Disaster in the making

In financial journalist Michael Lewis’s latest book – Boomerang: The Meltdown Tour – the author engages in a bit of light-hearted “financial disaster tourism” across Europe’s sovereign debt hotspots.
Lewis traipsed around the continent with one question in mind:

What did these countries do during the credit bubble, when they suddenly found themselves in a dark room with lots of cash and no questions asked?

Here’s some examples of what he found:

Iceland, traditionally a nation of fi shermen, decided to transform its small economy into a giant high-risk hedge fund. Greece, the epicentre of the sovereign debt crisis, used the money to “turn [its]
government into a piñata […] and give as many citizens as possible a whack at it”. It did this by generously boosting public sector salaries and turning a blind eye to tax evasion.

Portugal – the small Iberian nation of 10 million people that was the third European Union (EU) country to apply for help from its peers and the International Monetary Fund (IMF) – did not fall under
Lewis’s roving eye. Had it done so, he might have concluded that the Portuguese used cheap debt to build roads – lots and lots of roads – using public-private partnerships (PPPs).

In a report in August 2011, a unit of Portugal’s Finance Ministry signalled that the country might just have built one road too many. According to the study, Estradas de Portugal (EP), the country’s roads
agency, risks going bust in 2014 unless the government intervenes. That means pot-holes may go untended – and concessionaires developing Portugal’s roads network may potentially go unpaid.

POSSIBLE COLLAPSE

EP’s possible collapse matters because “about 80 percent of [Portugal’s total] PPP liabilities [are] in the transport sector,” Portuguese economist Mariana Abrantes de Sousa noted in a recent paper.
And Portugal’s PPP programme carries a staggering €25 billion in liabilities, equivalent to more than 14 percent of its gross domestic product (GDP) “in present value terms”, a June report by a unit of the European Commission, also cited by de Sousa, pointed out.

The situation is serious enough for the new conservative government to acknowledge, in its recent transport plan, that EP’s debt requirements are so big they again threaten to place“public finances on a non-sustainable path”. In other words, if the situation doesn’t change, Portugal may have to go cap in hand to the EU/IMF again in a few years’ time.

So when did Portugal start bingeing on PPPs? The answer is: around the time former socialist Prime Minister José Sócrates took office in 2005.

As de Sousa points out in her paper, a 2005 report by financial services firm PricewaterhouseCoopers
showed that “Portugal had more than 20 PPP projects contracted or in procurement, with average PPP activity of about 1.3 percent of GDP” from 2001 to 2005. In June 2011, according to the
European Commission report, cumulative PPP investments in Portugal since 1995 amounted to close to 10 percent of GDP.

A big part of the increase was down to Sócrates’ ambitious €25 billion PPP programme, comprising everything from roads to hospitals and high-speed rail. While the 2008 financial crisis eventually derailed
part of that programme, about €5 billion of new roads capital expenditure (capex) was awarded in the midst of the maelstrom – with EP playing an instrumental part.

ORIGINAL SIN

EP was established in 2007 and awarded a 75-year concession for Portugal’s entire roads network. It was thus made responsible for developing and financing the country’s roads, including the right to grant sub-concessions to private partners.

With self-sustainability as a founding goal, EP was granted a portion of the fuel tax and the ability to collect tolls across the network. Since the former would almost certainly be insufficient to fund EP’s
needs, it was hoped the agency would be able to attract large amounts of bank debt on the back of its significant assets. In hindsight, EP’s highly geared strategy was its original sin.

Without cost-cutting measures, EP would accumulate €28.4 billion in debt by 2034, the new government said in its transport plan. However, its guaranteed revenues from its portion of the fuel tax
and toll collection will only amount to €19 billion by 2050, Sérgio Monteiro, Portugal’s transport secretary, told Parliament recently.

Sócrates’ seven sub-concessions alone will cost EP €6.24 billion between 2010 and 2030 and will only turn profitable for the roads agency in 2039, when most of the sub-concession contracts expire,
the Finance Ministry report shows. But these are not the only private sector payments EP has to dole out. The roads agency also inherited a substantial batch of shadow toll roads, which will cost it €4.4 billion until 2025. Additionally, EP has to shoulder the costs of maintaining and developing Portugal’s
publicly managed roads. Looking at the numbers, it’s hard to see how EP would ever be able meet its
commitments without a steady stream of revolving bank debt.

REFINANCING RISK

In 2008, EP had close to €910 million of bank debt on its balance sheet. That amount rose to €2 billion in 2010 and is set to increase to €4.2 billion between 2011 and 2015, when EP will need to start making payments for the seven subconcessions awarded by Sócrates’ government. But here’s the catch:

“Unless the [Portuguese] state intervenes, EP will face serious difficulties in obtaining financing until 2013, and it will be financially unsustainable starting in 2014,” the Finance Ministry report warns.

