On Tuesday the FSA announced tough new rules for banks to keep more liquidity. They tightened the rules on what qualifies as a liquid asset, and will over the years ahead require more liquid assets to be held. The bottom line is that banks will have to lend much more to the government, buying government bonds to do so. The FSA’s guide figure was for an increase of £110 billion in bank holdings of government bonds, but other commentators think it could end up considerably higher than that figure. Banks may also need to sell some corporate bonds to make room for more government paper.
In normal circumstances you would say “buy government bonds and sell corporate bonds”, as this is a major change to the demand side of the supply/demand equation. In practise gilt prices changed little. This was probably for three related reasons. Firstly, UK government bond yields are already low compared to past experience and relative to corporate bonds. Secondly, investors are well aware of the large borrowing requirements lining up for future years, so they see no need to rush to buy more gilts. Thirdly, they want to know what will happen to government bond prices when quantitative easing stops. Just ending the automatic purchase of large quantities by the Bank of England could damage prices. Any attempt to sell off the £170 billion portfolio would also have a big impact. We do not regard the new bank rules as a reason to recommend gilts again. We still think the extreme conditions of UK policy suggests to cautious investors to stay clear of UK government bonds. There should be easier ways of making money than lending to such a highly borrowed government at 4% or less.
We also need to ask what might happen in the UK after a general election. The last two weeks have seen the main political parties at their conferences. The Labour government has now accepted that there do need to be cuts to start to bring the deficit under control. We will learn more of their plans at the time of the Autumn Statement. What is clear is the spending continues this year. They claim to want to halve the deficit subsequently but have not yet spelt out the detail of how such a big gap can be closed.
The Conservative Opposition has stated that it wishes to start curbing the deficit immediately. It has now spelt out some proposals that will reduce spending, including raising the retirement age and placing a freeze on most public sector pay. It has also said it will still introduce higher state pensions. There is nothing yet on the table from any political party that would dramatically cut the deficit in a way which would drive bond prices higher and yields lower. The issue is whether the Opposition has said enough to prevent rates from rising, which is likely on unchanged government policies.
You cannot solve a crisis brought on by borrowing too much, by just borrowing more. You cannot solve a banking crisis by simply transferring all the losses and toxic debts to the taxpayer. You cannot sustain a recovery on excess public spending and borrowing.
The problem now is crowding-out. The government is putting everything through the public sector, starving the private sector of the cash and credit it needs to get moving again. The main risk is that markets will lose confidence in government borrowing and in the currency at some point, devaluing the pound more, forcing higher interest rates and more cuts.
The government has to help the country tackle the treble deficits - past excess credit in the private sector, present and future excess borrowing in the public sector, and broken and over-extended banks. You cannot have a sustainable recovery until the banks are mended and able to advance money to the private sector again in sensible quantities at affordable rates.
So what does the government need to do?
1. End the requirement on the banks to make such a large increase in their holdings of government debt. Higher bank liquidity should wait until the banks have worked out more of their bad debts and have strengthened their capital through retained profits, asset sales and share issues.
2. End Quantitative easing. The Bank's strategy is punishing the pound and pushing up asset and commodity prices very early in the cycle.
3. Implement a first round of sensible reductions in spending. At the very least it should end new pay awards to the public sector, reform welfare to encourage more back to work, and impose a staff freeze on all non front line posts. Markets want some sign that government is going to get a grip on its spending.
4. Bring forward asset sales, and accelerate the transfer of banks back to the private sector, splitting up the monoliths.
5. End the idea of government insurance for the bad debts of the banks and make them find private sector solutions to those problems. The authorities would continue to act as lender of last resort and to stand behind the deposit guarantee scheme.
This is likely to include the weaker banks raising more capital from markets and selling more assets as a matter of urgency.