Hopes that China will bail out Greece rise as she issues a new Budget. Is the UK base rate now irrelevant?

4th October 2010 by Shaun Richards

At the end of last week we saw something of a quiet trading day in equity markets with the Dow Jones Industrial Average rising by some 41 points to 10829. In general Asian equity markets have followed this lead except for Japan where the Nikkei 225 equity index has dropped by some 23 points to 9381. This leaves the spread between the Dow and the Nikkei at some 1448 points or 15.4% of the Nikkei’s value showing us that for some months this year the Nikkei 225 has underperformed as equity markets have rallied. The fallers in the Nikkei this morning were mostly banks who were worried about capital concerns which will not be improved by a report that a Swiss panel suggested  that the two main Swiss banks UBS AG and Credit Suisse Group AG hold almost twice the capital recommended by the Basel Committee on Banking Supervision.

Indeed this news this morning is intriguing. In my article on the new Basel 111 rules on the 13th September  I was critical of them. Well it seems that the Swiss did not think much of them either as UBS and Credit Suisse, Switzerland’s two biggest banks, should hold total capital equal to at least 19 % of their assets, compared with the 10.5 % the Basel Committee recommended according to the Swiss proposal. This continues a trend of this year where officials and politicians make statements and announcements which fall apart very quickly sometimes being undermined in effect by a rather similar group of people. Do they think that everyone has the attention span of a gnat? Also should other countries repeat this requirement for higher capital ratios going for wards it will have implications for both banking profits and bank lending going forwards both of which are likely to be affected in a downwards direction.

UK banking and the Special Liquidity Scheme

For those unaware of what this is it is one of the ways the Bank of England supported the UK banking sector when the credit crunch hit. A recent speech by Paul Tucker from the Bank of England explains it in more detail.

During early 2008, following the collapse of Bear Stearns, and with the continued closure of the securitisation markets making mortgage-backed securities and hence mortgages substantially illiquid, it became clear that additional and exceptional liquidity support would be needed for the UK banking system. The Special Liquidity Scheme [SLS] was designed to provide that support on a one-off basis, in large size and for a long maturity. The form of the Scheme was an asset swap (effectively a collateral upgrade). For a fee, the commercial banks were lent nine-month Treasury bills against a broad set of eligible collateral.

So in a nutshell it was a way of providing liquidity support for the UK banking system that in liquidity terms was long -term as in the panic of 2008 looking to 2012 looked a massive distance away. There has been some debate about whether it will be extended but Mr.Tucker was quite clear in his speech.

The Scheme will expire at the end of January 2012. It will not be extended or replaced. After three years of large-scale liquidity support the Bank expects each institution to be in a position to fund itself through normal market mechanisms.

There are those who are worried about this. Whilst the size of the SLS has fallen from a peak of £187 billion to £128 billion it is still a substantial sum. They worry where the money will come from to replace it? If you think about it this indicates a lack of faith in the recovery of our banking system which again rather contradicts official pronouncements and the return of the bonus culture. Also if banks are squeezed for liquidity they may lend even less which as broader measures of the money supply as struggling even now has worrying implications for money supply growth with clear implications for the wider economy. One does not have to think particularly hard to see the potential for this to impact on mortgage lending and indeed lending to businesses. Both of which are currently weak and we could do without them becoming weaker.


I do believe that the Bank of England wants to get rid of the SLS but not for the most conventional reason. Although the ending may be badged as a return to normal conditions I notice that Mr. Tucker said

In order to prevent a refinancing ‘cliff’ at the end of 2011, the Bank has had bilateral discussions with the main users of the Scheme to ensure that there are credible funding plans in place to reduce their use of it in a smooth fashion.

In my opinion the reason is from the asset swaps themselves. You see to quote Mr. Tuckers this scheme allowed in his words “a collateral upgrade”. You may not be entirely surprised to learn that some took this as an invitation to have more of a collateral upgrade than the Bank of England intended. This has left the Bank worried about what it calls “phantom securities”. Now whilst bad this is not quite as bad as it may sound I do not want to you to worry that they do not exist, what I do want you to worry about is that these securities are not what they said they were on the tin. If you like this operation downgraded the credit rating of the Bank of England and was one more rather complex and surreptitious example of a bail out for the banking sector with the taxpayer taking the strain with the complexity hiding the risk from many. This is the real reason why the Bank of England wants to remove it.

