Bank of England warns risk of UK financial crisis hasn’t gone away

By Mark Thompson, CNN Business

For the second time in two days, the Bank of England has been forced to offer extra support to UK markets still reeling from the government’s announcement last month that it would slash taxes and increase borrowing.

The central bank warned Tuesday that there was still a “material risk to UK financial stability” from a sharp-sell off in government bonds that has sent yields soaring, pushing up borrowing costs across the economy and forcing some pension funds to dump assets to raise cash.

A slump in UK government bonds that promise to protect investors from inflation — known as index-linked gilts — was the latest source of risk, it said.

“Dysfunction in this market, and the prospect of self-reinforcing ‘fire sale’ dynamics pose a material risk to UK financial stability,” it said in a statement.

The extent of the bond market strain was underscored Tuesday when the UK government sold £900 million ($994 million) of index-linked gilts due in 2051 at the highest yield since October 2008, according to Reuters.

Starting Tuesday, the Bank of England will include index-linked gilts in its emergency £65 billion ($71.7 billion) bond-buying program announced on Sept. 28. “These additional operations will act as a further backstop to restore orderly market conditions,” it added.

The bank said the program would end as planned on Friday, despite calls for it to continue for another three weeks.

On Monday, it doubled the daily limit on its bond-buying to £10 billion through the end of the week. It also announced a new facility that will make it easier for banks to tap central bank cash by accepting a wider range of assets as collateral. That program will continue once the emergency bond-buying program ends.

The market meltdown began after Prime Minister Liz Truss’ government unveiled £45 billion in unfunded tax cuts on Sept. 23. Truss and her finance minister, Kwasi Kwarteng, also chose to present their “mini budget” without an independent analysis from the UK’s fiscal watchdog, the Office for Budget Responsibility (OBR), of what the plan would mean for government borrowing and economic growth.

The pound and UK government bonds crashed, forcing some pension funds near default and pushing them to dump assets as a hedging strategy came unstuck. Mortgage rates shot higher.

Under pressure from markets, the International Monetary Fund, ratings agencies, poll ratings and restive members of their own Conservative Party, Truss and Kwarteng have already had to backpedal fast. They’ve ditched plans to slash the top rate of income tax for people earning more than £150,000 a year, but that shaves only about £2 billion off the cost of the tax-cutting package.

Kwarteng has also brought forward his full budget announcement by more than three weeks to Oct. 31, meaning it will now take place before the next meeting of the Bank of England on Nov. 3, when interest rates are likely to be raised significantly. The finance minister will also publish OBR forecasts at the same time.

But the government still faces an uphill struggle in persuading investors it can pay for its program and fulfill Kwarteng’s promise to “get debt falling in the medium term.”

The Pensions and Lifetime Savings Association, which represents funds providing retirement incomes for 30 million people, said many of its members wanted to see the Bank of England continue to buy bonds until the end of the month, and possibly beyond.

Huge uncertainty

The independent Institute for Fiscal Studies said Tuesday the government would need to announce spending cuts of more than £60 billion just to stabilize debt as a share of national income by 2026-2027.

Those cuts may be politically impossible to achieve given the cost-of-living crisis and pressure on public services such as health and social care.

‘It is just about possible to see how Mr. Kwarteng could get debt on a stable, or ever-so-slightly falling, path in the final year of his forecast,” IFS director Paul Johnson said in a statement. “But the specifics of the UK government’s fiscal strategy are under more scrutiny by financial markets than at any point in the recent past.”

Relying on overly optimistic forecasts for growth or vague promises to reduce spending down the road could lack credibility.

Benjamin Nabarro, chief UK economist at Citigroup, said that the United Kingdom has few easy answers to the difficult economic outlook.

“In the near term, further demand stimulus merely risks aggravating the near-term challenges. And with monetary and fiscal policy now working in opposite directions, we think the broader risks around UK monetary [and] financial stability are growing,” he added.

— Julia Horowitz and Hanna Ziady contributed to this article.

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