According to the UK’s Chancellor of the Exchequer, George Osborne, the recent declines in gilt yields are “a huge vote of confidence in the credibility of British Government debt and a major source of stability for the British economy at a time of exceptional instability”.
In a statement to parliament yesterday, Osborne said the fall in government bond yields to their lowest levels in 100 years, together with the decline in the UK government’s credit default swap (CDS) spread this week to below that of Germany, were reasons for optimism about the country’s economic outlook.
A longer-term view of one key measure of sovereign risk doesn’t provide grounds for such unbridled optimism. The chart below, using data sourced from Markit, illustrates a steady rise in the UK government’s CDS spread since the end of 2006. Even if UK default risk has fallen back from the peak recorded in late 2008, the notion that government bonds are “risk-free”, a principle that still underlies finance textbooks, hasn’t been tenable for several years.
But you’d surely rather be in Osborne’s shoes, and have the opportunity of extending the UK’s debt profile at the current low rates, than in the position of the finance ministers of most eurozone members. In an increasing number of countries, default risk measures have hit peaks, bond yields are at multi-year highs, and the short-term refinancing burden is also typically much more acute than in the UK.
But there’s a story Osborne wasn’t telling yesterday. That’s a far more worrying tale of a yawning black hole in the government’s finances, which is a direct consequence of falling bond yields.
I’m referring to the cost of providing unfunded public sector pensions, which balloons whenever interest rates fall.
The UK’s Treasury currently calculates the cost of providing state pensions in its annual accounts by using a discount rate based on projected GDP growth (which it estimates at 3 percent).
According to pensions consultant John Ralfe and an increasing number of independent experts, this approach is wrong. In a recent Financial Times article, Ralfe said: “The correct discount rate to measure the economic cost of public sector pension promises must be the yield on long-dated index-linked gilts, since they share similar characteristics: both are obligations of the UK government, both are legally-binding contracts and both are inflation-linked.”
This may all sound arcane, but the implications for the UK’s overall financial position of changes in that discount rate are staggering.
The UK’s Office for Budget Responsibility (OBR), a state-funded watchdog, recently produced a figure of £1.1 trillion as the net present value of public sector pension liabilities as at the end of March 2010, based upon a discount rate of 1.8 percent. That’s substantially bigger than the UK’s official net debt of £944 billion.
The OBR’s discount rate of 1.8 percent was derived from real yields on corporate index-linked bonds. If the statisticians were to apply the actual market rate on long-dated government inflation-linked bonds, 0.5 percent, we’d be talking about a liability that’s many hundreds of billions of pounds greater, and a sum that dwarfs reported figures of state obligations.
This all goes to show how acute the debt trap that Western governments face actually is. And, far from being a cause for celebration, low interest rates may not be making things any better at all.