The age of deficits

In 2009, Americans have received warning after warning that their governments face alternatively a ‘decade of debt’ or a ‘lost decade’ due to massive, painful and protracted budget deficits that are here to stay. Opportunities are abound for infrastructure investors – but so are the pitfalls.

Hardly a month goes by that Americans aren’t reminded they are living in the age of deficits.

In April, there was the Moody’s report assigning a negative outlook to US local governments, marking the first time the credit rating agency ever assigned such an outlook to an entire class of debt issuers, according to Bloomberg.

In August, there was the White House forecast of $9 trillion in additional debt the US government would take on over the next decade as a result of its fiscal woes, prompting the Wall Street Journal to label the next 10 years the “decade of debt”.

State governments need not feel left out. In November, the National Association of State Budget Officers and the National Governors Association warned that US states face a “lost decade” of economic growth during which they will have to face down $250 billion in budget gaps and revenue shortfalls that will persist into 2015.

So the times they are a little difficult. If only some of the gloomy predictions pan out, words like furlough, deficit, budget cuts and tax increases are likely to stay in the headlines for a long, long time.

Can infra investors benefit? 

For infrastructure investors who have long been waiting on the sidelines of the US market for public-private partnerships (PPPs), this news has often been heralded as a blessing in disguise. After all, the conventional wisdom goes, the more cash-strapped governments become, the more likely they are to finally embrace private investment in infrastructure.

And indeed, there is some truth to this: at each level of government – federal, state and municipal – more budget woes mean more attention will be paid to new ways of financing infrastructure. But each level of government will also present its own unique risks and challenges for investors looking to capitalise on the macro-trends.

On the federal level, one phrase our editorial team keeps hearing over and over again from investors is “printing money”. The federal government, many argue, is pursuing radically inflationary policies that will devalue the dollar and spur a massive tide of inflation.

On the one hand, this bodes well for infrastructure investors since the asset class is viewed as a good way to hedge inflation. Just as utilities can build rising costs into their rate case, concessionaires can annually adjust long-term contracts for the consumer price index and developers of new assets can reprice contracts if construction costs go up prior to putting shovels in the ground.

The problem: while many pensions rightfully put infrastructure into their “inflation-linked” asset allocations, it is only the newest one of many sub-asset classes investors can access to hedge inflation risk. A longer established alternative is treasury inflation-protected securities, which investors are much more familiar with. So if infrastructure is to benefit from the government’s inflationary policies, it will have to prove that it can deliver. Otherwise, there’s always other ways to get inflation protection at a lower cost.

On the state level, yes – there is hardly a state government out there that isn’t slashing its budget or contemplating tax (or, in an election year, “fee”) increases. This has undoubtedly played a role in convincing the legislatures of several cash-strapped states like California and Arizona to pass legislation to enable their transportation agencies to pursue PPPs. It is also why Indiana Governor Mitch Daniels has taken to the pages of the Wall Street Journal to boast of his state’s better-than-most fiscal situation, thanks in no small part to a $3.8 billion toll road deal struck at the height of the credit bubble.

But a stark illustration of the downside came when New Jersey’s Governor-elect, Chris Christie, asked his state’s pension managers to freeze all new commitments to alternative investments, including infrastructure, while leaders in Trenton try to figure out how to plug the growing NJ deficit. So if you are raising an infrastructure fund in the hopes of helping New Jersey someday move the turnpike off its books, don’t hold your breath – right now is probably not the time to pitch the idea to the man in charge.

What about the municipalities, then? It is tempting to think there will be monetisation opportunities there. After all, it is at this level that governments are feeling the pinch the most and have the least avenues available to them to plug budget deficits. A state government can raise all kinds of fees and taxes. But in many places, local governments, like the City of Milwaukee, for instance, do not have a lot of taxing authority. Small wonder that, unable to levy a sales or an income tax, and unwilling to raise property taxes, the city’s leaders floated the idea of leasing out its water utility earlier this year.

The flip side, however, is that executing such deals remains as politically difficult as ever. Across the US, city council members who promote asset sales or leases face instant criticism from their counterparts, and as soon as they return to their offices, the phones start ringing from investors, advisors and consultants who more often than not do not speak their language. Small wonder that Milwaukee eventually decided to take more time to study the idea of leasing out its water operations. Likewise a general suggestion by Chicago’s Mayor Daley that the city also keep a water deal “on the table”  quickly met with strong opposition. A Chicago Tribune poll asking readers whether they would support such a move found 97 percent of respondents saying “no”.

And whatever level of government you look at, politicians, while warming up to the concept of PPP and looking to educate themselves about it, are more aware than ever that PPP is not the panacea to their problems. Chicago’s ongoing budget battle is just one example: with nearly $1 billion in reserves from infrastructure asset monetisations, you’d think plugging a $550 million 2010 budget deficit would be a no-brainer for the city’s leaders. But as the recent debate in city council shows, tapping such reserves is anything but simple. The money from a 99- or 75-year lease belongs not just to today’s Chicagoans but future generations as well. Difficult moral and ethical issues surrounding the proceeds from such deals are just now beginning to be addressed.

The outcome will certainly be closely watched by investors everywhere. Whoever is eyeing a PPP opportunity in America today, they must never forget that risks and challenges will apply – no matter how big the public deficits grow.