Britain's secret weapon against a fiscal crisis
First published in the Telegraph on 22 October 2009
Warning: this blog is about the government debt market. But hold on – before you click the “back” button or expunge this blog from your RSS feed, know this: it is also, by extension, about two of the biggest questions facing us today, namely 1) how vulnerable are major governments including the UK and the US to an IMF-style funding crisis and 2) how likely are they to be able to inflate away their debt in a re-run of the 1970s? For in the end, these and so many questions in economics come down to the way in which a government raises cash to pay its bills. I’ll tackle the first question today and the second in a future blog.
If you dig a little bit into the way the UK debt market is structured, there are actually some pretty reassuring quirks which imply that Britain may be that little more resistant to the armageddon-style outcome of a debt crisis about which some are so worried.
As we all know so well, governments around the world have rather a lot of money to raise in the next few years to pay those bills to mop up the mess of the economic crisis. Britain, for instance, will increase its deficit by 175bn this year alone, partly because of the cost of the recession (extra unemployment benefit etc), partly due to the sudden disappearance, perhaps permanently, of tax revenues the Treasury thought were permanent features – ie from the City and those associated with the property bubble. But the UK is not alone; with everyone around the world raising so much money, and, after the Bank of England and central banks slowing their quantitative easing programmes with little option of printing money and selling the stuff to yourself (one presumes), there may be limited demand for this debt. The big question over the next few years is whether investors will feel ready to stump up the necessary cash to keep these governments functioning.
If they get worried because, for instance, they suspect a government is not good for its money, and will either default or inflate away its debt, they will ask for a higher price for that debt; the government will have to offer them a steeper rate of interest. Eventually, if the cost of financing these interest payments become too big, the government can get trapped in a debt spiral out of which it may struggle to escape alone. It is precisely the same as any household borrowing too much on a credit card, and in time seeing that they cannot afford to make the minimum payments each month, let alone pay off the bill in full.
According to Moody’s that danger level of interest payments is about 12.5pc of a country’s tax revenues (in other words when 12.5p of every pound you pay in tax goes straight towards paying off interest on your pile of debt). Although circumstances differ from country to country, it views it as broadly unacceptable for a triple-A rated economy to have a debt interest burden much higher than this. The worrying thing is that in the UK, the debt interest level is likely, according to Standard & Poors, to head up to the 12pc level within a few years.
But here’s where the structure of the market comes in. In order to finance its deficit, a government issues lots of bonds to investors at varying different lengths of maturity, from the short ones of three to five years to ones which last for half a century and will still be paid off well into the next generation. At any one time, the Government is paying interest to investors on bonds from a whole variety of periods – whether it is short term stuff it issued a year or so ago in the wake of the financial crisis or long term stuff from back in the 1980s.
Every week old bonds expire and in their place the Government has to issue new bonds to take their place (unless, of course, it is in budget surplus and is trying to erode away its debt – but that’s hardly something we have to worry about right now). So although the Government’s deficit this year will be 175bn (public sector net borrowing), the actual amount of cash it must raise in the markets is 221bn, with much of the difference accounted for by those extra bonds it has to issue to replace those that are expiring. This last figure is referred to by Treasury wonks as the net cash requirement.
If you’re a government, should an investor get worried about your creditworthiness and demand higher interest rates for lending to you, those higher rates only apply to the new bonds you’re issuing – not the existing bonds accumulated over the previous years. Once those bonds (or gilts, as they’re known in the UK) are issued by the Government, the, say, 4.5pc rate is set in stone (for the Government) for the bond’s lifetime. It is rather like a fixed-rate mortgage: some of them may be fixed for two years, some for five years, but when that moment arrives you may have to re-fix (or, if you’re a government, reissue the bond) at a far higher level.
The upshot of this is that a government’s vulnerability to a sudden increase in interest costs is largely affected by the amount of extra debt it has to issue to replace these expiring bonds each year – above and beyond the simple increase in its overall level of indebtedness. Which is why I wrote [http://blogs.telegraph.co.uk/finance/edmundconway/100001160/britains-rollover-crunch/]a couple of weeks ago that it was alarming that the IMF had said countries had, in the face of the crisis, taken to borrowing in shorter maturities during the crisis.
What I hadn’t realised was that the UK’s debt market is peculiar. In the US, average length of the existing Treasury bonds was, at recent count, 4.7 years and falling. Because this is such a short maturity, it means the debt has to be rolled over far more often, and at every point the government runs the risk of setting in stone any changes in interest rates. In France, the average maturity is 7.1 years, in Italy 6.9 years, in Germany 6.35 and in Japan 5.7 years.
In Britain, the weighted average maturity of government bonds is a whopping 14.2 years. Admittedly, as the IMF points out this is slightly lower in the wake of the crisis, but it is still significantly longer than any other major economy.
This peculiarity – largely a result of the way Britain’s pensions and savings market is constructed – happens to be one of the few things in the UK’s fiscal favour these days: it means the UK is that little bit more insulated from the chance of a sudden jump in overall debt servicing costs in a way that other major nations simply are not.
Unfortunately, this hardly offsets the simple fact that because the deficit is climbing so rapidly in the next few years, we have to issue a disturbing chunk of new debt for the foreseeable future, so it does little to rule out a crisis. But it is worth bearing in mind given that so many other countries around the world are seeing large increases in their deficits but also having to issue a hell of a lot of new bonds simply to replace the ones that are expiring.
There is a downside, of course, which is that if investors start demanding higher interest rates on government bonds, and if we issue a lot of long-dated stuff, those high rates will still have to be paid off many years into the future.
Still, this is an important and underappreciated issue with extremely important consequences. This coming week, the Debt Management Office [http://www.dmo.gov.uk/]is set to issue the longest-dated normal gilt in history, with an expiry date in 2060, by which time, one presumes, most in the DMO will be long dead. Whether this is enough to protect the UK from a funding crisis remains to be seen.
UPDATE: Thur 22 18.35
Simon Ward has written an interesting rejoinder to my (unusually) optimistic take on the UK fiscal position on his blog [http://www.moneymovesmarkets.com/journal/2009/10/22/uk-debt-life-shortened-by-boe-gilt-buying.html]. Do check it out. His point is that although the UK has far longer maturities than most other nations, they are falling rather quickly in the face of the financial crisis. However, my understanding is that this is also the case for, at the very least, the US. Not that that should be any reassurance