COPING WITH BREXIT: INVESTING IN NEW CAPITAL INFRASTRUCTURE IS A MUST
Fergal O’Brien, Director of Policy and Chief Economist, IBEC
Brexit presents one of the greatest policy uncertainties for Ireland in decades. It will provide many opportunities in some sectors of the economy; while for others the risks are substantial. It will also entail varying trends at a regional level. Our cities could be net beneficiaries but rural areas are likely to experience the most severe downsides. On balance, Brexit is likely to be a net negative event for the Irish economy but the scale of economic loss will be greatly impacted by the final nature of the exit arrangements and, crucially, by the domestic policy decisions we take to insulate ourselves from the downsides and to maximise the opportunities which are already presenting themselves.
CRITICAL INFRASTRUCTURAL DEFICITS
In this context, putting in place proper 21st century infrastructure will become more crucial to making sure Ireland succeeds in an even more competitive global environment. Over recent years Ibec has consistently drawn attention to a lack of ambition when it comes to the State’s delivery of key infrastructure. In the early years of the crisis, this was unfortunate, but understandable, in the context of Ireland’s fiscal position. Today it is unsustainable. Ireland is now the highest per capita income country in Europe, and in the top 10 globally, with a rapidly growing population but without sufficient infrastructure to match:
Not only is a more ambitious capital programme economically sensible but the State has the fiscal capacity to undertake it. Increases in capital spending under the existing plan will be back-loaded until 2019 – with many projects unlikely to be completed before the middle of the next decade at the earliest. By this time, it is likely Ireland will have critical infrastructure deficits across a number of areas – having seen over a decade of underinvestment relative to any international or historical norm. In the face of the potential impact of Brexit, the need to invest more – particularly in connective infrastructure – has increased dramatically. This is the only prudent course at a time when interest rates are at an all-time low and demographics mean there have never been more projects with high social and economic rates of return.
The upcoming mid-term review of the capital plan presents an important opportunity to show more ambition for future growth and to react strategically to Brexit related challenges and opportunities. Some projects will take time to come on stream but the mid-term review should see provision made in order to aid fast tracking of planning and procurement for key projects. There are already some very positive signs in Government’s recent Summer Economic Statement that infrastructure investment is becoming a higher policy priority. As we seek to navigate the challenges of Brexit while at the same time planning for a more effective long-term approach to regional development, more ambition in infrastructure investment can hold the solution to both.
2. The economic rationale for increased investment
2.1 Ireland is not investing enough
State capital investment has been falling across the developed world over the past two decades. Despite this, Ireland’s long-term record on capital investment has been poor compared to our competitors. Figure 1 shows Ireland’s Government capital investment versus other similarly developed OECD countries over the past 32 years. What is notable is that Ireland has been a below average investor amongst those countries in two thirds of the years since 1984 and has been at, or near, the frontier of those countries in only six of those years. This has left us with an infrastructure which is not only underdeveloped compared to other rich nations but also falling further behind.
Figure 1: Gross fixed capital formation as a % of net national income, Ireland versus competitor countries.
Figure 2: Ibec investment target and capital plans % of GDP
It is also worth drawing attention to the low levels of net investment which will be undertaken, even taking into account additional resources announced in the context of the mid-term review and also in the recent Summer Economic Statement. Figure 3 shows the levels of gross capital formation by Government and the depreciation of Government capital stock as a proportion of net national product. In the decade from 2008 to 2018 the total spend on new capital stock will equal only an average of 0.6% of GDP annually.
Figure 3: Gross and net fixed capital formation of Government as a % of net national product
This is not to suggest this money is wasted; research shows that spending on maintenance is more cost effective in a great many circumstances. Ireland, however, has a rapidly expanding population and severe bottlenecks are emerging which can only be solved by expanding expenditure on new infrastructural capacity.
As such, a lack of spending on expanding new capital infrastructure not only makes no commercial or economic sense but will inevitably lead to severe social problems as the volume of demand for infrastructure outstrips supply. We can already see the results of this in housing but it is quickly becoming evident on our roads, in our schools and hospitals and will result in deteriorating quality of life and increasing costs for households and business.
