

By Anthony Reuben

Business reporter, BBC News

The amount the economy grew in the last three months of 2009 has been revised up from 0.1% to 0.3%. Even the first estimate, that it had grown a miserly 0.1%, was enough to take the country out of recession. So why does this 0.2 percentage point change matter? In large part, because of two key effects on the country's debt position. Firstly, if the economy is not growing, the amount of tax paid to the government will not grow, which means that the amount it has to borrow to fund its spending programmes will increase. Figures released last week showed that the government borrowed £4.3bn in January, which is usually a month when bumper corporate tax receipts mean that it does not have to borrow any money. Secondly, the UK does not want to get a reputation as a weak economy, because that would increase the interest rate it has to pay to borrow money. It is the same as an individual trying to take out a loan from a bank: if the bank is absolutely confident that the individual has enough money coming in to pay back the loan then it will charge a much lower interest rate than it will for somebody it is a bit less sure about. In the case of the country as a whole, the way it borrows money is by issuing gilts, which are IOUs, promising to repay an amount of money on a particular date and a specified interest rate until then. Gilts are sold at auction, so the government does not know how much money it will be paid for each gilt or who will buy them.

The biggest owners of gilts are insurance companies and pension funds. For them, gilts are predictable investments, which are particularly useful when a low-risk product is needed. Pension funds, for example, will usually switch an individual's holdings from higher risk investments, such as shares in companies, and put them in gilts as the person gets closer to retirement. Next on the list comes investors overseas. Unfortunately, nobody keeps records showing in which countries these gilts are held. This is in contrast to, for example, the US, which regularly publishes lists of the countries that own its Treasury Bills. So we know that at the end of 2009, $302.5bn (£196bn) of US government debt was held in the UK, making the UK the third-biggest investor behind Japan and China. Anecdotally though, it appears that much of the growth in overseas investment in gilts in recent years has come from other central banks buying them as part of their foreign currency reserves, as all gilts are sold in pounds sterling. The next biggest category holding UK government debt is banks, which includes the Bank of England. Since March 2009, as part of its quantitative easing programme, the Bank of England has bought just short of £200bn of gilts, making it the third-biggest holder of UK government debt.

As well as helping the Monetary Policy Committee to fulfil its inflationary aims, the quantitative easing policy has helped to stoke demand for gilts. In the graph above it is clear that most of the growth in demand for gilts has come from the banks category, and within that category, almost all the demand has been from the Bank of England. The Bank has now suspended its quantitative easing programme, but the government needs to borrow a great deal of money in the coming year. The investment managers Threadneedle estimate that the Debt Management Office, which sells gilts on behalf of the government, is having to sell £18.75bn of gilts a month to meet funding requirements. The question now is who will step in to buy all these new gilts now that the Bank of England has withdrawn from the market. There are concerns that demand for gilts could decline ahead of the general election, amid worries that a hung parliament could get in the way of forming plans to reduce the country's deficit. Also, there is a danger that inflation and a weakening pound could reduce the value of overseas holdings. The government counters that there is plenty of demand for gilts and that there are still plenty of investors snapping up UK government debt at its auctions. Nonetheless, the key issue remains confidence, and that is why there is so much attention paid to the minutiae of the economic growth figures.



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