The problem remains as I discussed above what if the banking sector still needs cash as £128 billion is a substantial sum? On this topic I notice that the New Economics Foundation has produced a report today which suggests that the banking sector will need some £25 billion a month of funding in 2011. We are left with the thought that a lot of money is going to have to come from somewhere. Perhaps such thoughts contributed to the talk by Adam Posen of a return to the policy of Quantitative Easing although should this be so it would also reveal for whom the policy is actually implemented.

Official and unofficial interest rates

This subject returns me to a theme I have been writing about on here all year. That is the dislocation between the official base rate and market interest rates. For example the UK base rate is 0.5% but savings rates can reach around 3% and mortgage rates are usually higher if one can get one. There will be a debate on Thursday about whether the Monetary Policy Committee should raise rates but to my mind if you stop and think it becomes clear that the base rate has become to many participants an irrelevance. It is another victim of the credit crunch and the policy mistakes of our central bank.This is one of the reasons why I would have raised the base rate at the beginning of this year.

The Greece/China link.

This is an interesting development and when Wen Jiabao, China’s premier, offered to buy Greek government bonds when she returns to the market on a weekend visit to Athens we saw a new type of realpolitik. This follows on from a visit to Greece in June by China’s vice premier who according to Greek officials offered deals which concerned “maritime affairs, telecoms and a project to renovate a landmark tower building in Athens’ port of Piraeus.” I guess there was no great surprise about rumours of a shipping deal which have continued. This link with China may have been behind an improvement in the yield on Greece’s ten-year government bond yield which dropped by around one percent last week and now stands at 10.33%. In an essentially illiquid market even the rumour of Chinese buying might have a substantial impact, although a cautionary note is required as a similar deal foundered earlier this year when the Greek government refused to sell a stake in the National Bank of Greece.

We will get an update on the proposed budget for Greece in 2011 later today. However I am still troubled by the nature of the tax amnesty that I discussed on Friday. I notice that back in September the IMF said this “The program’s credibility hinges critically on improving tax compliance.” On this subject I can only agree with this from Kathimerini’s editorial.

Papandreou must take control of the state apparatus and close the tap that keeps pouring money into a corrupt system. If he doesn’t, the people’s sacrifices will have been in vain.

Ireland and financial problems

Last week saw a well received report on her financial circumstances from her central bank governor which helped reduce fears about her creditworthiness. Accordingly her government bond yields retreated a little and at the end of the week her ten-year bond was yielding 6.45%. Indeed if we look at her whole government bond market there was a recovery all along the curve and at the shortest maturity of November 2011  we saw a decline to below 3% from the highs of nearly 3.5%.

However many problems remain and it is not as reported in the Sunday Times yesterday which quoted market sources as saying that the bank bailout might only cost 34 billion Euros. As Anglo-Irish Bank may cost that on its own and there are plenty of other banks needing help perhaps a calculator is required for the market sources. In an atmosphere of rumour and counter-rumour there was some talk that on a conference call organised by Citi ,which has perhaps wisely dropped the bank bit from its name, the Irish Finance Minister Mr.Lenihan was subject to investors making chimp sounds. This strikes me as very unfair as we have no evidence at all that chimps faced with a financial crisis would resort to cronyism and incompetence!

I do not use the word incompetence lightly. There are starting to be quite a few examples of investors using flaws in the Irish legal system to in effect dip their hands in the pockets of the Irish taxpayer. For example one investor walked away from a deal with 274 million Euros by spotting a flaw in leasehold law. It seems possible that Roman Abramovich may have spotted a weakness in Irish law around bank debt as he is threatening legal action over a holding by one of his investment companies Millhouse LLC. At such a time Irish taxpayers cannot afford such problems.

We have also seen a delay in tranche 3 of properties going into NAMA the Irish bank bad. This is happening just at the time that many are questioning NAMA’ s business model and enquiring as to whether it is overpaying for assets. One further problem is the apparent decline of the Irish Nationwide Building Society which were it to be a football club might currently be subject to the chant “Are you Anglo-Irish in disguise”. Whilst generally being in favour of the Governors report here are his past views on INBS’ S likely losses. These have been 2.5-2.7 billion Euros in May of this year followed by 3.2-4 billion Euros in August and now 5.4 billion Euros in September. So a doubling in six months. Ouch

George Osbourne’s plan to take Child Benefit from “higher earners”

On the face of it this seems reasonably logical. In a time of financial stringency then a benefit being withdrawn from a relatively well-off section of the population has the advantage of seeming fair. Unfortunately the way that this will be implemented has two flaws.