Figure 4: World Economic Forum infrastructure scoresThe social implications of our low levels of infrastructure development are obvious in our health, education and housing systems. The impacts on business are less well documented but are a constant source of feedback from Ibec members. In areas from roads to broadband, poorly developed infrastructure pushes up operating costs directly for business by making trade more difficult or expensive. Improved accessibility also increases the effective size of a local labour market and therefore boosts the productivity of firms and individual workers. There are also indirect impacts. The biggest single driver of ongoing wage pressures is the lack of housing supply, a lack of quality outcomes at third level will have a deleterious impact on skills availability, and higher commuting costs for workers mean lower productivity and higher wage demands.
The best indicator of Ireland’s standing internationally for infrastructure is found in the World Economic Forum’s Global Competitiveness Report. Six of the nine indicators which make up the infrastructure ranking are made up directly of survey responses from business leaders. By this measure Ireland ranks 2nd lowest of any EU15 country for our infrastructure development. The impact of this for investment and productivity cannot be understated.
2.2 How much should we be investing?
The best estimates of Ireland’s public capital stock as a proportion of output come to around 53% of GDP. Multiple studies have looked at the optimum level of public capital to support economic growth. The most well-known studies on this have estimated a level in the region of 60% to 80% of GDP. The OECD on the other hand (2016) provides evidence that the optimal stock of public capital may be as high as 75% to 110% of GDP. Given Ireland’s strong demographics and ageing population, it is arguable that the optimal public capital level may increase over time as social needs for infrastructure may gain pace faster than economic needs.
Figure 5: Public capital stock under different investment to GDP ratios
As the Irish Fiscal Advisory Council (IFAC) amongst others has noted, the ratio of Irish public capital to GDP will continue to fall under current plans. In Figure 5, we assume nominal GDP growth will be in line with the Government’s draft stability programme update forecasts until 2021 and will run on average at 3.5% per annum on to 2030. We also assume depreciation of public capital stock runs at, a conservative, 2% of GDP over that same period. In a scenario where we adhere to the investment levels outlined in the consultation document for the mid-term review of the capital plan to 2021 and to a 3% of GDP investment rate thereafter, public capital stock will fall from 53% of GDP now to 43% of GDP by 2030. By ramping up to 4% of investment by 2021, and then maintaining that level over a decade, the public capital stock to output ratio will more or less stay at its current levels. To increase the public capital stock to 60% of GDP by 2030, investment would have to reach 5% of GDP annually by 2021 and remain at that level for a decade. In this context, the 4% of GDP investment target we have outlined is a steady state budget, the actual needs of the economy may well be higher over the long-term. Despite the welcome increase in capital spending flagged in recent Budgets and again in the Summer Economic Statement, the State’s investment as a percentage of GDP will only reach 2.5% by 2021 and will remain below the EU average and well below that in the top performing EU economies.
2.3 The fiscal position of the State should allow increased investment without excessive risk
Ireland is in a better position to weather the uncertainty of Brexit now than it has been over previous years. Our fiscal position has improved rapidly with debt ratios now reaching developed world norms and the State reaching a primary surplus in 2015. By 2018 it is expected that we will have reached our medium-term objective under the fiscal rules. The Government has set out its intention to run a significant primary surplus (Government revenue minus non-interest spending) over the period from 2016 to 2021 totalling €12.6 billion. Additionally, given the average interest rate on our current stock of Government debt (3%) is lower than expected nominal growth rates of GDP (4.6%) over the period, both the debt ratio and the relative cost of debt servicing should fall significantly.
Recent OECD studies have gone into depth on the space Ireland has to invest in a manner which is debt neutral over the long-run. One study looked at the number of years during which a country could finance a permanent 0.5% of GDP stimulus by increasing its deficit, without raising its public debt-to-GDP above the value it would have had without the stimulus by 2040. Of the countries studied, Ireland had the highest such number at 6.3 years.
This is due to our below optimal initial level of capital stock, low public investment and our nominal growth rates outstripping the interest rate on debt. These factors together result in a growth impact of investment sufficient that a debt financed investment expansion can be achieved without long-term impact on debt to GDP. In other words, over the long-run investment expansion of 0.5% of GDP for 6 years would pay for itself.
