Why Buying Gilts In Quantitative Easing Is So Wrong!

by Dr. Ros Altmann

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11 March 2009

• Bank of England should buy corporate bonds – directly getting money where it is needed – rather than buying gilts
• Bank of England does not understand institutional investors – sellers of gilts will not just switch to UK corporate debt
• Policy shooting at the wrong target, causing collateral damage and not actually stimulating corporate UK
• Bank of England is buying gilts today, but then tomorrow Government needs to sell gilts to fund its borrowing – where is the sense in this?!
• Policy again ignoring collateral damage to pensions – artificially depressing long yields will damage pension funding and worsen annuity rates

The Bank of England, is today implementing its first major ‘quantitative easing’. It will create about £2billion and use this money to buy gilts from institutions in the market. This is supposed to stimulate the economy as the institutions selling gilts are expected to invest the money in UK company debt instead. This is not going to happen! Institutions will switch to overseas debt or top quality bonds, but will not put much into smaller companies who desperately need the funds. Whoever is advising the Government on this simply does not understand how institutional investors operate. Buying gilts is a huge mistake and, once again (as with cutting rates too far and cutting VAT while prices were already falling), will cause significant collateral damage, yet miss the intended target.

Buying gilts is indirect and inefficient way to stimulate the economy:
Forcing down gilt yields is not actually the aim of the policy; the aim is to lower interest rates on corporate bonds! Why not buy these other bonds directly then? In particular, it is medium sized and smaller companies (FTSE 350 and below) who desperately need money to survive. Large companies have been managing to borrow and do not have funding problems. So for the policy to work, investors must use the money they receive from selling their gilt holdings to buy smaller or medium sized corporate bonds. This is then supposed to help UK companies who need to borrow to survive. But institutions can invest in non-UK companies and there is nothing that will force them to focus only on sterling debt.

Leakages:
Institutions who sell gilts have a wide opportunity set to invest in instead, so there will be substantial leakage to other assets. Many will switch to overseas Government bonds, some will buy index-linked gilts, some will buy top quality corporate bonds of overseas companies, not UK companies, but very few will want to switch to smaller UK company credit – where the need for new investment is most urgent. So QE will help overseas government and corporate borrowers more than domestic companies who so urgently need the money as money leaks away to other fixed income instruments!

Mandate restrictions:
Furthermore, many investors’ mandates do not even allow them to switch to smaller company debt, they can only invest in top quality paper, so again operating QE via the gilt market will not work.

Buying gilts will aggravate the gilt bubble at medium to long maturities:
Buying up gilts will force gilt yields down, but medium-long gilts yields were already artificially low due to insufficient supply of longer maturities. QE will, therefore, aggravate the ‘bubble’ in the gilt market and create problems in future – have we not already seen how painful the unwinding of asset price bubbles can be?

Government buying gilts today but selling gilts tomorrow to fund deficit – crazy!
With the massive increase in Government borrowing that is already underway, we have the spectacle of the Bank of England buying up gilts today, but then the Government having to sell gilts tomorrow to fund its deficit. So one arm is buying gilts and the other arm is selling gilts, with dealers taking a cut on both sides. What kind of policy is this? Taxpayers are sitting and watching helplessly as the policy proceeds.

Artificially depressing gilt yields damages pension funding and annuities:
But, at the same time, many taxpayers are also being damaged by this incoherent policy. As long interest rates are artificially forced lower – and short rates have already virtually hit zero, pension funding gets worse and worse. This hits companies, whose pension deficits are ballooning and it hits individuals who find the cost of buying their annuity has soared.

End-March pension deficits will be dreadful – timing of QE awful:
As gilt and corporate bond yields have plunged in recent days, the impact on pension deficits is significant. The lower yields go, the bigger pension liabilities will be and sensitivity to long rates is higher for liabilities than for assets. This will hasten the demise of final salary schemes, but will also cause problems for companies already struggling with their deficits. As end-March is a critical date for many schemes who report at this date, the timing of QE is awful.

Newly retiring pensioners will be dreadfully hit – pension 35% lower for life:
Workers coming up for retirement this year are in a dreadful dilemma. Someone with, say, £30,000 in their pension fund last year could have retired with a pension of £2,100 a year for life (using a 7% annuity rate). Someone with £30,000 in their pension fund this year, would only get £1,800 a year (using a 6% annuity rate), this is about 20% less pension for the same money.

However, someone with £30,000 in their pension fund last year is likely to have far less than that this year, as the markets have plunged. Most funds have lost over a quarter of their value, so the £30,000 fund value last year would be worth only around £22,500 this year. That would only buy an annuity worth £1,350 a year now – a loss of £750 a year or nearly 35% loss of pension! This year nearly half a million people will buy an annuity and all of them will suffer lower pension income for the rest of their lives as a direct result of artificially depressed interest rates following QE.

Summary
Buying gilts is the wrong way to pursue quantitative easing. The money will leak away to overseas bond markets and artificially depressing yields will damage pensions. This is another example of using an indirect route to try to deal with a problem, instead of aiming directly at the right target. Bank of England should buy up corporate bonds, not gilts. Government should be getting money directly to the companies which need it. It is clear we cannot rely on the banks to do this, so Government must take charge and spend our money wisely, rather than spraying it around indiscriminately and making other problems worse.

Dr. Ros Altmann
07799 404747

ENDS