EEF blog

On Monday, Chancellor George Osborne announced at the Conservative Party Conference that his officials were working on options for credit easing. Since then there has been intense speculation about precisely what he means by this.

Yesterday the Governor of the Bank of England, Sir Mervyn King, did a round of interviews explaining the MPC's decision to start QE again by voting to extend its asset purchases facility by £75 billion. The focus for the purchases will very much be gilts (rather than a riskier range of private sector assets).

This morning, the Chancellor was again speaking, this time on The Today Show to discuss QE and his own announcement. Some interesting thoughts came out of this.

The Chancellor repeatedly stressed that both he and the Prime Minister have been consistent since they were in opposition in saying that the current situation called for fiscal prudence but monetary radicalism. Like Monday he again seemed to be pushing the idea that his credit easing policy was in the monetary sphere of macroeconomic policy.

But he also noted that it was the bank's domain to expand the volume of credit (via QE) but the government's to steer it to where it needed to go in the economy, including to SMEs (via CE).

Asked further what credit easing meant, the Chancellor said there were several options being explored. He mentioned the relative size of the UK's corporate bond markets compared with those in the U.S. In the UK minimum corporate bond issuance seems to be £100-200 million. In the U.S. as little as $25 million can be raised in these markets.

This has been an issue floating around 1 Horse Guards Road (HM Treasury) since at least July 2010 as it was included in the government's access to finance green paper as a weakness in the UK funding environment that may need strengthening.

No doubt this is a weakness worth looking to strengthen. But I wonder if it is the priority. SMEs (say firms with turnover of up to £25 million) are consistently reporting the worst access to finance. Even if corporate bond markets could be made as accessible tomorrow as in the U.S., this isn't going to help SMEs.

So this suggestion seems to me more about having a meaningful outcome from the government's current Mid Caps Growth Review than targetting the most important problems afflicting the flow of credit to SMEs.

The government action is a little unclear too. Are they going to create demand by buying these bonds - with fiscal implications? Are they going to try to bring down some of the hurdles companies face to issuing bonds - such as fees from ratings agencies? And how quickly will this influence change, even were the government sitting ready to buy billions of corporate bonds tomorrow, will companies be in a position to issue them?

To be fair my earlier post didn't cover everything the Chancellor said.

He also mentioned the possibility of the government using its balance sheet (made credible by him) to act a guarantor behind SME lending, thereby encouraging banks to lend more. There are already schemes in place with a similar theme - the Enterprise Finance Guarantee and the Export Enterprise Finance Guarantee.

These schemes are being used but demand for them is hardly overwhelming.When the scheme was first introduced it was to support facilities of up to £1.3 billion from Jan 2009 to March 2010. BIS figures show in the end the scheme was used to support loan offers of less than £950 million of which around £780 million was actually drawn. Over the next year to March 2011, with facilities of up to £700 million able to be supported, loans of £490 were offered with £460 million actually drawn.It's a little unclear what more the government may do further here.

Will they extend the scope of the EFG to cover larger businesses or larger loans? Will they increase the guarantee from 75%? Will they lower the fee charged for using it? If they did any or all of these things there would be a cost. And if the Chancellor considers this a macroeconomically meaningful intervention it would have to be done on a very large scale - so it might be a considerable cost. And being on the hook for what could be a very large potential liability would presumably be something that people who judge the credit-worthiness of the UK might look at quite closely.

The government could buy packages of SME loans - securities that offered a stream of payments based on a portfolio of individual loans made by banks. Banks would then have cash that they might be inclined to lend out to SMEs who are currently struggling to get a loan. There is some element of uncertainty about that though - because the banks may have reasons - such as shoring up their own capital - for not doing this.

For this to happen there would have to be a suitably qualified securitising agent - perhaps a market participant but in the current conditions maybe a government entity would be required to perform this role. It will be important that the securitising is done robustly and that credit worthiness of the package of loans is accurately assessed.

But assuming the government can rapidly assemble the entity and it can do a quick and thorough job - someone still has to buy these assets.

If that someone is NOT going to be the Bank of England, then does that mean it's up to the government? If the government's buying a whole lot of assets, will it have to borrow a whole lot more ££ to do so? What does that mean for its fiscal plans?

So a lot more questions than answers still on credit easing.

