The New GDP: Gilts, Debts and ‘PIIGS’

During 2010 the most talked-about consequence of the housing and banking crisis has been its knock-on effect for governments – those charged with masterminding the bailout. We examine the state of what is euphemistically known as the ‘public finances’.

There are ultimately only three sources of revenue for any government – taxes, borrowing and printing money. The economic crisis has led to a media preoccupation with all three. Because of the bailout of the banks and massive financial stimulus programmes initiated by governments the world over in an attempt to avoid another Great Depression, there is quite some interest in how all this is going to be paid for.

One aspect of this, which the Cameron government is now grappling with, is to try to compensate for the bailout and the costs of the recession by reducing other government expenditure (e.g. on state-provided services like education, on defence, and on staffing in the civil service, etc). However, if printing money causes inflation, and there are limits to the amount that can be raised through taxes, why not just borrow more to avoid the need for big public spending cuts?

The borrowing option is very often there, but government borrowing is not always as straight forward and risk-free an exercise within capitalism as it may appear at first sight.

Good as gilts
Governments borrow money through the issuance of bonds, which are sold to investors with the promise to pay a rate of interest and – usually – to return the original capital advanced by the investor at a pre-determined time (when the bond ‘matures’). The issuance of debt in the UK is overseen by an agency of HM Treasury called the Debt Management Office. Bonds issued with maturities of less than a year in the UK are called Treasury Bills and are traded on the money markets, typically by big financial institutions who only want to tie-up some of their money for short periods. However, the vast bulk of the bonds issued in the UK to finance government debt are for maturities over a year and are called ‘gilt-edged securities’ because the original bond certificates had a gilt-edge to the paper.

Gilts are usually issued for £100 each but come in various types and maturities – which means that the issuing and paying back of government debt is a far from straightforward business. The defining features of a conventional gilt are its ‘coupon’ (the interest payment) and its maturity, both reflected in the name of the gilt e.g. 8% Treasury 2013, a gilt which pays 8 per cent a year – in other words £8 – and for which the government will pay back the initial £100 in 2013.

Other gilts are ‘index-linked’ in that the coupon and final repayment amount are linked to movements in the Retail Price Index, while another category are undated or ‘irredeemable’ gilts such as 4% Consols, gilts often originally issued in the nineteenth century and which pay a regular coupon but for which the government is not bound to pay back the original sum advanced at any set date. The vast majority – nearly three-quarters – of UK gilts in issuance today are of the conventional variety and these are clustered into ‘shorts’ of under seven years maturity, ‘mediums’ of seven to 15 years and ‘longs’ of over 15 years.

The issuance of gilts, as they are commonly called, is a regular activity because government revenue from taxation does not neatly match patterns of government expenditure, either because spending is running ahead of government revenues, as at present, or because tax-collection typically has greater seasonal variations than government spending. And even when governments might be paying back some gilts as they mature (‘redeeming’ them) they will usually still be issuing others.

Other countries have similar mechanisms for issuing debt (in the US the bonds are called ‘Treasuries’) and all have similar issues at root. In particular, the laws of supply and demand will affect the level of the interest payments demanded by investors as will the general level of confidence in a country’s ability to pay both the coupons and the original capital advanced when the bonds mature. In the UK there are usually weekly gilt auctions and the government will have to respond to a lack of demand for gilts by increasing the coupon on new issues thereby making them more attractive – but at the same time making them more expensive from the government’s own point of view.

A big influencing factor on this is the ‘secondary market’ for already existing gilts – the billions of pounds of gilts in circulation until they mature do not usually trade at their face value after they have been issued, but at rates determined by the market. For instance, the return investors want on long-dated gilts may rise to 5% (the interest payment in relation to the price paid is called the ‘running yield’). If so, this means that a long-dated gilt with a 4% coupon is not going to trade at the original £100 face value it was sold at but only at £80 instead, as this is what would give a 5% running yield (a gilt costing £80 which pays £4 on the coupon). This type of shift in price and yield opens up the possibility for investors of capital gains and losses, and also leads to the concept known as the ‘redemption yield’, the running yield investors achieve adjusted for such capital gains and losses. In its simplest form, buying above the initial £100 face value will give a redemption yield lower than the gilt’s coupon rate as there will eventually be a capital loss to be taken into account, buying below face value will increase the redemption yield above the coupon rate as there will be a capital gain when the government repays the face value of the gilt.

