Debt financing and rail: thoughts after reading Eleven Minutes Late

Debt financing and rail

Finally having got around to reading Eleven Minutes Late: The Book about British Railways I would have written myself if it was about Australian Railways instead (actually A Train Journey into the Soul of Britain) by Matthew Engel, I’m now in a position to put to paper some more coherent discussion on what the true nature of the problems of Australian rail, its history and its future.

Of a millions gems and true insights Engel gives us, I’ll start on his quoting an interview with John Major after the event, where Major informs Engel that due to the Public Sector Borrowing Requirement, rail would always have to compete with health and education for investment funds from government. “The PBSR is such that the railways would have always limped on for ever…[and should be privatised] so that when there was a crisis in government it would not be in a position of having its budget cut…The railways shouldn’t be subject to the day-to-day whims of government.” To which Engel replied “Are you saying privatisation was necessary because of flaws in government, rather than flaws in the railways?”. Should we say touché at this point?

Maybe Major was scoring an own goal, indicting his own government, and perhaps one hundred or more years of predecessor governments, admitting that perhaps the art of government is not done as well as some politicians might present it.

But I would like to look at the context in which he put it – debt financing.

Many have railed against crude global borrowing limits in Australia over the years, and made them a spectre in the same way as the road lobby has frightened generations of train-loving children when they go to bed – only to see the sun rise in the morning and the road lobby monster has gone.

The private sector has them too. In fact I would go so far as to say that investment funding is one of my favorite paradoxes of corporate management.

The paradox is the finite investment funding paradox.

If you believe in free markets and all that jazz, you’ll know the supply curve of investment funds is infinite at a practical level, perfectly elastic. This means that for a given rate of return above the risk free rate, any project that is going to pay that return has access to a practically infinite supply of investment funds, because that project is small, while the capital market is large. Many sellers.

If the market is practically infinite, then why would a company board ration investment funds to its divisions? Why would BHP, with say a Coal Division and an Iron Division, have to make a choice of which project to give funds it sourced from the market (for example, by withholding dividends) if both Division heads came to the board with projects that would earn above the required rate of return? Why should it make that choice? Can’t it do both a coal project and an iron project at the same time?

This begs an even deeper question: if the board is REQUIRED to maximise profits to shareholders, and both Coal and Iron Divisions had projects ready to go that would do this, why did the Board deliberately NOT do this, actually REDUCE the profitability of the company by choosing between the projects rather than funding both?

Say the required rate of return at BHP was 20%. The Coal project will rate 30% and the Iron project will make 24%. So both projects will boost BHP returns above the hurdle rate. But the BHP board, having sourced funds at 20% from an infinite market, chose the Coal project and effectively rationed capital at 29%, the Iron project failed to clear this hurdle and BHP Board “shrunk the market” for investment capital inside its firm.

I can only suggest two reasons, both plausible. One is the optimism bias of the Division heads. They SAY they will make 30% and 24% respectively, but they are probably overestimating it. Both have risk and one project might fail. Or both. The Division heads are not indifferent to whether the projects go ahead or not. Their own bonuses increase; their empires grow. They have a greater stake in each project than the board does.

Or another reason. It gives the board something to do. If the Division heads were honestly appraising the projects, there is no reason not to fund both. As long as both projects and their risks are disclosed to the market, let the investors decide.

This is classic textbook case for splitting the company. To let the two businesses compete, sell both onto the market and they will compete in an infinite market. Both clear a market cost of capital of 20% and both will go ahead. Everyone is better off, even that grumpy board who no longer get to watch presentations and act as God.

So this is the private sector paradox. Why does the market produce conglomerates to ration capital when the investment market doesn’t need third party rationing (it can do it itself)?

Obviously the word “synergy” has captured too many financiers. The belief that BHP can get economies of scale from different businesses merged together.

In the public sector, the failings of a global borrowing limit have led people to draw the analogy with personal finance. The argument goes, you wouldn’t confuse your credit card (high interest borrowings to fund current consumption) with your mortgage (low interest borrowings to fund long term asset asquisitions) so why does government confuse short term deficit financing in health and other ‘current’ expenditure, with asset investment in infrastructure designed to make a return over many years?

