My Recent PublicationOctober 14, 2008
Malaysian Financial System Can Weather Current Global Financial TurmoilOctober 20, 2008
A policy success amid the disaster. Quoted from the Financial Times By Martin Wolf
Will the UK government’s scheme for rescuing the financial system work? The answer to this question depends on the meaning of the word “work”. I can identify three issues: will the scheme rescue banking? Will it cost too much? Will it prevent a recession?
The eight eligible UK banks are to raise £48bn in new capital, of which £12bn will be in preference shares paying a dividend of 12 per cent. The government is making capital investments in Royal Bank of Scotland and, upon merger, HBOS and Lloyds TSB, totalling £37bn. The guarantee on new debt for maturities of up to three years will carry a fee of 50 basis points, plus the median credit default swap rates, over the year to October 7 2008. So charges will end up at 110-150 basis points.
Recapitalised banks must maintain loans to the non-financial sector at 2007 levels, help people struggling with mortgages and accept a governmental say on compensation, board membership and dividends.
Will this scheme rescue the system? Overall, the answer has to be “yes”, though it may not promote much new lending. Evidently, the government must also trade protecting the interests of taxpayers against promoting lending. Knowing where to draw the line is hard. But the scheme looks a bit harsh.
First, it is tougher than that of the US, where preference shares pay only 5 per cent, guarantees are free for the first 30 days and subsequently charged at a flat 75 basis points and there is no requirement to halt dividends. At the same time, accepting government capital is – rightly – voluntary in the UK. Nevertheless, the assisted UK banks will be at a competitive disadvantage and their spreads on lending larger.Second, the scheme will create an incentive for assisted banks to pay the government back quickly. This also makes it more likely that banks will try to limit the size of their balance sheets, to reduce the capital they need. This militates against the new lending the government wants. Third, while restrictions on pay and dividends are understandable, the government has an interest in the quality of banks’ staff and their ability to raise capital privately.
Finally, the government needs an exit strategy. Private banking has indeed disgraced itself. But a politicised banking system, run by bureaucrats with an interest in a quiet life, would be a horror. Crisis-prone private banking is bad; state monopoly banking is still worse. Will the scheme cost too much? On the face of it, the answer is “no”. In fact, the current income of the government should rise, with fees on its guarantees exceeding the interest cost of additional debt. Its gain should be some 0.2 per cent of GDP. Meanwhile, the direct cost of the recapitalisation should add less than 3 per cent of GDP to public debt. If the scheme limits the recession, as it should, it will be cheap at the price.
The fiscal risks the government is taking on, as financial-sector insurer of last resort, are substantial. The guarantees on new lending might end up at £250bn (18 per cent of GDP), or even more. If this money were to be lost, UK net public debt would still be below 60 per cent of GDP (if one ignores the effect on the public finances of the recession itself). But the UK might end up relatively highly indebted, though that would depend on what happened with the similar schemes now emerging in other high-income countries. In any case, the idea that the UK government will lose a great deal on these guarantees seems almost inconceivable. The programme looks quite affordable.
The fiscal position will depend far more on the severity of the recession. The International Monetary Fund forecasts the economy will stagnate next year, after 1 per cent growth in 2008. Tight credit, the collapse of house prices and global weakness make a far worse outcome likely. Public sector net borrowing could hit £70bn this year and £100bn (7 per cent of GDP) in the next two. This would raise public indebtedness swiftly. But a collapsed financial system would have made the outcome vastly worse. Opposing the scheme on cost grounds would be a superb example of being penny wise and pound foolish.
This recession cannot now be prevented. But its impact can be minimised. Saving the financial system is part of the answer. But, with inflation threats dwindling and recession looming, the case for substantially lower interest rates is overwhelming. Another half a percentage point cut is the least I would expect at the next meeting of the monetary policy committee. I would argue for more. The UK also needs a renewed fiscal framework if fiscal credibility and sterling’s acceptability are to be preserved. Without these, all will be lost.
The costs of decisive action were, in short, vastly less than those of inaction. The fiscal burden should prove quite manageable, provided the UK remains a country with credible policies, where people want to invest. Much will depend on the exit strategy from these crisis measures. Much will depend, too, on how far monetary and fiscal policymakers continue to respond sensibly to events. These are, in short, extraordinary times, in which governments must take big gambles. But they seem to have made the right bets this time.
UNIVERSITY OF DURHAM