Borrowing strategy

Report: 6
Date: 21 January 2010
By: MPA Treasurer

Summary

This report provides information on MPA cash flow planning, the funding of the capital programme and the decision making process when assessing the scale and timing of external borrowing to support the capital programme. It shows how current long term borrowing is historically low priced illustrated by the PWLB yields and as assessment of future changes.

A. Recommendations

 That Members

1. Note the report and the context within which decisions to borrow are made.
2. Note the borrowing strategy for Quarter 4 2009/10 and 2010/11 outlined from paragraph 30 including estimated new external borrowing of £50m to be undertaken in January 2010 in consultation with the Treasurer and in accordance with the approved treasury management strategy.

B. Supporting information

Background

1. The Resources and Productivity sub-committee, on 5 November, and Finance and Resources Committee, on 19 November, considered a draft borrowing and capital spending plan for financial years 2010/11 to 2016/17. This included an estimate of the possible funding required to support the capital programme for the next seven years.

2. The borrowing and capital spending plan is submitted to the GLA as part of the MPA’s overall budget submission. The Mayor must produce a composite capital spending plan and will set borrowing limits for each of the constituent bodies, for formal approval by the Treasury. The MPA’s borrowing limit is therefore set within the context of competing demands from all GLA the constituent bodies. Current MPA borrowing limits are sufficient to allow the Authority to consider taking on additional external borrowing.

3. The MPA borrowing and capital spending plan set out the sources of capital funding available which includes borrowing. This report examines the processes that determine how decisions are reached about the amount of borrowing that is required and for external borrowing the term, type and timing of that borrowing.

Historical approach to external borrowing

4. Table 1 below is a summary of MPA external borrowing from 2004/05 to 2008/09 and the average rate of interest payable on that debt.

Table 1: Debt outstanding at 31 March for financial years 2004/05 to 2008/09

5. At 31 March 2009 MPA outstanding loan debt was £47.338m all funded on a long tem basis with an average rate of 5.37%. So far during 2009/10 additional long term borrowing of £30m has been undertaken taking the outstanding debt position to £76.538m.

6. Table 1 shows that external loan debt has reduced because maturing loans have not been replaced. Due to the high level of cash balances throughout this period there has been no need to borrow externally (except in February 2009 as paragraph 6 below explains), either to replace maturing loans or to support the capital programme. The Authority has used instead its internal resources, such as reserves which are held as part of overall cash balances.

7. Cash balances in December 2008 were such that of the significant capital expenditure of circa £130m to acquire New Scotland Yard £120m was found internally. It was necessary in February 2009 to undertake external borrowing of £10m which has reversed the downward trend in external loan debt. It should be noted that the Authority’s level of external loan debt is considered low in comparison to other authorities and when considering the size of the Authority’s budget.

Cash flow

8. The decisions to fund £120m of the purchase of New Scotland Yard internally with the balance of £10m funded with an external loan are driven by the cash position of the Authority. The Authority must monitor constantly its cash position and one of the objectives of the treasury management strategy is to “ensure that sufficient cash is available such that the MPA is able to discharge its financial obligations in accordance with approved spending plans”.

9. The cash position of the Authority represents balances from various sources including:

• Earmarked reserves, provisions and balances held to cover specific or general liabilities
• Unapplied capital receipts and grants pending payments in respect of capital projects
• The net cashflow position of revenue income and expenditure

10. A record of future daily scheduled and estimated large receipts and payments is maintained to ensure that the Authority is able to discharge its liabilities. Typically these receipts will be grants or maturing short term investments and the payments will be payroll or payments to HMRC or to large suppliers.

11. Each day the cash position of the Authority determines the value of short term investments undertaken. It also determines the balance of instant access cash balance held in a call account with the Authority’s banker RBS. The maturity profile of short term investments is arranged to match future expenditure requirements. Revenue receipts such as grants are received typically at the start of a monthly cycle with payments made as the month progresses. This results in a fluctuating cash position which reduces towards month end. Should the need arise the Authority is able to cover in the short term any cash requirements by short term borrowing (including from the GLA) or by using an overdraft facility available from RBS.

