Boris Johnson was considered by many to be the troublemaker at 10 Downing Street. Hardly a month went by during his tenure without at least a small outcry from his own or opposing camp. But hopes on the financial markets that his departure would at least bring some calm to British politics have not been fulfilled.
On September 23, Chancellor of the Exchequer Kwasi Kwarteng published a “mini-budget,” a supplementary budget — and plunged the country into one of the biggest financial turmoil of recent years. Within a few days, the British pound, which was already battered, plummeted, pension funds in Great Britain tumbled – and the central bank had to prevent the worst with emergency intervention. And all because of a few tax plans. What happened?
Great Britain’s new Prime Minister Liz Truss had promised direct and strong tax cuts in the bitter struggle for the head of the Tory party and thus the post of head of government. It was said that this was the only way to stimulate the slow-growing British economy. With his “mini-budget” her Chancellor of the Exchequer has now reduced taxes by a whopping £45 billion (51 billion euros). Among other things, the higher earners should benefit, which led to heated discussions. Financial markets, however, were rattled by another event, and one that fueled the riots: it was not at all clear how the British government planned to finance the tax package – if not through debt.
The markets reacted with uncertainty to the tax plans
Contrary to what Chancellor Kwarteng and Prime Minister Truss had expected, the financial markets did not react positively to the tax plans. The pound sterling sold off in a very short time, losing sharply against the US dollar and the euro. On Tuesday last week, a pound sterling was only 1.11 euros, hitting a record low. A similar kink was observed in government bonds, where interest rates rose sharply. This makes it more difficult for the UK to take on new debt, but has even more far-reaching consequences, including national pension schemes.
Because British pension funds are heavily invested in British government bonds, so-called Gilts, and they have partly used these investments as collateral for other financial transactions. The sudden rise in interest rates of over a percentage point in two days and the collapse in demand for gilts presented them with major problems because the bonds with their old, low interest rates were suddenly worth less. The pension funds had to provide additional collateral for their business, which they hardly had. In the absence of buyers, they could not sell Gilts either. As a result, the Bank of England feared an implosion of the Gilt market and with it the collapse of numerous pension funds – and intervened. It buys Gilts for £65bn to prop up demand. For Salomon Fiedler, economist at Berenberg Bank, this is an important step: “Without the intervention, there could have been a downward spiral,” the market observer suspects.
It sounds a bit like Mario Draghi
How important the step was can also be read between the bureaucratic lines of the Bank of England. “The purpose of these purchases will be to restore orderly market conditions,” the central bank said in a statement. “Purchases will be made to the extent necessary to achieve that goal.” That sounds a bit like “Whatever it takes” by the then ECB boss Mario Draghi in 2012 and shows how serious the situation is.
After turbulent days, there is talk of the markets calming down on Tuesday. The Bank of England’s action has so far been successful. Interest rates fell, the Gilt market is active again. But the bank wants to end the purchases in mid-October. Then it turns out whether the pension funds have been able to rearrange their long-term liabilities by then. The outlook is not bad: the Truss government has already reversed part of the tax cuts and the long-term prospects for the UK could also be worse.
Market observer Fiedler von Berenberg was surprised that the exchange rates for the pound fell so sharply as a result of the new plans. “The fundamental data do not support such a crash,” he explains. “Britain’s level of debt is comparatively low and the long-term prospects are good,” said Fiedler. “You just have to save yourself in the long term.” For the Prime Minister and her Chancellor of the Exchequer, this is probably only a small consolation after the past few days.