Economic downturn

In an uncertain financial climate, the Sector needs to look at existing funding streams and consider what the likely impact of a recession may be on these. One area of interest is the Lottery. Is it recession proof?

Unsuprisingly there is little UK evidence due to the relatively short time the Lottery has operated in this country. However, evidence from the US suggests that Lottery spending may not necessarily decline in a period of hardship. In fact, an article I read recently quotes research by John Mikesell, a professor at Indiana University published in 1994 showing that from 1983 to 1991, lottery sales tended to rise with unemployment rates.

However, the same article goes on to refer to a survey of regular players by Independent Lottery Research, a consulting firm based in Chicago, which found that last month 20 percent of them were already playing less or buying less expensive tickets.

Either way, a combination of this uncertainty and less Lottery money followng the diversion of funds to support the Olympics, makes the need for VCOs to diversify their income streams, ever more important.

Details of the article:
New York Times, September 13, 2008 – Sweet Dreams in Hard Times Add to Lottery Sales

The Pre-Budget report published by the Treasury last Monday outlines a number of changes to try and kick-start the economy, and provide a buffer from further misfortune. You can read various reations to the pre-budget report here:

Institute for Fiscal Studies

Deloitte analysis

PricewaterhouseCoopers

How small businesses have benefitted

What the Pre-Budget means for your region

And a bit of a green tint on it: policy think tank Green Alliance’s response has some interesting comments on the implications for fuel poverty and social housing.
If you have read any other reports that analyse the impact, why not add them to the list?

I recently read some research which found that the most trusted source of information on the economic situation is not the Prime Minister or even the Chancellor of the Exchequer, but the BBC’s business editor, Robert Peston. This raises interesting questions about trust in institutions and where people get their information about events impacting on their lives. Something to think about for information providers?

A good point of reference is the Sustainable Funding Project which offers a range of information and practical resources that enable VCOs to explore their income base, and develop new skills to manage income and expenditure more effectively and efficiently.

SFP has detailed information regarding financial management and case studies of organisations implementing a sustainable income approach.

We have also outlined 5 tips for VCOs to survive and thrive in the economic downturn.

The financial times has carried out a series of interviews with what they term ‘chief protagonists’ of the credit crunch about their thoughts on what happened, and how they think finance will change when the economy recovers. Some interesting viewpoints and well worth a watch

The Local Government Association has just published a report, ‘From Recession to Recovery: the Local Dimension’ that analyses the local effects of a recession and the impact of the economic slowdown on towns and cities, regions and sub-regions in England.

The report predicts the following:
- The hardest hit industries will be construction and manufacturing whilst high skilled industries look set to remain relatively unscathed.
- The recent growth of big northern cities means they are relatively well placed to cope with the effects of the recession.
- Almost two in five jobs that could be at risk over the next two years are in London and the South East.
- Even within specific regions there are likely to be marked differences in how particular localities fare.

It warns that a national, blanket policy to deal with the recession will be unable to target help effectively to specific areas. Instead, it calls for as many economic decisions as possible to be taken at a local level to ensure that local solutions can be found to local problems. As major employers, purchasers and providers, the report argues that councils are best placed to revive local economies and help people in need.

As the real economy moves into recession, we can now see how governments around the world are responding to the crisis. In general, there has been a bail out of the banking sector around the world. This has been coupled to a loosening of monetary policy as interest rates have been aggressively reduced, along with the announcements of relatively large fiscal stimuli. We have yet to see whether this action alone will be enough to mitigate the worst effects of the incipient recession. While we wait for the unfolding of events, we might be usefully engaged in giving some consideration to the longer term impact of these policy changes.

Most attention in the UK has been directed at the size of the fiscal stimulus. Two factors dominate the conversation – the amount that needs to be borrowed and how will it be paid back. Indeed, there is currently a very public row between the UK and German governments about the wisdom of such large borrowings, which, in turn, is feeding into the domestic political agenda. The more critical reviews of policy estimate borrowing to be in the region of £1 trillion (see article). This is highly unlikely to happen and represents more of a political calculation rather than a financial one.

We ran some scenarios based upon the recent Pre-Budget Report, and we estimate borrowing to be in the region of £355 billion over the next 8 years. Interestingly enough, Barclays Capital estimates total borrowing at about £370n billion over the next 7 years. This suggests a more reasonable order of magnitude. Of course, all estimates are, at the present, quite speculative. The duration and severity of the incipient recession will have a greater role to pay on the actual outcome, and, at present, this factor is a critical unknown.

The estimates presume that the economy will continue into recession until the middle of 2009, with unemployment peaking at about 2.25 million. If the recovery is delayed until 2010, or if unemployment rises appreciably beyond the forecast levels, then the automatic stabilisers (lower tax receipts and higher unemployment benefit payments) will push the borrowing requirement beyond the current projections. Of course, if the base assumptions turn out to be unduly pessimistic, then the opposite will occur. At present, the pressure valve to the economy is the Sterling exchange rate, which has been allowed to fall with something of a public outcry, but without too great a policy response. This gives rise to hopes for exports playing a role in the recovery.

Irrespective of whether the estimate for PSBR is higher or lower in the coming years, the point remains that the government will undertake record levels of borrowing, which will have to be repaid. This raises the question of where the money will come from to repay the debt. We feel that the situation is not as bad as has been painted. The government has bailed out the banking sector to the tune of £37 billion (with borrowed money). The bailout has been implemented by taking 12% preference shares in the UK banks. We like the horizon of 8 years because, in that horizon, at 12% return, the £37 billion will have been repaid in the form of a preference dividend. You should note that these figures are averages – a holding that averages at 8 years in duration and which pays an average of 12%. However, on this reckoning, the original loan taken out by the government more or less can be repaid from income, leaving the Treasury holding 12% preference shares that cost £37 billion.

