Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 20-39)

MR ROBERT STHEEMAN, MS JO WHELAN AND MR JIM JUFFS

10 JANUARY 2007

  Q20  Peter Viggers: Congratulations on your excellent record of sickness absence or non-absence for sickness, 2.3%, I think one of the lowest levels in the Civil Service. Have you any tips to pass on to other departments?

  Mr Stheeman: If I knew how to do that I would. I think the one point I would make is linked to your question about staff and what motivates staff. I do think that we are very fortunate—and I say that quite advisedly—in having both excellent staff and staff who are genuinely very motivated and enjoy doing what they are doing.

  Q21  John Thurso: Can I ask about borrowing costs. While the borrowing cost trend since 1988-99 has generally been downward it seems that 2006-07 will see a rise in average issuance yields. Given that 2006-07 sees a probably further increase in gross gilt issuance, is the increase in yields a sign that we are reaching the upper limits of cost-effective government borrowing?

  Mr Stheeman: I would not think so, I certainly hope not. The increase in yields effectively is a direct result of the macro economic environment in which we operate. In the same way as we certainly never take any credit for the decrease in effectively coupons over the last few years, similarly we cannot say that we have a direct impact on that. Yields tend to be driven much more by macro economic factors, by global markets in particular as well. Anyone who is familiar with the gilts market is probably aware that whatever happens in the US market will have an impact on all other markets around the world. The same applies to the Far East or the eurozone. Very often yields if they have been declining in the UK will certainly be declining elsewhere, in Europe, the US and elsewhere. Similarly, if they rise they will rise for similar reasons. I do not believe there is a direct link to the limit of government borrowing or that government borrowing has an impact. There has been some analysis from time to time or attempts to analyse that also internationally where the supply itself can have an impact but the academic literature on that is not at all clear to what extent that happens. I would put out there as a thought the possibility that at times when we were effectively in a net surplus situation and there were issues with liquidity in the gilts market, as we had perhaps five or six years ago, at that time I think arguably the market was potentially crying out for supply which it could not have. That just shows the two are not directly linked.

  Q22  John Thurso: It would be fair to say, would it not, that your activities in achieving cost-effective borrowing for the Government are a part of keeping that cost down, ie the yields? You are not entirely at the mercy of the markets?

  Mr Stheeman: In as much as we do have this primary debt management objective of minimising costs that is absolutely the case, yes, but I would not say we are at the mercy of the markets, the way I would phrase it is perhaps slightly different, we do not take a view on the level of interest rates when we issue, we have to issue and we issue at whatever is the prevailing rate in the market at that time. We will of course take a view in terms of the strategic advice we give to the Treasury about rates and about what the structure of the borrowing in any given year should be but we are, I would say, to a large extent, at the mercy of the market. I do not believe that we affect the level of rates in a significant fashion

  Q23  John Thurso: The NAO told us that since you were established and Government borrowing has increased unit borrowing costs have generally come down. I would think that is to some degree due to your efforts at managing that?

  Mr Stheeman: Again, it is something which I would love to claim credit for.

  Q24  John Thurso: But you do not want the blame when it goes the other way; is that it?

  Mr Stheeman: I do think that it is important to stress that we are ultimately a price-taker.

  Q25  John Thurso: Is there any way of judging what impact you do have or measuring whether you have actually got any impact on that at all?

  Mr Stheeman: It goes back, I think, to the whole discussion which we had at the beginning. It is extremely hard, and that is why, in terms of actually saying whether we are doing a good or a bad job, some of this has, to a certain extent, to be intuitive. If I can just give you a specific example: if government issues (as the current Government is issuing in the current year) the majority of gilts in long-dated and very long-dated bonds and in linkers and in longs, we are doing it clearly for a reason, and the reason is that there is a demand out there, which we know, which has impacted, or sought to impact, on the shape the yield curve. It is cost-effective for us to do that. If we were to have completely ignored that and issued everything in the most expensive part of the curve, I think you could turn round and say, "Surely you are not doing anything remotely like trying to meet your primary debt management objective." I am slightly rephrasing it, but that is the way I look at it.

  Q26  John Thurso: Can I ask one last question. Have the high borrowing levels in recent years placed any operational pressures on the DMO, and what are they?

  Mr Stheeman: Yes, and that is a very valid point. If you think about it, I think there was a four-week period in November/December, from mid November to early mid December, where we actually conducted more auctions than we did in the whole first year of the DMO's existence. This year, for instance, we have got 36 auctions scheduled. If you compare that to, I think, four in the first year of our existence, it has risen consistently with the borrowing requirement. Each time that happens there are operational issues, operational risks, which we are very much aware of, and every auction contains an element of risk. Systems have to work, people have to be there to actually help make sure that these things occur, and the same applies when we are doing cash management. I think the straight answer is, yes, these are issues and they consistently occupy our mind.

