Saturday 20 December 2008

Spending The Kid's Inheritance

As the real economy moves into recession, we can now see how governments around the world are responding to the crisis. In general, there has been a bail out of the banking sector around the world. This has been coupled to a loosening of monetary policy as interest rates have been aggressively reduced, along with the announcements of relatively large fiscal stimuli. We have yet to see whether this action alone will be enough to mitigate the worst effects of the incipient recession. While we wait for the unfolding of events, we might be usefully engaged in giving some consideration to the longer term impact of these policy changes.

Most attention in the UK has been directed at the size of the fiscal stimulus. Two factors dominate the conversation – the amount that needs to be borrowed and how will it be paid back. Indeed, there is currently a very public row between the UK and German governments about the wisdom of such large borrowings, which, in turn, is feeding into the domestic political agenda. The more critical reviews of policy estimate borrowing to be in the region of £1 trillion (see article). This is highly unlikely to happen and represents more of a political calculation rather than a financial one.

We ran some scenarios based upon the recent Pre-Budget Report, and we estimate borrowing to be in the region of £355 billion over the next 8 years. Interestingly enough, Barclays Capital estimates total borrowing at about £370n billion over the next 7 years. This suggests a more reasonable order of magnitude. Of course, all estimates are, at the present, quite speculative. The duration and severity of the incipient recession will have a greater role to pay on the actual outcome, and, at present, this factor is a critical unknown.

The estimates presume that the economy will continue into recession until the middle of 2009, with unemployment peaking at about 2.25 million. If the recovery is delayed until 2010, or if unemployment rises appreciably beyond the forecast levels, then the automatic stabilisers (lower tax receipts and higher unemployment benefit payments) will push the borrowing requirement beyond the current projections. Of course, if the base assumptions turn out to be unduly pessimistic, then the opposite will occur. At present, the pressure valve to the economy is the Sterling exchange rate, which has been allowed to fall with something of a public outcry, but without too great a policy response. This gives rise to hopes for exports playing a role in the recovery.

Irrespective of whether the estimate for PSBR is higher or lower in the coming years, the point remains that the government will undertake record levels of borrowing, which will have to be repaid. This raises the question of where the money will come from to repay the debt. We feel that the situation is not as bad as has been painted. The government has bailed out the banking sector to the tune of £37 billion (with borrowed money). The bailout has been implemented by taking 12% preference shares in the UK banks. We like the horizon of 8 years because, in that horizon, at 12% return, the £37 billion will have been repaid in the form of a preference dividend. You should note that these figures are averages – a holding that averages at 8 years in duration and which pays an average of 12%. However, on this reckoning, the original loan taken out by the government more or less can be repaid from income, leaving the Treasury holding 12% preference shares that cost £37 billion.

How much are these preference shares likely to be worth in 2017? Supposing that Base Rate normalises in 8 years at an average of around 4%, then the CAPM valuation model would suggest that the capital value of UK Financial Investments Ltd (the vehicle through which the Treasury owns the preference shares) would be in the region of £110 billion to £120 billion. This was the basis of our view that UK Financial Investments Ltd should become a Sovereign Wealth Fund (see note). However, as this sum represents about a third of the additional PSBR, one can see that the Kid’s Inheritance could well be spent upon repaying the new borrowing.

Furthermore, in a previous post (see post) we speculated that the New Normal would lead to greater supervision of the banking sector. One way in which this supervision will manifest itself is through tighter capital adequacy rules and tighter liquidity requirements. As a consequence of this, the banking sector will be required to hold a greater percentage of their asset base in gilts. The Financial Times estimates the additional gilt requirement for the UK banking sector to be in the region of £90 billion to £350 billion (see article), which raises the oddity of the Government lending the banks the money which they banks use to lend to the Government. Either way, this represents a further chunk of the additional PSBR being covered.

Finally, as equity markets fall across the world and as the global economy heads into recession, pension fund managers will be worrying about their long term commitments to pay a steady stream of income. One technique to allay those fears is to switch from the volatile income stream associated with equities into the more certain income stream associated with gilts. Of course, this gives rise to the perverse situation of pension funds selling equities at the bottom of the market and purchasing gilts as they become relatively dear. However, in terms of PSBR, this will put further demand into the gilts market. We are currently unable to estimate the extent of this demand – it depends upon how bad the equity markets become – but we could expect the figure to be in tens of billions of pounds.

Already we can start to see how the additional PSBR will be funded. Most of it will be funded by the banking sector as a consequence of greater state supervision and involvement in the sector. Politically, this is a good message that can be given to voters. The banks – who many hold responsible for causing the economic turndown – will have to pay to clean up their own mess.

The UK case has wider significance for two reasons. First, the UK government feels that it has been something of a thought leader in the G8 on how to respond to the current turmoil. There is something to this claim. The US, who ordinarily would take the lead, has been unable to do so because of the political paralysis caused by a change of President. In many respects, President Elect Obama, when he assumes office in January, will be playing catch up to the rest of the world. If the forecasts of the recovery starting in mid-2009 are correct, then the US is unlikely to gain the initiative in combating the recession. The resulting institutional structures could well have a distinct European feel about them. Perhaps Mark Leonard is right? (See Reference).

The second point to note is that we are discussing the response to the recession unwinding over the next decade or so. We are now only coming to realise that the immediate planning future has changed, and that a New Normal is emerging for the coming decade. This has yet to permeate into corporate planning structures, and when it does we might see a different approach to business emerging.

The impact of the credit crunch is likely to be with us for some years to come. Let us hope that, in dealing with it, we do not have to spend the Kid’s Inheritance.

© The European Futures Observatory 2008
We are organising a roundtable meeting in March 2009 to examine how ‘The New Normal’ might be structured in the years to come. The meeting will be in London and aims to develop and publish ‘A manifesto for the G20’ ahead of the meeting of the G20 in London in April 2009 in an attempt to introduce some futures thinking to the policy debate. If you would like to be involved in the roundtable, or if you would like to be informed of developments, please let me know and I will keep you in touch.

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