2.4 Buoyant corporate tax receipts should also be ring-fenced for investment
Ireland’s corporate tax base has become increasingly volatile in recent years. This was underlined by the 33% headline GDP growth (26% in volume terms) and strong growth in corporate tax returns witnessed in 2015. The impact of this volatility on the overall tax base is the product of the relatively small and hyper-globalised nature of the Irish economy.
This extreme concentration of corporate taxation in a small number of, mainly multinational, firms means that policy issues affecting them can have serious fiscal consequences. Nevertheless, the Irish Exchequer has benefited substantially from the surge in corporate tax revenues since 2015 and it is clear that while future revenues may be volatile they were not once-off in nature. From an economic measurement perspective it is accurate to fully reflect the international business activity which has resulted in the corporate tax surge. This has implications for amount of resources available to spend in the annual budgeting process. Recognising the risk of future volatility in corporate tax revenues, the prudent fiscal policy approach is to make windfall corporate tax receipts available for spending only for capital projects and to avoid building them into the day-to-day spending base.
Although Government must remain the principal funder of national infrastructure projects, there is a need to embrace a greater diversity of funding and co-funding options. Commitment to using non-Exchequer funding models such as (Public Private Partnership) PPP has, unfortunately, never been lower. Ireland needs greater diversification in its non-Exchequer funding sources and these need to be fully integrated into long-term national infrastructure planning.
3.1 PPP should be the key delivery mechanism
Government needs to be ambitious in delivering a programme of infrastructural investment and PPP will increasingly offer a cost effective means of spreading public funding over a greater number of projects. In Ireland, PPP has been used as an active and successful model to date in the transport, education and civic building sectors. All projects procured to date through this model in Ireland have been delivered on or ahead of time and with no cost overrun exposure to the public sector.
Direct funding of infrastructure projects in areas where PPP has a considerable track record of delivery in this country is still occurring. For example, two PPP education contracts (Schools Bundles 4 & 5) achieved financial close in recent years. This will result in the building of nine new schools and one replacement Institute of Further Education. However, during the same period three Schools (non-PPP) bundles were awarded and funded from the Exchequer directly. These will deliver six new builds and extensions and remedial works to nine schools. The competition was run on behalf of the Department of Education & Skills by the NDFA. No reason was provided for not testing the marketplace through a competition for a Schools Bundle 6 programme to deliver these schools via PPP rather than direct Exchequer financing. A policy of explaining the funding structure selected for a given infrastructure project should be mandated across Government.
3.2 The current PPP pipeline is running dry
It is crucially important for Government to maintain an attractive PPP project tracker. Such a pipeline of projects will provide certainty to the market by presenting clear timelines for delivery of capital projects (e.g. procurement procedure, anticipated financial close, commencement of construction etc). This gives contractors notice of when they will be required to mobilise their teams and will result in competitive bidding processes. The current pipeline, however, contains only two projects likely to proceed to the procurement process this year.
The PPP pipeline is running dry. There are no new projects scheduled to come online following the two social housing bundles. The new Metro North initiative is currently the only project likely for PPP delivery in the medium-term. No timelines exist beyond the anticipated construction commencement date of 2021. In order to attract and maintain interest from international banks and investors in Irish PPP projects, a clear deal flow of infrastructure projects needs to be evident. An attractive PPP pipeline also offers visibility in terms of the specific timing for projects and the delivery approach.
3.3 The right projects will attract investment
Investment opportunities will increase over the coming years for the right type of projects. PPPs should be the key delivery mechanism for investment for new capital projects (2018-2021) and beyond. The current and future capital expenditure programmes should contain an ambitious new project pipeline. This can be achieved through:
3.4 Remove the arbitrary cap on PPPs
Government currently limits the annual cost of PPP payments to no more than 10% of total annual Exchequer capital spending. There is little evidence for how this was calculated. It is too vague to simply claim fiscal prudence as justification for this arbitrary cap. The net effect will be a reduced national capacity to address Ireland’s infrastructure backlog.
The 10% cap on PPP projects is set as a proportion of the total capital budget. The down-side of this is that in times where the Exchequer flows to investment may be limited there is a consequent squeeze on private investment. This accelerates the pro-cylicality of infrastructure development by taking sources of private financing off the table at the exact same time as public capital investment is falling.
