Quantitative Easing – The Facts
In his recent budget speech, Rishi Sunak stated that estimates on borrowing are the highest figures seen outside of wartime. The Office for Budget Responsibility (OBR) confirmed that borrowing is estimated at £355 billion for the financial year to April 2021. So how exactly does the government borrow money? The answer is that the government borrows money by selling gilts. This is useful reading as you prepare for any of the CII R01, R02, R06, AF4, or J10 exams.
THIS ARTICLE IS RELEVANT TO EXAMINABLE TAX YEAR 2020/21.
A gilt is a fixed-interest security (also known as a bond) issued by the Treasury and listed on the London Stock Exchange (so its price can rise and fall). The bond is called a ‘gilt’ because the original issue had gilded edges. They are a low-risk investment as the government has never failed to meet interest or final repayments.
The government pays interest to whoever owns the bond (which is usually pension and investment funds, insurance companies, and banks, although private investors can also buy them).
The rate of interest (or coupon as it is also known) is fixed and designed to generate a steady income for the purchaser. Investors often look to gain at least as good an interest rate as paid by the bank, while the government is borrowing money at a cheaper rate than going to a bank.
The return is fixed over an agreed term, and at the end of the term, repayment of the original capital is made. Some gilts are repaid in a year whilst others do not have to be repaid for 50 years. Often the government has to issue new gilts (i.e. borrow again) in order to repay the debt due on the repayment date.
Corporate bonds work in exactly the same way as gilts, the idea being that companies can raise cheap finance by issuing bonds.
The Bank of England buys gilts and corporate bonds from the private sector in an attempt to boost the economy through spending and investment. So far, the Bank of England’s total purchases of UK government bonds totals £875 billion with another £20 billion having been used to buy investment-grade corporate bonds – a grand total of £895 billion.What is quantitative easing? Here are the facts... Click To Tweet
Where does the money come from?
So where does the money come from to carry out these purchases – does the Bank of England simply print more money like it does the banknotes we use every day?
The simple answer is that banknotes are not printed, instead, money is created digitally and then used to buy the corporate bonds and gilts through the process of quantitative easing (QE). The aim is simple; by creating ‘new money’, the Bank of England’s aim is to put more cash back into the economy through spending and investment. The policy is based on the strength of quality fixed interest securities like gilts and investment-grade corporate bonds.
So how does QE help the economy?
Firstly it helps the Government:
- The Bank of England buys gilts from the private sector, i.e. from pension funds and insurance companies
- Demand for the gilts pushes the price up which means the yield (or return) goes down
- Lower yields mean it is cheaper for the Government to borrow as they can issue more debt at lower rates
Then it helps households and businesses:
- Lower gilt yields influence banks’ interest rates and so they reduce, making it cheaper for households and businesses to borrow money encouraging spending to boost the economy
- The pension fund and insurance companies use the money to buy other assets, e.g. shares
- Demand for the shares pushes prices up making those holding the shares wealthier meaning they are more likely to spend
Whether QE works is a hotly debated topic; most research suggests that QE has helped to keep the economy stronger but there are other side effects such as the increase in the prices of shares and property meaning the owners of such assets are getting wealthier whilst making it even harder for younger people to build up savings and get on the property ladder.
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