Such market gyrations in gilt prices and yields as determined by capitalist investors daily will influence the way and cost at which a government can borrow by issuing new gilts, with shifts in yields being crucial. Because investors may be tying their money up for long periods it is normal for the yield on long-term bonds to be generally higher than for short-term bonds too. However, periods of financial uncertainty and likely recession usually lead to interest rates being temporarily higher for shorts than for longs as investors do not want to tie their money up for extended periods. This leads to what is called an ‘inverted yield curve’, with higher short-term interest rates in the economy than long-term rates, as happened for a time at the start of the credit crunch  (the yield curve is the relation between interest rates, i.e. the cost of borrowing, and the time maturity of debt).

These ever-changing market interest rates at which governments have to issue gilts in order to finance their borrowings is of obvious concern to them. But the maturity of the bonds is a significant issue too.

‘PIIGS’ at the trough
In the last few months a new acronym has arisen in the financial press reflecting the times. Instead of the talk being of the fast-growing emerging market ‘BRIC’ countries of Brazil, Russia, India and China, we have the ‘PIIGS’ instead. These are countries that have been deemed by the international bond markets to have issues regarding the amount and/or nature of the government debt they have outstanding, the unfortunate acronym standing for Portugal, Italy, Ireland, Greece and Spain. The most serious situation, now accompanied by massive government spending cuts and riots on the streets, has been that encountered by Greece, which has implemented austerity measures of around 30 billion euros in return for a 110 billion euro rescue package from the EU.

Interestingly, Greece’s annual budget deficit – its annual expenditure over its annual revenue – is projected to amount to about 8 per cent of GDP this year, actually less than the US’s 11 per cent (Financial Times, 23 June). And its total accumulated national debt built up over time is, at around 110 per cent of one year’s GDP, a lot less than Japan’s at 190 per cent of GDP. The problem, however, with Greece has been that much of its debt was due to be retired in the next couple of years (i.e. a large proportion of the bonds it had issued were due to mature) and there was no guarantee it had the money to be able to do this. This prospect sent the bond markets into fright to the extent that long-dated Greek debt was yielding over 10 per cent at one stage, more than double that typical for other western economies. This was because investors dumped their bonds, in the belief they may not get their original investment back, sending the prices of the bonds plummeting and their yields soaring.

This has been a clear example of the way in which the bond markets are able to determine which countries are able to carry on issuing debt investors are willing to buy, and which countries investors have lost confidence in. This is precisely what has happened to a number of Latin American states such as Argentina during the last 30 years too – and the retribution has usually been severe. When a country shows signs that it cannot pay back its debts or may default on coupon payments on its bonds, a restructuring programme initiated by the International Monetary Fund is not far away, typically leading to cuts in state spending coupled with tax rises and the inevitable social unrest.

Once a government defaults on its debts, the bond markets tend to have long memories, and the fear of future default will push up interest rates (yields) for years to come, making the cost of government borrowing high. In such situations, international investors retreat to ‘safe havens’ like the US and UK, countries that have never had any significant default on their debts during their history.

Just like BP?
In this respect, the markets treat countries and their governments rather like they treat individual companies. Just as credit rating agencies like Moody’s or Fitch  give credit ratings to companies (the highest being ‘Triple A’) so they rate nations too and this influences market perceptions. Credit rating agencies and other financial firms view companies likely to default on their debt (whether to banks, or to investors such as the owners of corporate bonds) with the utmost suspicion. Defaulting on debt or inability to pay coupon payments on bonds or on promised dividends is one of the greatest corporate sins and companies deemed at risk of default have their bonds rated as ‘junk’ and are punished by markets.

