Public Finances - A New Paradigm?

It would be disingenuous to state that the current pandemic has not adversely affected the UK economy. With a stringent first lockdown weighing heavily on predominantly service-based industries, UK GDP shrank 20% between the first and second quarter this year [1] – the worst contraction amongst OECD countries. HM Treasury’s £322bn unprecedented response in the form of the Job Retention Scheme, the Business Loan Schemes and the Bounce Back Loan Scheme (amongst other support for self-employed workers and businesses) has helped to ease the impact on firms and individuals. But with the prospect of a second national lockdown in addition to the new tiered lockdown system – in conjunction with harbingers doom of falling month-on-month GDP growth – Rishi Sunak must be sat in his office in 11 Downing Street with a fiscal headache: to borrow more now to ease the burden of the second wave but face the prospect of future austerity, or face criticism from Conservative backbenchers for not aiming to balance the books? With the debt-to-GDP ratio set to reach over 100% of 2018-19 GDP by the end of this year [2], it seems like Mr Sunak is stuck in a zero-sum game.

UK debt-to-GDP is expected to rise above 100%.

A Wider Change?

However, the change in the UK’s public finances is largely symptomatic of a more general movement to higher indebtedness, with the IMF [3] calculating that US debt-to-GDP at 131% (pre second stimulus package); France’s figure being 119%; and Japan’s figure rising to 266%. The average for advanced economies has reached 125.46%, an astonishingly high figure given the effort to reduce debt levels after the response to the global financial crisis. The UK’s position is certainly not idiosyncratic, as all developed economies have taken to fiscal measures to support their ailing economies. The first US stimulus package (where eligible individuals were sent cheques) was largely seen as successful, until it ran its course. With the prospect of Joe Biden’s election and a Democrat-controlled Congress, that aggressive fiscal response is set to continue. Similar job retention schemes have been rolled out in other European economies, with the timescale extending until at least 2021. It seems like no developed nation is in any rush to pull the purse strings tight – it really is a case of “whatever it takes” – Sunak’s words at a COVID briefing in March after announcing latest fiscal measures. We now seem to have reached what will most likely be a naturally higher level of debt in the developed world, with a general acceptance that pre-pandemic debt levels (and even pre-2008 levels) will not be seen until we have fully recovered from the virus.

Developing Economies

One significant concern is regarding the level of debt in developing (or non-developed) nations. Last week, Zambia was the latest developing country to announce that it was on the brink of default [4]. The copper rich nation is currently stuck in an acrimonious dispute with private investors holding its debt – the consortium effectively holds enough debt to veto any proposal from Zambia’s Ministry of Finance. Argentina defaulted for an eighth time in its history in August and many other developing economies are facing the prospect of default, which would only serve as a circular process where credit ratings are downgraded, debt becomes more expensive and more defaults become more likely.

Although the IMF has pledged support in the form of loans, grants and debt relief, developing nations are at a natural disadvantage given their higher cost of debt, less liquid capital markets, central banks with smaller arsenals, and private investor groups holding their debt. Due to these factors, there is an increase in the spread – or diversion – between the ease of “doing” public finances between the developed and developing world. In this new paradigm, it is becoming increasingly difficult for developing countries to follow the same tactics as their developed counterparts, especially from a monetary perspective. The IMF can only do so much – the developed nations will need to be more generous in terms of debt relief.

QE and the Question of Monetary Financing

Proponents of Modern Monetary Theory ultimately argue that deficits do not matter as long as a country’s central bank is the sole issuer of its currency. Although there are a lot more nuances, amongst many flaws, the reader is encouraged to read up on a macroeconomic theory which has entered the macro discourse in the last year or so.

Although there is no significant evidence of that, central banks have adopted unprecedented purchasing levels in developed fixed-income markets as part of another round of Quantitative Easing, in order to lower borrowing costs (yields fall as prices rise). Additionally, portfolio substitution effects have filtered through, lowering yields across the corporate and developing world as well – such a movement has been responsible for the rise in the Renminbi (which could be a precursor for what’s to come in the US-China trade dispute).

Although no deficit is being financed directly by a central bank, the holdings of sovereign debt by their own central banks (especially the US and UK) have significantly increased. Given that the Bank of England remunerates interest paid on its holdings, the Treasury has been able to cope with issuing large amounts of debt, with the pace of BoE purchases matching the pace of issuances as to keep prices high, therefore keeping yields low. Additionally, the Fed has acted as the firefighter of US financial markets, and does not need to hesitate to douse the flames of any large rise in US yields. As stated earlier, the same cannot be said for developing economies, whose central bank resources are strained in relation to the behemoths on Threadneedle Street and Constitution Avenue. Conversely, countries in the Eurozone have still benefitted from balance sheet expansion, but ultimately do not control the ECB, given its autonomy.

 New issuances of debt have been matched by Bank of England purchases, helping to keep yield low

What Next For Mr Sunak?

A key opportunity has opened up for Mr Sunak – he’s most likely aware of it. With the Bank of England showing no sign in reducing its pace of gilt purchases and with some debate about the introduction of negative interest rates, the weighted gilt yield is expected to be 0.33% for the rest of this year; it is expected to be 0.61% in 2024-25 [5]. By taking a simple government budget constraint of:

Δb = pd - (i-y)b

Where delta b is the change in debt-to-GDP ratio; pd is the primary deficit (tax receipts minus government spending); (i-y) is the difference between the nominal interest rate and the growth rate of GDP; and b is the current debt-to-GDP ratio. Solving for 0 and the optimal ratio:

b* = (g-t) / (y-i)

So the ratio can be reduced if the growth rate of the economy exceeds the nominal interest rate, even if the UK runs a primary deficit. With gilt yields expected to stay at below 1% for the next five years, growth is most likely expected to outstrip that as we recover from the pandemic, and hence the ratio could fall, even if Mr Sunak continues the increase in expenditure.

As long as the Bank of England (and other similar central banks) does not reduce its accommodative measures, the shift in paradigm will benefit sovereign currency issuers – Mr Sunak should take advantage of this unique opportunity.