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QE – fuelling the downturn

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Patrick Kelliher

The announcement of a further £60bn of Quantitative Easing (QE) by the Bank of England (BoE) on Thursday 4th August [1] has been welcomed as A Good Thing, but is it ?

The markets certainly thought so. The FTSE100 has risen by 3.5% since [2]. Bond prices have risen on the back of QE together with £10bn of Corporate Bond purchases also announced.

However the corollary of higher bond prices is lower bond yields. 20-year Gilt yields have fallen by nearly 40bps from 1.65% p.a. on the 3rd August to 1.27% on the 10th August. Index-linked Gilt yields have fallen similarly – the 20-year index-linked Gilt yield has fallen from -1.40% p.a. to -1.70% p.a.[3].

These falls in yields have pushed up the value of defined benefit pension scheme liabilities more than the rise in scheme assets. Hymans Robertson, a leading pensions consultancy, has estimated that the fall in yields has increased pension scheme liabilities by £70bn to £2.4 trillion (compared to UK GDP of £1.8 trillion) and increased total pension scheme deficits to £945m [4].

It should be noted that the £70bn increase is on top of increases in pension scheme liabilities as a result of the Brexit vote. This pushed down yields, with 20-year Gilt yields falling 60bps from 2.25% p.a. on 23rd June to 1.65% p.a. on 3rd August, and with 20-year index-linked Gilt yields falling 44bps from -0.96% p.a. to -1.4% p.a. in the same period. While the BoE intended to counter the effect of Brexit, in terms of pension scheme liabilities and deficits, QE has made things worse.

The increase in deficits caused by Brexit and QE will have to be met by higher contributions and/or reductions in benefits, most likely the former. Higher employer contributions to pension schemes will reduce the amount available for companies to invest, lowering growth rates in the long-term.

To understand the impact on investment, it should be noted that between 2010 and 2015, some £88bn was paid in special contributions to defined benefit schemes [5] to help fund deficits caused mainly by falling Gilt yields resulting from previous QE exercises. To put this in context, over the same period average annual business investment by UK companies was £160bn [6], so the special contributions amounted to over 6 months of lost investment in the UK economy.

As well as the cashflow strain of having to pay special contributions to fund wider deficits over coming years, firms may also face more immediate balance sheet strains from rising values of pension scheme liabilities due to lower bond yields. For accounting purposes, these are discounted using high-grade AA-rated Corporate Bond yields. Not only will these yields fall with lower Gilt yields, they will also fall as the spread between Corporate Bond and Gilts is narrowing because of the BoE’s plan to buy £10bn of Corporate Bonds. The spread of AA-rated Corporate Bonds has narrowed by ca.10bps since the 4th August [7], and together with a 40bps fall in long-dated Gilt yields, pension scheme discount rates are likely to have fallen by ca.50bps since the BoE’s announcement.

To take one example of the impact of this on corporate balance sheets, British Airway’s noted in its 2015 Report and Accounts that a 10bps fall in discount rate would increase defined benefit pension scheme liabilities by £327m [8] so a 50bps fall in yield could increase BA’s balance sheet pension scheme liabilities by ca.£1.6bn equivalent to nearly 40% of shareholder equity of £4.4bn. This would be on top of strains caused by the falls in bond yields in the aftermath of Brexit.

So QE is likely to give rise to a toxic combination of balance sheet strains and higher contributions to pension schemes to fund deficits it has caused. Far from giving a boost to the economy suffering from the Brexit vote, QE could exacerbate the impact of Brexit on business investment, further reducing economic growth in the long-term.

Of course, QE could make it easier for the UK government to reverse its policy of austerity and fund the resulting deficits. This is one policy which can offset the negative impact of Brexit. Whether the Conservatives take advantage of this room for fiscal manoeuvre remains to be seen.

This is but one of the political risks associated with QE. Another is the possibility of Scottish independence which has risen sharply following the Brexit vote. This round of QE will increase the BoE’s holdings of Gilts to £435bn, making it by far the UK’s largest creditor. In the previous independence referendum, the UK government refused to consider Scotland sharing either the pound or the Bank of England. It is not inconceivable that an independent Scotland, refused a share in the assets of the BoE, might repudiate its share of UK debt owed to the BoE [9]. The rest of the UK would then have a choice of accepting this burden or reneging on this, leaving the BoE with a £35-40bn hole in its balance sheet.

An extension of this scenario might be a future left-wing government elected on a platform rejecting austerity. Rather than the UK government owing £435bn to a connected, if independent, part of the UK establishment, it might decide to renege on this part of the debt altogether [10]. This would leave the BoE insolvent, though it could continue in existence as it does not have any funding issues given its right to print money.

Looking back in a few years’ time, Mark Carney’s might come to rue his bold move to dispel Brexit fears with QE. While initial market reaction was positive and it may maintain confidence in the UK economy post-Brexit, I am sceptical of the long-term benefits of QE for the UK economy as I think it will depress business investment further due to its effects on pension scheme. It might only be effective in connection with a relaxation of austerity but this might not be forthcoming. Finally, in increasing the amount it is owed by the UK government, the Bank is adding to remote yet existential political risks to its future. 

 

[1] http://www.bankofengland.co.uk/publications/Pages/news/2016/008.aspx  

[2] From 6634 on the 3rd August to 6866 on the 10th August – see: http://www.investing.com/indices/uk-100-historical-data

[3] http://www.bankofengland.co.uk/statistics/pages/yieldcurve/default.aspx

[4] https://www.hymans.co.uk/news-and-insights/news-and-blogs/news/boe-announcement-plunges-gilt-yields-to-record-lows-and-pension-liabilities/ - note that Gilt yields fell further since 4th August when Hymans produced this note, and by 10th August they were estimating that aggregate deficits had risen a further £5bn to £950bn despite rising asset prices.

[5] ONS “MQ5: Investment by Insurance Companies, Pension Funds and Trusts, Quarter 3 (July to September) 2015” – see table 4.3 of supporting data at: http://webarchive.nationalarchives.gov.uk/20160105160709/http://www.ons.gov.uk/ons/publications/re-reference-tables.html?edition=tcm%3A77-393749  

[6] ONS “Business Investment: Quarter 1 (Jan to Mar) 2016 revised results” - http://www.ons.gov.uk/economy/grossdomesticproductgdp/bulletins/businessinvestment/quarter1jantomar2016revisedresults#methodology

[7] Based on option-adjusted spread data from Bank of America Merrill Lynch’s UC28 index of UK AA-rated Corporate Bonds over 15 years (http://www.mlindex.ml.com/gispublic/default.asp - need to register). 

[8] See p18 and p67 of BA's 31/12/2015 Report and Accounts which can be found at: http://www.iagshares.com/phoenix.zhtml?c=240949&p=irol-reportsannual

[9] It is likely that Gilts in issue at the point of a successful independence referendum would remain an obligation of the remainder of the UK (rUK), with Scotland issuing an IOU to the rUK for its share of this debt, as the alternative of hypothecating a portion of Gilts to Scotland might constitute a technical default. Scotland’s share of the UK’s debt based on GDP and/or population is roughly 8-9% which is where the figure of £35-40bn comes from.

[10] This is not as fanciful as it seems. George Osborne has already taken back Gilt coupon payments to the BoE in excess of the interest the BoE pays on QE balances - see http://www.bbc.com/news/business-20268679.

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