1. Under the proposed changes, a couple both earning just under £44,000 will continue to receive child benefit while a single parent with an annual income of just above £44,000 or a family where one parent is not working and the other’s salary is above the limit will lose the payment. Whilst I doubt there are that many families who each earn just below the limit there is a clear bias towards families with two earners rather than an individual and single parent families are also potentially punished.

2. I have written before about the dangers of high marginal tax rates and their effects on economic efficiency. Well at an income level of £44,001 we in effect have an incredible marginal tax rate of well over 100% as the whole benefit is withdrawn. The exact rate depends on how may children someone has for example for someone with four children it looks as though an extra £1 in earned income could cost them around £3100 in lost benefits for an extraordinarily high marginal income tax rate.

12 thoughts on “Hopes that China will bail out Greece rise as she issues a new Budget. Is the UK base rate now irrelevant?”

  1. Shireblogger says:

    SLS : isnt this one of several collateralised liquidity support/swap operations – discount window, long term repos, short term repos, gilts repos, credit guarantees. The BoE say they musnt start getting sucked in to a medium term financing role to the British banking sector and that they must wean banks off the support. Isnt much of the problem arising from banks being unable to liquidate covered bonds and RMBSs some of which may have originated overseas – are you saying QE Mk 2 ( BoE) might start to ‘buy’ these? Wont banks switch between schemes ie if SLS terminates, switch to repos etc. Or are there different eligibilities..

    1. Graeme B says:

      I would be interested to see a list of all the liquidity support / swap operations now in existence, with eligibility criteria. I think it’s a bit late in the day for central banks to worry about getting sucked in though – I would say they are already well and truly mired!

      On the subject of “Whilst the size of the SLS has fallen from a peak of £187 billion to £128 billion”, I am sure I heard that the assets the banks are now left with are the worst ones (in the first place, banks specifically created securities consisting of ‘investment grade’ rubbish in order to offload them onto the BoE) – i.e. they still have not recognized the losses and nothing has been solved. Lots of interesting stuff at FT Alphaville: http://tinyurl.com/35ss5r4

      Still, I don’t see why QE 2 would be required to finance more liquidity operations – QE 1 already provided the government with sufficient funds to soak up the problem ‘assets’ for longer than 2 years (they focused on gilt maturities of 5-25 years, no?). This makes me think that they have decided either 1) the banks need to offload *more* assets to start lending again, or 2) they must help fund the government’s deficit for a few more years to prevent rising bond yields choking a recovery.

      1. Hi Shire and Graeme
        I will try and answer the points that you have asked about. The SLS was introduced to do the following according to the Bank of England
        “To tackle this problem decisively, the Bank of England has designed a Special
        Liquidity Scheme to allow banks and building societies to swap for up to three years
        some of their illiquid assets for liquid Treasury Bills. The purpose of the Scheme is
        to finance part of the overhang of currently illiquid assets by exchanging them
        temporarily with more easily tradable assets. The banks can then use these assets to
        finance themselves more normally.”

        So the scheme gave banks plenty of time (at least as was conceived then to fix their balance sheets and lend again). The problem is that as we come to late 2011 then around the world there are going to be a lot of places wanting cash. For example quite a few sovereign nations including our own are likely to be heavy issuers and we have banks which even under the new weak Basel rules need to recapitalise. So the question is where will the money come from?

        True short-date repos or overnight operations will bale the banks out for immediate liquidity but they give them much less security about the future. This is what I meant by adding QE2 into the mix not particularly as a replacement for SLS but as a way of oiling the wheels of the system as it is quite plain that the banks were big beneficiaries of QE1. I was not explicitly saying that QE2 would buy mortgage backed securities but it might end up being part of the plan B that Adam Posen talked about last week.

        One sighter the Bank will get is from watching the ECB which drained liquidity on the first of July when its one year repos ended and has again been draining recently in a type of exit strategy but as I will discuss tomorrow the Securities Markets Programme has been busy in the last week. So whilst they are not directly related they are indirectly and we have yet to see what the ECB would do if conditions deterirorated again.

