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ITEM CG6

EXECUTIVE – 17 FEBRUARY 2004

TREASURY MANAGEMENT STRATEGY FOR 2004/05

Report by Head of Finance

Introduction

  1. This report sets out a Treasury Management strategy for the authority for the financial year 2004/05. The Council has customarily considered an annual Treasury Strategy Statement under the requirement of the CIPFA Code of Practice on Treasury Management, which was adopted by this Council on 1 April 2003. The Prudential Code for Capital Finance in local authorities has introduced new requirements for the manner in which capital spending plans are to be considered and approved, and in conjunction with this, for the development of an integrated treasury management strategy.

  2. The Prudential Code requires the Council to set a number of Prudential Indicators, certain of which replace the borrowing/variable interest limits previously determined as part of the strategy statement, whilst also extending the period covered from one to three years. This report does therefore incorporate the indicators to which regard should be given when determining the Council’s treasury management strategy for the next 3 years. The Indicators are shown in Annex 1.

  3. The suggested strategy for 2004/05 in respect of the following aspects of the treasury management function is based upon the Treasury Management Strategy team’s views on interest rates, supplemented with leading market forecasts. The strategy covers:

    • the current treasury position;

    • proposed changes to the Councils debt portfolio;

    • prospects for interest rates;

      • the borrowing strategy;

      • the investment strategy.

  1. Regulations under the Local Government Act 2000 reserve the approval of any "… plan or strategy for the control of the authority’s borrowing …" to the full Council. This description applies to a substantial part of this report, which should accordingly be referred for comment to the Corporate Governance Scrutiny Committee for comment before the Executive makes a formal recommendation to Council, in accordance with the Budget and Policy Framework Procedure Rules set out in the Constitution.

    2. The current treasury position

  2. The Council’s Treasury portfolio at 28 January 2004 comprised:

    3. Average Rate

    Fixed Rate Funding PWLB £230m 5.40%

    Money Market Investments were £63.9m, these include approximately £18m pension fund cash. During the year to date the average daily investment balance was £67.1m.

    Proposed changes to the Council’s debt portfolio during 2004-05

  3. The Council’s overall debt is projected to increase from £244m from April 2004 to £297m at 31 March 2005, which is a net increase of £53m. This reflects supported and unsupported borrowing approvals from the Government. In addition to the increase in debt, the Council has £5m PWLB loans maturing, which need to be replaced. From 2004/05 there will be no formal quota system for borrowing from the PWLB. Councils can determine their own borrowing requirement under Prudential Guidelines subject to this being consistent with the Prudential Indicators which the Council are required to approve.

    4. Prospects for interest rates

    Shorter-term rates

  4. Base rate was cut by 0.25% in July 2003, to a new 48-year low of 3.5% due to hesitant recovery after the Iraq war and a climbing pound. With hindsight, this now appears to have been an over cautious move by the Monetary Policy Committee (MPC) as this cut was reversed in November. However, the Chancellor announced a switch of inflation target for the MPC in the pre-budget report in December 2003 from plus or minus 1% around 2.5% on RPIX to plus or minus 1% around 2% on CPI (consumer prices index; this was formerly known as the harmonised index of consumer prices). CPI has been running at 1.1 – 1.6% throughout 2003 and is forecast to average 1.4% in 2003, 1.7% in 2004 and 1.4% in 2005 i.e. below the likely target.

  5. In addition, wage inflation and producer price inflation are running at benign levels and oil prices are likely to come down from current high levels. Therefore, there is likely to be little inflationary pressure to raise base rate. In addition, the upside potential for base rate is limited by the heightened sensitivity of consumers to interest rate rises due to the huge increase in personal borrowing in recent years e.g. an increase in base rate from 3.5% to say 4.5% is an increase of 29% in likely borrowing rates. In view of the likely fragility of consumer demand in 2004 in the UK, and due to the likelihood of growth in the Eurozone in 2004, it is expected that base rate will only rise to 4.25% by the end of 2004 after being at 4% for most of the year. Annex 2 shows a summary of a number of current city analyst forecasts for short-term interest rates.

    6. Longer-term interest rates

  6. PWLB rates were at low levels during the first half of 2003 due to investor fears over the Iraq war which depressed share values and gilt yields. Equity values have increased by about 25-30% from the low point to which they plummeted before the Iraq war, on expectations that the surge in economic recovery in the second half of 2003 will last well into 2004 and beyond and so boost corporate earnings. Gilt prices have consequently fallen, causing increases in gilt yields and long-term PWLB rates which incurred a sharp unexpected increase in October 2003 on a surge in optimism on US economic recovery; this pushed the PWLB 20-25 year lower quota rate up to 5%-5.15% and it is forecast that this rate will stabilise around 5% for most of 2004/05.

    7. Borrowing Strategy

  7. The principal objective for the management of debt is to borrow at the most advantageous terms for the authority in order to finance the capital programme, to achieve, the lowest level of interest payable and to minimise the volatility of the average rate of interest.

  8. Opportunities to repay existing PWLB loans early will be taken if it is demonstrated that there are guaranteed savings and only where prematurely repaid debt is replaced with debt of a similar maturity period.

  9. It is intended that most of the authority’s borrowing during 2004-05 will be medium or long term PWLB fixed rate loans, in order to minimise interest rate risk. However, while short-term variable rates are expected to rise during the year in line with increases in base rate they are likely to continue to be cheaper than long-term PWLB fixed rates.

  10. Money Market institutions are able to provide alternatives to long-term PWLB borrowing in the form of Lenders Option/Borrowers Option loans (LOBOs). These instruments have a fixed initial term (typically one to five years) and then move to an arrangement whereby the lender can decide at pre-determined intervals to adjust the rate on the loan. At this stage the borrower has the option to terminate the loan with no penalties. It is a strategy that several local authorities have adopted.

