Tuesday, 27 March 2012

The UK economy

The U.K. Is Not O.K.

26 March, 2012

Britain's 'austerity drive' really has been nothing of the sort when you look at the numbers (which we shall do in a moment), but somehow, in a brilliant piece of marketing, the coalition government have managed to talk tough whilst simultaneously bringing the UK’s Public Sector Borrowing Requirement (PSBR) to a little over 60% ABOVE where it was when they took office in May 2010.

In his most recent piece of surgical brilliance, Greg Weldon (www.weldononline.com) laid out the numbers in simple fashion, revealing just how bad things have become in the Sceptered Isle:

February’s £12.909 billion in Net Borrowing represents the thirteenth largest single-month borrowing by the UK government since the Treasury was founded four centuries ago … and, also represents … the LARGEST EVER Public Borrowing for the month of February.

Further, February’s £12.909 billion in the UK government’s borrowing represents a disturbing +112.8% increase compared to the February 2011 borrowing of £6.066 billion. Indeed, note the horrifying sequential rise in UK government borrowing during the month of February, dating back to 2001, when the government was actually ‘paying down’ debt (monthly Net Public Borrowing, all figures in £, a negative number indicates a ‘net retiring’ of government debt):

Feb-2012 … 12.909 billion
Feb-2011 … 6.066 billion
Feb-2010 … 7.955 billion
Feb-2009 … 7.178 billion
Feb-2008 … 0.833 billion
Feb-2007 … (-) 0.015 billion
Feb-2006 … 1.486 billion
Feb-2005 … 2.034 billion
Feb-2004 … (-) 1.445 billion
Feb-2003 … 0.272 billion
Feb-2002 … (-) 1.565 billion
Feb-2001 … (-) 3.296 billion

Greg continued with a look at the UK government’s debt outstanding NOT including the expansion in the BoE’s balance sheet and points out the following chilling statistic:

We observe the growth in UK Government Debt Outstanding, NOT including the expansion in the Bank of England’s Balance Sheet and official ‘financial intervention’ … revealing the upside acceleration in 2009, and February’s figure, which at 955 billion GBP is the second highest EVER recorded, and is +13.5% higher than the year-ago February total of 877.3 billion.

In just four short years, since February of 2007, UK government debt has nearly DOUBLED, rising by +98.8% !!!! (see chart below)

Certainly not the kind of austerity demanded by Frau Merkel und freunde.

Britain’s budget deficit currently stands at 8.24% of GDP (admittedly, an improvement upon the 11.14% it reached in 2010) so even if David Cameron HAD acquiesced to the pleas from the rest of Europe to join the fiscal compact, it is abundantly clear that there is absolutely zero chance that he would have been able to comply with its terms. In fact, by comparison, Spain and the Netherlands look positively austere (see chart below).

Source: Bloomberg

But it is in amongst the weeds of the UK’s budget projections that the full horror of Britain’s fiscal situation presents itself.

Having wildly optimistic estimates that don’t go anywhere near standing up to any kind of real-world scrutiny is nothing new these days - one only has to look at the forecast curves for the US deficit of the US Congressional Budget Office to witness an exercise in the triumph of hope over experience, but the UK’s own ‘austerity’ program - so loudly praised by those responsible for selling it - appears to be almost devoid of cuts altogether. In assembling any such projection, those responsible are fortunate to have two sides of the ledger to play with and, if everybody is focusing on the level of spending cuts required, it is often safe to assume that nobody is looking at the revenue projections and so that is where one can find the more ... ‘optimistic’ numbers. That fact has been curiously missed by many commentators who have fallen for the siren song of the coalition, amongst them Bloomberg’s very own Clive Crook:

To help restore financial confidence, the government would tighten fiscal policy at once. The idea was that austerity, done correctly, would promote growth. It would remove the threat of fiscal collapse. With public borrowing in check and confidence improved, the private sector would take up the slack.

It didn’t happen. Britain’s households aren’t spending, and its businesses, despite running big financial surpluses, aren’t investing. For the past 18 months output has been essentially flat, still well below its level when the recession began. Official forecasters think output won’t regain its 2008 level until 2014 -- a slower pace of recovery than Britain experienced after the Great Depression.

In one way, the figures flatter the Tories’ fiscal experiment, because the Bank of England has been more forceful than the Federal Reserve in supporting the economy with quantitative easing (where the central bank buys debt to increase the money supply). The Bank of England persisted in this approach despite high inflation, which peaked at more than 5 percent last year, against the Bank’s official target of 2 percent. Without such aggressive loosening of monetary policy, the economy would be in even worse trouble.