On Monday, Chancellor George Osborne announced at the Conservative Party Conference that his officials were working on options for credit easing. Since then there has been intense speculation about precisely what he means by this.

Yesterday the Governor of the Bank of England, Sir Mervyn King, did a round of interviews explaining the MPC's decision to start QE again by voting to extend its asset purchases facility by £75 billion. The focus for the purchases will very much be gilts (rather than a riskier range of private sector assets).

This morning, the Chancellor was again speaking, this time on The Today Show to discuss QE and his own announcement. Some interesting thoughts came out of this.

The Chancellor repeatedly stressed that both he and the Prime Minister have been consistent since they were in opposition in saying that the current situation called for fiscal prudence but monetary radicalism. Like Monday he again seemed to be pushing the idea that his credit easing policy was in the monetary sphere of macroeconomic policy.

But he also noted that it was the bank's domain to expand the volume of credit (via QE) but the government's to steer it to where it needed to go in the economy, including to SMEs (via CE).

Asked further what credit easing meant, the Chancellor said there were several options being explored. He mentioned the relative size of the UK's corporate bond markets compared with those in the U.S. In the UK minimum corporate bond issuance seems to be £100-200 million. In the U.S. as little as $25 million can be raised in these markets.

This has been an issue floating around 1 Horse Guards Road (HM Treasury) since at least July 2010 as it was included in the government's access to finance green paper as a weakness in the UK funding environment that may need strengthening.

No doubt this is a weakness worth looking to strengthen. But I wonder if it is the priority. SMEs (say firms with turnover of up to £25 million) are consistently reporting the worst access to finance. Even if corporate bond markets could be made as accessible tomorrow as in the U.S., this isn't going to help SMEs.

So this suggestion seems to me more about having a meaningful outcome from the government's current Mid Caps Growth Review than targetting the most important problems afflicting the flow of credit to SMEs.

The government action is a little unclear too. Are they going to create demand by buying these bonds - with fiscal implications? Are they going to try to bring down some of the hurdles companies face to issuing bonds - such as fees from ratings agencies? And how quickly will this influence change, even were the government sitting ready to buy billions of corporate bonds tomorrow, will companies be in a position to issue them?

The UK commentariat has been wringing its hands about growth prospects following Tuesday’s poor first estimate for 2010q4 GDP (0.5% contraction). Perhaps it’s time to ease up on ‘the cuts’ and get jobs and growth going, the line goes – as if they are somehow perfect substitutes. S&P’s downgrade of Japan’s sovereign credit risk, noting the country ‘lacked a coherent strategy’ to manage down its debts, should be a reminder that even major economies cannot postpone putting their fiscal houses in order.

True, Japan’s forecast overall public debt level (110-200% of GDP depending on whether pension funds are included) is much higher than the UK’s (60.8% of GDP). But on the other hand its 2010/11 fiscal deficit is slightly less at 9.1% v our 10.0%. And for 2010 at least, Japan’s growth performance is actually forecast to be far superior to the UK’s at 4.3% v 1.7% (though further out Japan slips behind us and they also suffered a worse recession in 2009).

How much confidence do you think the markets gained on Japan’s fiscal plans when PM Naoto Kan’s response to a question on the downgrade was “I just came out of parliament and wasn’t aware, so please ask me about it later.”

If you’re thinking not much, you could be forgiven for drawing parallel’s to the Chancellor’s equally facile response to the UK’s GDP numbers.

“We will not be blown off course by bad weather,” said Osborne...except as many others have pointed out removing the estimated -0.5pp impact of the snow (which itself seems very large to me) doesn’t even get you back to the lowest forecast from economists prior to the announcement (0.2% overall growth).

And the UK wasn’t alone in facing terrible December weather. Faisal Islam has highlighted this week Germany’s continuing growth despite running out of grit and facing snow disruption, like Britain. Even if you swallow the snow story, why should that be an acceptable explanation? Isn’t it shocking that the snow can dent the UK economy so considerably – and following three cold winters in a row and an inability to stop the white stuff falling down again at some point – shouldn’t we be worried about it? So whether it was or wasn't 'just' the weather the government's response looks too weak to me.