12. The £130m cash purchase in December 2008 of New Scotland Yard meant that there were fewer short term investments maturing to cover future liabilities and a reduction to the amount of instantly accessible cash in the call account. The critical impact of this was insufficient funds to cover liabilities towards the end of the monthly receipts / expenditure cycle. While the overdraft facility with RBS could be used each month this is not a practical solution and illustrates a situation where external borrowing, providing an injection of cash, is a practical solution. In early 2009 cash flow projections indicated a shortage of cash towards the end of February 2009 leading to the Treasurer approving external borrowing of £10m that month.

13. While the planning of cash flow in the short term provides an assessment of the cash position for the forthcoming few weeks or months a cash flow model has been developed that attempts to estimate cash balances for the current and next financial years. The model is similar to the short term model discussed above and is populated with known receipt and payment streams but can incorporate assumptions on the level of capital expenditure or other variables that impact significantly on the cash position.

Long term debt

14. The Authority is able to enter into long term loan arrangements for the purposes of supporting capital expenditure. For example all of the debt at Table 1 is a result of decisions made in the past to support capital expenditure through external borrowing. Entering into long term loan arrangements commits the Authority to future expenditure streams that affect the revenue budget. To ensure that decisions made are affordable, sustainable and prudent the Authority meets the requirement under the Local Government Act 2003 to have regard to the CIPFA Prudential Code for Capital Finance by setting, and reviewing, a set of Prudential Indicators. The draft borrowing and capital spending plan considered in November 2009 by the Finance and Resources Committee and Resources and Productivity sub-committee included an updated set of key Prudential Indicators that reflected funding decisions proposed in the plan.

15. The Prudential Code Indicators which set a limit for external debt are the authorised limit and operational boundary (the authorised limit is higher to allow for temporary borrowing to meet short term cash flow requirements as discussed at paragraph 10 above). These limits are significantly higher than actual external debt that the Authority currently has so will not restrict the negotiation of new loans. (For example the 2009/10 operational boundary is £217.3m against the current actual external debt of £77.3m).

16. The borrowing and capital spending plan confirmed the borrowing element that supports the capital programme which (including the additional borrowing contingency of £60m approved in July 2009 to address the lack of capital receipts due to the depressed property market) is set out below at Table 2.

Table 2: Borrowing (Supported and Unsupported) to Fund the Capital Programme

External borrowing 2009/10

17. The 2009/10 borrowing element to support the capital spending plan is £54.8m. Due to cash flow requirements it was necessary to take up borrowing in May 2009. The circumstances under which this borrowing was undertaken are the same as those that led to the borrowing of £10m in February 2009 and explained above. Cash flow planning indicated there were repeated cash flow shortfalls at month end and to address these shortfalls (along with other considerations explained below) the Treasurer approved £30m of external borrowing.

18. It is worth noting that cash flow planning does not differentiate between revenue cash and capital cash but examines the aggregate of a number of cash flow streams. This determines the position with regard to both investments and borrowings. Should the Authority need to borrow that amount of external debt cannot be specifically linked to a particular capital project or the capital programme as a whole, but is a decision reached as a consequence of all financial transactions of the Authority.

19. The most recent cash flow prediction to the end of 2009/10 indicates that further external borrowing will need to be undertaken in January 2010. Although the lack of liquidity is a major factor in triggering the borrowing process, there are other variables to be considered such as the amount, term, type and timing of borrowing.

The cost of borrowing

20. The discussion above under external borrowing is about borrowing undertaken to support the cash flow position. However, the Authority’s underlying need to borrow for capital purposes (regardless of whether or not it takes up external debt) is the Capital Financing Requirement (CFR). Due to the Authority historically taking the decision to largely fund its capital programme from internal sources the CFR is significantly higher than the actual level of external debt. The level of CFR determines the amount of the Minimum Revenue Provision for Debt Redemption (MRP) and this is charged to revenue.

