Often people ask me how does government borrow money and who does it borrow from?

Or How to Borrow £220,000,000,000 in a year and keep smiling...

The Bank of England used to be responsible for selling UK government debt. But, now that responsibility is undertaken by the Debt Management Office DMO (part of the UK Treasury)

Given the eye watering figures involved this year, (the DMO will need to raise around £220bn) their job has been made more interesting to say the least... Nearly every week the government is having a gilt auction, where they sell gilts either directly or indirectly to intermediaries who sell on the government's behalf.

The Debt Management Office sell a range of financial securities which are basically loans or I O Us. 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.

Increasingly popular are index linked bonds, this means the interest payment is fixed to the rate of inflation to ensure the real value is maintained.

Because the DMO has to sell so many bonds, they are keen to attract 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.

A Rating Downgrade would make it more difficult to sell government debt - especially to oversees investors. A rating downgrade or genuine concerns over the UK's ability to repay would lead to investors requiring higher interest payments to compensate for risk.

After a failed gilt auction in March, recent gilt auctions have been oversubscribed - this will come as a relief for UK treasury, but, there is still a long way to go and the Treasury will be hoping demand for UK government debt will remain strong.

At the moment certain factors make the job of the Debt management office easier in selling debt.

• 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.
• The Bank's policy of quantitative easing - buying a range of bonds, increases 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.

What Could make selling debt more difficult in Future?

• 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 quantiative 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

Related

• National debt from a historical perspective
• Government borrowing in recessions
• UK National Debt