3.5 New infrastructure plan needs to provide certainty
Reputational issues are intimately linked with access to external funding. Deferring high profile projects such as Metro North do not help market confidence in this regard. Infrastructure investment is a global marketplace and Irish projects compete for interest from contractors, investors and funders from across the world. Ireland is a very small market player internationally and companies may become reluctant to bid for Irish projects if Government is seen to behave in an inconsistent manner. For example, shifting previously promoted PPP projects to a direct funding delivery model (e.g. Garda Divisional Headquarters Project) conveys to the market a lack of Government buy-in to external finance.
Reputational damage from project abandonment may also have a negative impact of the availability of external finance for infrastructure investment, where interested parties simply move on to the next strong viable opportunity. The past two capital expenditure programmes postponed a number of high profile infrastructure projects. The rationale for this was that in the context of the public finances, it was difficult to proceed with major new projects such as the new prison, Thornton Hall, to be built via PPP. The A5 motorway project linking Co Monaghan with Co Derry and improving access links to Donegal was shelved. Whilst the Luas Cross City (formally Luas BXD) received the go ahead and will commence operations later this year, other flagship transport PPP projects have been deferred, effectively cancelled in the short-term. The current infrastructure and capital programme (2016-21) prioritises a new Metro North project linking Dublin city centre to the airport and Swords. However, the deferral of Dart Underground is extended into the “longer term” and will be “redesigned to provide a lower cost technical solution, whilst retaining the required rail connectivity”. Thus Government through the forthcoming capital programme should provide a clear statement in the medium-term on the status of all projects postponed/deferred. Indications should be given on whether they will be added to the PPP pipeline and early indicative timelines for doing so should be supplied.
3.6 The role of the European Investment Bank
Ireland must look to European Union sources for funding mechanisms. Ireland needs to build on its track record of successfully utilising cohesion funding to support economic development during the current and future rounds of funding. However, the European Investment Bank (EIB) represents an important source of funding for long-term capital investment. All options to attracting EIB financial support should be pursued by Government. However, EIB investment in Ireland is one of the lowest in the EU (Figure 7).
The EIB, with the European Fund for Strategic Investments (EFSI or ‘Juncker Plan’), offers a number of senior to subordinated and equity-type products to support strategic investment across Europe. Infrastructure, and enabling Member States to meet their commitments under EU2020 targets and beyond, is a key area for which EIB support can be accessed. Bank lending can be a substitute to Exchequer finance in PPP projects.
The EIB is keen to invest more in Ireland than ever before. The bank has recently opened an Irish office and has earmarked at least €1 billion annually to invest in Irish projects. Government must take advantage of the opportunities EIB funding could unlock in housing, health, education, broadband and other sectors. It has a track record in supporting PPP projects. It has lent a half a billion euro in funding specifically to seven Irish PPP projects since 2010. There is little doubt that the EIB will be interested in backing local and regional projects identified under the NPF, in addition to national infrastructure. This includes potential investment under the Joint European Support for Sustainable Investment in City Areas (JESSICA) and the Joint Assistance to Support Projects in European Regions (JASPERS) financial instruments.
3.7 Realise a public infrastructure dividend from sale of State assets
Any future sale or disposal of State assets should be conducted from the point of view of generating a public infrastructure dividend. Proceeds arising from the sale of State assets should be re-invested in infrastructure and not used for debt restructuring. For example, part-funding the construction of the new National Children’s Hospital from the upfront payment received for the twenty-year exclusive license to operate the National Lottery in Ireland. Likewise, in 2014 Government’s capital expenditure programme benefitted from an additional €200 million generated from the proceeds of the sale of the Bord Gáis Energy business and some of ESB’s non-strategic power generation assets.
Taxpayers should be considered shareholders in any potential asset sale or disposal. Public buy-in would be achieved through a direct assurance that the sale would directly support the provision of much needed infrastructure. Assets could be identified and prioritised according to public and national needs, including existing public infrastructure. Proceeds from asset sales would be hypothecated for infrastructure provision. This approach is successfully used globally (e.g. Australia). Direct reinvestment of proceeds would require alteration of the EU fiscal rules.
