position that matters. Most of the CDS are traded between a small number of traders speculating with each other on rises and falls in CDS prices, rather than investors hedging their credit risk. And once they have set off all the IOUs from the you-owe-me’s, it has left a much more manageable $3.2 billion in CDS to be settled in cash at Monday’s auction.

The CIPFA treasury management Code of Practice requires local authorities to measure their exposures to fixed and variable interest rates on a net basis. In the past treasurers were often fearful of borrowing variable rate loans in case interest rates rose, forgetting that short-term investments are exposed to the same market interest rates and that increasing debt interest payments would have been offset by increasing investment income. In recent years of course, the opposite has been true – how many Councils now wish that their falling investment rates had been offset by some variable rate PWLB loans, currently at just 0.6%.

CIPFA has recently closed its consultation on changing the Prudential Code to compare local authorities’ capital financing requirement (CFR) to their gross debt, instead of their net debt as at present. This follows the general concern in central government that Councils are borrowing money long in advance of when they intend to spend it, as shown in the new requirements in the 2010 CLG Investment Guidance and the PWLB now asking when loans will be spent by.

The trouble is, there are a lot of entirely sensible reasons why local authorities should not be prevented from having gross debt higher than their CFR. The most obvious is when the CFR is negative – gross debt can’t be less than zero and these authorities will automatically fail. Those with a zero CFR would also be prevented from borrowing, even for cash flow purposes. Councils borrowing large sums at once, e.g. through a bond issue, for capital expenditure several years in advance would also fall foul of the rules.
Local authorities are being encouraged to share back office services, and one way efficiencies can be made in treasury management is through investment pooling, e.g. where the district councils lend their cash to the county, who adds their own funds and invests the total, sharing expertise and costs for the benefit of all. But since the administering authority is required to show the cash lent to it as borrowing, this could also be ruled out under the proposed changes to the Code.

On the other hand, it is rather odd that the Prudential Code doesn’t currently ask local authorities to compare their CFR (the underlying need to borrow) with the amount actually borrowed! A solution is for the revised Code to compare gross debt to the CFR, but require officers to explain, and members to approve, the reasons why debt is higher. Inadvertently banning a lot of good treasury management practice would be rather a gross act itself.

David Green is the Head of Sterling Consultancy Services, a provider of treasury management advice to local authorities and other not for profit organisations. This is the writer’s personal opinion and does not constitute investment advice. It should not be relied upon when making investment decisions.