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Keeping the treasure

20th March 2015

If low inflation is here to stay, writes Howard Webb, then a number of the standard tenets of good treasury management may well not apply...

Inflation has been the norm for my generation. During some periods it has been over 10 per cent. There has been little reason to question the typical inflation assumption of RPI at +2.5% (or CPI at +2%) for long-term business planning purposes.

But this familiar world seems to be changing. With the latest CPI figure at +0.3 per cent and with negative inflation in France, Germany and Spain, the past, as they say in the financial promotions, may not be a good guide to the future.

At the macro-level there is a very interesting debate going on about whether we are entering into an age of ‘secular stagnation’ or whether we are at the dawn of a new age of rapid growth on the back of the new technologies, such as ‘big data’.

At the micro-level of treasury management there is the more immediate question for all treasury advisers as to what we should be telling our clients.

If low inflation is a temporary phenomenon then life and treasury management can carry on more or less as usual. If low inflation, or indeed deflation is here to stay, then a number of the standard tenets of good treasury management may well not apply.

It has long been accepted that for an HA, inflation is a good thing as it is good for most leveraged asset purchases, indebted governments and anyone with a mortgage.

If inflation is no longer going to be eroding the value of our debt and increasing the income we have available to support new debt, we may have a problem.

What is going to happen to all the new debt that HAs are taking on? There is no doubt that it is fantastically cheap but, in the absence of inflation, will they be able to generate the revenues needed to repay that debt?

One solution may be to establish a sinking fund. However, in a deflationary environment, returns on such a sinking fund might be negative.

Alternatively, maybe we should be looking to borrow by way of amortising loan structures. At today’s ultra-low long term borrowing rates we should be generating the sufficient cash to pay down our borrowings.

But what do we do about interest rate risk hedging in this new low inflation or deflationary world?

In a deflationary environment the real interest rate on what appears to be fantastically low borrowing costs may turn out to be not so ‘cheap’ after all.

By way of example if we have 0 per cent inflation for the next 10 years the real borrowing costs of a ten year loan fixed at 2 per cent plus a margin of 1.5 per cent (ie 3.5 per cent all-in) at current market rates, is 2.5 per cent p.a.

With deflation of 0.5 per cent over the same period the real cost increases to 3 per cent. Within my working life the real cost of borrowing in a high interest rate and inflationary environment has been much lower, and indeed negative, for short periods of time.

If price stagnation becomes deflation and we see a series of negative inflation numbers for any length of time the real borrowing costs for many organisations that locked into 30-year fixed rate debt at around 4.0 per cent might turn out to be way above the historic ‘norm’.

So what is the answer to this potentially doom-laden scenario?

Do we all bury our heads in our hands and hope that things turn out differently and that inflation returns with a vengeance to erode our debts and boost our incomes?

The answer my friends is that salvation may be at hand…

Good treasury management policy has always emphasised the importance of a balanced portfolio. In a deflationary environment LIBOR would be likely to remain low.

In this context it is not surprising that the governor of the Bank of England is not talking about an imminent rise, but a potential cut in base rates.
If inflation remains near zero or if we slip into negative inflation, and stay there, variable interest rates will stay low.

But a ‘balanced’ loan portfolio will not be a panacea.

Like many advisers to the sector I have advised RPs to steer clear of index-linked borrowing.

I am not about to undergo a Damascene conversion and recommend index-linked debt. My prejudice against index-linked hedging has always been based on the view that the cost base of HAs provides a natural hedge against inflation.

It is now time for HAs to prove the case.

In the absence of a magic hedging-wand, RPs need to focus on their cost base even more than ever, to ensure that the low inflation impacting their incomes is also reflected in their costs. If deflation is affecting the economy as a whole there is no reasonable reason why it should not result in deflation in RPs’ operating costs.

The golden scenario for any organisation is income increasing at a faster rate than costs.

If, as a result of deflation, this is not happening the golden scenario can only be maintained if costs are being cut at least as fast as income.

With a ten year guarantee of rent increases at CPI plus 1 per cent RPs’ need to work extra hard at controlling their costs to maintain the trend of rising surpluses.


Howard Webb is a director at Capita Asset Services.

This article first appeared in Social Housing magazine


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