The UK’s public finances are currently facing acute pressure due to the current pandemic and the government’s policy response. These short-term difficulties have negative knock-on effects for a number of existing long-term challenges that UK Exchequer faces.
The cost of the coronavirus response
The Chancellor, by early July, had spent around £190 billion on measures to support the economy. Between April and June the government borrowed nearly £128 billion. The overall impact on the government’s fiscal position is forecast to be very considerable. Office for Budget Responsibility (OBR) forecasts have suggested that the Public Sector Net Borrowing (PSNB) for the fiscal year 2020-21 could end up between £263 billion to £391 billion. While the total debt could increase to as much as 113% of GDP.
The deficit and in-turn the accumulated debt increases are being driven by several factors. The expenditure, by the government, on various schemes (such as “Furlough”) that the government has devised and implemented to help the economy “get through” the crisis, as well as the increased spending on benefits e.g. for the unemployed. Which is likely to get worse before it gets better. The OBR, for example, have suggested unemployment could be as high as 13% by the first quarter of 2021.
The extensive borrowing is also because of the fall in tax revenues which are a result of the unprecedented contraction that the UK economy has experienced during the peak of the “lockdown”. In the second quarter of 2020, there was a 20% fall in GDP.
A further potential pressure resulting from the government’s response to the present crisis comes from “Project Birch”, which might involve the government taking direct stakes in British companies to ensure their future, in these economically strained times. Such a move would see the government taking new risks onto the public balance sheet.
Pre-existing medium and long-term pressures on the public balance sheet
In addition to the coronavirus related impacts on the public finances, there are pre-existing public expenditure promises made by the current government in areas such as health, education and infrastructure (e.g. they are pledged to spend around £640 billion on infrastructure over the coming years) that were already straining the public finances. Beyond these medium-term expenditures, there are longer-term pressures, too. These latter pressures are associated with positive long-term social trends such as increasing longevity among the population. Table 1 below sets out the OBR’s estimates of the cost, as a percentage of GDP, of these longer-term costs facing UK taxpayers.
Finding answers to the UK’s fiscal difficulties
While there are no silver bullets to dealing with the UK’s post-COVID-19 fiscal situation, nevertheless, there are policy measures which can help improve the UK’s long-term financial position. Which, it should be noted, will no doubt be additionally buffeted by other “shocks” similar to the current coronavirus one, from time-to-time, which will deliver similar “blows” to the fiscal position, further worsening the longer-term position. One way of establishing a degree of insurance against future short-term and the almost inevitable long-term fiscal difficulties would be to establish a “Sovereign Investment Fund” (SIF – also often referred to as Sovereign Wealth Funds [SWF}) which can act as both a stabilising force for the public finances in the face of short-term “shocks” and provide a fiscal reserve to help cover the inter-generational fiscal impacts of trends like increasing longevity, as highlighted in Table 1.
What is a Sovereign Investment Fund?
A SIF is nothing more than:
“…a mechanism through which countries make investments. A pot of money…that is then invested in shares, bonds, property or other areas of potential growth…”.
Specific examples of SIF’s
A more in-depth look at the use of SIF’s by two very different but highly successful countries illustrates the kinds of long-term financial benefits that can accrue as a result of establishing and managing a SIF effectively.
Norway’s Sovereign Wealth Fund (SWF)
Norway set up its SWF in 1998. It is primarily a “savings fund”. It invests revenues generated by the sale of Norway’s gas and oil resources, putting its capital into a variety of assets, all around the world. Figure 1 below illustrates the asset mix held by Norway’s SWF and the trend in its total market value since its inception in 1998.
As Figure 1 also illustrates, by the end of 2019, Norway’s SWF had a market value of $1,148 billion. That is more than twice the size of Norway’s GDP in 2019. The fund has achieved this by generating an annual nominal return of 6.1% over the 21 years of its existence. The return has been around a third higher than would have been accrued if the same amount of money had been deposited in a long-term savings account in Norway for the same period of time.
The success of Norway’s SWF has meant that the Norwegian government has access to a reserve of money, which can help it cover the costs of the impact of the coronavirus on the Norwegian economy. Consequently, it is expected that the Norwegian government will liquidate assets held by its SWF that are equivalent to around 9% of Norway’s annual GDP. If the UK had a similar resource to call upon, it would see the UK government liquidating around £246 billion worth of assets to help fund the policies that the UK has brought in, to tackle the virus.
