CONTRIBUTION Lessons learned from the UK gilt tantrum

Consider fiscal sustainability before taking stimulus steps, and central banks should be at least prioritizing financial stability in crisis moments

Stephen Lee is the chief economist at Meritz Securities, Seoul. Courtesy of Meritz Securities

By Stephen Lee

Financial market participants, including myself are witnessing episodes that we haven't seen for decades. DXY ― an index of the dollar value vis-a-vis six major currencies ― is at a 20-year high, with the weakest euro in 20 years. The Japanese yen has once breached 150 versus the U.S. dollar for the first time since 1990. Inflation is running at the highest level since the 1980s, while the U.S. Federal Reserve has implemented its fastest rate hike cycle since then. In addition, most recently, we've witnessed the Great Britain Pound dropping to its historical low against the dollar. Most of the things that are happening are new to most of us, even to policymakers. We are still learning to live and adapt ourselves to this new environment.

Every historical episode teaches a lesson. The global response to COVID-19 was a reflection of what we've learned through the global financial crisis. But it brought about the overheating of the economy and eventually inflation by reacting too much―another lesson learned. What can be the future implications we can derive from the turbulence in the UK's financial markets?

Gilt tantrum: How did it happen and what were the consequences?

Before detailing current affairs, I would like to begin by taking a step back and see how the UK addressed the COVID recession. During 2020-21, the nation allowed a primary government deficit equivalent to 8.6 percent of their national GDP. This was the second largest stimuli next to the U.S., which allowed 10.3 percent of GDP as the primary deficit. Government gross debt-to-GDP ratio jumped to 95.3 percent as of end-2021, from 83.9 percent in 2019. Compared to its advanced nation peers, the government debt position was relatively stable.

The second-round of post-COVID fiscal response came as gas prices surged following the Russian invasion of Ukraine in February. Natural gas is the primary source of energy in the British economy, and most of this is imported through the European continent. Tariffs were added beyond the gas price rise as Brexit took effect, which led entities in the UK to bear higher energy prices.

Wholesale gas price was increased by four-fold during the past year, and during the same period, the UK government allocated 6.5 percent of their GDP as subsidies to minimize the private sector's energy burden ― larger than ant of the EU nations. Despite massive subsidies, government debt was still manageable. As energy prices continued to rise, it became inevitable for the private sector to share the burden somewhat ― the government announced that the consumer price cap for energy would rise 27 percent to ￡2,500 effective Oct 1.

Energy is one of the essential needs for living. Hence, a surge in energy tariffs will likely limit expenditures for other goods and services. To offset such welfare losses from the household, Liz Truss' Cabinet initiated a mini-budget, comprised of ￡45 billion in unfunded tax cuts to revive the economy. Those included: 1) a basic income tax rate cut; 2) the abolishment of 45 percent additional income tax rate for highest earners; 3) scrapping of plans to increase the corporate tax rate in 2023; and 4) the lifting of stamp duty thresholds, and much more. The plan was more of a universal tax cut, rather than being a targeted plan.

The same day, Bank of England (BOE) announced that it would conduct outright gilt sales ―- an active form of quantitative tightening ― in order to curb inflation by further tightening monetary policy. This implied that supply of gilts would surge in the market ― one with unfunded tax cuts and the other with BOE's asset sales.

With concerns on UK government's lack of fiscal discipline added to this, the 30-year gilt surged by 80 basis points in just one day. This tantrum led to margin calls for pension funds, which were managing their assets with Liability-Driven Investment Strategy. Gilt yields were rising and asset sales and halts in fund redemption occurred. BOE stepped in by initiating an emergency bond-purchasing program effective until Oct 14 and temporarily delaying their outright bond sales to Oct 31. One may cast blame for the inconsistency of the central bank policies, but BOE seems to have done the right thing by choosing to be a lender of the last resort.

While BOE was saving the financial market from severe turbulence, the UK government compromised to the market concerns by making U-turns on high income tax cuts and corporate tax increase delays. That said, there were still concerns that the UK's fiscal path will prove to be unsustainable in the longer-run. Chancellor Kwasi Kwarteng, who initiated the plan, was replaced by Jeremy Hunt, who was opposed to the plan. Most of the tax cuts were reversed, and the Prime Minister herself, resigned after staying in the office for just 45 days.

Chancellor Hunt is now planning to make up for a ￡40 billion deficit partly created due to gilt yield surge, and eventually have government debt-to-GDP to downtrend in the longer run by cutting welfare and construction budgets, as well as introducing a stealth tax hike.

What lessons can be learned?

I believe there are two major lessons that we can learn from this gilt tantrum.

Always consider fiscal sustainability: Fiscal policy should be playing their roles, but only with fiscal discipline and consideration of fiscal space. The UK's fiscal position was stable before the mini-budget, but unfunded tax cut plans with lack of discipline had led the government debt-t0-GDP ratio to rise persistently. Governments can rollout stimulus at emergencies, but should have a long-term plan to bring back debt to a sustainable level. Otherwise, you may run into paying undesirable costs not only from the financial markets but also from private sector. The latter is now due for a larger tax bills.

I believe market participants will be watching Italy very closely, because Giorgia Meloni ― now the prime minister ― pledged similar policy combinations during the election. She initially planned to: 1) apply a uniform tax rate of 15 percent to those who are earning less than 100K euros (from 65K euros previously); 2) expand those uniform tax rate to all taxpayers; 3) further soften impact of energy price spikes; 4) increase minimum pensions, and etc. Italy's government debt-to-GDP is projected to run at 135.4 percent in 2022 according to October IMF World Economic Outlook. If the new cabinet watched the consequence of what happened in the UK, they may opt for some policy adjustments ahead.

Central banks should be mindful of financial instability: Today's central banks have given mandates, which are achieving price stability to foster sustainable growth. That said, their raison d'etre is to be the lender of the last resort in times of crisis. This is exactly what the Bank of England did during the market turbulence.

Controlling inflation is important, but if monetary tightening occurs financial instability, central banks would have to address the matter as well. The recent treasury liquidity debacle in the United States is partly occuring from rising treasury yields and a strong dollar. With core inflation likely slowing in the coming months, I believe it is now necessary for the Fed to consider slowing the pace of policy rate hikes.

The same story applies for the Bank of Korea. We've started to observe severe vulnerabilities in the money and credit markets recently. Although there exist core inflation pressures with a weaker won amplifying it, I believe it is reasonable for the Bank of Korea to address the vulnerability first and calm the financial market by introducing smaller hikes in the upcoming meetings.

The writer is the chief economist at Meritz Securities, Seoul.