The UKs Current Debt Situation - Term Paper Example

Introduction 2007 was the year when world markets officially went into recession as the major developed markets of the world experienced economic crisis. GDP started to slide in countries like US and UK besides a systematic crumbling of strongest financial institutions of the world. This created uncertainty within the markets and increased the overall risk premium which was charged on the rates of return on various instruments including stocks and other securities. What is also significant to note that this uncertainty not only culminated into the deflation in asset values but the overall confidence of investors went down too. Consistent actions such as quantitative easing in money market, though helped to control the money supply in the market, but it also hinted at the weakening of major currencies of the world also specially dollar. UK’s current debt situation and the debate on it during recent past indicated that there are subtle doubts within the minds of investors that countries like UK can default too. This was mostly due to higher budget deficit and faltering in the credit ratings of the country itself. It has been reported in the Bank of England (BoE) financial stability report that the markets have started to put strain on different markets including the sovereign markets. This clearly indicates the overall sentiments in the market and how market actually perceives the future risks. This paper will therefore focus on what economic future markets are basically pricing and how the overall risk is being perceived in the UK markets. Financial Stability It has been discussed in the financial stability review of the BoE that the overall conditions are improving for the economy as a whole and the financial system of the country has been able to manage its essential activities. This signifies the slow recovery and stability which is emerging in the financial markets of the country and a such the sign of stability in the financial markets can also serve as one of the important indicators for the improved investor confidence and hence the correct pricing of risk of the assets. Financial stability review also indicates that the financial institutions have been able to cushion themselves against the losses which can erode their capital with the systematic increase of their capital base to meet the Basel II requirements. Thus the overall risk faced due to higher sovereign risk in cases of Greece and Ireland may be easily absorbed by the larger UK firms. (Bank of England, 2010) Bond Markets in UK and US A closer look at the discussion and data presented in the financial stability report would suggest that the overall market sentiments are not good enough. The increasing level of sovereign risk especially in the wake of the Greece’s bailout and current episode of Ireland, indicates that the due to increase in the counterparty risks. The financial market in UK however, was able to strengthen itself mainly due to introduction of new buffer capital by the Banks specially to help them provide a cushion against the potential losses. During the early months of 2010, the overall confidence in the US bonds market started to shack after a period of relative stability in US bond markets. The yield fluctuated during the month of March 2010 on US treasury bonds mainly due to the price deflation as well as the rising unemployment level in the economy. Similar situation happened in UK also before the last election when the budget presented by Gordon Brown’s government failed to take any concrete efforts to overcome the rising budget deficit of the government. (Mackenzie & Oakley 2010). Around that time, the overall yields on the bonds increased in order to account for the increasing volatility in the markets and the non willingness of the investors to actually take long term risks. The current yields on the 10 year UK Guilt bond is around 3.40% 1however, it remain consistent in recent past due to some stronger performance by the UK economy specially its services sector. Source: Office for National Statistics2 The above graph shows the changes in the GDP of UK over the period of last five years and an indicating a healthy recovery in the economy. What is however, significant to note that this rise is relatively slow and as such the overall response of the market towards these growth trends may not be as rapid as expected? Thus the overall element of uncertainty may remain in the market and the investors may not be willing to place higher bets on the overall prospects of the markets in near future. The following graph therefore is the vivid example of how the UK guilt market is behaving and what the trends in market are. It indicates that during the last six months of 2008, yields on UK Guilt bonds went high however, the overall efforts to stabilize the economy increased, the yield on the bonds started to come within an acceptable range. Similarily, there are concerns for the Irish bonds as Irish government is facing difficulties in meeting its obligations falling due. It has been announced however, that a bailout package will be announced for the country based on the funding from IMF. What is signficiant to note that this has increased the yields on the 10 year bonds issued by the Irish government. This is critical owing to the overall economic sensitivity of the Euro Zone as a whole and its impact on the different markets in the region including those of UK and it may inavariably put pressure on the yields in the UK market also. Corporate Bonds Spreads A closer look at the above graph would suggest that UK’s corporate bonds spreads remained relatively from 2005 to the mid of 2007 however, the yield on the same started to rise during 2007 and touched the peak and than started to fall down. The current situation in the market therefore indicates that the yields are falling and the markets are probably better integrating the changing situation of the market. The fall in the corporate bond yields may also be a direct result of the better performance by the financial sectors of the country which not only strengthened itself through systematic introduction of fresh capital to buffer against the losses but also remained profitable too. This has probably helped build the overall investor confidence in the corporate bond market and resulted into