Hamish McRae: Brown takes bonds back to the future

The old Labour idea that if the state needed money it went out and borrowed it seems to be dead
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The Independent Online

From the point of view of the financial markets the only surprise in the Budget was that there were no surprises: no overt pandering to the electorate in a pre-election Budget. But there was a surprise in public relations terms, wasn't there? That was the response in the Commons to the news of the repayment of £34bn of debt. The Labour benches cheered. The old Labour idea that if the state needed money it went out and borrowed it seems to be dead. A surplus equals not just prudence but by cutting debt service costs releases resources for spending on things people really want from the state.

From the point of view of the financial markets the only surprise in the Budget was that there were no surprises: no overt pandering to the electorate in a pre-election Budget. But there was a surprise in public relations terms, wasn't there? That was the response in the Commons to the news of the repayment of £34bn of debt. The Labour benches cheered. The old Labour idea that if the state needed money it went out and borrowed it seems to be dead. A surplus equals not just prudence but by cutting debt service costs releases resources for spending on things people really want from the state.

If this attitude sticks it has profound implications for financial markets. It means, for a start, that the Government here will not be a significant supplier of gilts to the pensions industry for the foreseeable future. But that is a parochial way of looking at things: If Government borrowing goes out of fashion more generally then Government long-dated securities are going to be in short supply the world over - unless you want some Japanese yen ones.

Of course, it may not happen. In the late 1980s people here wondered whether the rate of repayment of debt then would lead to a gilt famine. Well, the period of surplus did not last long. The early 1990s recession destroyed that. And now, though the period is longer, a move back to balance (and indeed modest deficit) is projected. True, neither the 1980s debt repayment, nor the present one, have been simply the result of taxes running ahead of spending. In the 1980s it was boosted by receipts from privatisation and the current repayment benefits from the windfall from the auction of the spectrum licences. But governments cannot forever expect to find assets to sell. There is not much left to privatise and the £22.5 billion raised from the spectrum auction looks most unlikely to be repeated. Had they held the auction now the sums raised would have been much smaller.

So the realistic assumption for the UK, looking forward, should be that we will only get significant debt repayment if taxes run ahead of income and as you can see from the graph this happy state of affairs does not tend to last very long.

Look elsewhere and there are similar constraints on debt repayment. On the continent there are still significant assets to be privatised but proceeds from these will in general be required to shore up unfunded public pension schemes. And while there are significant surpluses in the US, Canada and Australia, if is not hard to see circumstances (particularly in the US) that would erode these - such as a recession.

Nevertheless the general proposition still stands that the supply of government debt will tend to be much tighter than in the past and that this lack of supply will coincide with a rise in demand for savings products from funded pension schemes.

So what gives? Markets are markets and their job is to balance supply and demand. They will do that but the price may be unsatisfactory to the lenders or the borrowers. At the moment in the UK they are unsatisfactory to lenders; at below 5 per cent we have lower nominal long-term rates than any country bar Japan. But there have been long periods, particularly during the 1970s and early 1980s when they were unsatisfactory to borrowers. Interest rates then of 15 per cent and more on 20-year debt gave unreasonably high returns to holders and placed an intolerable burden on taxpayers.

So assume that yields on most government stock will continue to be extremely low for the foreseeable future. If there is a slight uplift in inflation, yields will rise but the general assumption of investors should surely be that government stock is likely to remain an unexciting investment for a decade, maybe longer. This is new to anyone alive now: it is a partial return to the market conditions of the last quarter of the 19th century, partial because equity markets were much less developed then. But from now on the bond market will take on a 19th century hue.

What happened then was a hunt for yield. One place where you could get higher returns was abroad. The flood of money that left London then did so because the returns available in the UK were unacceptably low. Expect that to resume. The trouble then was that the quality of risk assessment was, shall we say, uneven. Actually it was better in London than in Paris, thanks in part to the independent press, which criticised many new issues - France ended up losing nearly half its foreign investments following the Russian revolution.

So expect similar pressure here to improve the quality of analysis of foreign bond issues. But especially expect pressure to improve the analysis of domestic corporate bonds - and expect a surge in issues. The odd thing about the corporate bond market is that there are wonderful opportunities but the amount of resources devoted to analysis is tiny by comparison with the analysis devoted to equities. A century ago it was the other way round.

Next, expect more ingenious ways of securing bonds to be developed. One example is the New York subway's issue of bonds secured as a first charge on the revenues of the subway. Bob Kiley, appointed by Ken Livingstone to run the London Underground, has suggested this plan here. That may well not fly but expect similar devices to be developed.

Third, as the higher yield bond market develops, expect it to bite just a little into the cult of the equity. Over the past 150 years, returns on bonds have in general been lower than those on equities. But there have been quite long periods within that 150-year period, particularly during the 19th century, when the reverse was true. The non-government bond market was destroyed by a combination of excessive government borrowing and rising inflation. Neither seem likely to apply in the next decade. So it may be - for investors - back to the future.

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