The cost of borrowing: what happens when the debtor is sanctioned by a creditor?
Will financial markets discipline governments or will governments discipline financial markets? Recent events in the UK seem to provide a clear answer to this question. What clearer proof of the power of the markets do we need than the recent dismissal of the UK Chancellor of the Exchequer in response to the financial market chaos.
On September 23, the UK government’s new chief finance minister announced his mini-budget. The following week, the cost of government borrowing soared as investors dumped UK government bonds.
The cost to the UK government of borrowing sterling for 10 years rose from 3.3% the day before the budget to a peak of 4.6% the following Wednesday. At the same time, the pound has fallen in international markets against most other currencies.
On October 3, the government went back on some of its budget promises. The outsized movement in the price of UK government debt and the pound’s exchange rate appear to be clear examples of how financial markets have disciplined the government of the world’s fifth-largest economy. On October 14, the finance minister was sacked.
If the UK can be so disciplined by the markets, who is safe from having its policy goals derailed by the reluctance of its creditors to fund them?
Behind this simple story of a debtor sanctioned by a creditor, something more complex is happening. As the cost of UK public debt skyrocketed after the budget announcement, the Bank of England was forced to step in to buy that debt and prevent further increases in the cost of borrowing.
The immediate cause of this intervention was a problem in the UK pensions market which forced these funds to further liquidate UK government debt and other assets to post collateral against their derivative positions.
This liquidity crisis for the pensions sector had been triggered by higher interest rates and it forced the Bank of England to cap bond yields to prevent further forced selling and an even higher cost of borrowing for the British government. This intervention by the Bank of England was imposed on it, but it is a clear example of the authorities, in this case the central bank rather than the government, disciplining the markets.
There is a certain level of interest rates that society can live with and there are certain levels that portend poor economic performance and even financial difficulties.
Learning from the consequences of the disastrous UK mini-budget of September 23, when the cost of long-term borrowing approaches 4.5%, the UK authorities will take measures to discipline the financial markets.
Governments are particularly powerful and history shows that it is a debtor who can discipline his creditor.
While the Bank of England’s intervention to reduce the cost of government borrowing focused on liquidity problems in the pension fund industry, behind it was likely an even deeper crisis.
When the government’s cost of borrowing increases, the private sector’s cost of borrowing also increases. Within days of the budget, volatility in the cost of long-term borrowing had made it very difficult for UK financial institutions to price mortgages for UK households. Many mortgage offers were withdrawn and households began to focus on what might happen to their interest costs when financial markets force the cost of government borrowing higher.
In September 2020, it was possible to borrow a two-year fixed mortgage at an annual rate of 1.75%. Bank of England intervention may have reduced government bond yields from 4.7% to 4.1%, but the cost of a two-year fixed mortgage in the UK is now greater than 5.75%.
For those whose last two-year fixed mortgage expires in October, there is now the possibility that their interest expense will increase by more than 200%! The Bank of England may have stepped in to discipline the market, ostensibly to allow pension funds to resolve their liquidity crisis, but the consequences of a continued rise in bond yields for UK households will also have been a key consideration.
We are beginning to establish at what level of interest rates a private sector debt crisis is likely.
The lesson from events in the UK may not be that markets will discipline governments but that since interest rates cannot be allowed to rise any further, the authorities will discipline markets. For savers who lend sterling to the UK government at the new capped rate of 4.0%, they face an erosion in the purchasing power of their savings as UK inflation hits 9.90% .
In a free market, creditors would normally charge an interest rate on their loans that would compensate them for future inflation. The intervention of the Bank of England now forces them to accept a return well below the rate of inflation and, in the opinion of this columnist, this return of 4.0% should remain well below the rate of inflation in the foreseeable future.
The consequence of intervention is that the authorities discipline the markets and that savers pay the price of being forced to lend well below the rate of inflation. Savers are forced to subsidize debtors. The bad news is that it’s not just the UK that can’t live with the consequences of this magnitude of rising long-term interest rates.
In previous columns I have explored the excessive level of debt in the world. Global debt to GDP, of the private and public sectors combined, is now almost certainly well above World War II levels. As we saw in the recessions of 2008 and 2020, the private sector struggles to service this debt when cash flow declines. This led to massive government intervention in both recessions to underwrite private sector credit risk. The result has been that the private sector has chosen to take on more debt, assured that it is now too politically important to fail.
At the end of September, we found out what level of interest rates would disrupt the overleveraged UK economy – a 10-year bond yield of around 4.5%. That this level of bond yields heralds distress is worrying, as the UK has one of the longest-lasting debt burdens in an over-indebted world.
A key indicator for establishing vulnerability to rising interest rates is the debt service ratio (DSR) of the private sector. It measures the percentage of private sector revenue that is used to service debt. When the private sector’s RSD is high, a rise in interest rates is likely to cause the private sector to struggle to service its debts and lead to a debt crisis.
The UK private sector DSR at the end of March 2022, the latest data available, was just 13.3%. Historically, countries’ private sectors have struggled to service their debts when more than 20% of their income is needed and interest rates have risen. The fact that the UK has already found itself in such a position is testament to how quickly the ability to repay debt can evaporate when interest rates rise from historically low levels.
While the Bank of England is already acting to discipline the debt market due to the negative impact of rising rates on the pensions sector and the mortgage market, other countries will soon find themselves in the same position as well. The following countries already had private sector debt service ratios above 20% at the end of March 2022, before the start of the sharp rise in interest rates: Brazil, Canada, China, Denmark, France, Hong Kong, Korea South, Netherlands, Sweden, Turkey.
Of the 19 countries in the developed world for which the Bank for International Settlements publishes private DSRs, only Germany and Italy had better ratios than the UK at the end of March 2022. While the actions of UK authorities suggest that ‘they can’t live with long-term interest rates much higher than 4.0%, there will be many other authorities in the same situation.
If the price is the truth, the Bank of England’s intervention shows that the UK economy cannot handle the key truth which is the cost of borrowing. The central bank can only hold the line on the cost of UK government borrowing for so long.
Regular readers of this column will know that the task of rigging the price of government bonds is likely to be shifted from the central bank to the regulator. If the cost of long-term borrowing is to be brought under control, the regulator will need to force thrift institutions to hold government bonds at yields well below the rate of inflation. Such action is normal in war. In the post-World War II era, it continued for decades as debts ballooned and a more robust financial system could be built.
Private sector DSRs suggest that such intervention to discipline markets will be necessary across the developed world as long-term interest rates rise around or above the 4.0% level. With high inflation, creditors are unlikely to choose to lend their savings to governments at such high interest rates.
The debacle in the UK shows the limits that the authorities can allow creditors to dictate to them.
We are now approaching that period when market forces, especially the market force that determines the cost at which government and the private sector can borrow, will have to be suspended.
Savers will be forced to lend to governments at or around 4.0% when inflation is much higher.
September 2022 will go down in history not as the time when financial markets disciplined governments, but when we set the price at which governments had to discipline financial markets.