Should the UK create a post-Covid Sovereign Wealth Fund?

Soon, the short-term credit being lent abundantly to Britain’s small and medium firms to stave off bankruptcy during the shutdown will be due to be repaid. The prospect of this forcing many businesses to shed jobs by the thousands is rightly ringing alarm bells. The can could be kicked down the road for a few months by postponing repayment. But the people who kicked the can would still have to confront the problem. They would find that firms saddled with accumulated short-term debt, and revenues that remain reduced, will want to shed workers.

The latest proposed solution, initially proposed in the Financial Times, is that these short-term liabilities should be converted into state-owned equity and handed to a new national Sovereign Wealth Fund, like those of Norway, Singapore and Saudi Arabia. Momentarily it sounds like a masterstroke: in the teeth of despair, not only are firms liberated from the new debts, but in the process we create wealth. Like many propositions that sound too good to be true, there is a downside. The state would instantly own a slice of thousands of small firms – and some major ones. Whitehall is already wildly overstretched in its attempts to micromanage our society, and letting its fingers reach into thousands of firms would only make things worse. As for the appealing glamour of those words ‘Sovereign Wealth Fund’: inevitably it is a conjuring trick.

‘Wealth’ sounds uplifting at a time of unprecedented economic contraction, but it is a new form of ‘magic money tree’. There is no new ‘wealth’: all the publicly acquired equity would be matched by cancelling firms’ new debts, and so would need to be financed by selling more government bonds. The net change in assets would therefore be zero. Nevertheless, debt-financed purchases of equity can make sense: it is fully consistent with fiscal conservatism, as I argued here. Indeed, the strategy should be revenue-positive. With long-term government borrowing costs so low, the cost of servicing the debt would be negligible, while once the economy recovers, the debt service would be more than covered by the return on the new equity. Historically, it has been around 6 per cent, and somewhat higher for equity in smaller firms. It would without cost get firms back to safety, but ‘wealth?’, sorry.

Calling it a ‘Fund’ would also be pretentious illusion. It would not be a Fund in any way analogous to those of Norway, Singapore and Saudi Arabia. They hold vast claims on foreign economies through having saved government revenues and invested them in global public equity and bonds. A UK fund would consist entirely of holdings of equity and long-term debt in domestic firms. And it would not even be ‘Sovereign’ in the grandiose sense of actively managing a global portfolio.

But having shown the danger of an overweening state, and doused the glamour, it is time to move on. This really bad proposal has within the germ of a really good one.

Britain needs successful small firms as never before. A post-Covid economy will look different in ways that we cannot yet fathom. For the moment decisions are on hold: a tracking survey that examines the words used in public briefings of shareholders by chief executives finds that this month the most common single word they are using in connection with Covid is ‘uncertainty’. But decisions won’t stay on hold for much longer. Such a profound economic shock is likely to change people’s spending habits. Many firms will need to adjust to permanently lower demand, and some will go out of business. The Treasury should not prop these firms up for long: subsidising failure was the policy of the 1970s. But as they contract and exit, with them will go many thousands of jobs. If this is not to return Britain to the days of high unemployment and deepen despondency in the regions, these job losses will need to be countered by the emergence of many new ones. As spending habits change, many new opportunities will open up. But they cannot be predicted or generated from Whitehall. Spotting them and converting them into jobs is the role of local entrepreneurs. But whether the ideas of entrepreneurs turn into innovation and expansion depends upon whether they can get growth-oriented finance. We will most need these successful new firms in the poorer regions: how else will levelling-up occur? In contrast to New Labour’s strategy of Benefits Street, levelling-up aims to generate productive jobs in the places where they have been lost. That is why the Conservatives have a majority.

Yet currently, small firms in the regions are in no position to finance expansion and innovation. Their balance sheets have already been weakened. Equity finance is what they need: the weakness of the Sovereign Wealth Fund proposal is not the conversion of short-term debt to equity and long-dated loans, but how those holdings would be managed. Putting equity and debt into a small firm locks an investor – in this case the government – into a long-term commitment. This only makes sense if it is matched by thorough knowledge of the firm’s management and prospects, and this comes from being locally-based and having a long-term relationship with it. Whitehall does not have this knowledge, but despite Britain’s bloated financial sector, nor do our London-based banks and wealth managers. Like the Treasury, they are far-removed from local knowledge and their financing horizons are short-term. Their offer to small firms is overdrafts backed by collateral, which is suitable only for working capital.

We have twice had periods of pro-growth local finance. In the 19^th Century, banking was local – it was only centralised in London by the Bank of England early in the 20th Century. By the 1930s we realised we had created a problem: small firms couldn’t raise finance for growth, and a solution was agreed. With the War interrupting, it had to wait until 1945 to be implemented. The Bank of England, in collaboration with the clearing banks, launched ‘3i’ to hold the equity and long-term loans of small firms. It was decentralised through delegating authority to local branches, whose staff were expected to develop a real understanding of their clients’ businesses. It grew to become Europe’s most successful venture capital firm and endured in that form until 1990, when the Treasury privatised it in a fit of fiscal opportunism.

And so, inadvertently, we are back in the problem of the 1930s: small firms in the regions cannot raise finance for growth. That is one of the reasons why the regional problem has emerged. Whitehall realises the problem, but hasn’t yet hit on a solution. What we have instead is the British Business Bank. It may soon acquire another ‘B’ - there is talk from the clearing banks that they will soon need a state-owned ‘Bad Bank’ to carry the can for a flood of non-performing loans. But we do not need yet another London-based bank, we need another 3i. The equity and long-loans that the Treasury acquires in return for cancelling the new short-term debts could be rebundled into localised packets, and bid out to locally-based private equity management teams. A few cities like Leeds already have such teams, but we need to create many more.

Fortuitously, during the Covid lockdown, many City-based asset managers have realised that life in London is much less attractive than that offered by the provincial cities they left in their youth. The new narrative is post-London. Now is the ideal time to create the expertise that every region needs in order to thrive.

Whitehall faces a choice: the present financing model for small firms in the regions has not worked even in times more benign than we are now facing. More of the same will result in failure. Of course, to give Whitehall its due, it has plenty of experience of managing failure. One of its core skills is to respond to cock-up with cover-up. But this time there are several million voters who will know only too well if they have lost their jobs and can’t find a new one. The phrase that captures the moment is TINA – this time, there is no alternative to real change.