14 July 2016
The Great National Investment Opportunity
A case for long term hypothecated bonds.
by Frank O’Nomics
Amidst the posturing, politicking and hyperbole of the Tory leadership election mess there may have been a very good idea which merits a full evaluation and, potentially, prompt adoption. It came in the manifesto delivered by early drop-out Stephen Crabb and has strong support from the business minister, Sajid Javid. Their notion is to take advantage of the exceptionally low level of long-term interest rates to borrow money (the sum of £100 billion) for key infrastructure projects, which Crabb called the “Growing Britain Fund”. This could go a long way towards generating the investment capital needed for the NHS and transport systems – areas that have long been regarded as suffering from chronic under investment, and Crabb cited infrastructure projects such as social housing, school buildings and flood defences. The key watchword for both the Blair-Brown and Cameron administrations has been that of prudence in relation to public finances, and increasing the ratio of debt to GDP at a time when government receipts are likely to come under pressure from the threat of a post-Brexit slowdown, might seem anything but prudent. However, borrowing for specific projects at such unprecedented cheap levels may be just too good an opportunity to pass up.
The Crabb-Javid plan was to issue £20 billion of long-dated gilts over each of the next 5 years. Such plans always create the danger of raising money that just gets lost in the vast edifice of government finance, but if the money is kept separate from the national debt, only to be used for specific projects, this risk can be negated, and there is a history of doing that. Some years ago specific gilts were issued to finance both the nationalisation of the rail and gas industries, as well as to pay for wars. While most this debt has long since been redeemed (War Loan was actually only redeemed last year) there seems no reason why the concept should not be rejuvenated. Who would have a problem with buying a NHS 2% 2066 bond? Many savings institutions would see virtue in doing so, as would their investors. There may also be scope to further broaden the UK investor base if the issues could be made sharia compliant.
Such an increase in government borrowing might fly in the face of the accepted wisdom of keeping a tight rein on the budget deficit. Both the 2010 coalition and the 2015 Tory government have tried to keep in the national debt in check, but at least now George Osborne has realised that attaining a budget surplus by 2020 is unrealistic and potentially too damaging for an economy coming to terms with Brexit. Further, there is no reason why the increase in borrowing should negate the drive for structural reform and efficiency. There is still a great need to maintain pressure on spending departments and to look for ways of saving money. In a true Keynesian sense the benefits of borrowing to invest for specific projects can create jobs and generate prosperity to the extent that government revenues increase to help reduce the burden of existing debt. As long as there is spare capacity in the economy such a move should not be inflationary, and should not be viewed negatively by the ratings agencies. These agencies have a tendency to look favourably on nations which increase the average term of their debt, given that this reduces short-term refinancing needs.
The demand for long-term debt is amply illustrated by the fall in the absolute level of long-term bond yields, and the margin between borrowing long and short, over the last few years. 2 year UK government bond yields are currently around 0.18%, 39 basis points lower than last year, while 10 year yields have fallen 125bps to 0.83% and 30 year yields 114bps to 1.67%, the lowest levels ever recorded. At the time of the 2010 election, 30 year gilt yields were 4.20%, so if the government were able to raise £100 billion at current yields, they would be doing so £2.5 billion per annum cheaper than just 6 years ago.
Clearly the creation of greater supply could have a negative impact on prices, forcing yields back up, but at present it seems that pension funds in particular just can’t get enough long-term debt. The combination of poor investment returns in equities and the increase in longevity has significantly increased pension fund deficits, and the only way they can reduce these is by buying long-term government bonds – the only risk-free asset that neutralizes their liabilities. Last month the UK Debt Management Office managed to sell £1.5 billion of 30 year bonds at a yield of 2.1% – and the auction was 1.3 times over-subscribed. Since then the Brexit vote has reduced the yield on these bonds, and hence the borrowing cost for the government, by 0.5%. There may even be a case for issuing even longer debt, so that pension funds can hedge all of their tail liabilities from defined benefit schemes. There may be limited demand for 100 year bonds but they have been successfully issued by other countries, notably Ireland and Belgium this year alone. There has also been an increase in corporate entities looking to raise very long-term finance at these cheap levels – and this creates the danger of the UK government being “crowded out”; if there is finite demand for long-term bonds, would it not be best for the government to satisfy it rather than letting companies do so – particularly if they are based outside the UK?
It is entirely reasonable to argue that increasing long-term borrowing at this juncture risks the moral hazard of just passing on the bill for our economic ills to future generations, but if those future generations have a properly functioning health care service and a fit-for-purpose rail and road network this is a price that should be seriously considered. As I write we await the announcement of the darling buds of Mrs May’s cabinet and, despite the recent furore over the cvs of politician’s, it is worth noting that Mr Javid spent much of his career working in fixed income markets at Deutsche Bank. This may prove a very good background for a potential Chancellor of the Exchequer.
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