Fiscal Illusions

Today the Office for Budgetary Responsibility has published its biennial Fiscal Risks report. Outstanding student loan balances reached £100billion at the end of March with over 85% of those now the responsibility of the Department for Education. As such, they have an increasing relevance for thinking about the financial health of the nation.

OBR identifies various risks associated with student loans.

Firstly, they expect loans to grow at a rate of 0.8 per cent of GDP each year in the short-term, but should student numbers increase faster than estimates then loan outlay would have to increase and that requires more issuance of gilts. Loans are a national asset (money owed to government) but are created by borrowing, which is a national liability (money government owes).

Secondly, ‘economic drivers’ such as RPI, which affect interest rates, maintenance loan outlay and repayments. Graduate earnings are obviously another factor, with the OBR stressing that the spread of graduate earnings (not just averages or medians) matter in relation to income contingent repayment loans. That is, the number of graduates earning above the thresholds is crucial for repayments.

Thirdly, the sale of student loans. OBR describes further delays to the sale of student loans as the ‘largest downside risk’ in relation to the national balance sheet. I think there is some inconsistency here so I will quote from the report in detail.

§7.34 Student loan sales: These remain subject to market conditions and a final value-for-money assessment. Our March forecast assumed that the first sale would be completed in early 2017-18 and a second by the end of that year. These timings are likely to have been affected by the early general election. Selling the loan book affects the flow of cash to the Exchequer, with more recorded upfront as sales proceeds and less in future years, as repayments flow to the private sector instead. In effect this crystallises losses on the loans sold – the level of debt is permanently higher relative to no loans having been issued, because sale prices will reflect the interest rate and write-off subsidies implicit in the loans.

Elsewhere, OBR introduces adopts the IMF’s term ‘fiscal illusions’ to describe

… any transaction that improves or worsens measured fiscal aggregates without genuinely affecting the true health of the fiscal position in the same way. An example would be the effect of financial asset sales on PSND, where they lower the measured aggregate without improving fiscal sustainability. (§7.65)

It seems odd that OBR doesn’t flag up that student loan sales are exactly this kind of ‘fiscal illusion’ – they are financial asset sales – and moreover OBR doesn’t point out that the government’s value for money test for a loan sale uses the social time preference discount rate, a higher discount rate than that used to value student loans in the DfE accounts. Respectively, RPI + 3.5% (plus some adjusments) as compared to RPI + 0.7% – a higher discount rate puts a lower valuation on financial assets and so the government’s VfM test would sell at a loss.

It’s not just that a sale would ‘crystallises losses’ but it would worsen the fiscal position; the price may not ‘relect the interest rate and write-off subsidies’ but instead undervalue them.

Another fiscal illusion identified is the effect of student loan interest rates on public sector net borrowing (PSNB).

§7.13 Interest on student loans: this is recorded in PSNB as it accrues, which we expect to subtract £3.0 billion from the deficit this year. Interest starts accruing from the time the loan is extended and it is recorded within the public finances for the full amount owed rather than the amount expected to be paid. In reality some of this will never result in actual cash payments, because some borrowers will not earn enough to require their loans to be repaid. Eventually, this initial over-recording will be resolved by writing off any outstanding portion of the loan. But this may not be until years later – the write-offs associated with recently issued loans are not expected to pick up until the mid-2040s. So accruing interest will flatter the fiscal position in the meantime.

Although student loans as illiquid assets do not appear in PSND, the nominal interest accruing against their outstanding balances turns up as a positive in the deficit. At around £50billion in total, that £3billion is significant and may colour debates around the removal of real rates of interest on post-2012 loans.