The Tories’ missed opportunities to stem the soaring cost of Britain’s debt

rishi sunak - REUTERS/Scott Heppell/Pool/File Photo
rishi sunak - REUTERS/Scott Heppell/Pool/File Photo

The era of ultra-cheap money is fast becoming a distant memory.

Public sector borrowing surpassed £27bn in December, reaching its highest level that month since records began in the early 1990s.

The uptick was partially due to a large increase in debt interest, which soared to £17.3bn, the highest December figure on record, data from the Office for National Statistics showed.

The jump was driven by rising inflation that has pushed up the cost of inflation-linked government bonds, known as linkers.

Meanwhile rising interest rates to combat inflation have forced the Treasury to hand billions to the Bank of England under the terms of its quantitative easing programme.

The turn of events will leave many in Westminster rueing missed chances to restructure the Government’s huge debt pile and lock in low rates of borrowing while they still could.

A string of politicians called for measures to reorganise the UK’s growing debt pile before rates started rising. The idea of turning debt issued during Covid into “war bonds” by significantly lengthening the term was floated by short-lived prime minister Liz Truss. David Davis, the Tory MP, raised a similar idea a year earlier but warned the window of opportunity was short.

George Soros, the billionaire investor and advocate of European integration, also called on Rishi Sunak to consider perpetual bonds when he became prime minister. Much like an interest-only mortgage the principal would never be repaid. The bonds can then be redeemed and replaced with another such perpetual loan once interest rates come down, he argued. Such ideas have however also been criticised for saddling future generations with debts far into the future.

While these ideas were specifically targeted at the Government’s Covid borrowings, any effort to restructure state finances on such a scale could have included significantly reducing the proportion of linkers when issuing new debt.

Asked whether the Government might have come to regret the high proportion of linkers now, Janette Rutterford, a professor of finance and history of finance, says: “Of course they do”.

“Over the last 20 years, they’ve had an unprecedented opportunity to invest in infrastructure and everything else. Now everything's falling apart, we haven't got the money to do it because the markets aren't going to let it.”

Now it looks like the moment to reduce the reliance on linkers may have passed: The free money era of Covid has been replaced by the return of so-called “bond vigilantes”. These investors enforce sound money by imposing fiscal discipline, a phenomenon played out most recently after the disastrous mini-Budget.

One reason for the sharp increase in the Government’s debt interest is that the gilts are tied to the retail price index (RPI), a way to measure inflation that has largely been shelved. It was at 13.4pc in December, significantly higher than other more common ways to measure how fast prices in shops are growing. The consumer price index (CPI) was at 10.5pc last month, while another version including housing costs stood at 9.2pc.

Statisticians have warned against using RPI since 2013, as it typically overstates inflation. Yet it remains used for anything from deciding rises to phone bills, rail fares and student debt. Rishi Sunak - then Chancellor - decided back in 2020 that it only be phased out in 2030 when a portion of government debt will instead be linked to the much lower CPIH.

It means a portion of the interest the UK pays its lenders is rising faster than what the ONS perceives the most accurate measure of inflation to be, at a time when there are already huge demands on public spending. It also implies it might be a while before the Chancellor dares look at cutting taxes again.

“Worse-than-expected public finances figures will only embolden the Chancellor in the Budget to keep a tight grip on the public finances and mean that he waits until closer to the next general election, perhaps in 2024, before announcing any significant tax cuts,” says Ruth Gregory of Capital Economics.

The UK is relatively unique in just how much of its debt interest is linked to inflation, making up nearly a quarter of the £2 trillion central government debt. In the US, this figure is less than a tenth, while in Germany it is less than 5pc.

One reason for this is that the UK was the pioneer of this type of debt, according to George Buckley at Nomura.

“The incidence of index linkers is much greater in the UK because we started earlier. The first index linker was sold back in the very early 1980s, so the market is quite mature,” he says.

The UK was one of the first developed countries to issue debt linked to inflation back in 1981. Much like today it was a time when prices were rising rapidly and interest rates were high. This made it tricky to raise money in the traditional way.

If the Government offered to pay interest competitive with inflation to make it worthwhile for investors, it would commit to paying extremely high rates over decades in some instances. It was also struggling to raise all of the money it needed, according to Rutterford.

Margaret Thatcher who was in power at the time was said to be sceptical of linkers, worrying that it would make inflation become entrenched. But she gave in because of the circumstances, Rutterford says.

“They were struggling to sell,” Rutterford says. “They were committing themselves to very, very high interest rates and people weren't willing to buy them because they'd already bought quite a lot.”

The Government was even preventing the private sector from raising financing in fear that there wouldn’t be enough demand to mop up the gilts, she says.

“The government needed to raise long term debt to pay as well to finance itself and so it didn't let companies issue bonds,” Rutterford adds. “They were terrified that that would take the investment money away from gilts. You had to get permission from the Bank of England to issue any of these fancy bonds.”

They were largely regarded as a success at the time and grew increasingly more common, proving especially popular with pension funds. The idea behind them was also that the Government had an extra incentive to keep inflation low and stable, as this was before the Bank of England became independent. In other words, it would remove some of the temptation to slash rates just before elections or to boost poll numbers.

The linkers, worth £493.2bn at the end of 2021, have historically saved the Government money, according to a report by the Treasury. This is because of strong investor demand and financial resilience through supporting long loans and a broader base of lenders. However, it acknowledges that the “relatively large stock of index-linked debt also increases the sensitivity of the public finances to inflation shocks”.

The Government even announced back in 2018 that it would over time try to reduce the amount of debt linked to inflation to limit such risks. It did take some steps to do so: In the five years to 2018-2019, linkers made up a quarter of bonds issued. In the following four years, this dropped to 15pc. As a result, the share of such gilts in the total has fallen from 28.4pc in 2019 to 23.9pc in 2021. But while this is much higher than in many other countries, the Government is now content with the level, according to the Treasury report.

Michael Oliver, an accounting lecturer at the Open University, believes linkers will likely be around for a long time despite what some perceive as drawbacks. “I'm sure they will still be a big staple of government debt going forward,” he says.

Nomura’s Buckley still sees advantages too: “The fact that we do have a big linkers market means that it gives investors a great deal of choice. So it helps with selling the debt,” he says.