  Q27  Peter Viggers: Approaching the same issue as that raised by John Thurso but from the point of view of the pensions industry, where I have a declared interest, can I put to you a scenario that longevity has consistently been underestimated and there has been some weakness in the stock exchange and some changes in the bond sector as well, and all of this has impacted on the pensions industry, which increasingly has gone in for asset and liability modelling, seeking to match its liabilities with its assets. There has, therefore, been a very heavy demand for longer-dated gilts. You have issued increasing amounts of long-dated gilts in response to market demand, and in 2006 we saw historically low yields in such gilts because of the strong demand for them. Some commentators reported the existence of a self-perpetuating downward spiral in long-dated gilts that was damaging to the pensions industry. Has the Government been reaping the benefit of low borrowing costs at the expense of the pensions industry? I can rephrase the question if you like. Have you been very good at your job of selling at advantageous rates to Government but has that had other damaging effects elsewhere in the city world? Is your brief perhaps too narrow? Are you not taking as broad a view as you should?

  Mr Stheeman: I think it is a very legitimate question. I certainly prefer the second version, or the first part of the second version. The comment that I would make is, first of all, yes, you are absolutely right, clearly the decline in yields, especially at the ultra-long end, which was very pronounced exactly a year ago and is still low, certainly by recent historical standards, was the subject of much press speculation: it caused significant issues, problems, arguably, stress for the pension fund industry. We have, indeed, a debt management objective, which is cost minimisation. We could just happily sit back and wash our hands and say, "Well, we are just following." We are, indeed, as you say, reaping the benefit for the taxpayer (which I would stress) of this very low rate environment. To suggest that we do so without due regard to the consequences elsewhere I think would not be correct. We are very much aware of the needs of the pension fund industry. The pension fund industry still represents the largest part of our investor base. We have dialogue with a number of pension funds constantly, with representatives of investor groups and we are very much aware of their needs, but there is an issue. You said: are we not ignoring potentially the needs of that group? If you were to talk about changing the debt management objective to take in the needs, for instance, of the pension fund industry to make us arguably more responsive towards those, you are potentially giving an agent of the Treasury conflicting objectives, and that is something which I think is quite hard. What I am trying to say is that I think it is an issue for government and for wider government, and I know that the Treasury—and I have been part of the group—has been discussing these issues with the Pension Regulator, with the Pension Protection Fund, also with the Department of Work and Pensions and officials in various meetings. It is something which we are all aware of. For us, you could argue I am being very narrow in my perspective, but I think I have to be and I think it is quite a good thing. If you ask a debt manager to minimise cost, he has to stick to that.

  Q28  Peter Viggers: I respect that answer. The question might be perhaps addressed elsewhere. Your default position in issuance is to split between short, medium and long gilts. How valid is this default position given the high level of demand for long-dated gilts?

  Mr Stheeman: You are right. We have talked about this default position, and I would stress it is only that. It is a starting point for the analysis. Clearly, if you see what we are doing this year, the fact that we have skewed as much as we have in literally record amounts towards longs and linkers suggests that we are willing to deviate from this default position where we believe it does meet these objectives. I stress that the default position does not necessarily mean that this is a specific preference of what government wants its portfolio to look like. It is more a default position which is used as a starting point for analysis and for working out what the issuance strategy should actually be given the environment, given the yield curve, given all these things which we face each year. It is based on things such as risk minimisation in terms of maturity profile, all these sorts of things, but it is perhaps worth mentioning that the UK already has a longer average maturity in its debt portfolio than any other major OECD country by a very long way.

  Q29  Mr Newmark: May I just ask you a pension question. I think you are absolutely right; I think your remit should be focused on cash management and debt issuance and I would be saying, "Yippee", if there was all this demand from the pension industry, but I will get back to that in a minute. According to the NAO's briefing,[3] overseas holdings of gilts have increased significantly since 2002. How do you account for this trend and how dependent is the successive government borrowing programme on the demand from overseas investors?

  Mr Stheeman: You are absolutely right. It has increased significantly. You have seen the chart in the report, but just to put that in numbers, I think since I have joined the amount of overseas holdings have doubled, effectively, from about 60 to roughly 120 billion, which is clearly significant. There are a couple of reasons for that. One is quite simply because we have increased issuance, the gilts market has become that much more liquid. It is therefore, arguably, as a more liquid mature market, more attractive, but I think the key point is that it is a result of investor diversification in particular by overseas investors, who, for instance, in the case of, let us say, central banks, are looking to divest holdings out of purely US Treasuries or Euro government bonds, potentially also into gilts. It is also arguably a consequence of—

  Q30  Mr Newmark: How have our rates fared versus the dollar? What has been driving that? Why are we a more attractive market to go into than dollars? It has to be other than simply diversifying currency risk.

  Mr Stheeman: It is largely to diversify currencies. Put it this way, absolute yield levels in some, but not all, maturities are at times higher here than elsewhere, but in terms of what drives, for instance, reserves managers, I think that does tend to be very much diversification trades.

  Q31  Mr Newmark: I am curious as to where on the yield curve this demand has been happening. Is it throughout, is it mid term, is it the far end? Where have overseas people really been demanding our gilts?

  Mr Stheeman: To a large extent, but not exclusively, interestingly enough, intuitively most people are familiar with what reserves central banks invest in, what reserves managers do, and would expect that demand to be very much in the shorter and medium level, three to five years to 10 years.