Actually people DO confuse their credit cards with their mortgages; people default on the latter and personal bankruptcies increase. Financial writers from the conservative Paul Clitheroe to the radical Robert Kiyasaki decry how few people know how to manage their money, and how people get themselves into financial distress over indulging their consumption habits.

So maybe the analogy is not a great guide to good government. If a government cannot trust itself (and Major implied this) to distinguish short term gains in social policy over long term gains in infrastructure efficiency, then, like the BHP example, maybe the “Board” needs to divest itself of the latter to the capital markets.

But to return to then analogy, maybe Clitheroe and Kiyazaki have a point. Is it really the practicality of distinguishing two different businesses that is the problem? Or the lack of discipline of those not doing the distinguishing? When I did Corporate Finance at University, they always spoke against conglomerates, the analysts would have trouble coming up with a cost of capital for a diversified business, too complicated they said.

Is it really? Five tabs on the spreadsheet rather than one? Don’t analysts have to EARN their salaries by analysing, not just quoting company ASX releases?

Equally an individual who is spending up on new plasma TVs or a boat and putting it on the mortgage, don’t they know they are not acting in their own best interests?

I think this is the real issue. The government could borrow what it likes if the public knew the REAL purpose of the borrowings. Arguments about leaving our grandchildren paupers because of the insulation or the school halls are one thing, but its another thing to say they will be paupers because of new roads or rail that they will also use. The problem is how to distinguish between these not just in budget papers, but in public discourse.

There are two immediate culprits for this: opposition parties, and the Treasury. Opposition politicians are an inevitability, but like our infinite supply of investment funds, the ‘market’ for opposition scare campaigns is infinite. With a poorly informed population, who can’t distinguish their credit card from their mortgage, how can the line between government ‘consumption’ spending be distinguished from investment spending?

But Treasuries are supposed to be ‘professional’, why do they deliberately conflate the two forms of debt, and offer the same bond rate regardless of purpose? And do nothing in public discourse (at least until Ken Henry appeared) to clarify this?

I would liken Treasury activity as to the hypothetical board of BHP. Global borrowing limits gives them something to do. The Treasury ’scare campaign’ is not to the public, but to the government. Your voters will remember the debt for the Sydney Harbour Bridge long after they’ve forgotten how grateful they were to you for building it (and discount the benefits it continues to deliver 80 years on).

So what was Major’s real rationale for privatising? By the logic offered above, not to make it more efficient, but to get it away from a Treasury he clearly couldn’t control. We all think Sir Humphrey Appleby was a 1970s confection, they don’t do it this way any more. It’s all spin and 24 hour new cycles now. Maybe the long lunches in gentleman’s clubs and the school ties have gone, but I’m guessing at the heart of it Major was admitting it was still there.

If I can recommend Engel’s book for one thing, it is that he and I are of one mind on the weakness and illegitimacy of modern western governments. He is quite clear that the crimes of Beeching and other notorious figures were not their explicit deeds, eg in Beeching’s case his Reshaping report and branchline closures. Like me, Engel believes this was all window dressing over the real issues.

No, Beeching’s crime was that he had an opinion at all, stick his head above the sandbags, in a political world that has turned into a dull blanc-mange of nothingness. The existential problem of our age. Politics with no purpose.

He argues, as I would, the Labour politics was already just gesture and too late to have any real effect on rail’s destiny, whether in 1948 or 1997. Conservative politics were just as hypocritical.

You can delete the ‘u’ from Labour in this country and get roughly the same answers. In fact for us it was worse; Engel argues railways might have been saved in 1948 in the UK; I doubt they could have been after the 1920s here and certainly the political will was even weaker.

Where does the political will come from in our blanc-mange world? I’ll leave that to my readers to think about. Careerist politicians will always defer to a Treasury that comforts them by absolving them of guilt when their careers are over. A global borrowing limit makes a convenient fig leaf, to help them sleep at nights. No one wants to really face the facts of what an unfunded welfare, health and social system will actually DO to the government.

But what do I recommend? First, that some rail operations actually are profitable, and need to be physically separated out from the rest (while vertically integrated) and given to the capital markets. Forget cross subsidies, they punish the good and reward the bad.

