(Bloomberg) — The sharp rise in gilt yields and fall in sterling after today’s mini-budget may force the UK government to direct domestic savers and banks to own more government debt.
It’s not overly alarmist to say the UK is in some trouble – especially with the pound falling more than 3% against the dollar so far today. Already trying to finance one of the world’s largest twin (budget + current) deficits, while growth is in structural decline and inflation is surging, the UK has to contend with its new government today announcing a fiscal package that will massively ramp up spending through a combination of energy subsidies and tax cuts.
UK bonds and sterling are selling off rapidly as a result. The Bank of England is in an emerging market-style dilemma as it needs to continue raising rates to keep a lid on inflation. More aggressive hikes will eviscerate growth, further deterring the capital inflow necessary to balance the UK’s vast external deficit.
The UK may thus be forced to try to stabilize yields. More quantitative easing is a risky option as this would counter the BoE’s inflation fight and send very mixed signals to the market. Ditto for some sort of yield-curve control. Such a policy is more viable when you don’t have a huge current-account deficit and inflation nudging 10%. Either policy would probably result in sterling going into an even greater free-fall.
Instead, the government can direct UK entities to channel private-sector flows into the public debt market – a type of financial repression – allowing the government to borrow at below-market rates.
This would lead to sharp selloffs in equities, as private flows are directed toward bonds, triggering yet more capital outflow and a weaker currency. Investment would be in jeopardy due to crowding out, further imperiling already-stagnant UK productivity. Overall, history shows that financial repression regresses the development of the economic system.
But the UK is running out of options. Its economic model of a commodity-dependent, export-orientated country, reliant on large capital inflows, doesn’t work in a resource-constrained, de-globalizing world economy. The luxury of palatable choices is one the UK can no longer enjoy.
- NOTE: Simon White is a macro strategist for Bloomberg’s Markets Live blog. The observations he makes are his own and are not intended as investment advice. For more markets commentary see the MLIV blog