On October 20, British Prime Minister Truss announced his resignation as Prime Minister and Conservative Party leader. There were many reasons for Truss' resignation. The tax cut plan launched shortly after she took office and the resulting financial market turmoil were the most important main. The intervention of the Bank of England and the reversal of the fiscal plan have temporarily alleviated the crisis, but they cannot fundamentally restore market confidence.
The 2022 growth plan was introduced inadvertently
On September 23, the Telas government announced the "2022 Growth Plan", which made growth the core of its economic policy and clearly set a 2.5% gross domestic product (GDP) growth target. The plan hopes to rely on economic growth to create higher wages and continue to increase investment in public services. The core of this plan is a tax cut plan totaling about 45 billion pounds, including the abolition of the 45% top income tax rate that only applies to high-income groups, a sharp cut in income tax and stamp duty on home ownership, and a plan to increase corporate tax to 25%. . If implemented, this will be the most radical tax cut plan in the UK since 1972, so it is also known as the British version of "Reaganomics".
The problem is that the aggressive tax cut plan runs counter to the Bank of England's policy of fighting inflation. The U.K. consumer price index (CPI) is currently at record highs, rising to 10.1% in September, and there is no sign that it will fall anytime soon. To combat inflation, the Bank of England has adopted aggressive tightening measures, raising interest rates seven times in a row since December 2021, raising the policy rate by a total of 225 basis points. The Telas government hopes to appease the people through tax cuts and energy subsidies, but because large-scale fiscal expenditures without financial support will further worsen inflation, such policies are actually drinking poison to quench their thirst. More monetary tightening measures are still on the way, but the central bank's efforts have been offset by massive tax cuts. If the government does not correct its mistakes in time, it will lead to more conflicts between monetary policy and fiscal policy, and inflation will be more serious.
The tax cut plan also triggered the collapse of the market's confidence in assets, and the financial market suffered a triple kill of "stock, bond and foreign exchange". After the announcement of the tax cut plan on September 23, the yield of the 30-year government bond in the UK continued to rise, reaching a cumulative increase of 80 basis points on the 26th. The rapid rise in government bond yields means that the government will have to bear more debt interest burdens, which will exacerbate inflationary pressures and curb economic growth. On the 23rd, the British pound fell 4% against the US dollar and 2% against the euro, and the British FTSE 100 index also fell sharply.
Pension fund crisis widens rapidly
50% of the pension funds in the UK are fixed-income, and they need to make fixed payments every month in the future. In order to achieve higher investment returns, fixed-income pension funds adopt an investment strategy called liability-driven. This type of investment often adopts a highly leveraged aggressive investment method, obtaining higher returns through repeated mortgages of bonds, and smoothing cash flow through interest rate swaps. From a practical point of view, long-term gilts linked to inflation (that is, long-term British government bonds) are the best choice to match this strategy. The debt-driven strategy has been used in the UK for many years. According to the statistics of the British Investment Association, the total amount of debt invested through this strategy has quadrupled between 2011 and 2021, reaching nearly 1.6 trillion pounds, while the size of the UK government bond market is 2.3 trillion pounds. Trillions of pounds or so.
The sharp volatility in the treasury bond market triggered a pension fund crisis. At the start of 2022, UK 30-year government bond yields are only around 1.2%. After the announcement of the tax cut plan, in the four trading days from September 23 to 28, the interest rate on 30-year British government bonds rose by 160 basis points to 4.99%. On September 28 alone, the 30-year Treasury yield fluctuated by 127 basis points. The speed and scale of changes in UK government bond yields in the short term are unprecedented, and far exceed the safety boundaries set by investment institutions.
Specifically, if the net asset value of pension funds drops sharply, the corresponding leverage ratio will rise sharply, and some small funds may even become insolvent. On September 28, many pension fund institutions reported to the central bank that if yields rise further, they will have to sell a large amount of long-term treasury bonds to meet capital requirements. The Bank of England estimates that such a short-term sell-off will reach 50 billion pounds, while the market's daily trading volume is only 12 billion pounds, which is far from enough to deal with such a large-scale sell-off. This will amplify the pressure on the financial system and further damage the national debt market, which in turn will force other financial institutions to sell assets to increase liquidity. In the credit crisis, the bankruptcy of American bank Lehman Brothers triggered the global financial crisis).
