Part-paid gilts should return

April 23, 2009

REUTERS– Neil Collins is a Reuters columnist. The opinions expressed are his own –

LONDON, April 23 (Reuters) – The UK Government needs to raise four billion pounds a week, every week, in the financial year to next April, to bridge the gap between its tax income and its spending.

Raising such stupendous sums — getting on for 15 percent of each week’s British national output — has never been tried before, and nobody really knows whether it can be done.

The optimists point to the financial year just ended, in which the government raised 146.5 billion pounds, as evidence that this year’s plan for 220 billion pounds can be met.

But during last year’s financial panic, savers decided that the return of their money was more important than the return on their money.

This year will be different. Given the dire outlook for the economy, UK government stocks look horribly overpriced. The benchmark five-year issue returns 2.54 percent, and the corresponding 10-year stock 3.45 percent.

These miserable yields are a consequence of the “flight to safety” coupled with the Bank of England’s desperate programme to inject cash into the economy. Its chosen route of Quantitative Easing has led it to buying existing government debt to prevent the money supply falling.

This has produced the bizarre spectacle of the government’s Debt Management Office issuing stocks which are virtually identical to those the Bank is buying. Essentially, the UK Treasury is selling paper to itself, with the traders making hay from the price difference.

Already the doubts are creeping in about whether this expensive circle makes sense, and next month the Bank has promised to review it.

The best plan would be to follow the example of the Americans in Vietnam, to declare victory and go home. At that point, or when QE is finally abandoned, the DMO will be on its own, leaving Britain’s finances at the mercy of the international bond markets.

While the UK’s credit holds, even four billion pounds a week is not too much for this vast, global market to find. Yet as the western world’s banks discovered last year, if your credit is not considered good enough, the markets can close to you almost overnight.

The DMO has no experience of anything like this. Those at the Bank who can remember when the UK government last had a credit crisis have either retired, or were fired when Gordon Brown wrenched management of the market from the Bank and created the DMO in 1998.

It promises to be a steep learning curve. Selling gilts when they look like a safe haven is one thing, selling them into a buyers’ strike is quite another, and a buyers’ strike is only too likely once the true cost of Alistair Darling’s fantasy Budget becomes apparent.

Prices would collapse as the yields demanded by the buyers rose, raising his borrowing costs still further. Transmitted to the currency, this vicious spiral is a threat to sterling itself.

Like the traders themselves, the DMO should make hay while the sun shines. Its simple wish list of stocks might be blown clean away when the weather changes, so at the very least, it should lock in those low yields now by issuing partly-paid stocks, with balancing payments due later in the financial year — or even next, since the financing problem is not going away. The deeper question is whether the DMO has the guile and low cunning to take on the traders from a position of extreme weakness, but at least showing some imagination would be a start.

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