Financing the deficit: bonds, borrowing and crowding out

Overview

Government bond, implications of financing a deficit by borrowing from abroad and why the maturity structure of government debt matters.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is a government bond?

   Model answer

   A government bond is a tradable certificate of debt: the government receives a sum from the buyer and promises to pay a fixed rate of interest, called the coupon, at stated intervals, and to repay a fixed sum, the face or par value, on a stated maturity date. The buyer can sell it to someone else before maturity in the secondary market, and the price at which it trades varies with market interest rates and with the perceived risk of the issuer. Bonds are the main instrument through which governments borrow, because they allow very large sums to be raised from many lenders for long periods, and because their tradability makes lenders willing to accept a lower interest rate than they would for an illiquid loan.

2. 2

   How are government bonds sold, and what determines the interest rate the government ends up paying?

   Model answer

   New bonds are normally sold at auction to a group of large financial institutions, which bid for them, and the price at which the issue clears determines the effective interest rate the government pays. That price reflects what investors require: the expected path of central bank interest rates over the life of the bond, expected inflation, a premium for tying money up for a long period, and a premium for the risk that the government might not repay in full. It also reflects supply and demand on the day, so an unusually large issue, or an issue at a time when investors are wary, clears only at a lower price and therefore a higher yield. Once issued, the bond trades in the secondary market, and it is those market yields that determine the terms on which the government can issue next time.

3. 3

   A bond with a face value of £100 pays an annual coupon of £4. Calculate the running yield if it trades at £80 and if it trades at £125, and explain the relationship.

   Model answer

   The running yield is the annual coupon divided by the market price. At £80 it is 4 divided by 80, which is 0.05, or 5%. At £125 it is 4 divided by 125, which is 0.032, or 3.2%. The coupon is fixed in pounds, so the return per pound invested falls as the price rises and rises as the price falls; price and yield therefore always move in opposite directions. The practical significance is that when investors lose confidence in a government and sell its bonds, the price falls and the yield rises, and it is that higher yield the government must offer on any new debt it issues.

4. 4

   Who buys government debt, and why does the answer matter?

   Model answer

   The main holders are domestic pension funds and insurance companies, which need long-dated, low-risk assets to match obligations stretching decades into the future; banks, which hold government bonds as liquid assets to meet regulatory requirements; overseas investors, including foreign central banks holding reserves; and, where asset purchases have taken place, the domestic central bank. The composition matters because it determines both the stability of demand and where the interest goes. Domestic institutional holders are relatively stable buyers whose interest receipts stay in the country; overseas holders can be quicker to sell if confidence shifts and their interest is a payment abroad; and central bank holdings return the interest to the government but leave the public finances exposed to short-term interest rates.

5. 5

   Why does it matter whether a deficit is financed by selling bonds to the non-bank private sector or to the banking system?

   Model answer

   When bonds are sold to households, pension funds and insurers, the buyers pay with existing deposits, so money is transferred from private hands to the government and then spent back into the economy; the money supply is broadly unchanged and the operation transfers purchasing power rather than creating it. When bonds are sold to commercial banks, banks acquire an asset and the government spends the proceeds into the accounts of households and firms, so deposits, and therefore broad money, rise. When they are bought by the central bank, new central bank money is created outright. Financing that expands the money supply adds to demand on top of the government's own spending, so it is more inflationary for a deficit of a given size, which is why the source of the finance matters as much as its scale.

6. 6

   What are the implications of financing a deficit by borrowing from abroad?

   Model answer

   The advantages are that the government can tap a much larger pool of savings than the domestic one, so it can borrow more without pushing domestic interest rates up as far, and domestic saving is left available for private investment. The costs are that the interest is paid to non-residents, so it is a real outflow of national income recorded on the current account rather than a transfer between residents; that the government becomes dependent on the continued willingness of foreign investors to hold its debt, and that willingness can change abruptly; and that inflows of capital tend to raise the exchange rate, which weakens exporters. If the debt is denominated in a foreign currency the exposure becomes far more dangerous, because a depreciation raises the domestic cost of servicing it at exactly the moment the country is under strain.

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