21. The borrowing and capital spending plan therefore has implications for the revenue budget, both in terms of MRP and interest on the borrowing element of the funding. For example when considering the additional £60m of unsupported borrowing included in Table 2 above the MRP charges and estimated interest rate charges (of 4%) have been included in the revenue budget submission.

22. While the revenue budget includes the estimated cost of borrowing, decisions made when taking on external debt generate actual costs in terms of interest payments to the loan provider. It should be remembered that the decision not to borrow externally and fund the capital programme by internal means results in loss of interest income from funds that would otherwise be invested.

23. The Authority is able to access funding from the Public Works Loan Board (PWLB) which is part of the Government’s Debt Management Office. The PWLB provides loans to public bodies at rates reflecting those at which the Government is able to sell gilts. The PWLB rates are more competitive that loans available through banks and all the Authority’s outstanding debt is with the PWLB.

The borrowing decision - interest rates

24. The monitoring of the cash flow identifies that external borrowing is required. It was mentioned at paragraph 19 above that cash flow analysis currently predicts that further borrowing is required during 2009/10 and to provide liquidity borrowing should be undertaken during January 2010. While the timing of borrowing could be driven solely by the absolute need for cash the view on movement of interest rates should also be considered. With a view that future interest rates will rise, an early decision to borrow and lock into a lower rate will be beneficial.

25. The interest rates available from the PWLB increase with the term of the loan as shown in Chart 1 below. The rates quoted by the PWLB are set by gilt market yields and are sensitive to the quantity of new gilts issued (or purchased). The Quantitative Easing programme is expected to end during 2010 with the Bank of England set to withdraw as a principal buyer of gilts. Other things being equal the supply and demand impact will have an adverse effect on yields and PWLB rates of borrowing.

Chart 1: PWLB interest rates (borrowing) at 19 Nov 2009 is attached (Source: Arlingclose)

26. While there is expected to be upward pressure on long term PWLB rates during 2010 the pressure on short term rates (i.e. base rate) remains limited. Chart 2 plots estimated future base rate versus 10 year gilt yield. This illustrates the increase in 10 year gilt yields throughout 2010 before the anticipated increase to base rate during 2011.

Chart 2: Historical and projected UK base rate versus 10 year gift yields is attached (Source: Arlingclose)

The borrowing decision - term

27. When considering the term of new borrowing the maturity profile of the existing debt portfolio must be considered. A spread of maturity dates reduces the refinancing risk of having to replace a significant number of maturing loans when interest rates are high. CIPFA also recommend a spread of maturity dates and the setting of appropriate upper and lower limits for the maturity structure Prudential Code indicator.

The borrowing decision - type

28. There are two methods of loan repayment available from the PWLB that the MPA currently use. A maturity loan has half yearly interest payments and the principal repaid in full on maturity. An Equal Instalment of Principal (EIP) loan with half yearly payments of principal and interest (on the outstanding balance). An EIP loan has the benefit of spreading the repayment of principal throughout the term of the loan.

29. Loans can be either fixed rate or variable rate. Currently all of the Authority’s external debt with the PWLB is fixed rate. However, the relevant Prudential Code indicator for gross outstanding borrowing does allow for up to 15% of the portfolio to be at variable rate. The rate of interest on variable rate loans is linked to the six month London Inter-Bank Offered Rate (Libor), currently in the region of 0.8% to 0.9%.

The borrowing strategy

30. As mentioned above the cash flow model estimates that further borrowing will be required. Current estimates are that £50m of external borrowing will be required during 4th quarter 2009/10 to be taken up during January 2010. In reaching a decision on the type of borrowing all of the factors set out above are considered. In line with Treasury Management Policy, which is aligned to financial regulations, the MPA Treasurer will take the decision on external borrowing ensuring compliance with the CIPFA Treasury Management Code of Practice. While approval for borrowing rests with the Treasurer guidance is provided by the MPS treasury team and the recently appointed treasury advisors, Arlingclose.