But what about network effects? Then enforce them as “Standards”, like the computer languages and the plugs on electrical appliances. When your railway comes to Sydney, your train will pull up at a platform, your passengers will walk across to the platform of the other rail company. The small marginal cost of this you will absorb. You are entitled to collect the appropriate fare including profit from your passengers, but you will use the same standard ticketing technology, so multi-route passengers don’t need a wallet full of different tickets.

Some operations are profitable, but only with subsidies collected from market failure remedies, such as congestion taxes or pollution taxes. Let the market bid for these, based on outcomes. An excellent example of congestion busting was in Albuquerque, where the state was going to spend hundreds of millions on a freeway upgrade to cope with about one hour of daily congestion, probably 2000-4000 cars.

When they worked out that the funding could be spent on a couple of classic commuter locomotives and bilevel carriages on a daily commuter route along a freight corridor, they saw sense and funded that instead. Not a comprehensive P T solution at any level, but a start. A recognition of the power of rail over road congestion.

Now if some crazy comes up with a different solution say monorail or maglev or hovercraft or whatever, let him go to the market. As long as he meets standards (fares, ticketing, legibility) he should convince the market that the subsidy plus whatever revenue he picks up (fares, real estate, advertising) will pay a return. I suspect the generic US diesel commuter train will beat the maglev for some time to come.

This places the investment risk where it belongs – on the capital markets. Let it not be said I don’t recognise capital market failure. Engel cites as many authors do the railway mania of the 1840s, no different from the dot coms and sub primes of our time. But he acknowledges the real failure was not the overbuilding, but the keeping of this stuff, in poor condition, for a century afterwards. Ditto Australia, amplified.

There is a still a role for public ownership of mass transit systems. I would make this analogous to the BHP example, in this case the iron ore railways. They are ‘profitable’ in that they contribute to the system of mining and selling iron ore. The markets agree selling iron is profitable; they agree you need rail to get it to market; they agree to whatever investment is required to make it happen.

Thus should it be with cities. A city is (I won’t say profitable) worthwhile. It needs mass transit to function. This should be paid for by government, while still attempting to get it back through farebox and real estate.

The investors will flee if there is no efficient mass transit system. I’ve seen this in Dubai, for example, where the Sheik is expending billions on a new metro, to keep his city attractive even after the traffic has become impassable.

But this is no carte-blanche to union rorts or political pork barrelling. The Sheik still has something John Major lacked, returning to the theme I picked up earlier. Legitimacy. Sad to say, a dictator with more legitimacy than a democratically elected pollie. He has made a compact with his people, build Dubai prosperous and diversified away from oil, a guided market, and open for business and trade. What did Major have to offer? A privatisation policy, dressed up as efficiency but, as admitted to Engel, really a way of fixing his government, not the railways.

The Sheik has other advantages. Sure he may have oil revenue, but Australia is not poor. We also have mining revenue. The Sheik has a free flowing labour market, millions of Indians and Filipinos who can come and go to serve his needs. These people, despite being poor, are financially literate. They know the difference between a credit card and a mortgage, in this case between spending on current consumption and on building their families’ futures. Repatriated funds get spent on children’s education, English lessons, eventually on new and better housing. What does Australia have?

Australia not only has a financially illiterate poor, but also a middle class with the same curse. Who can’t distinguish government spending on the balance sheet, a bit like our hypothetical investment analyst who doesn’t want a spreadsheet with multiple tabs. Politicians can play to this, then seek absolution from their Treasury. Al Maktoum doesn’t need to seek absolution from his Treasury.

I see the way back towards legitimacy in western governments through financial literacy. Whether you prefer a measured Clitheroe or an outlandish Kiyazaki, only better financial literacy will help people distinguish between their credit card and their mortgage, between the Sydney Harbour Bridge and the current spending on welfare.

As an aside, I find it amusing that people can say of Dubai, in reference to Australia “Apples and oranges, they have mineral wealth [as if Australia doesn't], they have immigrant labour [while we spend billions on concentration camps and using our navy to fend them off] we have a fragile environment [while His Highness spends up on water recycling, solar power and mass transit] and we are worried about our national identity [while Gulf Arabs actively assert their identify by towering in wealth and position over the immigrants who outnumber them].”

All I see is we have a ‘free’ press which means free scandal and outrage at the normal business of government, we have a welfare-base (the poor who have no incentive to work) and taxation that takes from what is good and encourages what is bad, rather than the other way round.

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