Pound crisis is not exclusively British

In summary, it all seems quite manageable: on Friday 23 September, the new British Prime Minister Liz Truss presented an interim budget together with her Finance Minister Kwasi Kwarteng in which, in addition to a colossal amount of energy compensation for households and companies, 45 billion pounds was released for tax cuts. which are mainly aimed at the wealthiest households.

Five days later, on Wednesday, September 28, the chaos was complete.

The pound plummeted, reaching a record low of $1.03 on Monday. The 10-year British interest rate shot up to more than 4.5 percent on Wednesday, the highest interest rate since the financial crisis of 2008 and 2009.

The International Monetary Fund openly criticized Truss’s budget plans, in a tone usually only struck by emerging countries that have yet to learn.

British banks put their mortgage lending on pause, because they no longer knew how much they could borrow themselves. Pension funds sounded the alarm. And the British central bank, the Bank of England, was only able to calm the financial markets on Wednesday by promising to buy 5 billion pounds (5.5 billion euros) in government bonds every day for 13 days. That supports the rate of those government bonds, and a higher rate means a lower interest rate for these types of tradable loans.

Scratches and dents

After that, the mood on the financial markets turned into a sort of truce. The pound is back at $1.10 – still low, but less dramatic. And the interest on ten-year government bonds has fallen half a percentage point, to 4 percent, thanks to the intervention of the central bank.

Peace may have returned a bit, but the damage is extensive. This of course applies to politics. But also financially and economically, the United Kingdom has suffered new scratches and dents after Brexit and the pandemic.

Truss and Kwarteng made their way to Canossa on Friday: they still went to visit the independent Office for Budget Responsibility, a budget watchdog that they had passed by last week when they presented their controversial budget. Against any tradition.

It was not yet known during the day on Friday whether the institute had given them other ideas. Just before their visit, the latest statistics showed that the UK’s economy, as the only western country, is still smaller than it was before the pandemic.

Meanwhile, Truss has put the British central bank in an impossible position. While the Bank of England, like other central banks, raises short-term interest rates to curb inflation, it is now forced to do the exact opposite by buying government bonds: keeping long-term rates low. The bench presses the brake and the accelerator at the same time.

‘Monetary financing’

Moreover, the £65 billion in loans that the central bank is now buying, and against which pounds are being put into circulation, is very similar to the 45 billion (plus the energy compensation) that Kwarteng wants to spend.

The term ‘monetary financing’ was buzzing on Wednesday: the mortal sin that a central bank creates money to finance a budget deficit. Literally, and legally, it isn’t, but it’s pretty close.

It also fuels doubts about how long the Bank of England will remain strictly politically independent. Such suspicion alone is extremely bad for the UK’s reputation in the financial markets, of which the country is so keen to be the global hub itself.

Moreover, the crisis on Wednesday was so acute because the British pension funds were in serious trouble. They usually try to use all kinds of financial derivatives such as options, forward contracts and especially interest rate swaps (swaps) to shape their current assets in such a way that it fits seamlessly with their future obligations – hoping, for example, to free up more capital for risky investments with a higher expected value. efficiency.

This system of Liability Directed Investment (LDI) is used in many other countries, including the Netherlands. But it is suspected that British pension funds are taking a more rough approach and taking stronger positions in derivatives.

When the floor under the market for government bonds and other loans threatened to fall on Wednesday in London, pension funds were urged by their banks to make additional deposits to offset their rising risks on those derivatives. They had to free up that money by selling the government bonds they owned, which only exacerbated the problem: a so-called doom loop. In that sense, the Bank of England did not intervene to save the prime minister, but the pension system.

The fact that Truss and Kwarteng presented a budget that stimulates the economy and increases inequality in the midst of soaring inflation is very different from the practice in many other countries. In that sense, the crisis this week was very British – the criticism from, for example, the IMF was also about this.

Nevertheless, many other countries, especially in Europe, are currently more like the United Kingdom than they would like. London is struggling with a twin deficit: a deficit on the budget and on the balance of payments with other countries. That makes it very dependent on the whims of international capital.

Eurozone also vulnerable

Most countries in the eurozone have a budget deficit, but a positive balance of payments. Or rather, they had them. Although there are not many definitive figures yet, it can be assumed that the enormously increased amounts for energy imports have caused the balance of payments in the eurozone to deteriorate sharply this year as well. The eurozone is also vulnerable.

And buying government bonds by the British central bank while at the same time raising interest rates? That combination of accelerator and brake pedal can also occur in the eurozone. Not only did the massive buying up of government bonds by the ECB continued long when inflation was already rising, the central bank has only just stopped doing so.

But if a crisis breaks out around the euro, the ECB can do exactly the same as the Bank of England. The tool has been there since July this year: the Transmission Protection Instrument. This allows the ECB to buy government bonds in a targeted manner to prevent the interest on government bonds in one country (read: Italy) from skyrocketing and falling too far out of step with other countries (read: Germany). If the financial markets had reacted with panic on Monday this week to Giorgia Meloni’s election win in Italy, it could have happened. And the ECB had been earlier than the Bank of England.

And then there’s what everyone outside of the United States has in common: the total dominance of the dollar, the US financial markets and therefore US policy at the moment. The pound lost heavily against the dollar this week before rallying again. But the euro did the same, landing at $0.95 per euro at its lowest rate since the end of 2002. The rise in interest rates on government bonds, as in the United Kingdom, is everywhere. The United States is leading the way in the interest rate markets. The prices of government bonds, and therefore the interest rates, in most countries go up and down in sync to the music from Washington. Not only the interest on ten-year British government bonds rose sharply this week. The Dutch ten-year yield rose to 2.55 percent – ​​the highest since the end of 2011.

This does not alter the fact that the Truss administration brought this week’s crisis on itself. But European countries, including the Netherlands, have been given an example of what not to do. And they would perhaps do well to reconsider their own pension funds.