decline in the bond market spreads. UK Equity Markets During 2008 housing sector of the economy were probably badly affected sectors in terms of their performance on the stock exchange. This was mostly due to the lack of the risk appetite of the investors to invest in these sectors due to their increased risk profile. Equity markets therefore during 2008 and 2009 remained volatile and the stock market remained at suppressed levels owing to the performance of financial services and housing sector of the economy. The current situation and the analyst predictions for the FTSE 100- the leading stock market index in UK suggest that the index may end up at higher note at the end of the year. Currently, FTSE 100 is trading above 5700 range which is much higher when the index actually hit the low during the middle of this year. (Adam, 2010). This consistent increase in the index over the period of last six months however, indicates the rising confidence of the investors in the overall prospects of the UK economy. It is however, also important to note that many economists including Stieglitz are of the opinion that current steps taken by David Cameron’s government- specially the spending cuts, might result into further slump in the economy in near future. If these forecasts prove to be correct it would therefore be easier to conclude that the markets are probably mispricing the current economic situation and have probably failed to take into account the recent changes in the fiscal policy of UK. It is also important to note that FTSE100 went though some of the trouble as episodes such that of the BP and BA has badly affected the confidence of the investors. Both of these factors are relatively different and distinct from what is happening due to credit crunch in the market. As such the overall sentiments in the equity markets of the country are the mix of the uncertainty about the future as well as the concerns about the performance and conduct of some of the larger companies on the index. It is also therefore important to note that the PE ratios of the major companies listed on FTSE 100 have been encouraging. For example, PE ratio of AstraZeneca is over 7 indicating the confidence of the investors in the firm’s ability to generate sufficient cash flows in the future to support itself. Similarly, PE ratio of Barclays is over 11 again indicating that the investors are placing higher bets on the future of these firms and their ability to rebound in the wake of the current economic crisis.3 Higher PE ratios therefore indicate the degree of confidence of the shareholders in anticipating the market and its future conduct. It is however, important to note that higher PE ratios may also be the result of the accounting maneuvering as many firms take advantage of the accounting loopholes to magnify their earnings and as such may not correct reflect the actual strength of these institutions. It is also significant that the markets must also take into account the macroeconomic variables also as they are going to certainly affect the way markets are going to behave in near future. It is also important to note that significant chunk of the ownership of the FTSE 100 companies rests with the foreign investors therefore the changes in the way FTSE 100 might have been integrating and pricing the future risks may not be properly priced by the investors.( Sunderland, 2010). Access to Credit Extension to the credit is one of the key indicators for the external investors to remain confident about the company’s prospects. However, during the recent times in UK, credit extension to large firms remained good however; the situation for smaller firms remained volatile. Though, this may indicate that the things for larger firms are easing up however, the overall confidence remain low and restricted for smaller firms. Access to credit is also significant due to the fact that it provides a better indication of how well the capital markets of the economy are integrated with each other. In a situation where financial markets are already squeezed access to new capital restricts the capacity of the firms raise new funds to cushion themselves against the potential changes which may take place. It is therefore critical that proper access to the credit as well as capital is essential for judging the overall flexibility of the markets and their overall risk appetite to accommodate the large as well as small firms. Conclusion Current situation indicates that the markets are probably in recovery mode wherein the overall pricing of the different securities seems to be inflating gradually. Major markets including debt and equity markets experienced the slump during last few years however, there is a gradual recovery. Spreads on the government as well as corporate bonds are reducing and so does the yields and as such the overall mood of the investors seems to be bullish. FTSE 100 index is also gradually increasing and it has been anticipated that the index might reach to the level of 6000 by the end of this year. What is however, critical to reflect upon is the fact that the actual impact of the steps taken by the current government has not yet materialized fully and it has been anticipated that the economy may slow down as a result of the spending cuts and increases in taxes. If these forecasts are credible, it may be possible that the currently markets may be mispricing the risk and the markets may experience the slump again once the actual impact of the steps taken by Conservative government start to manifest in reality due to contractionary fiscal policies. References 1. Adam, A (2010). FTSE Could Rally 10% By End Of This Year [online]. [Accessed 21st November 2010]. Available from: . 2. Financial Stability Report [online]. (2010) [Accessed 21st November 2010]. Available from: . 3. Irish bond yields dip as UK, EU urge calm [online]. (2010) [Accessed 21st November 2010]. Available from: . 4. Mackenzie, M, Oakley, D (2010). Supply fears start to hit Treasuries [online]. [Accessed 21st November 2010]. Available from: . 5. Shares Over the Year: FTSE 100 a distant memory for housebuilders [online]. (2009) [Accessed 21st November 2010]. Available from: . 6. Sunderland, R (2010). FTSE 100: how Londons leading share index lost touch with the rest of Britain [online]. [Accessed 21st November 2010]. Available from: . Read More