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The Green Budget
Funding issues and debt management
January 2006
Professor David Miles +44 20 7425 1820 [email protected]
Niki Anderson +44 20 7677 6951 [email protected]
Morgan Stanley does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
Please refer to important disclosures at the end of this presentation
Overview:
Public sector net debt is likely to continue rising as a share of national income over the next few years, but empirical evidence suggests that this is unlikely in itself to trigger higher real interest rates.
Demand for long-dated assets by defined-benefit pension schemes is set to continue, but does not guarantee long term real interest rates will stay low.
The Debt Management Office would benefit from locking in low real rates of interest now. Higher issuance of long-dated debt, significantly in index linked form, could also support cost effective wider pension provision.
The proportion of debt outstanding in index-linked gilts has been broadly constant in recent years. But the DMO seems prepared to take a more flexible approach going forward.
The Government may need to explore new ways to raise funds as debt reaches the 40% of GDP limit.
Please refer to important disclosures at the end of this presentation
Public sector net borrowing
30.634.737.038.536.435.838.8MS worse case
27.831.333.637.237.036.038.8MS central case
25.028.831.536.736.736.838.8Base case 1
22232631343738.8PBR
2010-11
2009-102008-92007-82006-72005-62004-5£ billion
(1) Base case refers to IFS estimates based on PBR economic forecasts
Source: IFS, Morgan Stanley Research estimates, HM Treasury
Please refer to important disclosures at the end of this presentation
Public sector net debt
40.840.339.738.637.636.434.7MS worse case
40.139.839.438.637.636.434.7MS central case
39.639.539.238.637.636.534.7Base case1
38.238.238.237.937.436.534.7PBR
2010-112009-102008-92007-82006-72005-62004-5% of GDP
(1) Base case refers to IFS estimates based on PBR economic forecasts
Source: IFS, Morgan Stanley Research estimates, HM Treasury
Please refer to important disclosures at the end of this presentation
Outlook for gross gilt issuance
565958727051Morgan Stanley worse case
535655707151Morgan Stanley central case
505353707152Base case1
474747646852DMO/PBR illustrative gilt sales
2010-112009-102008-92007-82006-72005-6£ billion
(1) Base case refers to IFS estimates based on PBR economic forecasts
Source: HM Treasury, IFS, Morgan Stanley Research
Please refer to important disclosures at the end of this presentation
How does gilt issuance affect yields?
The projections are based on an assumption of no change in tax rates and spending plans – so they exaggerate the likely scale of gilt issuance.
But more debt is likely.
The interesting question is whether increased issuance is likely to bring about a rise in yields.
Historical evidence suggests that this is unlikely.
Please refer to important disclosures at the end of this presentation
Gilt issuance and yields
Source: Bank of England, Debt Management Office
Year Gross (Net) Issuance (£bn)
15-Year Nominal Yield
15-Year Real Yield
2000/01 10 (-9) 4.66% 2.06% 2001/02 14 (-4) 4.86% 2.37% 2002/03 26 (9) 4.71% 2.21% 2003/04 50 (29) 4.70% 2.04% 2004/05 50 (35) 4.74% 1.85% 2005/06 52 (38) 4.30% 1.53%
Please refer to important disclosures at the end of this presentation
Change in debt to GDP ratios for G7 countries
Source: OECD
-30
-20
-10
0
10
20
30
Canada France Germany Italy Japan UnitedKingdom
UnitedStates
Deb
t to
GD
P r
atio
(%
)
Change in debt to GDP ratio 2000-05
Please refer to important disclosures at the end of this presentation
International real yields on inflation proof bonds
Source: Bloomberg
1
2
3
4
Jan-01 Oct-01 Jul-02 Apr-03 Jan-04 Oct-04 Jul-05
Rea
l yie
ld (
%)
3.875% TIPS 20293.4% OATi 20294.125% IG 2030
Please refer to important disclosures at the end of this presentation
Long-term real interest rates on UK conventional debt
Source: Morgan Stanley Research
0.0
1.0
2.0
3.0
4.0
5.0
6.0
1700-1749
1750-1799
1800-1849
1850-1899
1900-1939
1960-1969
1970-1979
1980-1989
1990-1999
2000-2004
2005
%
Average Long Term Real Interest Rates
Long Term Average (1700-2005)
0.0
1.0
2.0
3.0
4.0
5.0
6.0
1700-1749
1750-1799
1800-1849
1850-1899
1900-1939
1960-1969
1970-1979
1980-1989
1990-1999
2000-2004
2005
%
Average Long Term Real Interest Rates
Long Term Average (1700-2005)
0.0
1.0
2.0
3.0
4.0
5.0
6.0
1700-1749
1750-1799
1800-1849
1850-1899
1900-1939
1960-1969
1970-1979
1980-1989
1990-1999
2000-2004
2005
%
Average Long Term Real Interest Rates
Long Term Average (1700-2005)
Please refer to important disclosures at the end of this presentation
Government debt and real interest rates
Source: Morgan Stanley Research estimates, ONS, OECD, Global Financial Data
0
50
100
150
200
250
1700 1738 1776 1814 1852 1890 1928 1966 2004
% o
f G
DP
-4
-2
0
2
4
6
8
10
12
Government debt to GDP ratio
Real interest rates (right-hand-axis)
%
Please refer to important disclosures at the end of this presentation
The sustainability of low interest rates: Whether or not low interest rates are sustainable is important for debt
management.