In order to prevent financial risks, the Bank of England was forced to step down and intervene. On September 28, it urgently announced the temporary purchase of British long-term government bonds "at any necessary scale" starting that day. The bond purchase plan will continue until October 14; The plan to shrink the balance sheet of 100 million pounds of British government bonds was "unaffected and unchanged", but the sale originally scheduled to start on October 3 was postponed to October 31. The Bank of England has repeatedly emphasized that bond purchases are to achieve its statutory financial stability goals, not to create central bank money or limit long-term interest rates, and thus are not monetary policy operations. However, while the central bank is raising interest rates sharply and planning to shrink its balance sheet to curb inflation, it also actually buys bonds to expand its balance sheet. This contradictory operation is actually "paying" for the fiscal policy of the Truss government. In the following two weeks, the Bank of England purchased a total of 19.25 billion pounds of long-term government bonds, resulting in a rapid decline in the yield of 30-year government bonds, which once dropped 120 basis points to 3.8%.
The intensification of financial turmoil forced the Tesla government to urgently suspend the tax cut plan to fundamentally solve the crisis in the national debt market, prompting a sharp reversal of the fiscal plan. Although the Bank of England took the initiative to buy bonds, the strength of the bond market did not last long. After October 3, the yield of government bonds rose sharply again, especially after the central bank made it clear that it would not extend the purchase plan. By October 12, the 30-year Treasury yield rose again to 4.8%. The central bank ended its bond purchases on time on the 14th despite calls from pension funds to maintain the emergency program. The Bank of England understands that emergency programs cannot solve the fundamental problems facing the financial system. On October 14, Chancellor of the Exchequer Kwatten, who had only been in office for 38 days, resigned under the pressure of Prime Minister Truss. On the same day, Jeremy Hunt was appointed Chancellor of the Exchequer, becoming Britain's fourth chancellor in four months. On October 17, Hunt announced that "almost all" of the tax cuts in the "Growth Plan 2022" would be scrapped. Subsequently, the British financial market gradually returned to calm, and the 30-year government bond yield has now fallen to around 3.6%, falling back to the level before the announcement of the tax cut plan.
Bigger challenges lie ahead
Although Tesla has stepped down and replaced him with Sunak, a new prime minister who is familiar with financial affairs, the alarm of economic and financial risks in the UK has not been lifted. Treasurer Hunt has delayed the release of a "sound fiscal plan" (the "mini-budget"). The Bank of England originally planned to gradually sell government bonds after the fiscal plan was announced, with an annual reduction of 80 billion pounds. Now it needs to start shrinking its balance sheet without knowing the details of the new fiscal plan. The treasury bond market will soon face severe challenges again, and the turmoil in the pension fund market is far from over. At the same time, affected by factors such as the Brexit process and the Ukraine crisis, the British economy is facing problems such as labor shortages and energy crises, and its growth is sluggish. Before the introduction of the tax cut plan, the UK had already faced the problem of "fiscal and trade twin deficits" that would only be faced by a typical developing country. The UK's fiscal deficit and debt levels are currently at their highest point in 50 years. The budget deficit exceeds 200 billion pounds, and the total government debt reaches 2.4 trillion pounds, equivalent to more than 100% of the GDP. Imported inflation since 2022 has further exacerbated the trade imbalance. The current account deficit rose to a record 7.2% of GDP in the first quarter and narrowed to 5.5% in the second quarter, but it is still at a nearly 20-year high. The impact on the national debt market is essentially a response to the continued imbalance in macro fundamentals in the financial market. Sunak still faces many structural challenges in order to achieve his goal of "boosting the economy and rebuilding government credibility".
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