Long ReadJun 29 2022

Did Rishi Sunak really cost the taxpayer £11bn?

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Did Rishi Sunak really cost the taxpayer £11bn?
(HM Treasury/PA Wire)

Buried deep in the bowels of the Treasury is a unit called the debt management office, which has the remit of issuing, and paying the interest on, UK government bonds.

One of the challenges this office has to contend with is setting the different maturity levels for UK debt. This means ensuring that not all of the bonds need to be repaid in the same year, but rather have the maturities spread over multiple years. 

It was into this milieu that the think tank the National Institute of Economic and Social Research calculated that by not managing the maturity of the government’s bond exposure cleverly in 2021, the Treasury cost the taxpayer £11bn more in interest than it should have done, at a time when the government's bill for interest on debt is rising. 

In practical terms, this would mean the government having £11bn less to spend on public services than would otherwise have been the case. 

But, while conceding that the government interest bill is higher than it could otherwise have been, a number of leading economists and civil servants have expressed scepticism at the £11bn figure, and indeed at the principle of the government trying to be active in the bond market beyond its core role of selling bonds to investors. 

Fair warning

Refreshingly for a think tank, the NIESR was not operating purely from hindsight, having warned the government of the risks associated with its debt management in 2021. 

The principle criticism from NIESR is that the government did nothing to change the proportion of its total debt pile that was in inflation linked bonds. 

Unlike other parts of the fixed income market, the yields on inflation-linked bonds move in line with inflation, so if you are the issuer of the bonds – that is, the borrower – higher inflation is very expensive indeed.

The NIESR say that in 2021 they advised the government that, with the economic consensus being that higher inflation and interest rates are on the way, it would be prudent to reduce the proportion of the debt pile held in inflation-linked bonds, and other bonds with a shorter date to maturity.

Jagjit Chadha, director of the NIESR, told our sister publication the Financial Times that: “It would have been much better to have reduced the scale of short-term liabilities earlier, as we argued for some time, and to exploit the benefits of longer-term debt issuance.” 

They calculate that by not doing this the government paid £11bn more in interest than would otherwise have been the case. 

This is because bonds with different dates to maturity respond in different ways to higher inflation. Governments that persistently run budget deficits, as the UK does, have to issue new bonds every year. This means the government will have new interest rates and new repayment dates to contend with each year.

Bond yields

To deal with this, they aim to issue bonds with varying maturity dates ranging from three months to 30 years and beyond. 

Bond yields, which move inversely to prices, are impacted by a range of factors including inflation and growth expectations in the economy, and the movement or expected movement in the level of the UK base rate.

Bond yields tend to rise, and prices to fall, when the market expects inflation to rise and rates to rise. 

And while the other name for bonds is 'fixed income', this has less relevance for governments because, unlike most borrowers, the UK government runs a budget deficit every year, so needs to issue new bonds every year.

It would have been much better to have reduced the scale of short-term liabilities earlier.Jagjit Chadha, NIESR

The impact of that is, while they benefit from, or suffer as a result of the fixed interest rate on bonds issued in prior years, new bonds being issued today carry today’s interest rate. In addition, bonds that were maturing this year have to be refinanced this year and pay an interest rate that is reflective of current market conditions. 

The role of the Treasury is to manage the different exposures to different interest rate movements by issuing bonds that mature over multiple years. 

The central bank policy of quantitative easing to a large extent made this role easy in the decade after the financial crisis because, by buying UK government bonds, they ensured the yields on some remained low. 

But with inflation now sufficiently high that yields are rising sharply (the 10-year now yields 2.6 per cent, having been as low as 0.4 per cent over the past year) and central banks putting the base rate up, even as the remnants of the QE policy are being wound down by the bank, the debt management office’s work has become tougher. 

There are two possible ways the government could have done this. The first is by selling the inflation-linked bonds, and issuing more long-dated non-inflation-linked bonds. 

The yields on the latter will also have risen over the past year, but not in line with inflation, as the yields on inflation-linked bonds have. 

Insurance

The second approach would be to have taken out insurance against the risk of inflation rising. In such a scenario, while the interest bill would rise as a result of the inflation-linked bond holdings, the government would receive an insurance payout to compensate for this.

Of course, insurance premiums have to be paid, and this cost would be offset against the £11bn 'saved'.

Rupert Harrison, portfolio manager at BlackRock, and a former economic adviser to the government, says it would have been “absurd” for the government to take out insurance.

He explains this is because it would have been passing risk into the private sector, which is less able to deal with the consequences than the government is. 

But Simon French, chief economist at Panmure Gordon, says the £11bn figure is “unrealistic because if the government began to sell one type of bond in such huge volumes, and buy other types, there would be an impact on the yield, or interest rate, the government would have to pay on the non-inflation-linked bonds. 

When the Treasury tries to outwit the market, there's only one winner.Lord Nick Macpherson

The NIESR’s £11bn figure is based on the yield today on the bonds that could have been issued to fund the repurchase and cancellation of the inflation-linked bonds, but French’s point is that, given the scale of the new debt that would have to be issued, the yields on the non-inflation-linked bonds would rise markedly, so even if it was cheaper for the government to do this, it would not be cheaper by the full £11bn amount. 

French adds: “The Treasury [through the debt management office] takes a 'balance of risks' approach to its liabilities. It is not a hedge fund and while with hindsight it may have been profitable to reduce linkers/extend duration last year, I'm uncomfortable with fiscal authority acting like a hedge fund.”

Harrison also compared the range of remedies proposed as forcing the government to act like a hedge fund.

Lord Nick Macpherson, who served as permanent secretary to three different chancellors, including during the global financial crisis, also cautioned against the government trying to predict its debt market exposures. 

He said that while the gilt (UK government debt) market is more predictable now than was the case in the 1990s, “in my experience, when the Treasury tries to outwit the market, there's only one winner.”

David Thorpe is special projects editor of FTAdviser