        As to eligibility the Bank ended up actually relaxing its criteria earlier this year. I think it was hoping that it might get some loans it could value in the market rather than phantom securities. Accordingly there may yet be some problems with SLS collateral as many of the assets deposited never had a price. But if I remember rightly the relaxation was for all of its collateral rules not just SLS.

  2. Paul Holt says:


    I like simplicity and fairness. It won’t happen but the changes which I’d like to see are:

    a) A merger of NI and Income Tax
    b) All universal benefits to be taxed based on total household income at the tax rate which would apply if that household income accrued to one earner.
    c) Winter fuel allowances, bus passes and all other benefits for pensioners to be scrapped and replaced with a higher basic State Pension.
    d) An end to ISAs. The tax exemption benefits the better-off and encourages people to save at a time when the economy is depressed.
    e) A phased elimination or reduction of benefits and tax credits for the 3rd and subsequent children within a family. This one is complicated since existing large families need to be protected and there are difficult cases such as remarriages with children from previous relationships. However, I don’t understand why the state should support “reproduction careers”.

    Simplifying the tax and benefits system along these lines would have the following advantages:

    a) Reduce administrative costs.
    b) Fewer people would lose out by failing to claim benefits.
    c) Transparency
    d) Reduction of anomalies whereby at certain thresholds, very high effective marginal tax rates apply because of the withdrawal of benefits.

    1. andy of yarm says:

      Hi Paul.Of course the flaw in your approach is the simplicity.This would not sit well with Sir Humphrey ,would status and salary depends on the size and complexity of his empire.

    2. Hi Paul and welcome to my blog.

      I agree about the simplicity and fairness in a tax system they usually come as a pair. One point where there would be contention I feel is over d) an end to ISAs where there are a couple of issues. One is that they are used these days for retirement planning and there have been too many changes in that area in recent years. The other is the contentious nature of taxing savings which have been built up from income which has already been taxed…

      Talking of contention I am sure some would argue with e). For myself I think it has the flaw that it is impossible to implement without punishing an innocent child in practice. Perhaps also we do actually need in total more children to avoid the dangers of a shrinking population that is forecast for Japan.

  3. andy of yarm says:

    As a single family earner just in the higher tax bracket I am struggling to maintain a sense of objectivity around Mr Osbourne’s proposals!

    Cuts in public expenditure in a democracy require a careful sales pitch, which revolve around the tricky concept of fairness. This looks like an own goal. It makes me doubt whether Mr Osbourne is the right person for the job.Indeed it makes me doubt that the coalition’s political will to see this through will last.

    1. Jonathan Treloar says:

      Andy, if you are just inside the tax bracket, you may be better off if you ask for a pay reduction come 2013.

      The look on your boss’s face should be priceless.

      1. andy of yarm says:

        Indeed.Remember as well the working families tax credit is being abolished for earners in this bracket. I am likely to ask my employer for the opportunity to work reduced hours. The net result being I make less of a contribution to ‘production’ ,pay less tax and receive a tax free benefit that would otherwise have been withdrawn.

        George does not understand rational human behaviour.

  4. Basil says:

    What a rediculous proposal/decision by Osbourne. My wife is not working and I earn a bit more than £44k. We are counting on child benefit £80 pounds per month; it is important for us. I am so angry! Conservatives go home!

  5. Somerset yokel says:

    Andy – I stopped working every 2nd Friday last year. I decided it was no longer worth working that day just to keep the politicos and their banker buddies in bonuses and gold edged pensions.

    It’s been really great – but the 5-day weeks are a real chore now. With the 20% VAT, ever increasing fuel costs and other penalties, hopefully I might be able to put in 4 days a week every week pretty soon.

    Just got to try and stop the wife spending so much, fingers crossed.

  6. Fletch says:

    I have more concerns on the general points then the specifics of the chancellors plans:

    It will be costly to change the system when we need short term savings.

    There is no mandate for any of their actions, be shake ups should be at least mentioned to the voters.

    The policy has been clearly rushed and not thought through, this is clear for many reasons not least of which the size of backlash which ought to have been expected. Legislation is usually better when it can be debated for sometime.

    The speaker should question why this was not first announced to parliament.

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