Introduction
The economic background of any country is extremely dependent on the activities in the financial markets, including debt. As part of the analysis of such structures, valuable information can be obtained about the state’s financial condition, especially in comparison with other indicators, such as GDP. In addition, there are a lot of regulatory instruments, the application of which determines the result, both influencing foreign policy and domestic legislation affecting the economy. The debt market, or capital market, is a market in which long-term debt obligations with a maturity of more than one year are traded. Debt securities are documents that certify the right of the reciprocator of an individual or legal entity to repay a loan that must be repaid in the future under certain conditions. As a rule, they are bonds that confirm that their owner has paid for them and is then entitled to present them for payment at face value. The organization that issued the bonds undertakes to pay a fixed percentage of the face value or income in the form of winnings or payment of coupons to the bond. This market’s dynamics are fundamental in assessing the economic and financial performance of both individual organizations and entire countries.
London’s banking and financial center is one of the largest in the world. It is widely known among foreign investors and entrepreneurs. In the last decade, the British bond market has been developing actively, successfully competing with the American and Eurobond markets. Treasury-issued debt currently accounts for over 7% of the global representative bond market (World Bank, 2022). The UK has the highest AAA credit rating; therefore, British securities are highly trusted and in demand on international financial markets. This paper provides a comprehensive critical analysis of the UK debt market, from its historical background dating back to the 17th century to the present day, the regulatory framework, the role of the banking sector, and credit ratings.
Historical Review
The emergence of UK government debt has its roots in the distant past. In 1694, the British government was forced to borrow 1.2 million pounds from local financiers to cover the costs of the war with France. In return, the government gave creditors a pre-emptive right to open a bank, which later became the Bank of England. By the beginning of the First World War, the size of the public debt amounted to 650 million, and in 1919 it increased to 7.5 billion pounds. At the end of the Second World War, debt exceeded 21 billion pounds (Ellison and Scott, 2020). High inflation in the country from 1970 to 1980. It contributed to a further increase in government debt: 36 billion in 1972 and 197 billion in 1988.
To regulate and cover the debt, the Ministry of Finance issues two types of securities: bonds and treasury bills. Until 1998, the Bank of England was in charge of issuing securities (Ellison and Scott, 2020). In April 1998, the government’s decision transferred this function to the newly created Debt Management Department, which is part of the UK Treasury (Ellison and Scott, 2020). Bonds are the most widespread, accounting for 95% of all debt issued by DMOs. A distinctive feature of bonds is their very high reliability. This quality, in particular, is embedded in the official name of the bond – Guilt-edged stock with the highest guarantee (Abbas, Pienkowski and Rogoff, 2019). The British usually use the short form guilts, which refers to the category of marketable securities that are freely bought and sold on the London Stock Exchange.
In times of wars and global crises, the debt of Britain, which many times acted as a sponsor of warring coalitions, and in recent decades of its banks and corporations, grew many times and then declined over the decades. The last time such a surge occurred was in the early 1970s, the “lost decade” when public debt was more than 70% of GDP. By 1990, it was reduced to 27%, slowly rising to 40% by 2007, after which it inflated at a furious pace amid the crisis and measures to support the economy (Abbas, Pienkowski and Rogoff, 2019). Over three hundred years, a considerable amount of both positive and negative experiences in debt management has been accumulated, but in general, the British market remains a benchmark for other countries. Until now, although they have become an utterly exotic tool, one can buy “consoles” – perpetual bonds of the British government, which have been used for a long time. The fates of the British financial sector and the British budget are much more intertwined than, for example, in the United States and even financially preoccupied Switzerland (Ellison and Scott, 2020). It is essentially the result of the disproportionate role of the City of London in international finance and, consequently, the taxes received from bankers, lawyers, and insurers, as well as their employers, in the budgets of the country and London. In addition, Britain was an example in the organization of fire measures to combat the crisis.
At the end of December 2004, the UK government debt reached 436.1 billion pounds, which amounted to 37.7% of GDP. The volume of the indicator at the end of 2020 increased to £2.132 trillion, which is 99.4% of the country’s GDP. By comparison, the country’s current national debt is over 2.2 trillion pounds, exceeding 107-108% of GDP (Office for National Statistics, 2022). Such a significant change in just under two decades is due to several external and internal factors, including the pandemic, which will be described below. The most striking reforms, the trace of which can be observed, adjusted for the context of external factors, began in the last decade during the reign of Gordon Brown. Bank recapitalizations, emergency liquidity programs, nationalization and reorganization of troubled institutions, and even a highly populist tax on bank bonuses have set an example for other countries (Abbas, Pienkowski and Rogoff, 2019). Moreover, Brown played a critical role in coordinating the G7 and G20 to combat the “Great Recession.” If British finances become illiquid, it will turn out that even an exemplary anti-crisis policy has led the country to a dead end.