The bottom line is that the starkness from lacking fiscal credibility is real and a lack of a credible plan has real costs. The Japanese will now pay more for their sovereign debt - and that means more in the way of cuts to real spending to get the deficit and debt back under control - not a situation we want to face.

But the government’s responsibilities don’t start and end with balancing the budget.

We need credibility on economic policy too. How are we going to generate the growth we need to not only offset the impact of fiscal austerity and but allow Britain to compete in the post financial-crisis world? So far the government doesn’t seem to have much of a story to tell. How are we going to boost innovation, start finance flowing properly to business, and enhance the business environment? How are we going to get unemployment down, just as the public sector prepares to lay off hundreds of thousands of workers? And how are we going to do all that with no public money to use?

A bad quarter’s data doesn’t mean it’s time to panic and throw away the fiscal plan. It would be folly to sacrifice our fiscal credibility as Japan should highlight. But it should be a kick in the pants for Osborne and co to get serious about growth and the economic credibility of the UK. There's a lot riding now on Budget 2011's Growth Review.

Ireland and Greece have been ‘bailed out’ of their financial woes. Commentators have turned their gaze to Portugal and Spain as the next dominoes in the eurozone sovereign debt saga.

But what does bailing out mean? And does getting a bail out mean you’ve sorted your debt problems? The answer has at least as much to do with growth prospects as it does state-backed financial assistance.

Paul Krugman in the NY Times notes that getting a bail out simply means getting a guaranteed line of credit at a cheaper rate than what the market will provide. It doesn’t mean countries are bailed out of their debts – they still have to pay them back. It doesn’t even mean a particularly cheap rate on debt, which would be a welcome respite for a country trying to manage down its bills. The Irish deal secures credit at 5.8% interest - more than what the markets were charging them as recently as September.

So what does getting a bailout really get you? In short, a bit of time. Time to put in place fiscal reforms to get deficits and ultimately debts down. But just as importantly time to get growth in the economy up.

The growth part is absolutely essential if the fiscal reforms are to stick.

Growth was the aspect highlighted in a Radio 4 interview with Alistair Darling last Friday, where he discussed the perilous prospects for the eurozone periphery.

Perilous indeed.

The Irish numbers don’t even look like they stack up numerically. Ireland is relying on 1.75% growth in GDP 2011 – a number that will flow through into its tax receipts forecast. At the same time they are planning a contractionary (is that a word?) drag from the government equal to 3% of GDP.

Market commentators don’t seem to think such growth is likely. Many predict growth to be flat or even negative in 2011. What then for the bailout, will it be enough? How much more pain can the Irish people take if it isn't?

One of the big claims regarding the eurozone periphery is that they’re uncompetitive because their costs are too high. Becoming more competitive is a path to higher growth. Sharing the euro means currency devaluation is ruled out as an option. That leaves so-called internal devaluation, a long, slow grind of suppressing wage and cost rises in the economy.

Lower costs or even decreasing costs, could lead to lower inflation or deflation. Good for competitiveness maybe – except that will also make the cost of these countries’ debts higher in real terms, potentially necessitating further cuts.

So is that bailout really buying just another strap in the debt-growth straitjacket? And it seems to be tightening in.

As European leaders hammer out a deal on a permanent stability mechanism, they would be well to keep a close on their temporary fixes. Some ideas for boosting growth need to emerge for the periphery and soon. And if the periphery can't sort that out, maybe the core needs to think about it too - after all they're standing behind the bailouts. All this seems to be pointing to closer fiscal/political integration as the only sustainable way out.

Whitehall bureaucrats supposedly working up a Plan B for stimulating growth if the UK economy heads south would be wise to pay close attention.

The Spending Review announced £1 billion of Government funding plus ‘significant’ proceeds from the sale of assets to capitalise the Green Investment Bank (GIB). Details as to how the GIB will work are to be announced in the Spring. By itself this ain’t going to be enough.

Ernst and Young estimate the GIB would need to be capitalised to the tune of £4-6 billion to 2015 to meet the UK’s climate and energy goals. To be sure, funding alone won’t be enough from the Government in the absence of a coherent and stable climate and energy policy regime.

Forget about £ for capitalisation, the GIB’s funding issues appear even more fundamental. The £4-6 billion is supposed to help unlock investment of £250-450 billion to 2025, compared with a current expectation of only £50-80 billion. Where’s the extra money going to come from? Realistically it has to be the private sector. The Government’s modest £1 billion (so far) reflects the steep challenge of bringing the public finances under control. Fair enough.

