If government spending is greater than tax revenues, they need to make up the shortfall by borrowing from the private sector. To borrow, the government will sell bonds / gilts.
These Government bonds or gilts are bought by a variety of financial institutions, including:
- Pension funds
- Investment trusts
- Local councils
- Banks and building societies.
Graph Showing who the UK government is Borrowing from
- This shows that in the period 2007-2012, the percentage UK gilts held by insurance and pension funds has fallen from 50% to 22%. There has been a sharp rise in gilts held by the Bank of England.
- The percentage of UK gilts held by overseas holdings has held fairly constant at 30%
More detail on who government borrows from
How the UK government Borrows Money
- The Bank of England used to be responsible for selling UK government debt. But, now that responsibility is undertaken by the Debt Management Office (The DMO is part of the UK Treasury)
- Nearly every week the DMO is having a gilt auction, where they sell gilts and bonds
- The Debt Management Office sell a range of financial securities. These are basically loans or IOUs. These bonds have a fixed interest payment. e.g. a £1,000 bond may have an interest payment of £50, giving an interest rate of 5%.
- The most common type of debt is a long dated gilt. These have a maturity of say 30 years. They are often bought by pension funds and investment trusts looking for a guaranteed return over a long time. These pension funds are typically UK based funds, but, also include foreign buyers.
- Foreign buyers are often more attracted by short term gilts which reach maturity in a short time - 3 months, 1 year e.t.c.
- In the UK about 25-30% of government debt is held by foreigners. (see: UK debt held by foreigners)
- This % can vary between different countries. For example, in Italy, the % of debt held by foreigners is over 60%. In Japan only 5% of national debt is held by foreigners.
- In the US, about 32% of total US debt is held by foreigners. The biggest foreign holder of US debt is China, Japan and UK.
Central Bank and Bond HoldingsUsually government borrowing is financed by selling bonds to the private sector. But, in some circumstances, bonds can be bought by Central Banks. For example, in the UK, the Bank of England pursued quantitative easing. This involved creating money electronically, and using this to buy government bonds. Therefore, in 2011, the Bank held a substantial % of UK government debt.
However, the bank are committed to selling these bonds when the economy recovers and they end quantitative easing. (see: amount of bond purchases at Bank of England).
In the Eurozone, the ECB is not willing to act as this lender of last resort.
How Easy is it for the government to borrow?In some cases, some governments seem to be able to borrow very large amounts. In the 1950s, UK national debt was over 200% of GDP. In 2012, Japanese national debt has increased to over 229% yet markets are still willing to lend the government money (Who Japan borrows from). However, in the Eurozone, governments have found difficulty borrowing - even though debt levels are much lower. In some Eurozone economies, such as Greece and Ireland, governments have been forced to seek bailouts by institutions, such as the ECB and IMF.
Factors Which Make it Easier for the Government to Borrow
- Low interest rates mean the interest rate on government bonds is relatively low. This means the cost of servicing debt is relatively low. If interest rates rose, the cost of servicing national debt could in itself increase the borrowing requirement.
- Recession makes commercial bonds unattractive, therefore, investors are keener to go for the perceived security of government bonds.
- A policy of quantitative easing - when the Central Bank buys a range of bonds this increases the demand for government bonds and this increased demand makes it more attractive to buy bonds in an auction.
- The UK's fiscal position, although bad, is comparatively not as bad as many competitors, therefore there is still foreign demand for government bonds - despite threats of rating downgrades.
- If the economy didn't recover leading to a worse fiscal position than expected.
- More bank losses which government need to absorb.
- An end in quantitative easing would reduce demand for bonds
- Rising interest rates would make it more expensive to buy.
- Threat of inflation and devaluation of pound would make foreign investors want to leave UK