Singapore’s two SIFs
Singapore has two SIFs. Table 3 provides an overview of both.
The Singaporean government takes an annual “dividend” from Singapore’s SIFs to help pay for current spending. This “dividend pay-out” (from both Tamasek and the GIC) supplements the tax revenues that the Singaporean state raises annually. The contribution, known as the Net Investment Returns Contribution (NRIC) has become more and more important to Singaporean government revenues over the past decade. In addition to this regular benefit, the funds offer a large “reserve resource” that can be drawn-upon in extraordinary times, such as a global pandemic. The Singaporean government has taken such an action this year to help pay for some of the measures it has taken (and may yet take in the future) to tackle the virus and deal with its economic and social “fallout”. As was noted by the GIC, in their most recent annual report:
“…This year, with Singapore expected to experience a deep recession…the Government rolled out four relief packages totalling S$93 billion to support households, workers, and businesses. This required an extraordinary draw of S$52 billion from past reserves, in addition to the annual Net Investment Returns Contribution (NIRC), estimated at S$18 billion for FY2020. Before this, Singapore has only drawn on past reserves once, for the 2008 Global Financial Crisis (GFC). The S$52 billion expected to be drawn this year is more than ten times the amount that was last drawn for the GFC”.
Singapore’s nominal GDP in 2019 was S$507.6 billion. An “extraordinary draw-down” of around S$52 billion is therefore the equivalent to approximately 10% of Singapore’s total domestic output in 2019. If the UK had taken similar action to establish a SIF in decades past, the UK government might now be able to take similar measures. A draw-down of an equally large proportion to that which the Singaporean government is able to make, would have put approximately £270 billion at the disposal of the current Conservative government, to help deal with the current crisis.
An idea that is now more important than ever
In less dramatic times, a SFI for the UK was proposed in 2016 in a pamphlet for SMF by John Penrose MP. It was one among a suite of ideas he set out for the future stewardship of the UK’s public finances. Penrose argued at the time, that to fix some of the UK’s long-term fiscal problems policy needed to be informed by the idea of “generational justice”. Penrose suggested that:
“…the promises we’ve made in our pay-as-you-go pensions and benefits system fail our generational-justice test…We will have to reduce them through…a UK sovereign wealth fund to replace the taxpayer liability underpinning state pensions and benefits”.
He further argued the:
“…new sovereign wealth fund – would have profound social effects, as well as economic ones. They would affirm British social justice by ensuring we are not saddling our children and grandchildren with the bills for our lifestyle today, through future debt repayments. And the sovereign wealth fund would give low and high-paid taxpayers alike a personal stake in the system which underpins their individual state pension and benefits payments, creating a broadbased, socially-just, asset-owning democracy…”.
In the midst of the COVID crisis, those words resonate louder than in 2016, as the UK’s short-term fiscal position becomes more difficult and long-term challenges become more foreboding. Consequently, not only would a UK SIF have saved the UK government considerable fiscal difficulty in the current situation, but it could be of help with the longer-term fiscal challenges too. A reserve stock of capital generating revenues that a future government could utilise to pay for some of the deficits in future health, pension and long-term care spending could be very useful.
Establishing a UK SIF – Finding the initial endowment
Accepting the case, in principle, for the long-term benefit of setting-up a UK SIF, raises a number of detailed questions about its design. There are more than 80 examples around the world that the UK could learn from. However, unlike many of the countries with SIF’s, the UK is not a resource rich economy. Unless, the UK decides to make a determined effort to “frack” for unconventional gas, in which case it could have its own substantial gas revenues some of which could be used to fund a SIF, in a similar vein to Norway. In the absence of such a policy change from the government, the best alternative would seem to be to follow Singapore’s example and utilise some of the UK’s foreign reserves as the source of an initial capital endowment for the fund.
According to the Bank of England, in December 2019, the UK government held reserve assets of £182.7 billion. The Bank of England held reserve assets of £25.5 billion. Converting just 10% of these combined assets into an initial capital endowment for a UK SFI would provide a “pot of capital” of something in the region of £20 billion. Over 25 years, for example, a conservative 4% (nominal) return could see a fund with an initial £20 billion endowment accrue a “pot of capital” worth around £53 billion.[i] With additional injections of capital by the Exchequer at regular periods, the value of the SIF would go considerably higher.
