Bank of England November 2011 Inflation Report - Treasury Contents

Letter from Sir Mervyn King, Governor of the Bank of England, to the Chairman of the Committee

In your letter of 2 November, following our appearance before the Committee on 25 October, you asked for clarification on a number of points relating to the Asset Purchase Facility (APF). In addition you reminded us that we promised to send you a note on commercial bills. This letter responds to those two requests.

1.  At the hearing Andrea Leadsom asked about the potential for market movements in the price of gilts to result in losses for the APF. In my response I explained that any profit or loss arising from movements in the market price of gilts held by the APF would be offset by a loss or profit for the Government as issuer of the gilts. You asked for clarification of the mechanism by which the APF's profit or loss is offset elsewhere in the Government's accounts, given that the Government's liabilities are fixed at the point of issuing the securities. As I go on to explain, it is the different accounting treatment of the APF and Government accounts that reconciles these viewpoints.

The simple economic logic is that the gilts held in the APF are both an asset and a liability of the public sector. So, taking the public sector as a whole, fluctuations in the market price of the gilts held in the APF have no net impact on the public finances.

In practice, however, the gilts in the APF and on the Government's balance sheet are subject to different accounting conventions. The APF's assets are "marked to market" so that fluctuations in the market price of gilts affect the APF's accounts, while the Government's liabilities are not. But the use of different accounting conventions does not alter the underlying economic logic. Although you correctly observe that the face value of the Government's liabilities are fixed when the securities are issued, it is the present value of the resources needed to service those liabilities that matters economically, and that does vary.

A simple thought experiment makes these arguments clear. Suppose the market price of the gilts in the APF were to fall because of a rise in the prevailing risk-free interest rate, so that the APF incurred a loss on its gilt holdings. Those same gilts are liabilities of the Government, and are accounted for at face value in the Government's accounts. The Government could, however, choose to issue new gilts with a lower face value (matching the market value of the gilts held by the APF), and use the revenue raised to repurchase the gilts in the APF, and then retire them. That would reduce the overall face value of its outstanding liabilities, allowing the Government to book a gain matching the APF's losses on its gilt holdings.

In economic terms nothing would be gained (or lost) from this reshuffling of liabilities, since the present value of the Government's liabilities is unaffected by the exercise. Yet the face value of its liabilities would be lower afterwards. The outcome in an accounting sense would be the same as if it had marked its liabilities to market. The important point of economic substance is that such a fall in the market value of the gilts in the APF is matched by a fall in the current resources required to service the Government's future liabilities. Those two effects offset, and that is the sense in which the public sector can be unaffected by movements in the market value of gilts in the APF.

More generally, I am strongly of the view that the APF accounts do not provide a meaningful guide to the overall impact of asset purchases on the public finances. Monetary policy, however it is implemented, affects the market value of existing debt, whether on the balance sheet of the private sector, the central bank or the remainder of the public sector. It also has implications for the cost of issuing new debt. And it affects macro-economic conditions, including the level of output and inflation, and thereby both taxation and spending.

Any overall assessment of the impact of the MPC's asset purchases on the public finances would therefore have to take into account the improvement in the Government's financing costs, as well as the higher fiscal revenues and lower expenditures arising from the boost given to economic activity by asset purchases. In short, such an exercise would have to compare what actually happened to a hypothetical set of circumstances in which an alternative policy was followed. That is not what the APF accounts are designed to capture. Charles Bean's speech on 13 October 2009 provides further explanation of this issue.[1]

I continue to believe, however, that this type of financial assessment is not the appropriate basis on which to judge the success of monetary policy. We do not usually seek to isolate or evaluate the effect of monetary policy in these terms, by calculating the counterfactual profit or loss to the public finances. The judgement about the success or failure of asset purchases rests instead on their contribution to achieving the overall aims of monetary policy - exactly the same criterion on which we evaluate interest rate decisions.

2.  You ask also for further information about why the Bank stopped purchasing high-quality commercial bills - also sometimes known as "bankers" acceptances' - as part of our sterling monetary framework.

A useful discussion of the background is given in a short box published in the Bank's Winter 2005 Quarterly Bulletin at the time when these bills were made ineligible for the Bank's open market operations. In summary, the Bank ceased to accept commercial bills from 17 August 2005, largely because the size of the market had fallen to around only £1 billion. It had been evident for some time before then that the market for commercial bills continued to exist only because of the eligibility of such bills in the Bank's own operations. As the box explains, official operations in such a small market were at times problematic; partly for that reason, the Bank encouraged the development of a gilt repo market, which it began using in its own operations from Spring 1997. As gilt repo developed into a much larger, more homogeneous and hence more liquid market than that for commercial bills - the market for commercial bills contracted further, to the point where the Bank judged that eligibility should be removed.

In early 2009, the Bank considered potential ways of improving the availability of working capital finance for those firms which did not have access to modern corporate bond or commercial paper markets. This work, which included discussions with commercial bank treasurers and others, concluded that there was little evidence to suggest that renewed acceptance of commercial bills in the Bank's operations would successfully catalyse private markets. One reason for this was that banks said they would be less willing to trade bills in a secondary market than they had been in the 1980s and 1990s. That in turn reflected three main factors. First, such bills are individually small in size. Second, bills accepted by another bank count against counterparty exposure limits, which have been tightened since the financial crisis. And, third, commercial bills count as unsecured lending and attract the same capital charge, so any market making activity in bills might reduce capacity to lend directly to businesses.

In summary, it is clear that the market for commercial bills came to a natural end. In view of the factors underpinning that demise, I judge it unlikely that a significant private sector market for this particular form of asset will re-emerge in the future. As I said at the hearing, it would be inappropriate, indeed almost certainly futile, for the Bank to try to revive a market for which there appears no latent demand. Hitherto, other official sector efforts to support the provision of credit to SMEs through the issuance of tradable securities have also proved difficult. For example the Bank's Secured Commercial Paper Facility (SCPF), launched in July 2009, enables suppliers, which include many small and medium-sized companies, to have their invoices paid early (at a discount) rather than waiting for payment from their investment-grade corporate customers under their normal payment terms. The funding is provided by a commercial bank in return for the supplier's invoice. The commercial bank can then choose to retain these trade receivables or sell an interest in them to other investors, such as via the SCP programme. The scheme has, however, received limited take-up to date.

For these reasons, I have continued to advocate policies that would, instead, create incentives for banks to lend to SMEs through their existing infrastructure. I expect the Chancellor will have more to say on this in his Autumn Statement on 29 November.

24 November 2011

1   The speech is available on the Bank's website at  Back

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