A huge country-specific problem is the high share of private debt of companies and individuals, including mortgages, totaling about 200% of GDP – slightly less than in the United States. At the same time, the lion’s share of this debt, unlike in most developed countries, is taken at a floating interest rate (Office for National Statistics, 2022). In 1992, rising interest rates had already led to a private debt crisis, a recession, and the expulsion of the pound from the euro’s predecessor, the European monetary mechanism. Expelled at the same time, Italy returned to it a few years later, but in Britain, the monetary union began to cause a removal, and it saved the pound. Reducing government spending – the strong point of the conservatives – also carries the risk of decreasing consumer demand from the population and a new round of recession. The main hope for the budget is the growth of the economy and especially banking operations. It is not easy to achieve: the development of progressive taxation and a special tax on bonuses has already led to the migration of financial sharks to Switzerland, which is more loyal to them. Again, for the financial sector to develop, capital must flow in abundance from abroad, and public debt rates must be low, no matter how voters in the outlying districts blaspheme the bankers (Abbas, Pienkowski and Rogoff, 2019). Considering the complex impact of factors such as the pandemic, Brexit, and the aggravated geopolitical situation in Ukraine, which together significantly affect the global economy, Britain’s public debt is constantly increasing, and so far, there are no prerequisites for returning to a stable financial foundation, despite the country’s positive credit history.
Regulatory Framework
Britain has a complex structure of regulation at the highest levels of government. Financial and banking services are primarily dependent on the Financial Services and Markets Act 2000 (Kadiric and Korus, 2019). Various laws of the European Union have influenced this branch of legislation for a long time, establishing specific requirements for the regulation of banks and financial services. The governance structure has changed since Brexit, although the primary content of the laws has not changed. The European Union’s rules have impacted a wide range of legislation, and after the official withdrawal from this union, the country took time to close various legal gaps (Kadiric and Korus, 2019). Markets in financial instruments, capital regulation, short selling, and securities financing regulations are among the many directives that have fully regulated such economical relations in the UK by the EU (Kadiric and Korus, 2019). To avoid overreacting to leaving the common market, Britain introduced various transitional rules, which in turn were regulated by the three central bodies in the field of banking and finance.
Each institution listed below has specific powers and acts only in the state’s interests. The following functions are entrusted to the Bank of England: control over the level of inflation, ensuring the purchasing power of the national currency and the stability of its exchange rate, maintaining the reliability of the country’s financial system, and ensuring the efficiency of the banking sector. In the past two decades, the British government has pursued a redistribution policy of functions that the Bank of England previously performed. In 1998, he was stripped of his authority to manage the UK public debt, which was transferred to a specially created department. The same department, two years later, began to address the government’s finances. In 2004, the Bank of England ceased to be the registrar of British government bonds (Abbas, Pienkowski and Rogoff, 2019). Consequently, this body has had only a historical influence on public debt and bond circulation, which was described in the previous chapter.
The banking sector is one of the most difficult to regulate due to its volume and structure, confirming the high importance of instant response to changing economic and social realities. Among the preventive measures that make it possible to suppress the crisis at the initial stage is prudential regulation, through which the state controls compliance with the rules and regulations of banking activities, establishes barriers to entry into the industry through compulsory licensing, and supervises credit institutions to identify and suppress violations. Potential shocks and crises, which can be “smoothed out” through effective prudential measures, carry the risks of an excessive decrease in banks’ liquidity and the inability to meet the requirements of creditors and depositors. A second body was organized: the Prudential Regulation Authority or PRA, which is a division of the Bank of England.
The third body is the Financial Conduct Authority or FCA. This body is most involved in public debt strange in view of the fact that its mandate is to maintain the efficiency of financial markets. In addition, the FCA is endowed with business, competition, and consumer rights issues (Abbas, Pienkowski and Rogoff, 2019). However, several institutions interact more with public debt in addition to the identified central regulators of the country’s financial activity. The Treasury conducts monetary policy, and the Ministry of Finance monitors and corrects operational failures in the system.
Exchange Characteristics
Public debt can be long-term and short-term, and the budget deficit and its changes occur annually, either as debts and budget imbalances are paid off or as a result of the preservation of old debts, including through the formation of new loans. In this regard, public debt in the form of external and internal government and other net loans intended to offset the federal budget deficit is the total financial debt of the country, which is guaranteed by the state (Abbas, Pienkowski and Rogoff, 2019). First of all, the formation of public debt, its growth, and its existence is caused by the state of the federal budget: balance, surplus, or deficit. The budget deficit arises due to the excess of government spending over revenues coming to the funding from taxes, foreign trade operations, payments from the use of state property, and its privatization.