So, private sources: Bonds, deposits, potentially equity to support the GIB; plus direct debt or equity through co-financing. The GIB Commission, which published its report in July, discusses most of these. Let’s look at just one – bonds. The GIBC suggested that issuing bonds was the major way the GIB could draw in funding from major institutional investors like pension funds or insurance companies – perhaps the majority.

But issuing bonds means in addition to holding assets, the GIB would also have liabilities – just like a real bank. Majority ownership along with any Government conditions of control on the GIB would indicate the Government controls ‘general corporate policy’. The problem is that these liabilities will then be counted in Public Sector Net Debt (PSND), which the Government is publicly committed to have falling by 2015/16. PSND is defined as financial liabilities less liquid assets.

The GIBC is at least partly alive to the issue, noting that all the GIB’s investment decisions would be made independently from the Government. Unfortunately, with majority ownership, that is unlikely to be enough.

There are ways around this. The Government could pledge to sell a majority of its shares by the end of the Parliament (thus not hurting its debt goals). The problem with this is that the GIB might be a couple of years away from investing, longer before it issues bonds, and much longer still until investment returns that might attract private buyers starting rolling in.

Another idea would be to devolve the Government’s shareholding to individual taxpayers, again by the end of the Parliament, perhaps with a further restriction of say 5 years on on-selling. This ‘green shareholding’ could even help build popular enthusiasm for the GIB.

A third idea could be setting the GIB up to only issue third-party guarantees, much in the way the Government does currently with the Enterprise Finance Guarantee (EFG). To my knowledge, EFG-backed loans do not add to Public Sector Net Debt (PSND). Rather only the expected cost of the guarantees shows up, as government expenditure, which in excess of revenue leads to the flow of Public Sector Net Borrowing (PSNB). Only this small flow, not the whole value of loans, adds to the stock of PSND. PSNB is defined as the difference between total expenditure and receipts or equivalently the change in net financial liabilities.

The question remains though, whether dropping majority ownership will be enough to lose the GIB from the Government’s accounts, or, in the case of the guarantee option whether the GIB will be able to meet its mission. That’s because the Government wants the GIB to pursue an ambitious, largely public (at least for now), aim – financing green investments with sub-market risk-return profiles.

Could the Government force the GIB to retain this mission without a majority ownership and without falling within the definition of influencing ‘general corporate policy’?

And if the Government gave guarantees only, will that allow enough green investment? It might make finance for green investments available that isn’t there currently – but perhaps at a price that chokes off demand for such finance.

If all these fixes fail or are unacceptable to the Government e.g. because it doesn’t want to do things ‘off balance sheet’ – what then? It seems to me that keeping the GIB in the public sector, even if it issues bonds, will cause a hit on PSND – but it’s much less clear what the impact will be on PSNB. That’s because at the same time as creating financial liabilities (bonds) it would be creating financial assets (giving out loans and guarantees).

The Government’s major fiscal goal is to eliminate the structural fiscal deficit (the structural element of PSNB) over the course of the Parliament. For PSND, the goal is only that this will be falling by 2015/16. Given the PSND hit would likely come before 2015/16, this should still be achievable.

Whatever option the Government ultimately goes for it needs to keep in mind the scale of the investment challenge it is trying to address.

The government can promote business growth and investment by improving access to finance

SMEs in particular are still struggling to access the funding they require, so it is encouraging that the Prime Minister noted in his speech on Monday that opening up access to finance and getting banks lending will be crucial to drive growth. Government should promote access to finance through facilitating greater transparency around lending policies; encouraging increased competition in the banking sector; and promoting alternatives to bank lending.

The government could take better advantage of green opportunities if more resources are given to the Green Investment Bank

The scale of investment needed to really capitalise on the opportunities in green technologies will not be met by the current plans for a £1bn Green Investment Bank. The government should be more ambitious: estimates suggest that the development of a low carbon infrastructure and low-carbon technologies will require £5bn of funding over the next five years.

The government will maximise the returns to its investment, if it is clear about its plans, and the kinds of support that will be available.