Recent examples of those falling foul of financial markets because of a perceived inability to service their debts would not only include the banks but also major companies like William Hill and Premier Foods which have had to go back to their shareholders cap-in-hand asking for money to reduce their debt and shore up their balance sheets. Yet, a company like BP can have a temporary dip in its share price but otherwise largely escape the type of battering from the markets meted out to others despite its involvement in one of the biggest and costliest environmental disasters of all time. And the reason . . . ? BP’s net debt is little over one year’s typical profits (last year being $20 billion) and it has a flexible debt structure.  In other words, it is highly cash generative, has headroom on its debt and so investors have more confidence it can meet its financial obligations.

Little headroom
Like companies, some countries have more headroom to tackle their financial situation than others. Where confidence in government finances are high and where debt servicing is manageable, governments will be able to issue bonds at rates that are not exorbitant and thereby finance their expenditure. This also applies to governments that have more headroom to increase taxes because state spending in the economy is lower (another reason why the US and UK have been seen as safer havens for bond investors than countries like Greece).

But in truth there is an historical element to this as well. The story of the last 20 years or so isn’t that there has been a massive explosion in government debt – the explosion in debt has been in personal debt. In the US this rose from 80 per cent of average disposable income in 1990 to over 140 per cent, and in the UK a similar measure of personal debt rose from 100 per cent to 170 per cent of household income under New Labour (Financial Times, 9 August 2008). By contrast, while government deficits in a given year are now significant (a record £159 billion or 11.4 per cent of GDP last year in the UK) and have caused some market wobbles, the accumulated national debts of most countries have not been particularly high by historic standards.

Because of inflation over time, the big number headline figures of billions and trillions are misleading, and percentages give the best picture. By way of example, total accumulated national debt as a percentage of one year’s GDP is currently around 70 per cent in the UK. According to figures from the Bank of England this compares with over 250 per cent in 1946 at the end of the Second World War. Indeed, for all the period from the start of the First World War in 1914 until the early 1960s it was far higher than it is now, and the situation in the US has been very similar in percentage terms. Indeed, only as recently as 10-15 years ago governments in the US and UK were running big budget surpluses when the economy was booming and were paying back the national debt as quickly as they could, reducing national debt to GDP ratios to well below 50 per cent in both countries for a while.

What this means practically is that it usually tends to be sudden upward changes in the rate and nature of government debt that tends to really spook markets, drain them of confidence and lead to the type of government austerity measures we are now seeing, rather than particular total levels of debt as such. Indeed, a comparatively healthy economy like Singapore’s has a national debt equivalent to 113 per cent of GDP, while – perhaps counter-intuitively – Uganda, Iran and Mozambique have national debt of less than 20 per cent of GDP. After myriad failed government stimulus programmes over the last two decades Japan has accumulated the second highest national debt to GDP ratio in the entire world (after Zimbabwe) but despite its ongoing problems has comparatively little difficulty borrowing funds via the bond markets.

You can’t buck the market
What is certain from all this is that governments are far more like companies than they would ever generally like to admit, and certainly cannot ‘buck the markets’ and market perceptions, which are always crucial. But then again, who are ‘the markets’ anyway?

The market for UK gilts is typical and is dominated (at around 40 per cent) by insurance companies and domestic pension funds, followed by overseas investors and financial institutions, hedge funds, etc (at 35 per cent). The rest is made up of recognised collective investment vehicles like unit trusts, by banks and lastly by households (households being less than 3 per cent of the total). In other words, the bond markets – like the equity, commodity and currency markets – are dominated by the big capitalists and institutional investors. Their flows of investment capital are substantial and cross national boundaries at the press of a button. These are the people always on the look out for gilt-edged opportunities in life. The laws of the market economy dictate that no government will – or can – argue with them for long.


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