Public debt takes the form of a long-term unfavorable trend since loans and credits received require their guaranteed service and repayment at the expense of budget expenditures and the repayment of net debt, including through the savings of business companies and banks on their debts. Suppose debt obligations are not repaid on time. In that case, debtors will be forced to turn to new loans, postponing the prospect of repayment of duties or reproducing and multiplying debt will create a threat of insolvency, default, or bankruptcy of the debtor and the subsequent sale of its property in the form of various types of financial and capital assets. In the global economic system, public debt and budget deficits are typical but periodically positive situation that is typical for most of the leading and most developed countries (Abbas, Pienkowski and Rogoff, 2019). The description of bonds and bills in the debt market is described in the Historical Review chapter.
Banking Sector
Modern domestic analysts and experts commenting on the UK public debt ambiguously evaluate its features, trends, and related aspects. It is considered that this is not a primary problem compared to many other economic difficulties in this country. The structure of the public debt of the UK is presented as follows: the predominant part, 55% of the public debt, falls on commercial banks in the UK, the non-financial sector – 28.7%, the state and direct investment – 8% each, the remaining 0.3% debt refers to the obligations of the country’s central bank. The more significant the part of the debt attributable to the banking sector, the greater the share of short-term debt increases the country’s debt risks. The percentage of short-term debt in the UK is 68.3%: such a ratio of GDP to public debt, as well as long-term deficits, were observed, for example, before the First World War, analysts say (Küçük, Lenoël and Macqueen, 2021). It is believed that, at present, the risks are somewhat mitigated by the existing geopolitical situation, and the unsatisfactory state of many of the world’s major economies is only capable of contributing to significant crises or armed conflicts. Researchers have alternative opinions that the probability of a UK default is considered insignificant since its external debt is secured by an impressive amount and satisfactory quality of financial assets.
In the UK, the problem of rising public debt coincides with a downward trend in national savings, reducing the potential for investment and economic growth. The total British public debt, including external and net domestic borrowing, increases the cost of total interest payments on debt servicing. Net borrowing debt holders are essentially involved in a secondary tax redistribution mechanism used by the law to secure interest payments on government debt (Küçük, Lenoël and Macqueen, 2021). As a result, increasing restrictions on budgetary spending on direct investment could contribute to economic growth. These restrictions are beyond the individual interests and motives of the economic behavior of holders of debt securities on issuers’ loans if the guaranteed interest on paper obligations is paid on time. Consumer preferences and reasons are rational enough since they are based on the realization that taxpayers and holders of debt securities are essentially the same persons whose favor taxes are redistributed a second time through the state budget for interest payments on government debt. The fiscal and financial basis of interest payments is formed by the secondary redistribution of previously paid taxes, the present value of which corresponds to the value of interest payments on government debt securities. The role of the banking sector in this trend in implementing these regulatory mechanisms and constructing a risk mitigation strategy in connection with the country’s growing debt in the relevant markets.
Government and Non-Government Debt and Instruments
Although it exceeded the country’s GDP for the first time in a long time, public debt has a distinctive structure that allows you not to sound the alarm about such indicators. First, slightly less than half of the total comes from the UK government. At the same time, payments on this debt are the lowest in the history of humanity concerning GDP (Kadiric and Korus, 2019). Second, the country’s tax revenues still have growth potential, which could attract significant cash inflows to the budget. Of the G7 countries, the UK ranks only third in terms of tax revenue (Kadiric and Korus, 2019). Third, the private sector’s debt is significant – several times – more excellent than the government’s debt. The financial industry, being more crisis-prone than other developed countries, nevertheless has to pay the majority of bonds to people and institutions within the country, which helps stimulate the economy. These facts allow us to conclude that the public part of the debt is relatively small of the total volume, and the private sector dictates the constantly growing indicators of liabilities. At the same time, payments on bonds remain mainly within the country’s economy and will be restored at the expense of internal resources, respectively.
It is well known that the potential and limits of all forms of taxation are more limited than the growing pace and cost of servicing debt obligations through government budget expenditures. In practice, this was confirmed during the Thatcher era, when an unsuccessful attempt was made to tax British citizens per capita (Ellison and Scott, 2020). In this case, the fact was confirmed that the increase in taxation inevitably causes a change in the population’s economic behavior. It remains to be seen how much the per capita tax revenues and the interest income of government debt holders could be balanced if rational consumers voted for a change in the British government.
The effect of guarantees of government social programs and interest payments on various types of assets, such as “paper wealth” with its high quotations on the stock markets, create the illusion of perceived wealth for holders of debt securities, to a certain extent removing social tension and negative expectations of the consequences of the country’s growing public debt. The current situation has not yet received severe general discussion. Global crises await the global economy unless ways are found to limit public spending and determine the price society is willing to pay (Abbas, Pienkowski and Rogoff, 2019). The UK intended to solve the accumulated problems before the pandemic and Brexit based on the developed strategy called the UK Digital Strategy 2017.