Together, though, monetary and fiscal policy are still doing too little to support demand. Inflation has fallen in recent months and, according to the Bank, is on track to drop below the 2 percent target. Some of last year’s inflation surge was due to an increase in value added tax, which will drop out of the numbers. Expectations of inflation have stayed well under control -- a tribute to the Bank’s ability to explain itself -- and, crucially, with unemployment still very high, there’s no sign of wage inflation.

The Bank can do more QE if need be, but looser fiscal policy can and should be part of the mix. Unfortunately, the government is unlikely to admit its mistake and concede that fiscal policy has been too tight...

A looser fiscal policy than the one that has seen borrowing surge since it was implemented and that contains spending INCREASES in each of the next 5 years may NOT be such a good idea if looking for austerity, but to reveal the full horror of the UK government’s basis for their projections, we return to Greg Weldon, who has by no means been fooled for one second (these next paragraphs are definitely NOT for the fiscally faint of heart):

Not only are there NO spending cuts within the UK Budget projections for the next five years, annually through the year 2017 …

UK government spending will increase, every year, including an expansion of +2.8% scheduled to be implemented this year.

The UK government is ‘banking on’ growth in Revenue that will exceed the rate of growth in Expenditures, including growth of +3.5% cooked-into-the-books for this year.

But, the margin for error is slim, with year-over-year Revenue forecast to grow by more than the growth in year-over-year Spending, by a mere £1.4 billion.

Over the next five years things get even more interesting.

In order to ‘support’ a sizable EXPANSION in SPENDING over the next five years (pegged at +12.7%), the UK Treasury is RELYING on an astronomical rise in Revenue over that same five year period, pegged at +33.4%.

Revenue is forecast to rise by +£184.2 billion over the next five years, or by nearly +£40 billion per year.

Ahem, excuse me … perhaps the UK Treasury overlooked the FACT that Revenue in February, pegged at £38.631 billion was (-) 1.9% BELOW the year-ago February revenue of £39.381 billion.

A decline of nearly £1 billion is FAR from the projections calling for a near +£40 billion per year increase over the next five years.

(There is much, much more in Greg’s report - as there always is - and if you HAVEN’T already signed up for a free trial of his work then do yourselves a HUGE favour and click HERE)

Along with these fanciful estimates, the UK is also relying on a projected fall in the savings rate from 6.6% to 5.0% over the next 4 years to help it reach its targets - and all this in a country with inflation running at a little under double the targeted 2% rate (though admittedly trending in the right direction at last after reaching 5.5% in September of 2011).

But as incredible as all this sounds, perhaps the most oddly-shaped piece of this particular puzzle is the UK government bond market - or, as they are known colloquially, ‘gilts’.

Currently, the only thing remotely ‘gilt-edged’ about UK government bonds is the fact that they have a AAA rating from the geniuses at Moody’s and S&P - but that has, in recent years, become akin to having your accounts approved by Sino Forest’s audit team and so it’s hard to justify the fact that UK Gilts become the world’s best-performing asset class in 2011 (chart below).

A lot of this performance has been down to Britain’s willingness to be the most eager of Quantitative Easers over the last several years and the £300 billion in gilts that have been bought by the Bank of England since March of 2009 have gone a long way towards establishing perhaps the most curious of government bond markets anywhere in the world (with the possible exception of Japan).

Currently, the BoE has a further £25 billion of gilt purchases approved under the QE program and until the end of June to make those purchases (chart below). What happens after June is anybody’s guess, but, should further easing not be forthcoming, it is hard to see how UK bond yields do anything but go higher - po- tentially a LOT higher based on the underlying state of her finances.

The popularity of Liability Matching amongst UK pension funds has all but guaranteed a disastrous outcome for a generation of ‘savers’ as rates have been held artificially low in a highly inflationary environment but perhaps the biggest ‘tell’ that the status quo cannot possibly go on for much longer came last week when George Osborne tabled an idea not used since the aftermath of WWI - 100- year gilts:

(UK Daily Telegraph): Britain is to offer 100-year gilts, meaning current Government borrowing will not be repaid until the next century, ...

The Chancellor hopes that the 100-year gilts will help to “lock in” the benefits of Britain’s international “safe haven” status. The interest rates paid by the Government to borrow money have recently fallen to a record low and it is hoped the new gilts will mean “our great-grandchildren” can benefit from the low rates.

Currently, the average duration of the Government’s £1 trillion debt is around 14 years – with maturities ranging from months to a 50-year bond issued in 2005. Longer-dated debt is widely thought to offer a country more stability.