3.8 Diversification of funding streams
External finance should be recognised as a valuable source of inward investment, which in turn will assist in further boosting the attractiveness of Ireland as a location to do business. Trade missions to promote infrastructure investment opportunities should be replicated. These would complement the work by the NDFA and TII to promote infrastructure opportunities to international investors. On-going engagement needs to occur with international banks as well as institutional lenders from the pension and insurance sectors. All sources of external debt finance (i.e. bank, institutional, EIB etc) should be targeted to fund Ireland’s infrastructure needs.
It should be noted that Government has also taken a number of steps in providing additional sources of funding on commercial terms to support productive investment in the economy. This includes the establishment of the Ireland Strategic Investment Fund (ISIF), comprising the €6.4 billion discretionary portfolio of the National Pension Reserve Fund (NPRF), to support investment in key infrastructure projects in water, energy and next-generation telecommunications sectors.
3.9 Cross-border infrastructure projects must be able to access EIB and EFSI funding post-2020
Brexit will potentially impact on EIB activity. The UK is a large shareholder and has substantial projects and programmes funded by the bank. It is likely that the UK will be required to relinquish its EIB membership. This is unlikely to impact projects and payment plans already in place. Maintaining the existing level of involvement in the EIB would require treaty changes and unanimous agreement of Member States.
EU membership is not necessarily a prerequisite for accessing EIB funding. For example, the EIB funds projects in European Free Trade Area (EFTA) member countries. However, the UK has ruled out seeking EFTA membership. There is also precedence for funding projects in peripheral/border countries and regions. This has generally been used to support economic stability and cohesion neighbouring countries, as well as supporting those wishing to work towards EU membership. To extend this to the UK would require agreement by the remaining EU members States (i.e. EIB shareholders).
Regardless, projects already in the planning pipeline may be impacted by the uncertainty cast by Brexit. This affects Ireland due to EIB funding being earmarked as a source of finance to support must needed cross-border infrastructure. These include key transport projects to enhance accessibility and connectivity such as the A5 and A6 connecting Derry and the north west to Dublin and Belfast. New projects in Northern Ireland can only be funded through the EIB or European Fund for Strategic Investments (EFSI) if Ireland is involved. However, access to EIB finance only applies to our contribution but this should be extended to the non-EU partner as well. Clarity is needed on projects that have a significant cross-border dimension that will support the competitiveness of a Member State.
4.1 Prioritisation process
In terms of assessing the value of a particular project, a number of factors should be taken into account. In recent years the short-term needs of the economy took precedence when selecting projects. With the turnaround in the economy, Government now has an opportunity to take a longer-term view and put emphasis on projects based on strategic importance. The key drivers of project selection should now be to address supply side bottlenecks rather than investment for stimulus.
We must also be cognisant of providing value for money. In the past, cost-benefit analyses were produced on all major infrastructure projects, but these happened very much in isolation from each other and did not necessarily provide like-for-like information to aid project selection. Ibec has in the past argued that business cases or cost-benefit analyses should be done in a systematic and comparable manner across the entire public capital envelope.
Projects should be prioritised according to the impact they have on reducing Ireland’s cost base, enhancing the economy’s productive capacity by removing bottlenecks or expanding infrastructural capacity to facilitate demographic change. Investment in strategic infrastructure may also be necessary to facilitate Ireland’s compliance with binding national, EU and international obligations and targets. In addition, the capital plan must be coherent with existing strategies and action plans, including those on aviation, ports, energy and rural development. The most comprehensive and important of these is the NPF.
4.2 Policy cohesion with the NPF
Ibec warmly welcomed the development of the NPF. However, we would caution that to realise the desired outcomes over the period to 2040, the Government must implement the Framework more effectively than its predecessor, the National Spatial Strategy (NSS).
One of the key failures of the NSS was that it played little more than a piecemeal role in informing later capital plans. This cannot be allowed happen within the current framework. Without cohesion across policy, both plans will fall short of potential resulting in lower value for money for the taxpayer. With this in mind, two of our priorities for spatial development in the NPF are particularly relevant for the capital plan.