Within the framework of this program, many different solutions and long-term changes were proposed. However, it is who best demonstrates the possible tools for regulating the debt market. Indexed bonds, long-term assets, and government bonds of the country, called gilts, will receive additional control systems as part of the strategy, which will increase their reliability (Abbas, Pienkowski and Rogoff, 2019). These financial instruments account for nearly three-quarters of government loans (Kadiric and Korus, 2019). In addition, treasury bills are circulating on the market, similar to American papers of the same name. The yield is formed by the ratio of the discount to the face value upon purchase. Interest on gilts is paid two times a year: in early March and early September. The terms of walking are limited only by a minimum – of 1 month; while there is no Upper Rubicon, the average time is 15 years.
There is an opportunity to carry trade to work with UK government bonds. She makes the job very attractive. Since gilts are bought and sold in pounds sterling, you can make money on the difference in exchange rates. For example, a market participant invests his money in gilts. Their double conversion brings income. The yield of the bonds themselves is currently relatively low. Only short-term speculative operations allow you to get a substantial income. There is also a secondary market, which can be considered a separate mechanism that has a particular influence on securities pricing, but the difference between the face value and the value of gilts in the market is insignificant.
Therefore, the instruments include conventional bonds, which account for 75% of the government’s debt portfolio. In addition to them, there are indexed bonds in circulation. Their main difference from the usual ones is that semi-annual interest payments and the principal amount are indexed according to inflation, determined by the Retail Price Index – RPI. Statistics UK publishes RPI values regularly (Abbas, Pienkowski and Rogoff, 2019). The third type is bonds without a maturity date, the date of which is set by the Ministry of Finance, and the public is informed about it. Bonds without a maturity date are the most “ancient” debt obligations; some of them were issued as early as the 19th century. Bonds have a low-interest rate and are not widely used. Currently, the issue of this type of security has been terminated, and only those bonds are in circulation, the maturity of which has not yet come.
Treasury bills are short-term marketable securities issued by the British government. The Debt Management Department of the UK Treasury currently issues bills of exchange with maturities of one, three, and six months. Treasury bills pay no interest. The bills are sold at a discount, and at maturity, the investor has paid the face value of the security—bills of exchange account for about 5% of the debt of the British government. Finally, bonds with a double maturity date regulate the minimum and maximum terms. Given that there is uncertainty about maturity, these debt instruments are less liquid than conventional bonds and, therefore, are less in demand among investors. Double-dated bonds account for less than 1% of the market (Office for National Statistics, 2022). These instruments make up the main range of securities on the UK debt market.
Credit Ratings
The UK credit rating is a dynamic structure that has changed over the past decades within specific values. Most often, the ratings of the largest agencies vary depending on external and internal factors between stable and negative, but it has not fallen below the AA level over the past thirty years (Trading Economics, 2022). The negative impact on the ratings is mainly due to global issues like the pandemic and Brexit, which require time and appropriate recovery mechanisms. However, the UK has historically always found a way out of challenging crises, which allows it to remain attractive to investors in the long term.
Conclusion
The British debt market has many distinctive features and unique aspects that have historically turned into traditions. The country’s public debt is growing and recently, for the first time, broke the mark of 100% concerning GDP; however, the stability and competent management of this market, for several reasons, is not a cause for alarm. Moreover, the UK has the assets and the ability to deal with these circumstances, primarily dictated by external factors that affect not only the British market. Unlike in other countries, most of the debt is directed inside the country’s economy. The long history of thoughtful management of the country’s finances still bore fruit in such difficult times. As a result, credit ratings, despite such trends, mainly signal the stability of the UK debt market.
Reference List
Abbas, S. A., Pienkowski, A., and Rogoff, K. (Eds.). (2019) Sovereign debt: A guide for economists and practitioners. London: Oxford University Press.
Ellison, M., and Scott, A. (2020) ‘Managing the UK national debt 1694–2018’, American Economic Journal: Macroeconomics, 12(3), pp. 227-257.
Kadiric, S., and Korus, A. (2019) ‘The effects of Brexit on credit spreads: Evidence from UK and Eurozone corporate bond markets’, International Economics and Economic Policy, 16(1), pp. 65-102.
Küçük, H., Lenoël, C., and Macqueen, R. (2021) ‘UK economic outlook: Brexit Britain in Covid recovery ward’, National Institute Economic Review, 255.
Office for National Statistics. (2022) ‘UK government debt and deficit: December 2021’.
Trading Economics. (2022) ‘United Kingdom – Credit Rating’.
World Bank. (2022) ‘Central government debt, total (% of GDP) – United Kingdom’.