To make matters worse, 77.5 percent of EP’s bank debt is short term and thus “inadequate to the long-term profile of EP’s activity, which increases refinancing risk,” the report adds. Like bailed out Belgian bank Dexia, EP took the gamble of using short-term debt to fund long-term commitments.

Another aggravating factor is that EP never really put in place a framework to enable its funding strategy of securing bank debt against future revenues.

EP’s original idea was to repay debt using revenues from Portugal’s oldest road concessions – such as Lisbon’s bridges or the A1 highway crossing the country from north to south – once they reverted to the state starting in 2034. Whether it planned to do this by monetising future toll revenues or some
other strategy, it never got the all-important rating that would have allowed it to independently tap the markets.

Discounting bank debt, EP’s only true revenue source between 2008 and 2010 has been its portion of the fuel tax, which is not even adjusted for inflation. But fuel tax revenues have been decreasing because Portuguese are buying less fuel and driving less as a result of the country’s ongoing recession.

Worse, even between 2008 and 2010 – when EP’s obligations were more manageable – fuel tax revenues proved “manifestly insufficient to service its investments, namely, its sizeable commitments
to the road concessions,” the Finance Ministry report highlighted.

HIDDEN TIME BOMB

The other side of the EP story is that any problems with its funding system were, by design, not readily visible. Portuguese law states that if public companies can generate sufficient revenues to cover 50 percent of their costs, then these companies will not feature in the public deficit. This allowed EP to fly under the radar for the first years of its life, even as it piled up liabilities from Sócrates’ €5 billion roads programme.

The latter was possible due to a five-year ‘grace period’ agreed for the new roads, during which EP did not have to pay availability payments to concessionaires.

Coincidentally or not, that five-year time span covers a full electoral cycle, as Portuguese legislative elections are held every four years. Sócrates won two mandates as prime minister, starting in 2005. If the crisis hadn’t cut short his second term earlier this year – during which most of the new roads were awarded – he would have served until 2013, the year EP has to start paying for the new sub-concessions. EP also made some questionable decisions during the procurement of the new road concessions.

As the crisis shortened tenors and increased the price of bank debt, EP allowed concessionaires to freely determine the time span for receiving their availability payments. The result: in at least two of
the new sub-concessions, concessionaires will now be fully repaid during the concessions’ first 10 to 15 years – even though the contracts will last for close to 30 years.

Then there was the Court of Auditors saga in 2010, when Portugal’s spending watchdog rejected five of the awarded sub-concessions citing several procurement irregularities.

These included the absence of public sector comparator studies justifying the use of the PPP model for the new roads; and illegally allowing bidders to raise the net present value of their final proposals from their initial offers on the back of increased government contributions – which EP justified with the ongoing financial crisis and costlier bank debt. The Court eventually green lighted the concessions, even though many of the irregularities remained.

It’s hard to understand why EP decided to push through with procurement at the expense of more onerous conditions for itself and the government without appreciating the importance of the political angle. As de Sousa wrote in her blog in January: “It was useless to withdraw EP [and other public companies] from the perimeter of the deficit. This sort of ‘de-budgeting without de-politicising’ doesn’t convince anyone anymore”.

WHAT NEXT?

Depending on who you talk to, EP was either an exercise in deficitobfuscation; an unfortunate product of the credit bubble mentality, when cash flowed easily and refinancings rarely raised an eyebrow;
or both.

But that hardly matters compared with the roads agency’s unfortunate timing. Emerging in 2007 – just one year before the worst economic crisis of modern times – it was born in an ill-fitting suit, arriving at the party with an expensive debt habit that abruptly went out of fashion.

The most important question now is how will EP manage to pay its dues?

In its recent transport plan, the new government outlines cuts of almost 50 percent to EP’s projected debt requirements. It aims to do this by turning Portugal’s seven shadow toll roads into real tolls;
adjusting EP’s portion of the fuel tax for inflation; and, significantly, cutting capex and opex on the new sub-concessions to the tune of more than €1 billion.

Even with these measures, EP’s debt requirements would still hit €14.5 billion by 2034, prompting the government to acknowledge that further cost-cutting is needed. And here’s the rub: the €78 billion
EU/IMF bailout granted to Portugal does not take into account the debt of companies like EP, which, at the time of the bailout, did not show up in the deficit.

With nothing but negative growth on the horizon, it’s little wonder finance minister Vítor Gaspar has recently started muttering about “adjustments” to the bailout programme.