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How does the Government finance its Borrowing?

The UK government has a national debt of over 55% of GDP.

It finances its debt by borrowing from the private sector.

Its debt is managed by the Debt Management Office DMO

1. By issuing government bonds 
(gilt edged stocks) demand comes mainly from non- bank financial sector e.g. insurance co.

i) e.g. Treasury 10% 2004 fixed time period for repaying the loans
ii) CONSOLS (consolidated stock ) are irredeemable bonds. No time limit on repayment. They are held because they give a guaranteed interest payment
iii) Euro bonds bonds held in a foreign currency

2. It may issue non marketable debt in the form of national securities or tax instruments. Such securities are not traded but are encashable at face value by the National Savings authorities. The main market is the private saver

3. It may issue floating debt in the form of Treasury Bills. The main market is the banking sector. These are short term loans. No interest is paid so the gov’t sells at a discount e.g. £97, buys back at £100 in 3 months time

4. It may borrow from oversees. Selling bonds overseas.

5. Bank of England may purchase Government bonds through an asset purchas scheme. For example, in 2009, the Bank of England pursued a policy of quantitative easing, creating money to buy back government bonds from banks. Note the Bank of England is not able to directly buy debt off the government. Here it is indirectly financing the public sector borrowing requirement.

Price of Bonds and the Rate of interest

Bonds can be bought and sold on the market, the price of bonds will depend upon the rate of interest. If the market interest rate increases, the value of a fixed interest bond will fall, because it becomes less attractive compared to other financial investments.

Importance of expectations

– The further away in time the payment of the loan , the greater the influence of i.r. on the price
– For e.g. a £100 stock payable tomorrow will be worth £100 whatever the interest rate
– If the stock is repayable in 25 years and the interest rate is 5% the discounted value of £100 is about £10.
– The interest is worth £5 a year
– Therefore if market interest is 10% the interest payments on the bond is worth £50
– Market value is £60

2. The Term structure of Interest Rates

Usually we expect short term bonds to have a lower yield than long term bonds. This is because short term stocks have capital certainty. However short term stocks do have income uncertainty when they mature

Long term bonds have a higher yield to compensate for the greater uncertainty in the capital value. Income is fairly constant throughout the period. But investors prefer capital certainty to income certainty

Therefore Treasury bills have a lower rate of interest. But the advantage for banks is that they are fairly liquid, and can be bought and sold with the discount houses

3. National Savings

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