  Q32  Mr Newmark: So very different from the pension industry demand, for example?

  Mr Stheeman: Exactly. Having said that, I should say that I have specifically come across some investment management firms, for instance in Japan, which buy UK 30-year bonds, in one case 50-year bonds.

  Q33  Mr Newmark: I am curious. Has the fact that the price of oil went from $12 a barrel to $70 a barrel meant that effectively the suppliers of that oil now are flush with cash? Has that driven the demand for gilts as well, or is that not the case?

  Mr Stheeman: Quite possibly. Some of this is only conjecture on our part exactly where all this is going. There is a lot of talk about the far east and central banks, but it is fair to say that, for instance, the Russian Stabilization Fund—you have heard of that—which invests effectively oil revenues in Russia, announced publicly that they were diversifying last year their holdings, which were then effectively only in US dollars and Euros, to 45% each in those and 10% in gilts. So that is arguably a direct result of capital flows.

  Q34  Mr Newmark: Would the lower cost of borrowing happen without this foreign interest, or would it have been happening anyway or would you say it would only affect the shorter end of the yield curve and not the longer end of the yield curve?

  Mr Stheeman: I think probably it would have happened almost regardless. A benefit for us is that our investor bases become more diverse. That is good. It does not mean, as I say, that we ignore the needs of the pension funds or we do not realise how important they are overall as part of our investor base, but it is also quite nice to have a somewhat more diverse portfolio.

  Q35  Mr Newmark: I was fascinated by your strategic debt analysis model, so I just have a couple of questions on that, and I might have a supplementary depending on what your answers are. The NAO's briefing on debt management includes details about the DMO's work to develop a strategic debt analysis model that analyses quantitatively the expected cost and risk of various gilt issuance strategies.[4] How do you think this particular model of yours will be and what practical benefits will it provide? For example, will it enhance public accountability?

  Mr Stheeman: In answer specifically to that last question, yes, I hope it will, is the straight answer.

  Q36  Mr Newmark: Through what mechanism?

  Mr Stheeman: By effectively providing—

  Q37  Mr Newmark: Is it, effectively, a get-out-of-jail clause for the Treasury? You have said, "This is what our model says" and, therefore, they can say, when Gordon Brown, or whoever makes the decisions that he makes, "This is what the model has told me to do"?

  Mr Stheeman: This is why I should be quite explicit. The model is not there to tell us exactly what we are going to do, and that is quite important. If I may, can I just quote you something which Charlie Bean wrote in one of the Bank's quarterly reports which I think is worth quoting. He said that, "all economic models are highly imperfect reflections of the complex reality of the UK economy and, at best, they represent an aid to thinking about the forces affecting economic activity and inflation". I picked on that for a reason, which is that this is a tool which will illustrate, effectively, the results of potentially certain strategies in cost and risk terms, but it is based purely on assumptions and it is as good as any assumption or as bad as any assumption you put into it.

  Q38  Mr Newmark: It has no practical benefit to the decision-making you at the debt office make. It is an interesting intellectual exercise you and I can have a discussion about but there is no practical benefit, it sounds to me?

  Mr Stheeman: I would not go that far. I think, to pick up your words before, it is an aid to accountability. It allows us to show what the results are, what the trade-offs are, if we follow various strategies, to the extent that, if you can illustrate something by figures, it is useful and, if we can show the scale by which something might be cheaper or more expensive, it aids accountability. The article read probably very much to you (which it is) like a piece of academic research. It is the sort of work that one or two other major OECD debt managers are also interested in trying to pursue, and we have discussed this with them, because everybody has the Holy Grail, if you like, of trying to develop this issue of performance measurements, of trying to find out how can we be more accountable, and that is the real reason. The model is not a black box which will spew out an easy answer and tell us this is what we have got to do: because if we happen to put in assumptions that turn out to be wrong in—

  Q39  Mr Newmark: So there is no cost-benefit analysis to the output of the model? I guess what particularly perplexes me is that it is intellectually fascinating but I can pull out my HP12C or I can actually read the newspapers and decide the yield curve at the far end is at the lowest it has ever been, let us refinance. I do not need a model to tell me this. Shorter term gilts, middle term gilts. Let us do a favour for future generations, for my grandchildren and your grandchildren, and issue as many of these 50-year long-dated gilts as possible because we are doing our grandchildren a great benefit. Why go on with the fiction of paying a higher cost of capital for middle-term and shorter-term gilts today? I do not see the logic to it and I do not need a model to tell me that.

  Mr Stheeman: The model will not tell you that, that is absolutely correct, but (and I will move away from the model to try and answer that specific question) there is a reason why we have specifically, even in this environment, even with the shape of the yield curve that we have in the current remit, not ignored the short or the medium end of the market, and we have issued effectively the minimum that we can in order to create a single benchmark in both short to mediums, five or 10 years, 10 billion each, and everything else we put into longs and linkers.


3   http://www.nao.org.uk/publications/nao_reports/06-07/debt_management_office.pdf Back

4   http://www.nao.org.uk/publications/nao_reports/06-07/debt_management_office.pdf Back


 
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