The infrastructure handbrake
Everyone says we need to invest in and build more infrastructure. So in a world awash with cash, why aren’t we borrowing more and going for it? Part of the answer lies in a long-standing policy within the bureaucracy. Dileepa Fonseka reports.
Our attitude towards spending is a tale of two countries, according to Infrastructure New Zealand policy director Hamish Glenn. In one corner, Scotland, a country of nearly 5.5 million people with slowing population growth. By 2043 the whole country’s population will have grown by 2.5 per cent over 20 years.
In the other corner, our own team of 5 million, a figure growing on average 2.5 per cent every year.
And yet of the two, Scotland is set to spend more on infrastructure.
Over the next four years it will spend $80 billion. Over here the Government has announced plans to borrow $42b for infrastructure spending over the same period (on top of New Zealand Upgrade Programme transport spending, over a longer period).
‘‘We’ve seen the need for investment in New Zealand just explode the last five years,’’ Glenn says.
‘‘The need out there for access to employment and housing. The need for infrastructure to support development. The need for rural investment. It’s off the scale now, and we’re still not investing enough.’’
The need could be seen in the sheer number of applications made for the Government’s $3b shovel-ready fund. Almost 2000 project applications were submitted last term and it would have cost $134b to fund them all.
And a report commissioned by the Association of Consulting and Engineering earlier this year estimates our infrastructure deficit, the gap between what we need and what we actually have, currently sits at 25 per cent of GDP (or $75b).
‘‘Scotland with almost no population growth is going to spend one and a half times what our Government is spending in the next four years. This is unworkable. Our levels of investment are a fraction of what they need to be,’’ Glenn says.
The lack of long-term investment isn’t just a story of infrastructure. We see it right through our system with underspending in areas which have major long-term pay-offs. The latest example of the consequences is the anger boiling over in major metropolitan centres over skyrocketing house prices – a phenomenon largely caused by a lack of adequately zoned land close to employment centres. Houses are in short supply so orthodox monetary measures to curb unemployment are sending the prices of secondhand houses soaring.
And new social housing will be built at a slower rate than the growing need for them.
Frustration at the Government’s unwillingness to spend was also a topic of discussion at the Infrastructure NZ Rebuilding Nations conference this month.
Over pastries and hors d’oeuvres bankers, infrastructure wonks and construction firm managers shared their astonishment at the Government’s reluctance to borrow for infrastructure spending at the same level their international counterparts were.
From their perspective the cost of borrowing was so low projects simply had to deliver returns to the country slightly above 1 per cent a year to make it all worthwhile (10-year government bond yields have been at less than 1 per cent since April).
Treasury chief executive Caralee McLeish told the conference her department was more relaxed about debt as a percentage of GDP than they had been in the past, but were still focused on subjecting infrastructure projects to rigorous analysis.
‘‘It wouldn’t surprise you [to hear] as Treasury, that also value for money in fiscal policy is incredibly, incredibly important [for us].
‘‘We need to look at all of those different dimensions and make sure that it’s projects that have the highest net benefit that are the ones that are funded.’’
‘‘Our levels of investment are a fraction of what they need to be.’’ Hamish Glenn Infrastructure New Zealand policy director
Yet coming to an approximation of what value for money means is part of the problem. At the heart of this calculation lies a concept called the ‘‘discount rate’’. An estimate of how much money today is worth compared to future benefits.
It’s a key part of the types of cost-benefit analyses used to examine every form of government spending from infrastructure to health to see if it’s worth the investment.
Think of discount rates as a per-year interest cost which we use in our calculations to make sure we’re getting value for money for the amount of time taxpayer cash will be tied up in an investment.
A high discount rate means we value today’s cash more than tomorrow’s, so need a higher future return to justify forking money over today.
Private investors use these kinds of calculations all the time and it usually comes through in the cost of capital for companies and individuals.
The Government sets its discount rate well above its own cost of capital because it sees it as a good way of estimating the opportunity cost of other things it might have been able to use the money for.
The usual discount rate the Treasury advises government departments use is 5 per cent a year (over five times the Government’s own cost of borrowing), but for investments in communications, media, technology, IT and equipment they recommend a rate of 6 per cent.
Part of the rationale was set out in a 2015 Treasury paper. In it the department explained why its discount rate was set closer to the kind of returns investors expected of listed companies on the sharemarket, rather than the Government’s actual borrowing costs.
‘‘Discounting is one of the most controversial aspects of [cost-benefit analysis] and often has a bigger impact on the outcome than any other factor,’’ it says.
‘‘The Treasury’s rate is often considered to be high. It is said that it does not value future outcomes sufficiently, because future benefits are so heavily discounted.
