The Grattan Institute has released a new report questioning the new federal-state government deal to expand infrastructure investment through “capital recycling”, arguing that it can actually worsen longer-term government finances [my emphasis]:
Capital recycling – selling assets and spending the proceeds on new assets – would reduce the debt of state and territory governments. But it will not improve recurrent budget balances unless governments strike unusually good bargains in selling assets…
Capital recycling is the use of proceeds from the sale of government-owned assets to invest in new infrastructure. Such sales are claimed to free up capital for new capital works that would otherwise put the budget further into debt.
Capital recycling does affect net debt positions: the amount of cash that governments are liable to pay bondholders. If governments built new infrastructure, but did not sell existing infrastructure, their debt levels would be higher. Debt positions are relevant when ratings agencies calculate credit ratings for state governments. These ratings affect the interest rate paid on state debt.
Capital recycling usually does not markedly improve a government’s recurrent budget balance. If you sell an asset and use the funds to repay debt, then you avoid interest and operating expenses. However, the reduced expense is usually matched by reduced income given up when the asset is sold. The private sector usually values assets according to their future revenues. Because the private sector’s cost of capital is higher than public sector debt charges, assets are likely to be sold at prices so that the savings in interest payments are outweighed by the loss of future income.
However, capital recycling can improve a government’s recurrent budget balance if the purchaser thinks that they will be able to generate substantially more revenue from the asset than government did, and accordingly pays more for the asset. For example, the NSW government sold three ports for more than $5 billion at what were generally regarded as excellent prices. However, even at these prices, the interest saved will only just cover the current earnings given up. Although the ports had not paid dividends to government in the previous five years, they were generating profits, retained in the business. The purchasers paid about 25 times the current earnings, implying that the revenues were about 4% of the sale price. States currently pay an interest rate of around 4% on their borrowings. Privatisation of government assets may also lead to productivity gains. The value of these gains may be captured by the public, government, or the new operator. Who gains depends on the price paid, and whether user charges fall as costs are reduced.
Capital recycling may also effectively transfer risks from government to the private sector.
The construction of new assets affects recurrent budgets whether or not other assets are recycled. New assets create additional depreciation, and will drag on future budgets, except in the unusual situation where additional revenues from the asset (such as tolls) are greater than the depreciation and interest costs from building the asset.
Grattan is spot on. Capital recycling will only benefit long-term budget finances if the upfront funds received from the asset sale outweighs the expected net present value of future profits. If not, then the sale is likely to be detrimental to taxpayers.
In this respect, most asset sales are weighted against government. Because Australia’s governments tend to have a lower cost of borrowing than the private sector, private bidders are likely to low-ball the government, unless they believe that super profits can be gained by achieving major efficiency improvements and strong profit growth.
As noted by the Grattan Institute’s John Daley in The AFR, “recycling is not going to help state budget positions at all unless they turn out to be much cleverer than Macquarie Bank” – an improbable proposition in the majority of cases.
As argued previously, there are also efficiency and equity considerations that must also be considered. In general, any privatisation should boost competition within the relevant market, and at a minimum should not lessen competition. Moreover, there is generally a stronger case for public ownership or control where there are significant market failures. The clearest examples are those of natural monopolies – i.e. where the market can support only one supplier – although there are other situations of market failure requiring government intervention.
What does concern me about the federal-state deal is that it seems to presume that privatisation is superior in all cases – otherwise, why would the Federal Government agree to provide the states with an additional 15% incentive payment if they agree to sell-off state assets and invest in productivity-enhancing infrastructure?
Instead, decisions on what should be in public hands versus privately owned should proceed on a case-by-case basis and be based on objective economic criteria, not ideology or sweeping generalisations about private ownership being necessarily most efficient.
