Wednesday, October 29, 2008

When Confidence Vaporises

A question we've heard a few times over recent days is where is the government going to borrow all this money? Who's actually going to lend it to them?

But the real question we should be asking is how much will the lenders demand for making the loans?

In broad terms, the money will come from bond investors: pension funds, insurance companies, newly risk-averse banks, sovereign wealth funds, overseas central banks, and - whisper it - international speculators.

Right now, they'll lend money to our government for, say, 10 years at an annual interest rate of 4.4%.

Which is pretty decent of them, because with our 5% inflation rate, the real value of their investment is being eroded faster than the annual interest they'll receive. In other words, the real interest rate we're paying them is negative.

So why would any lender accept that?

Well, there are a number of reasons, including the fact that right now, many of the alternative homes for their cash look even dodgier.

But the big reason must be that investors think the present 5% inflation rate is temporary. They must figure it will soon come back down to the 2% target - maybe even lower - leaving investors with a respectable 2-3% pa real return over the ten years.

But what if they're overseas investors? Whatever they might think of the UK inflation outlook, surely they'd be put off by our collapsing currency?

To which the answer is yes, they would. And we might note that the 4.4% rate at which the UK government can borrow in sterling is higher than the 3.8% paid by the US government in dollars or the 3.8% paid by the German and French governments borrowing in Euros.

Still, a differential of 0.6% pa is a pretty small risk premium for a currency that has recently been falling through the floor. Which suggests that international bond investors have been persuaded that sterling's weakness will not continue.

The underlying point here is that the interest rate bond investors demand depends heavily on their confidence over the outlook for inflation and the value of sterling. It also depends critically on just how much borrowing the government needs to do.

As the chart above shows, through the easy years, that confidence held up pretty well. Despite their reckless public spending, the Labour government has been able to borrow at more or less the same rate as governments in the US and Europe. Specifically, they have only had to pay an average 0.2% pa more than the US government, and an average 0.5% pa more than the major European governments.

Unfortunately, that is set to change. The abandonment of Brown's fiscal rules and a deep recession mean much higher UK government borrowing. Lower interest rates combined with our chronic current account deficit is certain to send sterling spinning again at some stage. Weaker sterling will almost certainly feed back into UK inflation. A vicious 70s style circle could so easily recur.

What then of bond investors' confidence?

Let's remind ourselves how things were in the bad old days. The following chart is taken from a Bank of England research paper and shows how much more UK governments had to pay to borrow, relative to their US and German counterparts, in the 70s and 80s:

As we can see, for much of the period the yield (interest rate) on UK government bonds was 4-6% higher than that faced by the US and German governments.

That's a huge difference. It means that on £100bn of borrowing - now easily in prospect for next year - the debt interest would be perhaps £5bn pa higher than under recent rates. And that cost would be compounded as old cheaper debt matured and came up for refunding at the new rates: over the next three fiscal years that will total nearly £100bn.

After two or three years, a return to a 70's style loading on UK government borrowing costs could easily increase public spending by £15-20bn pa - say, 5p on the standard rate of income tax.

So will those 70s borrowing costs return?

It all depends on the bond investors and their confidence. How confident will they feel in a government that delivered reckless fiscal management in the easy years, and is now wanting to borrow more money than any UK government in peacetime has ever done.

I confess to having a very bad feeling about this.


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