Excessive returns on projects at home could put pressure on the National Pensions Reserve Fund, writes Philip R Lane.
The National Pensions Reserve Fund (NPRF) recently published its 2004 Annual Review. The report showed that the value of the fund now stands at €11.689 billion (9.6 per cent of GNP), having earned a 9.3 per cent return during 2004.
It also contained the news that the fund is modifying its investment strategy, with increased portfolio allocations to property, private equity and commodities. In addition, it confirmed the fund's continued interest in investing in public-private partnerships (PPPs): indeed, it has already become involved in a consortium (along with National Toll Roads, Ascon and ACS/Dragados) that is bidding for the project to upgrade the M50.
However, these developments carry several warning signals for public policy. The NPRF's involvement in bidding for the M50 project has already led to an entirely predictable conflict of interest within the multi-branched remit of the National Treasury Management Agency (NTMA).
Since the NTMA provides staff to both the fund and the National Development Finance Agency (NDFA), the announcement of the fund's entry into the M50 competition forced the NDFA to withdraw from advising the National Roads Authority on obtaining the best financial deal for the project.
In effect, in line with its mandate, the fund is interested in maximising the commercial return from a PPP project, whereas the NDFA was planning to offer its advice on how to get the lowest-cost financing for the very same project. How could these two objectives possibly be reconciled?
From a public policy perspective, it is striking that the conflict of interest in this case was resolved by the withdrawal of the NDFA, rather than the exit of the fund from the PPP competition. Although a "Chinese wall" arrangement within the NTMA means that these agencies do not co-ordinate decisions, the net result is that the fund's goal of obtaining the maximum private return from the PPP project has received priority over the NDFA's mandate to obtain the best financial deal for the State.
In further recognition of the conflict of interest, the fund has announced that it will change its method of entering future PPP competitions: rather than joining forces with one consortium, it will express a willingness to enter financial negotiations with whichever turns out to be the winning consortium.
However, this is not a complete resolution of the problem.
The inescapable constraint that binds the fund is that it is an arm of the State, not a private entity. As such, it faces a wide range of difficulties if its gets involved with PPPs in Ireland.
The recent controversy over the substantial profits earned by National Toll Roads on the Westlink Bridge highlights the political and media heat that can be generated if the private return on such projects is perceived as excessive.
The pressure would be much more intense if the project consortium involved a State-owned entity: one can envisage political arguments about the desirability of paying high tolls in order to help finance the pension liabilities of the State!
Another potential problem relates to the financial negotiations among the firms forming a PPP consortium.
For instance, what would be the view of the fund of a contractual arrangement that, although perfectly legal, serves to minimise the tax liability of the consortium?
These examples illustrate a general principle: the fund can minimise the politicisation of its allocation strategy by concentrating on foreign investment opportunities and avoiding significant involvement in the domestic economy. This does not threaten the funding of PPPs in Ireland: for instance, the NDFA is equipped not only to provide financial advice but also to provide direct funding to qualified projects.
The principle also applies to the fund's entry into the private equity sector: again, imagine the political opprobrium if the fund had been involved in the private equity consortium that took Eircom private and subsequently refloated it at a massive profit.
In making these criticisms, I am not against the decision to move into a wider range of asset classes. Indeed, other long-term funds (most famously, Harvard University's endowment fund) have demonstrated that substantially higher returns can be obtained by investing in such less-liquid instruments. However, there are many such opportunities in overseas markets and there is too much downside risk in the fund becoming an active investor in domestic projects.
Moreover, the general set-up of the fund has many desirable features.
The establishment of such a large fund has been an impressive logistical exercise and its operation is highly professional.
However, the difficulty goes back to the legislation that mandates the fund to operate on a commercial basis, with the goal of maximising the financial return (subject to prudent risk management).
For a State-owned entity, the definition of risk has to include "political risk". For the fund to fulfil the important long-term policy goal of moderating the burden of ageing and increased future State-financed pension payments, it must ensure its political viability.
This is threatened by its unnecessary involvement in major investment projects in the Irish economy.
Philip R. Lane is professor of international macroeconomics and director of the Institute for International Integration Studies (IIIS) at Trinity College Dublin. The views expressed are personal.