InvestmentsDec 18 2020

What do high UK government debt levels mean?

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What do high UK government debt levels mean?

In his annual spending review, chancellor Rishi Sunak revealed the UK government borrowed £246bn in the first six months of its financial year – which was to the end of September 2020 – while the total borrowing figure will be more than £300bn for the year.

Those numbers are record highs for the UK in peacetime, and contribute to an overall national debt of just more than £2tn. 

The deficit is the amount of extra net borrowing a country needs to do each year to finance itself; the debt is the total net amount of all of the previous years’ deficits that have not yet been repaid. 

The GDP drop this year, at 11 per cent, is the worst for centuries.      

But while the headline data looks bleak, Mr Sunak has two strong positives to work with.

Key points

  • The government is borrowing record amounts for peacetime
  • Interest rates are very low and all governments are in the same position
  • Some debt can be inflated away over time

The first is that bond yields – that is, the interest rate paid on the debt – is the lowest it has ever been, with some bonds trading at a negative yield.

The second advantage for Mr Sunak is that the economic malaise is not unique to the UK, so every other major economy is also issuing bonds in vast quantities at this time, so the UK was not alone in increasing its debt issuance in 2020. This helps to keep the yields lower as it means that investors in government debt will not have the option of fleeing one stricken country’s debt for another.

The interest rates the taxpayer will pay on the money borrowed this year are way below those previous generations had to endure, with all bonds the government issues with a maturity of up to five years presently trading with a negative yield. 

UK government bonds with a maturity of 20 years currently have a yield of 0.83 per cent.

Return on capital 

Having to make lower interest payments on the debt brings a range of benefits to the budget.

In the first instance, as a portion of the debt is held by overseas investors, minimising the interest payments owed on the debt means less sterling being moved abroad by those investors, which should help to preserve the value of sterling; maintaining this purchasing power for imported goods prevents inflation from rising too steeply.

But the more significant benefit to the government from paying a lower rate of interest is that it makes many more infrastructure projects viable. 

For example, the interest payable on a 10-year UK government bond is currently 0.3 per cent. If the government borrows £1bn and uses the cash to develop an infrastructure project, the extra economic activity, and revenue coming to the government from the taxes paid by workers who may otherwise have been claiming benefits, needs only to exceed the interest payments for the project to pay for itself.

Bank on it 

There are many reasons yields are so low, prime among them is the vast ‘savings glut’ that has built up in Asia. 

As those economies become more prosperous, local populations have saved more rather than spent, and the accrued capital has been invested in, among other things, developed market government bonds.

Historically, when a country or region develops it comes as a result of export-led manufacturing growth, and then evolves into consumer-led growth.

Then consumer spending increases markedly as populations spend their gains, and so the savings glut diminishes.  

But the size of the economies and populations of China, India and Indonesia and the pace of growth have amplified the impact of this effect compared to other periods of economic development in history, especially when combined with an ageing population in the western world.  

The comparatively nebulous welfare provisions in many emerging economies may also mean the inclination to save continues long-term.

This matters for the global economy as it means those accruing a relatively greater share of global wealth spend relatively less of it, meaning global economic demand is lower, pushing growth downwards and keeping bond yields lower for longer as inflation does not rise. 

The above is the central tenet of the economic theory of “secular stagnation” highlighted by Larry Summers, former chief economist of the World Bank.  

This matters to the UK government because it would mean bond yields remain relatively low in the decades ahead, so when the government refinances the 10-year debt, it would not be faced with sharply higher interest rates. 

The Bank of England owns roughly a quarter of the UK’s government debt. The central bank is, at least notionally, independent of government, and so can stop these purchases at any time.

Since it was granted independence in 1997, the BoE’s sole remit has been to achieve a rate of inflation in the UK of at, or near, 2 per cent.

If continued issuance of government debt, and its buying of that debt, risked a spike in inflation, it would be obliged by its mandate to stop buying more of the bonds and manage inflation, but if secular stagnation does happen, then inflation would not pick up, and the central bank could keep buying the bonds. 

Commercial banks and insurance companies are also obliged to own some of the debt for regulatory reasons, which is why debt with a negative yield gets bought, ensuring a permanent buyer of some of the bonds – though this has negative consequences for the profitability of those businesses.    

Half the world away  

A potential permanent lack of inflation does have negative effects, mainly that it means government debt will effectively stay more expensive for longer. 

This is because £1bn borrowed today by the government for 10 years will not actually be repaid in 10 years; it will be refinanced.

In a world with some inflation, £1bn in 10 years is worth much less in real terms than £1bn today, and this is effectively how the principal gets paid off, as the amount dwindles in real terms each time it is refinanced. 

The reason many people view deficit reduction as important is to ensure that the maximum benefit of this inflation is reflected in future. If a government keeps taking on new borrowing, then the full benefit of inflating away the old debt is lost.

So why can governments not just keep creating inflation to destroy the real value of the old debt?

The problem in this scenario, apart from the implications for the economy, is that when each line of debt matures, and the principal has to be repaid, the interest rate demanded by those buying the newly issued debt will be much higher than the interest payment on the old debt, as those buying the new debt will know that inflation is high and want a higher rate of interest in compensation.

This would become particularly acute if the bond market anticipated that rising inflation much above the BoE’s 2 per cent target had become long-term government policy.

In the event of the cost of servicing the debt rising, the possibility is that all of the cash leaving the economy to pay overseas owners of the bonds, or going into the vaults of banks and insurance companies, would be deflationary, as the supply of money in the economy falls, leaving people with less access to credit and capital.     

If this happens, the prevailing state of the economy is one where the principal is not being inflated away, and the interest costs are also high.

The UK government is presently operating in a world of historically low yields, and with vast pools of savings from around the world wanting to buy the bonds, but such a situation is unprecedented in history and cannot be relied on by advisers or clients to continue this way indefinitely. 

David Thorpe is special projects editor of Financial Adviser and FTAdviser