British collapse

Losing our AAA rating could mean bank collapse and deflation

Like a condemned man, the British government awaits the sentence. It’s ceased to be a question of whether we’ll lose our AAA rating, but when.

The Telegraph,

20 February, 2013

In the City, traders have started to ask each other nervously: “Could it be this evening? Have you heard anything?”

If the UK economy shrinking by 0.3pc at the end of 2012 wasn’t quite enough to kill off our AAA, the expected confirmation in next month’s Budget that the underlying 2012-13 deficit will be higher than the 2011-12 deficit may be. Even one-off factors aren’t going George Osborne’s way. The Autumn Statement allowed for £3.5bn in receipts from the sale of 4G mobile phone licences, and the Treasury expected to get more. On Wednesday, it turned out the sale yielded only £2.3bn.

At the 2010 General Election, Mr Osborne’s key “benchmark” against which “the public can judge the success or failure of their Chancellor and their Government over the next Parliament” was to “cut the deficit more quickly to safeguard Britain’s credit rating”. Losing the AAA rating would thus clearly be a political humiliation for the Chancellor.

But would it matter economically? Many commentators have started suggesting not. They note that after the US and France were downgraded, government bond yields did not spike up in the way they did when Ireland and Greece suffered the same fate, but instead actually fell — markets reacted to downgrades in the US and France by buying more government bonds, not fewer. Anyway, they ask, aren’t ratings agencies discredited by having failed to downgrade various assets early enough during the credit crisis?

And if the AAA is gone anyway, they say, we might as well be hanged for a sheep as a lamb and borrow more — in this very newspaper we have seen schemes for embracing the AAA loss to spend more on infrastructure or cut tax.

Now, of course, the key thing isn’t the AAA as such, but the underlying situation of which the AAA is just an indicator. But that underlying situation does matter, and the blasé attitude that both the US and France survived downgrades, so why shouldn’t we, is frankly dangerous.

We can think of government bond yields — the interest rate that the Government has to pay to borrow money — as dependent upon three things. First, the risk that the Government might default. Second, the growth prospects for the economy as a whole. Third, the quantitative easing (QE) programme of the Bank of England.

It’s obvious why the risk of default matters — higher default risk means a higher interest rate to compensate. The growth prospects for the economy as a whole matter because if people are willing to buy government bonds at a given yield, that must mean they don’t expect to get a better yield elsewhere, such as in shares or machines. If the yield on government bonds is very low, as it has been in the UK for the past couple of years, yet people are still buying government bonds, that must mean the expected return on all other assets is low as well. But if the expected return on all assets (all business assets, say) is low, that means the economy can be expected to grow only very slowly.

The third factor is QE. Most of it has been used to buy government bonds, bidding up the price and hence bidding down the yield, making interest rates low. That has probably reduced government bond yields by more than 1.5 percentage points. If more QE is expected, yields may fall further.

When a country is downgraded, the consequences for government interest rates depend on the interplay of these factors. A small downgrade, such as that of the US or France, indicates only a slight increase in the risk the country defaults, but might also indicate that growth prospects are weak and might trigger policy-makers to respond by printing extra money. If financial markets interpret a downgrade as materially damaging growth prospects and likely to trigger more QE, but only meaning a slight increase in default risk, they will react by buying more government bonds, so yields will fall.

Hence it should be no surprise that in the US and France, after their downgrades, yields fell. But that doesn’t mean those downgrades (or the underlying situation that triggered them) didn’t matter. A downgrade triggering a yields drop is a bad thing — it means growth prospects declining.

The one thing worse than a downgrade leading to yields dropping is a downgrade leading to them spiking, and there is no guarantee that for the UK the reaction would be the former. UK growth prospects are already terrible, and our banks are much more extended than US ones, while British households are more indebted than those in France. Furthermore, the AAA rating is central to the UK’s international reputation as a finance centre.

If our growth prospects deteriorate even further, then without even higher inflation, UK households will default on their mortgages, bankrupting British banks and thereby bankrupting the Government if it stands behind the banks. We have already seen that happen in Ireland and Spain. It could happen here, too.

Banks in this country are doubly exposed, because regulators have forced them to hold vast amounts of UK government debt. Even relatively modest rises in government bond yields, implying some fall in government bond prices, would impose huge losses on UK banks. The Bank of England has suggested that UK banks already need £60bn of extra capital. Taking large losses on UK government bonds could push them over the edge.

Falls in UK government bond prices would also mean huge losses for the Treasury via the QE programme. The original intention to unwind QE gradually as coupons were paid and bonds matured has recently been abandoned — the programme can now be unwound only by actively selling bonds, which would surely trigger a huge yield spike and losses for banks and the government of up to half their bond holdings.

On Wednesday, the Bank of England minutes revealed that the last Monetary Policy Committee meeting voted only by 6-3 against doing even more QE, despite inflation being expected to be above target for years. One factor affecting thinking is surely the consequences of losing the AAA. Perhaps more QE might buy more government bonds. Perhaps they might just buy bank bonds directly. Either way, policymakers are showing signs of desperation.

Following the AAA loss, the ways forward may be bank collapse and deflation, or even more QE and even more inflation. It’s not a happy choice.