  11. In order to achieve Best Value for the authority, the Treasury Management Strategy team is considering the use of LOBO loans as an alternative to PWLB. LOBO loans can be raised at significantly lower rates of interest than those currently offered by PWLB. LOBOs attract an element of interest rate risk because it is only the initial period that attracts a very low fixed rate. However, the authority can manage the risk by using a strategy of repaying the loan as soon as the lender exercises his option to increase the rate.

  12. If a LOBO loan is repaid when the lender increases the interest rate, the borrower does not incur any penalties. The disadvantage of a LOBO loan is that if the borrower wishes to repay during the fixed rate period or at any time other than when the lender wishes to increase the rate, then penalties will be charged.

  13. LOBOs can be used to the authority’s advantage, particularly if they are treated in the debt maturity profile as loans that are likely to be repaid at the end of the fixed rate period. It is recommended that the Council approve the use of LOBO loans, up to a maximum of 25% of the Council’s external debt over time, but with a maximum of £10m in 2004/05. This will be kept under constant review.

    14. Investments Strategy

    Security of Investments

  14. The Council’s in-house investments will be in specified sterling instruments in compliance with the authority’s approved lending list, for periods of less than 365 days.

  15. This Council subscribes to the FitchIBCA credit ratings service to establish the credit quality of counterparties and investment schemes. The Council has determined the credit criteria it deems to be "high" for each category of investment and only lends to top rated institutions.

  16. Ratings of the following institutions have been upgraded by the ratings agency and currently fulfil the Council’s criteria; it is recommended that the Council approve their addition to the authority’s approved lending list:

    • Australia and New Zealand Banking Group

    • Rabobank

    • Development Bank of Singapore

  1. It is intended to undertake a full review of the lending list during 2004-05, to ensure that the current approved rating criteria and lending limits remain appropriate for the authority. Any rating downgrading that results in a counterparty no longer meeting the Council’s minimum credit criteria will be immediately removed from the lending list.

    2. Liquidity of Investments

  2. Any investment decision will have regard to the Council’s cashflow requirements. There will be a mix of maturity periods at any one time. However, it is intended that 100% of the Council’s in-house investments will be short-term, ie for periods of less than one year. The Council has appointed an external manager to provide diversity in investing Council funds. The Council set a benchmark of 70% cash/30% gilts for its externally managed funds. A sum of £15m was given to them to manage in 2002.

  3. The money market yield curve is currently anticipating a rising base rate for the next year. This authority will aim to invest for longer periods when it considers that the markets expectation of base rate is too high. Investments will be kept short (under one month) when the Treasury officers expect a rise in base rate.

  4. The Council has traditionally invested short-term cash surpluses predominantly in fixed rate deposits. At maturity these are repaid to the Council, to meet cashflow demands or can often be rolled over for a further term at a new agreed rate of interest. The authority’s current lending list is very restrictive because many institutions that meet the Council’s criteria will only deal in very high value deposits, above the Council’s lending limits. This reduces the number of available counterparties and restricts the authority’s ability to diversify investments. However, while these institutions do not accept small fixed short-term deposits some will deal in accumulator deposits.

  5. Accumulator deposits require the lender to lend a fixed sum on a specified date every month, for a fixed period. On each of the monthly payment dates the borrower repays accumulated interest and has the option to repay the loan. Accumulator deposits attract higher rates of interest and are particularly attractive when base rates are expected to rise.

  6. In order to increase the Council’s investment returns, while maintaining the same level of investment security, accumulator deposits may be used during 2004-05. Accumulator deposit terms will be agreed within the Council’s approved lending limits (up to a maximum of £10m) and with regard to cashflow and interest rate forecasts.

    7. External Cash Fund Management

  7. The Council’s appointed fund managers, Alliance Capital, manage funds on behalf of the authority. The fund management agreement between the Council and the manager formally documents the instruments they can use within pre-agreed limits.

  8. The Council monitors the external fund and has appointed SECTOR to provide independent advice on the funds performance and the suitability of the benchmark. At the time of this report the fund is achieving the benchmark set by the authority and SECTOR consider that the fund manager is performing well in comparison to other similar funds.

  9. While 2004-05 is expected to be a poor year for returns on gilts, these investments are intended to be treated as longer-term and generally outperform the cash market over 3 years. Investments in the gilt market also offer the benefit of diversification of the authority’s investments. There are therefore, no immediate plans to change the 30% gilt and 70% cash benchmark set for the fund. However, the fund will be closely monitored during the year and the benchmark may be revised, if it is considered to be in the best interest of the authority.

    10. RECOMMENDATIONS

  10. The Executive are RECOMMENDED:

          1. subject to (b) below, to endorse the proposed Treasury Management Strategy 2004/05 set out in the report and in particular the proposals for:

            1. an increase in external debt by up to £53m to finance the capital programme;

            2. the addition of the named banks in paragraph 20 to the Council’s lending list;

            3. the use of Lenders Option/Borrowers Option loans to finance the capital programme, with a maximum limit of £10m in 2004/05;

            4. utilisation of accumulator deposits to improve investment returns subject to a £10m limit; and

            5. the Prudential Indicators in Annex 1;

          2. to refer the report to the Corporate Governance Scrutiny Committee for comments with a view to making a recommendation on the strategy to the April 2004 Council.

CHRIS GRAY
Head of Finance

Background Papers: Nil

Contact Officer: Donna Ross Tel: Oxford 815684

February 2004

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