‘‘In making investments, the public policy objective must be to maximise the return that is obtained from the taxpayer’s dollar . . . one place where the Government could invest is the sharemarket.
‘‘If it is able to generate high returns that way, then why should it make investments that have a lower rate of return? Doing so would leave taxpayers and the nation worse off.’’
Critics argue high discount rates actually leave taxpayers worse off in the long run because they discourage investment in major projects which eventually deliver big benefits to them.
A New Zealand Institute of Economic Research presentation shows how high discount rates can effectively discount long-term benefits out of existence.
At a discount rate of 6 per cent, 43 per cent of a project’s benefits would have to be delivered in the first decade to make an investment worthwhile.
Compare this to a 3 per cent discount rate which would allow benefits to be split much more evenly across decades (31 per cent in the first decade
through to 20 per cent in the fourth).
Calculating benefits this way makes it difficult to argue for measures to tackle big long-term issues like climate change.
Glenn says this makes it much harder to get approval for big infrastructure projects which make major changes to the way land can be used (for example, by opening up land by connecting them up to employment through a mass transit route or motorway).
Especially because high discount rates are often paired with low-ball population estimates, meaning a cost-benefit analysis will often underestimate the number of people who might benefit from a project going ahead.
‘‘Now we’ve got a housing crisis causing unimaginable economic and social costs which would easily exceed the costs of what these transport projects would have been 10, 20, 30 years ago.’’
Chair of wellbeing and public policy at Victoria University school of government Arthur Grimes says the thinking goes back to the political climate of the 1980s when the country was living with the financial aftermath of poor-quality spending on a lot of big projects and initiatives.
‘‘This was a roundabout way to make it look like government expenditure wasn’t worthwhile and to try and reduce it.
‘‘So it was used as a pressure tactic, if you like, to reduce the amount of poor-quality government expenditure that was going on. It wasn’t the right tool to do that.’’
Grimes argues we would be better off to focus on analysing projects properly using a more ‘‘realistic’’ discount rate so big long-term projects weren’t taken off the table in the first instance.
‘‘In a way it’s trying to make up for overoptimistic assessments of government analysts of their pet projects . . . but it shouldn’t be done that way.’’
Glenn says the discount rate was once set at 10 per cent per year, but has been steadily falling. First to 8 per cent, then 6, and now 5 per cent.
He says high discount rates historically discouraged spending on the kind of big projects we’ve since realised we needed.
‘‘We made these major projects go through such a high hurdle that none of them stacked up so all we did was minor curve realignments to achieve safety, maybe extend a bit of road.’’
Treasury looked at its discount rate in May and a spokeswoman says it has no plans to change it.
Sense Partners economist Shamubeel Eaqub believes the reason they’re using such a high discount rate is because the Treasury is simply slow to adapt to changing circumstances. ‘‘It [Treasury] is looking backwards not forwards.’’
Like others he argues the Government is essentially writing off a lot of potentially worthwhile projects right from the start by adopting such a high cost of capital in its analyses.
‘‘And we’ve seen this already. We’ve heard that you take some projects up to Treasury and they say the cost of implementation is going to be much more than the actual spend programme.
‘‘Because they are looking at the opportunity cost of that capital. And they’re saying the opportunity cost of the capital is not the cost of borrowing [less than 1 per cent], but at 5 per cent.’’
Oddly, for an approach rooted in theories around how capital markets operate, the high discount rate appears to be at odds with the way markets are operating at the moment.
Maui Capital managing director Paul Chrystall says that while in theory it is looking for 15 per cent returns on investments, those opportunities are diminishing.
With so much money being pumped into markets the individual characteristics of companies are now less important than the fact they are listed on a stockmarket somewhere.
‘‘We’re actually turning them [stocks] into currency. A stockmarket, an iShare, a share in a large company is just a pure replacement for money.
‘‘Just as we don’t expect to get a big return on money we’re probably not expecting to get a big return on a security in a firm in a stockmarket or an iShare around the world anymore.
‘‘It’s a place to simply warehouse money.’’
So, in such an environment is it wise for a big player like the Government to lower its discount rates and embark on more projects?
The main danger Chrystall can see lies in the capacity constraints around industries like construction. If we spend too much on infrastructure projects without the capacity to build them, we’ll simply drive up prices in the construction sector.
He believes thinking in terms of capacity would be a better way to judge whether we should or shouldn’t borrow money to pay for infrastructure, rather than a high discount rate.
‘‘This is going to the best opportunity we’ve ever had to borrow for infrastructure. It can’t get better than this.’’
‘‘This is going to the best opportunity we’ve ever had to borrow for infrastructure. It can’t get better than this.’’ Paul Chrystall Maui Capital managing director