Further, achieving a 4% return should not be too problematic for a well-managed SIF. Investing in a diverse portfolio of assets classes and industries, in both the UK and around the world, held for prolonged periods (i.e. in large part in illiquid investments) should enable the fund to benefit from compounding effects over long time horizons, and “ride-out” volatility which, for shorter-term investments, is a key risk factor (i.e. benefit from “time diversification”). Further, any higher risk investments can be made relatively confidently, if the portfolio has sufficient scale and the preponderance of the portfolio remains invested in assets that, over the long-run, are delivering a steady return.
Therefore, the right kind of investment strategy managed by experienced fund managers would be expected to yield a UK SIF more than 4% a year. As noted earlier, over the period 1998 to 2019 the Norwegian SIF for example, delivered a return on capital over 6%. A nominal return of 6%, could see a UK SIF with an initial £20 billion endowment worth approximately £85 billion, in 25 years-time. This could be boosted further, with occasional additional capital injections from future governments.
Whether the UK government would want to start to take an annual “dividend” from the fund’s investment profits in the near term to supplement current public expenditure, like the Singaporean government, should be debated. There is a good argument for doing so after the fund has had time to mature and build up its capital. Doing so too soon would undermine the fund’s ability to accrue capital and achieve scale. In such circumstances, the fund would be less useful to future governments and generations. If such a provision were implemented it would need to be strictly controlled by the rules governing the fund, to ensure future governments could not take advantage of this particular benefit.
In order to ensure any UK SIF was well run and political interference minimised, the UK SIF would need to be put on a statutory footing. It would require independent management by experienced investment professionals. It should have its own board of trustees and be tasked with a clear mandate setting out what is expected of those in-charge. Transparency and accountability would be essential. Therefore:
- Any UK SIF must operate to the highest transparency standards as established by global best practice.
- Those running the fund would need to be accountable to Parliament for their performance.
Other (potential) benefits of a SIF
In addition to the potential fiscal benefits of a SFI, which this post has primarily focussed upon, an appropriately designed SFI could help reduce other long-standing problems afflicting the UK economy. For example, a SFI which followed the model of Tamasek Holdings i.e. part of its mandate was to invest in supporting domestic industry, could help “plug” the UK’s estimated £15 billion funding gap that holds back many high-growth businesses. By investing long-term, as the fund will predominantly do, it could also help reduce some of the short-termism widely observed in UK equity investors over many years, and which has long been seen as a constraint on the success of British businesses.
If there was a “strategic” element to the remit of the UK SIF, Project Birch – a government programme to support UK firms who have hit significant financial trouble because of the coronavirus pandemic – could provide the genesis for it. One of the policy tools being considered, under the umbrella of Project Birch, is taking direct stakes in (what are judged to be fundamentally solvent) companies to help ensure their future in these uncertain times. Using some of the government’s and Bank of England’s reserve assets to purchase the stakes and bringing the management of those stakes under the umbrella of one entity (the UK’s SIF) would mirror the beginnings of Tamasek Holdings in Singapore.
The latter was set-up to manage holdings in Singaporean corporations (worth around $350 million). It has grown its investment stock since 1971, and as noted earlier in Table 3, it is now valued at more than $300 billion. The long-term investment that a UK SFI could offer to such companies would give them a more secure platform from which to invest for the future and in-turn deliver good returns for the SIF over time. Further, it would be a vote of confidence in both the British economy’s present and in its future.
The SIF could also provide long-term capital for UK infrastructure investment. It is widely acknowledged that UK infrastructure been under-invested in for many decades. It is also widely acknowledged that there has been a failure to attract private sector investment into infrastructure on the scale needed. Not all of the reasons for the UK’s under-investment are to do with finance in general and a lack of private investment in particular.
There are many factors that have contributed to the UK’s comparatively poor infrastructure performance. Finance is one of them. SMF explored this issue recently in a report. In that paper, SMF recommended encouraging some consolidation among UK pension funds to help build-up investment funds with sufficient scale to make the 25 year plus investments needed to help build-up the UK’s physical infrastructure. SMF also suggested pension fund reform should be complemented by a new British Investment Bank (BIB), to play a direct role in helping leverage more private capital into infrastructure.
The SIF could fit seamlessly into this new landscape. Its ability to provide very patient capital to any BIB that might be established by a government to support infrastructure investment, could help such an institution scale-up very quickly, and play a more significant role in the rebuilding of the UK’s infrastructure over the coming decades, than it might otherwise have been able to do.