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Markets

Britain's interest rate vulnerability: Mike Dolan

  • But the price is replacing bonds maturing in 13 years on average with overnight liabilities that would move up in lockstep with a rise in the BoE's policy rate.
09 Apr 2021

LONDON: Bank of England bond buying may actually increase the speed with which future interest rate rises make UK government debt unbearable and is one glimpse into why central banks need to tread lightly around post-pandemic debt piles for many years.

Britain publicly prides itself on keeping the average maturity of its national debt much longer than other major economic powers - sensibly reducing the threat of refinancing crunches, rollover risks and cutting short-term interest rate sensitivity into the bargain.

The UK Treasury's Debt Management Office claims the average maturity of its total stock of debt was a whopping 14 years at the end of last year - well over twice the US equivalent and six years longer than the next closest G7 partner France.

But after warning about the interest rate sensitivity of UK government debt for the past year, the Office for Budget Responsibility (OBR) - the government's own budget watchdog - last month detailed just why the seemingly comfortable G7 comparison disguised a counterintuitive effect of the BoE's bond buying.

The Bank of England's (BoE) on-off government bond buying programmes since the financial crash 12 years ago, at least partly designed to keep long-term borrowing rates low, basically involve the purchase of gilts from banks in return for interest-bearing reserves at the central bank rather than cash per se.

And the interest rate on those bank reserves - currently a record low 0.1% - is the very 'Bank Rate' the BoE uses to adjust its overall monetary policy and against which so much other household and corporate borrowing rates are referenced.

The OBR's point is that while the average maturity of outstanding government debt may indeed be 14 years, the length of net debt of the public sector as a whole - including bank reserves held at the BoE - has plummeted as those bank reserves have ballooned over the past decade or more.

By the end of next year, the OBR estimated that some 32% of gross government debt - or 875 billion pounds ($1.2 trillion) - will be held in the form of bank reserves.

The initial saving for government is obvious - replacing gilts with an average interest rate of 2.1% with bank reserves offering just 0.1% and bagging a net saving of almost 18 billion pounds for the current financial year in the process.

But the price is replacing bonds maturing in 13 years on average with overnight liabilities that would move up in lockstep with a rise in the BoE's policy rate.

"This dramatically increases the sensitivity of debt interest spending to changes in short-term interest rates," the OBR report warned.

With the BoE's latest quantitative easing programme still underway, the effect is increasing.