Why British government debt is a toxic investment
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Associate Editor
David Stevenson Oct 20, 2009
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The Treasury: managed to keep gilt yields down so far
Public spending has become one of the biggest pre-election battlegrounds. It's little wonder. Britain's finances are in a dreadful state. There's an £805bn hole in our state coffers, according to the Office for National Statistics.
Yet our national cash flow problems seem almost trivial compared with those afflicting one US local authority. Jefferson County in Alabama is facing "financial Armageddon" as its plans for funding its top-heavy borrowings have completely fallen apart.
Why does this matter? Because Britain may be more like Jefferson than we'd like to think. The government's true borrowing levels are almost certainly much higher than those official figures.
That's very bad news for holders of UK government debt – and it certainly doesn't bode well for those hoping for a V-shaped recovery...
How has Jefferson, Alabama reached 'financial Armageddon'?
"In its 190-year history, Jefferson County, Alabama, has endured a cholera epidemic, a pounding in the Civil War, gunslingers, labour riots and terrorism by the Ku Klux Klan", says Ken Wells at Bloomberg. "Now this namesake of Thomas Jefferson" – the third US president – "is staring at what one local politician calls financial Armageddon".
Here's what's happened. In 1996, the county decided to upgrade its sewers, which were polluting the local water supply. Good idea, you might think. But Jefferson didn't have the money available for the scheme, and so it had to borrow it. When the cost of the project more than doubled from the first estimate of $1.5bn to $3.2bn, Jefferson's politicians had to flog a lot more bonds (i.e. borrow a lot more money) than they'd planned in order to fund it.
Then in 2002, a new mayor started spending more money the county didn't have. Among other schemes, he embarked on a three-year project to repave every street in Jefferson's capital, Birmingham – all 1,100 miles of them. Borrowings mounted fast.
To make matters worse, Jefferson's politicians had a go at "financial engineering" by betting on interest-rate swaps – complex financial derivatives - to try to fund all this. That went wrong too. The cost of paying just the interest on the county's debt ballooned to more than twice the sewer system's annual revenue.
In other words, Jefferson's incomings can't even stretch to pay the interest on its debt, let alone the capital. The county has been forced to slash its workers' hours, and faces possible bankruptcy. The bottom line is that one way or another, local taxpayers will have to foot the bill. They'll be paying more in taxes, while at the same time, public service provision will have to be slashed.
Is this starting to ring any bells?
Sure, it's partly yet another sorry tale about the dangers of snake-oil salesmen selling complex booby-trapped derivatives to naïve investors. But the root cause is not toxic financial products – it's governments running up too much debt in the first place.
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Britain has more debt than you think
Which takes us back to Britain. Conservative MP Brooks Newmark in his report, "The Hidden Bombshell", published by the Centre for Policy Studies, reckons that the UK government debt has soared to almost three times the official figure to £2,200bn. That's the equivalent of £85,610 per household.
How does Newmark arrive at this figure? He claims that the official numbers don't include the full cost of private finance initiative (PFI) projects, which he reckons add £139bn to the public debt.
Also, he says, unfunded public sector pension liabilities – i.e. where no cash has been set aside – have been left off the Treasury figures. But the government will have to pick up the tab here, adding a further £1,104bn. So-called contingent liabilities – possible future obligations – such as Network Rail, add another £22bn, while Mr Newmark counts the cost of recent financial sector interventions at £130bn. In total, £1,395bn of "hidden liabilities" is added to the £805bn official figure.
Now of course, the author is a Tory and The Times describes the CPS as a "centre-right think tank". So this report is not neutral by any manner of means. But even if these figures are somewhere in the right ballpark, they're very scary. It almost certainly means a mix of big tax hikes and cutbacks in the public sector payroll – Alabama-style – whoever wins the next election.
Why gilts are a high-risk / low-reward investment
That will be painful enough. But a shortfall anywhere close to that £2,200bn would be very bad news indeed, long-term, for UK government borrowing. This is funded by the Treasury selling gilt-edged securities (gilts). If deficits are higher than expected, then investors will become more reluctant to hold gilts (in case we don't repay them or inflate our way out of debt). This would force gilt yields up, as investors otherwise simply wouldn't be prepared to buy them. In short, just like any other market, the riskier the borrower, the greater the interest rate that lenders will charge to lend to them.
The UK Treasury has so far managed to keep gilt yields suppressed, as the Bank of England prints money to buy them (quantitative easing or QE). Ten-year gilts yield just 3.6% right now, at the low end of their long-term range.
But that can't last forever. When QE ends, and international fixed-income investors start to focus on the full extent of Britain's liabilities, gilt yields will be forced a lot higher (in other words, prices of gilts will fall as investors dump them).
So in any economic scenario other than extreme Japan-style deflation, gilts look like a very high-risk / low-reward investment indeed, particularly as any hint that QE is coming to an end is likely to result in gilt prices dropping rapidly.
Extreme deflation may still be on the cards. But it's just one possible outcome of many. And in the face of uncertainty, we'd rather play it safe. That's why we're still most keen on defensive stocks, paying decent dividend yields – so for now you get a reliable inflation-beating income, being paid out by companies that can withstand even the most extreme economic conditions. The experts in our latest Roundtable discussion have picked their favourites – you can read all about it in the next issue of MoneyWeek, out on Friday (if you're not already a subscriber, claim your first three issues free here).
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