How much are these preference shares likely to be worth in 2017? Supposing that Base Rate normalises in 8 years at an average of around 4%, then the CAPM valuation model would suggest that the capital value of UK Financial Investments Ltd (the vehicle through which the Treasury owns the preference shares) would be in the region of £110 billion to £120 billion. This was the basis of our view that UK Financial Investments Ltd should become a Sovereign Wealth Fund (see note). However, as this sum represents about a third of the additional PSBR, one can see that the Kid’s Inheritance could well be spent upon repaying the new borrowing.

Furthermore, in a previous post (see post) we speculated that the New Normal would lead to greater supervision of the banking sector. One way in which this supervision will manifest itself is through tighter capital adequacy rules and tighter liquidity requirements. As a consequence of this, the banking sector will be required to hold a greater percentage of their asset base in gilts. The Financial Times estimates the additional gilt requirement for the UK banking sector to be in the region of £90 billion to £350 billion (see article), which raises the oddity of the Government lending the banks the money which they banks use to lend to the Government. Either way, this represents a further chunk of the additional PSBR being covered.

Finally, as equity markets fall across the world and as the global economy heads into recession, pension fund managers will be worrying about their long term commitments to pay a steady stream of income. One technique to allay those fears is to switch from the volatile income stream associated with equities into the more certain income stream associated with gilts. Of course, this gives rise to the perverse situation of pension funds selling equities at the bottom of the market and purchasing gilts as they become relatively dear. However, in terms of PSBR, this will put further demand into the gilts market. We are currently unable to estimate the extent of this demand – it depends upon how bad the equity markets become – but we could expect the figure to be in tens of billions of pounds.

Already we can start to see how the additional PSBR will be funded. Most of it will be funded by the banking sector as a consequence of greater state supervision and involvement in the sector. Politically, this is a good message that can be given to voters. The banks – who many hold responsible for causing the economic turndown – will have to pay to clean up their own mess.

The UK case has wider significance for two reasons. First, the UK government feels that it has been something of a thought leader in the G8 on how to respond to the current turmoil. There is something to this claim. The US, who ordinarily would take the lead, has been unable to do so because of the political paralysis caused by a change of President. In many respects, President Elect Obama, when he assumes office in January, will be playing catch up to the rest of the world. If the forecasts of the recovery starting in mid-2009 are correct, then the US is unlikely to gain the initiative in combating the recession. The resulting institutional structures could well have a distinct European feel about them. Perhaps Mark Leonard is right? (See Reference).

The second point to note is that we are discussing the response to the recession unwinding over the next decade or so. We are now only coming to realise that the immediate planning future has changed, and that a New Normal is emerging for the coming decade. This has yet to permeate into corporate planning structures, and when it does we might see a different approach to business emerging.

The impact of the credit crunch is likely to be with us for some years to come. Let us hope that, in dealing with it, we do not have to spend the Kid’s Inheritance.

This post was reproduced from The Futurist the Blog of The European Futures Observatory (www.eufo.blogspot.com)

Although aimed at businesses, this article from the Economist about managing in a downturn highlights the importance of cash to boost an organisation’s liquidity and ward off other economic problems in this era of no credit. The future success of many businesses is now increasingly dependent on how much cash investors can see in the coffers, and with the majority of VCOs having low reserves, these tips for how to preserve cash in the current crisis might come in handy to some organisations:

• Stretch out the payments on bank debt to preserve cash – organisations should also look out for opportunities to refinance existing loans early to give themselves greater financial flexibility.
• Try and generate more cash from existing operations – take a hard look at how you run areas such as finance, HR and technology. Outsourcing may also be a cheaper option.
• Try and release some cash trapped in day-to-day operations – make sure any products ordered are forecasted and planned properly so you don’t end up with unwanted stock.

However, the article warns against taking the phrase ‘cash is king’ to its extreme, pointing out that there is a risk that in a rush to build up mountains of cash too quickly, cuts may be made too fast and too deep when a more targeted approach is needed. There are a few areas where the article advises caution:

• Leave the technology budget alone – according to McKinsey Quarterly, technology budgets are often a favourite place to make cuts but indiscriminate chopping will be more damaging than ever before because IT systems are now often tightly interwoven with everything in an organisation.
• Be careful not to choke off investment in promising new products or services – paradoxically a recession can be a fantastic time to launch innovation. Tougher times can make consumers or indeed funders reconsider many of their purchasing decisions, leaving them open to trying something new. A less crowded marketplace also makes it easier – and cheaper – to create awareness of a new offering.

The article suggests that having plenty of cash can help businesses or organisations emerge not just having “survived the storm but having changed the game”. Any organisation who wants to succeed in the downturn will need to have the financial resources to seize any opportunities that arise during it and if they can do that, there are likely to be many rewards to be reaped in the future.

Another interesting newsletter from campaignstrategy.org – and relevant to the current economic climate – talks about why political communicators, governments and campaign groups need tax and why and how we can re-frame the issue of tax.

“We…need a new and more positive way to talk about tax”, says Chris Rose of campaignstrategy.org, arguing that “…instead of just advocating what governments should do in terms of delivery objectives…NGO campaigners should utilise their political advocacy networks to help reframe the tax that is needed to create the wherewithal for government spending.”

Do read the newsletter – what do you think and how might this affect your organisation?