31. Assessing market conditions at the time of writing the two elements of the strategy for January 2010 borrowing are £35m of long term fixed rate maturity loans and £15m of two year variable rate loans.

32. The £35m will be in seven loans of £5m each to mature between 30 and 36 years. These loans are added to the maturity profile of existing loans as shown at Appendix 1. The maturity profile is consistent with CIPFA guidance that the portfolio has a range of maturities.

33. The £15m two year variable rate loan will take advantage of low short term interest rates but also provides cash in the absence of capital receipts due to the depressed property market. This loan provides flexibility because in two years either capital receipts have increased with an improving property market, and the loan is repaid, or the loan is renegotiated into another short term variable rate loan or a long term fixed rate loan (depending on interest rates at that time). This loan is also reflected in Appendix 1.

34. While it is estimated that £50m borrowing is required to be undertaken as described the actual cash position will be monitored closely. Should there be an additional external borrowing requirement the treasury team and Arlingclose will advise the Treasurer of available options.

35. With estimated new borrowing of £50m, and the repayment of one maturity loan in March 2010, the estimated external debt on 1/4/2010 is £121.95m. This compares with the 2010/11 operational boundary of £303m. The 2010/11 capital programme is part funded by £90m of borrowing (Table 2). The decision to take up external loans, or to fund from internal sources, will again be determined by the estimated cash flow forecast. Indications are that cash will be required in December / January 2010/11 largely resulting from the size of the capital programme funded by £90m of borrowing.

36. During 1st quarter 2010/11, cash flow estimates and estimated future interest rates will be closely monitored prior to the anticipated increase in PWLB rates expected during quarters 3 and 4 of 2010/11 (as shown in Chart 2). It will be advantageous to schedule any new loans before anticipated rate increases even though the cash flow requirement may be later in the year.

37. The monitoring of cash flow and the continuing development of the cash flow model will assist with identifying future cash flow requirements. The 2010/11 treasury management strategy for member consideration and approval in March 2010 will include proposals for the scheduling of external borrowing during 2010/11.

Abbreviations

CFR

 Capital Financing Requirement

CIPFA

 Chartered Institute of Public Finance and Accountancy

EIP

 Equal Instalment of Principal

LIBOR

 London Interbank Offered Rate

MRP

 Minimum Revenue Provision

PWLB

 Public Works Loan Board

RBS

 Royal Bank of Scotland

C. Race and equality impact

There are no specific race, equality or diversity implications arising from this report.

D. Financial implications

This report discusses external borrowing to support the capital programme. The funding available to support the capital programme 2010/11 to 2016/17, including borrowing, is contained with the draft Borrowing and Capital Spending Plan considered by Finance and Resources Committee on 19 November 2009. The capital financing charges associated with the plan have been included in the 2010-13 draft budget submission.

E. Legal implications

1. Under Section 1 of the Local Government Act 2003, the MPA as local authority defined under s23 of that Act, may borrow money for any purpose relevant to its functions under any enactment, or for the purpose of the prudent management of its financial affairs.

2. The Mayor is required under s3 of the Local Government Act 2003 to determine how much money the GLA and each functional body (which includes the MPA) can afford to borrow. In complying with this duty, Regulation 2 of the Local Authorities (Capital Finance and Accounting)(England) Regulations 2003 requires the Mayor to have regard to the Prudential Code for Capital Finance in Local Authorities when determining how much the MPA can afford.

3. The MPA’s standing orders provide the Treasurer, as the s127 officer, is responsible for the proper administration of the MPA’s financial affairs. Part F of the MPA’s standing orders also requires the Treasurer to report to the Authority, or designated committee of the Authority, on treasury management operations on a quarterly basis. The borrowing issues raised in this report form part of the quarterly update to Resources and Productivity sub-committee.

4. Any further legal implications relating to the proposed capital programme will be reflected in the final report to the Authority on the capital programme in March 2010.

F. Background papers

None

G. Contact details

Report authors: Paul James, Director of Finance, MPS

For more information contact:

MPA general: 020 7202 0202
Media enquiries: 020 7202 0217/18

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