If today’s low levels of real interest rates on government debt are here to stay then it is not so clear that locking in borrowing costs by issuing long dated bonds is necessarily the best strategy.
But if the real cost of issuing debt is likely to be significantly higher than today in the next 10 years, then the cost of funding can be minimised by issuing long dated bonds now.
Please refer to important disclosures at the end of this presentation
The sustainability of low interest rates:
Global savings glut? Not big enough to explain large fall in interest rates
Please refer to important disclosures at the end of this presentation
Global savings
Source: IMF World Economic Outlook database (September 2005)
15
17
19
21
23
25
27
70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04
Please refer to important disclosures at the end of this presentation
The sustainability of low interest rates:
Global savings glut? Not big enough to explain large fall in interest rates
Rise in risk aversion/lower GDP growth? Cannot account for fall in context of asset pricing model
Please refer to important disclosures at the end of this presentation
The sustainability of low interest rates: Global savings glut?
Not big enough to explain large fall in interest rates
Rise in risk aversion/lower GDP growth? Cannot account for fall in context of asset pricing model
Pension fund rebalancing? Most convincing explanation for current low levels But future impact on yields could be muted
Please refer to important disclosures at the end of this presentation
Pension fund bond purchases versus gilt supply
Source: Morgan Stanley Research estimates
0.0
0.5
1.0
1.5
2.0
2.5
3.0
2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 2055 2060
Net bond buying as a proportion of giltsupply
Gilt supply assumes Morgan Stanley central case projections (Green Budget) until debt to GDP reaches 40% and then assumes debt is issued to keep debt at 40% GDP thereafter, with nominal GDP assumed to grow 4.5% a year
0.0
0.5
1.0
1.5
2.0
2.5
3.0
2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 2055 2060
Net bond buying as a proportion of giltsupply
Gilt supply assumes Morgan Stanley central case projections (Green Budget) until debt to GDP reaches 40% and then assumes debt is issued to keep debt at 40% GDP thereafter, with nominal GDP assumed to grow 4.5% a year
0.0
0.5
1.0
1.5
2.0
2.5
3.0
2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 2055 2060
Net bond buying as a proportion of giltsupply
Gilt supply assumes Morgan Stanley central case projections (Green Budget) until debt to GDP reaches 40% and then assumes debt is issued to keep debt at 40% GDP thereafter, with nominal GDP assumed to grow 4.5% a year
Please refer to important disclosures at the end of this presentation
Funding and funding strategy
Source: Debt Management Office
0%
25%
50%
75%
100%
2000-01 2001-02 2002-03 2003-04 2004-05 2005-06
Per
cent
age
of c
onve
ntio
nal g
ilt s
ales
Short
Medium
Long
Please refer to important disclosures at the end of this presentation
Funding and funding strategy
Source: Debt Management Office
0%
25%
50%
75%
100%
2000 2001 2002 2003 2004 2005Per
cent
age
of o
vera
ll de
bt p
ortf
olio
Conventional
Index-Linked
Please refer to important disclosures at the end of this presentation
Funding and funding strategy
Strong case for significant funding from long-dated, substantially index-linked, debt. This case is strengthened if long-dated yields are temporarily beneath sustainable levels.
It is not that one can be sure that we are in the midst of a bond market bubble - there are some reasons to believe that sustainable real yields may have moved down.
But the scale of the fall in real yields is so great that the risks have now become asymmetric - the chances of real yields going higher from here are greater than their going lower. Locking in at today’s low real yields by issuing long dated indexed debt is therefore sensible.
Please refer to important disclosures at the end of this presentation
Buying back company pension liabilities
David Willetts recently proposed that companies might be given the option of, effectively, selling to the government that part of their obligations to pay pensions to past and current employees that reflected the contracted out rebate. In principle the idea is simple, though in practice there are difficulties.
There would be an economic gain if the cost to the public sector of having the obligation to pay higher state second pensions in future were smaller than the cost to companies of holding the same obligations. That would be true if companies were less able to manage the risks of holding those obligations – longevity risks and risks of assets underperforming.
Please refer to important disclosures at the end of this presentation
Buying back company pension liabilities The issue of whether the government should buy some of these pension
obligations from companies is similar to the question of whether the government should issue longevity bonds.
But the government already has huge exposure to unanticipated rises in life expectancy. So it is far from clear that taking on more longevity risk is optimal.
Buying pension obligations from companies would, however, generate substantial cash. If those obligations were not treated as on a par with government debt, then the strategy would ease the constraint that the 40% net debt limit creates.
Please refer to important disclosures at the end of this presentation
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