Firstly, the Government must provide investment certainty. Effective spatial planning is a long-term project. Germany, for example, introduced its Federal Spatial Planning Act which focused on ‘decentralised concentration’ in 1965. This underpins all areas of Government policy and has been effective in limiting regional disparities despite major challenges. It is important that decisions made now are not undermined or ignored in a number of years. Business investment will be driven by certainty and constant change in regional planning or poor adherence of the capital plan to the new NPF will result in lack of certainty for regional investments.
Secondly, there must be coherence across policy and place based policies. Irish industrial policy, for example the framework underlying our successful FDI model, has been primarily concentrated on a ‘horizontal’ approach – across all of the country – rather than the ‘vertical’ in terms of regional policy. A focus on productivity and growing exporting industries of scale is needed in the regions. Key to this is access to adequate connective infrastructure. The new planning framework must be the basis underlying a more cohesive regional infrastructure policy into the future. Given the impact of Brexit on the regions, it is important that this is reflected in the mid-term review of the Capital plan.
There has been a two-speed economy over the past few decades. Judged by a diverse range of economic indicators, Dublin and the Eastern Region have consistently outperformed the rest of the country. This partly reflects the absence of effective policy measures to achieve the full potential of each and every region. During the period up to 2008, there was considerable investment in road transport connections between the capital and most of the regions. However, the motorway network was never completed and the regional cities themselves remain poorly connected to each other. This makes it more difficult for them collectively to provide an effective counterweight to Dublin. Without investment in infrastructure (be that connective or skills based) the regions will continue to lag in terms of productivity growth and Dublin will continue to grow in dominance. Spatial development cannot be seen as a zero sum game. A failure to address regional infrastructure deficits will lead to continued growth in diseconomies of scale such as housing costs, urban sprawl, congestion and pollution in Dublin. It is also particularly important that the NPF is seen as an opportunity to imbed a more systematic all island planning and provision approach to the connectivity requirements of business and citizens on the island of Ireland.
The Irish economy stands at a critical juncture. It has just come through the greatest crisis in the history of the State and still bears the scars of a lost decade for fiscal policy. The business economy has roared ahead over much of this period, however. Initially driven by the success of indigenous exporters and the acceleration of investment by foreign owned firms, and more recently by a broad based recovery right across the domestic economy. Ireland is now one of the most globalised and again one of the most successful and prosperous countries in the World. As evidenced by the recent publication of the CSO’s new economic metric -GNI star – economists will argue about the full extent of the benefits of the most recent globalisation boost accruing to Irish citizens. The clearest evidence of this lies in the surge in corporate tax receipts, strong investment by firms and crucially record levels of employment. The benefits of globalisation are at the disposal of policy makers but they must be used prudently and in a manner which supports competitiveness and prosperity without exposing the public finances to future economic shocks.
Brexit is going to pose particular challenges for regional and rural areas. The reliance of these areas on the agri-food, traditional manufacturing and tourism sectors means the percentage of employment exposed to Brexit threats is six times greater in some rural counties to that in Dublin. In Cavan, for example, almost one third of all employment is in Brexit exposed sectors. Infrastructure investment is a proven policy instrument to reduce regional disparities, enhance competitiveness and support sustainable business and employment growth.
In urban areas, and particularly in Dublin, Brexit will bring many opportunities but we are currently not well positioned to maximise these. Our cities are creaking at the seams due to housing shortages, congestion and other quality of life challenges. International business is very positive about the benefits that Ireland offers in relation to the quality of talent and the ease of doing business but needs to be convinced that we have the capacity to absorb additional investments of scale.
As we seek to deliver a National Planning Framework to shape a better Ireland by 2040, we have a once in a generation opportunity to achieve a well planned, world class stock of infrastructure which will underpin our future success and prosperity. We can do this by:
Despite the interruption of the crisis years, Ireland has clearly become one of the World’s most successful economies. If we make the right decisions now, this success can be sustained and its benefits can be more effectively shared regionally and across society. Increased infrastructure investment will insulate the regions from the worst effects of Brexit and can ensure that opportunities are grasped with both hands. External uncertainty is a feature of the globalised World but we can take back control by having an ambitious plan for the drivers of growth which we shape ourselves.
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