The UK economy is close to stall speed and credit conditions are deteriorating. Perversely, the Bank of England’s remedy, another round of quantitative easing, may make matters worse. A flatter yield curve is generally bad for banks’ net interest income (NII). Tumbling long-dated gilt yields have had the unintended consequence of increasing pension fund liabilities because they are calculated using the 15-year (and over) gilt index. This could result in businesses using cash that could be spent on investment in plant, machinery and labour, diverting it into their under-funded pension schemes.
There are better ways for the Bank to spend its QE windfall. Economies across the developed world are faced with the same dilemma – how to generate growth without destroying fiscal credibility. However, the UK is blessed with several important advantages over other countries. The deficit reduction plan has ensured that the UK remains one of a dwindling band of triple-A issuers. With France the latest country to find its triple-A status under scrutiny, UK government debt has scarcity value.
Further, because of the excellent work of the Debt Management Office, the average maturity of that debt is 14 years. The equivalent figure for US government debt is five years, for Greece six years, and for France and Germany it is eight years. The UK’s short-term funding needs and exposure to roll risk are lower than any other large developed nation. It is time to use those advantages creatively.
Instead of buying long-dated gilts, the Bank should buy around 50% of all gilts outstanding with maturities between zero and three years. The bill would be approximately £57 billion. In the short term, this might result in higher debt-funding costs. But if this buyback were sterilized, in full or in part, by the issuance of longer-dated debt, the increase would be minimal. Call it Operation Twist in reverse.
This should not be problematic. The reason that the DMO has been so successful at extending the maturity of UK debt is because there is demand for long-dated issuance. It would buy the government time, by all but eliminating roll risk, and greater flexibility to put in place stimulus measures. A positive side-effect would be a steeper yield curve at the short end, which would help boost bank’s NII and help the financial system recuperate.
| In a few years’ time a UK development bank could issue perhaps €40 billion annually. It could provide an enormous fillip to the economy |
Some of the £18 billion that is left over from QE should be used for credit easing. The Bank may not like it but this is our money and it is a nationalized institution. In the short term, a government agency should be set up to buy up parcels of corporate loans, particularly from the state-owned banks. It could then securitize them and sell them on.
It could also buy state bank debt, in the hope that this would lower their funding costs. The sooner these banks return to health, the better for taxpayers, the government and the economy. As the state-owned banks shrink their balance sheets – a necessary process anyway because of new capital requirements – they will need fewer bankers. They might be grateful for jobs in the new agency. Some might even have a repressed desire to serve the public good.
In the medium term, legislation should be introduced to transform this agency into a UK development bank along the lines of Germany’s KfW Bankengruppe. Like KfW, this bank should operate with an explicit guarantee from the UK government that covers all of its liabilities. Its goal would be supporting the government’s economic objectives. As these include rebalancing the economy away from the financial sector, the very act of its creation would be a great stride forward.
Lord Myners recently pointed out that the UK’s banks have assets and liabilities of £6 trillion. Of that total, loans to UK businesses are approximately £200 billion, less than 3% of their balance sheets. Either there is no demand for bank lending, banks do not want to lend, or bank lending rates are too expensive.
The creation of a development bank would find out which is true.
Because of its guarantee, KfW is able to issue at the same triple-A rating as the German government. Its last three benchmark five-year euro issues were priced at a spread between 38 basis points and 80bp over the equivalent Bunds. This year, it plans to issue €80 billion.
The UK economy is roughly one-third smaller than Germany’s and KfW has worked hard over 63 years to cultivate its investor base. But if in a few years’ time a UK development bank could issue perhaps €40 billion annually at a similar spread over gilts, it could provide an enormous fillip to the economy. If there is pent-up demand for short-term debt as a result of the QEII proposal above, it should target its issuance there.
Because of its ability to raise funds more cheaply than the commercial banks, it could finance export-oriented businesses at highly competitive rates, invest in long-term infrastructure projects and perhaps play a part in meeting the government’s overseas development goals.
This is a strategy for growth and a more balanced economy that would leave the UK’s triple-A status intact. It might even enhance it. The banks will doubtless bleat about the state crowding out the private sector. Let them.
Andrew Capon has won multiple awards for commentary and journalism on markets, investment and asset management. He welcomes comments from readers and can be reached at amcapon@btinternet.com