Government debt: how does it impact the currency markets?

Government debt: how does it impact the currency markets?

The news that the UK’s government debt has passed 100% of GDP for the first time since 1961 dominated the headlines last week. That said, while it’s a familiar term, what does government debt actually refer to – and how could it affect the currency markets?

UK government debt passes 100% of GDP

Let’s start with some context: figures released last week show that the British government’s net debt has crossed the 100% threshold for the first time since 1961, reaching £2.576 trillion.

The figure, which exceeded Office for Budget Responsibility expectations by £2.1 billion, has been pushed higher by spending on inflation-linked benefit payments, energy support schemes and interest payments on debt. While the actual sum borrowed in May that took government debt over the threshold was actually £3 billion lower month-on-month than in April, it is also the second-highest May figure since records began.

So, we’re talking about some big figures, but what’s behind this?

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What is government debt?

At its simplest, government debt refers to the credit owed by a government for money it has borrowed to fund expenditures that exceed its revenues. It might also be called sovereign debt or public debt.

This can also be expressed as either gross government debt – the total value of a government’s debt – or net government debt – the total value minus any cash assets. In this case, we’re talking about the UK’s net government debt.

Is government debt the same as a budget deficit?

It’s important to keep in mind when looking at news about government finances that a budget deficit isn’t quite the same thing. The deficit is the gap between government receipts and spending over a financial year, whereas the debt is the accumulation of money owed from borrowing to plug those gaps year after year. At the end of May, public debt was £2.567 trillion, as we said above. The deficit in the last financial year was £134.1 billion and is already £42.9 billion in this financial year to date.

To whom does the government owe money?

One of the main ways that the UK government borrows money is through government bonds. Essentially, the government will sell a bond, which is a type of debt security, to both domestic and foreign investors like pension funds, insurance companies and banks. These bonds have an agreed term, sometimes decades-long, sometimes shorter, after which it’s said to have “matured”. At this point, the government pays the sum of money owed (in layman’s terms, they pay back the debt). There may also be regular “coupon payments” where interest is paid to the investor throughout the bond’s lifetime.

By and large, investors see government bonds from wealthy countries as a safe, low-risk, but low-yield investment, as these kinds of governments are likely to be able to pay them back.

Some governments will also borrow money from other international organisations or governments. For instance, a development bank like the African Development Bank or the World Bank may provide loans to a government, usually of a low- or middle-income country, to help them carry out significant capital projects.

What kinds of bonds does the UK government issue?

In the UK, these are often known as “gilts”, as, in the old days, the paper certificate came with a gilt edge. There are two types: conventional and index-linked gilts.

The majority of UK gilts are conventional, which offer a fixed coupon payment, as above, every six months. Upon maturity, the final coupon and initial sum borrowed, known as the principal, is repaid. You can tell the details of the gilt from its name; 4¾% Treasury Gilt 2030, for instance, would have a coupon rate of 4.75% and mature in 2030.

Some, however, are index-linked. This means that their coupon price and principal follow (with a short time lag) the UK Retail Price Index, or RPI. This means that cash flows can both rise and fall depending on what happens to the index.

Are borrowing costs increasing?

As with many other things, the costs of government borrowing are growing as interest rates continue to rise. As of 3rd July, UK two-year gilt yields have hit the highest point since June 2008 at 5.406%, amid expectations for the Bank of England (BoE) to continue to raise rates as the economy struggles with inflation.

This means that the cost to the government of borrowing is, therefore, higher than it’s been since 2008 – in stark contrast to record lows in previous years. With the BoE expecting inflation to take longer to come down than previously forecast, it seems unlikely that it will fall any time soon.

What impact does government debt have on the FX markets?

Government debt and bond yields provide a way for investors to gauge the healthiness of an economy and its future outlook. For example, a government with high debt is going to find it more difficult to obtain foreign capital if it isn’t seen as reliable by investors. Likewise, a government with low debt or with a history of not defaulting on its debt is likely to be seen as a more stable option.

In some more extreme circumstances, if it seems likely that a government is going to struggle to service its debt, market actors can start to take action to protect their assets under the assumption that the government will draw on them, such as through taxation, to service that debt. In this case, if you see capital leaving a particular currency, it can cause that currency to drop due to lower demand.

Likewise, if investors lose confidence in the returns from their assets, like government bonds, then this can have a knock-on impact throughout the market – decreasing demand for that particular currency and causing it to fall against others.

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How can you protect your money against risk?

The simplest way to protect your money against this uncertainty is to lock in a fixed exchange rate with what’s known as a forward contract. To find out how to manage currency risk for your business, read our dedicated article. And if you’d rather wait until a particular rate is reached, find out how rate alerts work.

Alexander Fordham

Alexander is a writer specialising in foreign exchange and finance for companies with cross-border exposure. He’s written on topics including currency risk, international taxation and global employment for seven years. You can find him out hiking, travelling and working from Spain in the sunnier months.