A Treasury source said tonight: “This is about locking in for the future the tangible benefits of the safe haven status we have today. The prize is lower debt interest repayments for decades to come.

It is a chance for our great-grandchildren to pay less than they otherwise would have done because of the government’s fiscal credibility.”


Firstly, Britain's 'safe-haven status' is a fallacy. It is no more safe haven than many of the other major economies who are choking on debts that cannot be paid off. The only reason it HAS that status currently is because of the very Achilles Heel that will ultimately prove to be its demise - the ability to print its own currency. By NOT being a part of the euro experiment, Britain has kept control of its fate and has been able to print its way out of trouble - so far - while its neighbours to the east have all been lashed to the deck of the same sinking boat, but the day is coming when Britain’s profligacy will become important again. As I keep saying; none of this matters to anyone until it matters to everyone.

Secondly, interest rates may have ‘fallen to a record low’ but they have done so in the same way heavily-indebted gamblers often ‘fall’ from hotel rooms - with a big push (only this time from the Bank of England and not a guy called Fat Tony). Like US Treasurys, the price of UK gilts would be nowhere near these levels without a captive and very friendly buyer in the shape of the central bank.

And then there’s the ‘treasury source’ who spoke of ‘locking in for the future the tangible benefits of the safe haven status we have today’ before finishing with a flourish when he tugged at the heartstrings of investors by referring to great-grandchildren who would be paying less in interest repayments than they otherwise would have done because of (and I’m going to give this last comment the space it deserves):

...the government’s fiscal credibility

I have yet to find anything remotely credible about the UK governments fiscal policy - it’s marketing policy, yes, but fiscal policy? Not so much.

Clearly, any government looking to lock in rates for 100 years is supremely confident of two things:

1: Rates are as low as they are going to be for 100 years

2: They have suckers at the table willing to lock those rates in for that length of time.

But a funny thing happened on the way to locking in for the future the tangible benefits of the safe haven status Britain enjoys today - the once-in-a-lifetime offer received withering criticism:

(Jeremy Warner): ...from the investors’ point of view it makes no sense whatsoever and if it ever comes to pass, I can guarantee it will eventually be seen as one of the most colossal cases of mis-selling ever seen in the UK – and there have been quite a few.

As any student of economic history knows, periods of very low interest rates can last an awfully long time, but they have never lasted 100 years or anywhere close. Any such gilt is therefore a hostage to long term fluctuations in interest rates and inflation. One thing is absolutely guaranteed – inflation adjusted, £1,000 invested in a 100-year bond today, even with interest re-invested, won’t be worth anywhere close at maturity.

Anyone who invests is therefore more or less agreeing to a long term loss, or to a net transfer of part of his wealth to the Government.

Warner went on to examine how the last buyers of 100-year gilts made out:

From the Government’s point of view it was a masterstroke which transformed the public finances, but it was a disaster for investors. The new stock immediately plunged in value, yet the real damage was to come later from the value destructive effects of inflation. £1,000 invested in the War Loan back then would in today’s money be worth less than £20.

The National Association of Pension Fund Managers were similarly scathing:

(FT): The National Association of Pension Funds on Wednesday criticised the chancellor’s plans for an “Osborne bond” – a 100-year debt issue or even a perpetual gilt that never matures – saying it would prefer shorter maturity debt that was protected against inflation.

One senior UK fund manager said: “This could be of interest for pension funds as it would be a good match for their liabilities.” But another said: “We would not be buyers of this debt because the yields are too low. It would be great for the government and the British taxpayer, but I don’t think we would want to lock in yields so low for such a long time. Yields are artificially low because of the Bank of England’s quantitative easing initiative.”

And it is in this reaction that the writing on the wall for government bonds becomes clearer still.

We have reached the point where investors are comfortable enough that the fear of a systemic collapse has now more or less dissipated and faith in a resumption of growth (at least in the US) is slowly returning (though I have my doubts about that being the case but more of that another day). It was precisely this fear that drove them into government bonds in the first place but now that they have started to care once again about such trivial matters as price and yield, there is only one price-insensitive buyer left in the game - and that buyer (at least in the UK) only has £25 billion in his pocket. Sounds like a lot of money, huh? It used to be.

And so, Greece and Spain fail to reach the limits imposed by the fiscal compact, now it’s Holland’s turn and the UK couldn’t get near it even if it WERE a signatory.. Portugal is sinking rapidly into the swamp and this week Ireland, poster child for austerity, has announced that it has slipped back into recession.

Anybody out there think we have heard the last of this whole ‘Europe thing’?

Me either.

Of course, if Europe WERE to completely collapse, just think how low yields of government bonds would be...

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