In many areas of government spending, greater details are required. Particular areas the government should clarify include which types of adult apprenticeship will be funded by the £250mn announced; and how funding to help firms commercialise their innovative ideas will be allocated. 

The government can spur on regional and sub-regional growth if it sets out clearly what LEPs will do; how they will operate; and how they will be funded

If LEPs are going to drive economic growth then the government will have to:
- get the right balance between central and sub-national government
- ensure LEPs have a clear remit and are focused on the right issues
- achieve a critical mass for LEPs
- secure engagement from business
- deliver value for money

The government can reduce the burden on business by providing greater stability and predictability in the tax system

If the UK is going to have an internationally competitive tax regime, the government must provide a road map for which corporate, environmental and personal tax reforms it will seek over the next few years and explain how these changes will rebalance the economy by supporting investment.

The burden on business can also be reduced through pursuing alternatives to regulation

The government has made a good start by introducing a “one in one out” policy on regulation, but it must recognise that the cost of regulation is also a cumulative effect from the layers of regulations that have built up over time.  For this reason the government should consider seven-yearly sun-setting reviews and consultations with business and use these to discuss alternatives to regulation.

The government can only ensure that businesses will receive the support they need in the coming months if changes to business support are properly communicated and managed

The need to reduce public spending along with the transition from RDAs to LEPs will inevitably lead to changes in business support, but the government should do everything it can to smooth this transition. Businesses will need clarity over which services will continue to receive funding even if the delivery mechanisms, brokerage and costs are still to be determined.

FT Alphaville highlights a near 50-year low in 10-year gilts and puts the blame for this fall squarely at the feet of bearish comments from new MPC member Martin Weale in the Times:

'It would be “foolish” to rule out the possibility of a double-dip downturn, even if it was not the Bank’s central prediction, said Dr Martin Weale, the newest member of the Monetary Policy Committee (MPC). He also feared that the Bank’s central outlook — which is for growth of about 2.8 per cent in 2011 and 3.2 per cent in 2012 — could be too optimistic…

Dr Weale said that the Bank’s latest economic forecasts, published on August 11, had a 10 per cent outside chance of four-quarter long economic contractions in 2011 and 2013. “The forecast is putting a significant chance on the economy contracting over a four-quarter period,” said Dr Weale.'
 

The link between Weale's bearish-ness and the drop in gilt yields raises questions about what effect yields will have on business investment (remember - the Chancellor and the OBR are staking their reputations on fiscal restraint lowering 10-yr yields and so helping to encourage business investment).

So what's pushing 10-yr yields close to record lows?

Well three factors: global risk, domestic weakness and fiscal consolidation.

Let's breifly take those in turn.

1. Global risk. With the global recovery stumbling and sovereign default still a moderate risk, investors are seeking safety in the arms of US, UK and German government bonds. As demand for these longer-term bonds goes up, so does their price, pushing down the yield. So far, so good. The problem is the affect on business investment. If financial markets are shunning risk, then its because there's something worrying about the state of the global economy. Concerns about the global recovery makes businesses uncertain - and that's why most are sitting on piles of cash and holding off on investment.

2. Domestic (UK) risk. Well, a weak economy typically favours bonds as investors move out of relatively riskier equities in favour of relatively safer goverment bonds. This is the sentiment behind the Weale-driven dip in yields. But yet again, domestic weakness will make businesses cautious about investing.

3. Fiscal consolidation. I'll put this upfront so there is no second guessing our views: this isn't a 'deficit denier' arguement. There is a deficit, it needed to be tackled and EEF supports most of the government fiscal consolidation plans. And tackling the structural deficit will provide downward pressure on gilt yields (or at the very least limit any upward pressure). The question we're raising about the affect on investment. The government is making a 'crowding out arguement' that says shrinking the deficit will lower rates and boost private sector investment. Not only is this arguement weak - all interest rates were low prior to the recession, which was part of the problem behind the financial crisis, so there's only a weak case for the government to make. Add on top the uncertainty caused by their unnecessarily deep capital spending cuts, and you've got businesses being cautious about investment because they've got concerns about their public sector-related orders.

So in reality, two of the three drivers pushing gilt yields down will naturally imply only limited growth in business investment. And the government's gamble on fiscal consolidation boosting investment actually cuts both way, providing an uncertain benefit.