Are you ready for stage three of the credit crisis?

Published December 16th, 2009

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Insight from Christopher Gasson, GWI publisher

“As I see it, this crisis is going to go through three phases: firstly, it will work its way through the banking sector. Next, as banks reduce their lending, the bloodletting will move on to the business sector. Finally, as a result of rescuing both banks and businesses, the crisis will move on to the public sector.”

The above quote comes from this column twelve months ago when I was looking forward to what might happen in the water industry in 2009. I looked it up because it seemed to me that the first two stages of the recession are now behind us, and we are moving into the third stage, where the public sector starts to buckle under the weight of its liabilities.
California and Dubai – which both pride themselves on being ahead of the rest of the world – are naturally the first places to reach the third stage of the recession. Others will follow. Within Europe, Greece, Britain, Spain, and Italy are going to struggle to get their numbers to add up. In the US, state and municipal budget crises will threaten to become a federal problem. Japan and Korea may also face fiscal challenges. The only economies to escape the trend will be China, India, and the resource economies which feed them such as Saudi Arabia, Brazil, and Australia.

So what does this mean for the water industry? The direct impact is obvious. Around 90% of the world’s tap water is provided by the public sector, so squeezed public finances are likely to lead to reduced investment in water and wastewater infrastructure in the short term.

The indirect impact is more interesting. Three things tend to happen when large economies face budget crises: exchange rates become more volatile, inflation tends to rise, and political change occurs.

Volatile exchange rates have never been great for the global water business. The East Asian crisis of 1998, and the Argentine peso devaluation of 2000 nearly destroyed the international private water market. Water is supposed to be a low-risk, low-margin investment, and exchange rate volatility adds too much risk. This time around, the main impact of exchange rate volatility is likely to be the break-up of the two main currency blocs: the Dollar and the Euro. The smart strategy is to buy assets in places like China or the GCC which are currently pegged to the dollar, but which would appreciate in value should the dollar devalue. The fact that the appreciating currencies are in the East and the depreciating ones are in the West suggests a further eastward shift in the locus of the global economy.

The impact of inflation is potentially interesting. One of the most successful strategies for dealing with inflation during the 1970s was to borrow in order to acquire assets. Inflation erodes the value of debt and increases the value of assets. Acquiring water assets might therefore represent a good hedge against inflation, particularly as returns are regulated.

The third impact of fiscal crises is political change. Although governments may procrastinate about addressing budget deficits, economics forces them to make changes. In the good years, difficult questions about the efficiency of the water sector don’t need to be asked. Politicians can present water services as part of their munificence towards the public, and use them as a source of social employment for supporters. When public budgets get squeezed, utilities are expected to stand more on their own two feet. That means they either raise tariffs to a cost recovery level, or they look for private finance for their big projects – or both. The net result is greater financial independence for the water sector. In my view, this is the key to the long-term growth of the water economy. It is only when water utilities can be run like any other business, setting prices to cover costs, and making investment decisions based on what gives the best return in terms of performance, that money will go to where it is needed in the water sector.

In summary, my tip for 2010 is to invest in the eastern and southern hemispheres until things get really nasty in the US and Europe, then start looking for emerging new business models in those markets.