From Debt Management Office to Sovereign Portfolio Management Office

The United Kingdom’s Debt Management Office (DMO) should become the United Kingdom’s Office of Sovereign Portfolio Management. (PMO). It won’t, however, be necessary for the UK government to create a full-fledged Sovereign Wealth Fund. My proposal for a PMO is not prompted by a desire to manage the financial asset windfall that is the counterpart of the extraction of an exhaustible stock of natural resources. It is rather that without investing in additional financial assets, the UK government will not be able to issue sufficient quantities of the scarce long-dated and in some ways innovative financial liabilities that the private sector is clamouring for.

One consequence of a decade or more of fiscal prudence is that there is not enough public debt around any longer. It is therefore desirable for the UK government to issue a much larger volume of gross financial liabilities than it can do (given its outstanding stocks of financial liabilities and assets and its prospective financial deficits) without acquiring additional assets. As there is no point in the UK state acquiring real assets, a globally diversified portfolio of financial assets is called for.

Why should the UK government issue more financial liabilities, if this is not necessary to finance its deficits or to refinance its maturing debt? The reason is that the state is the best issuer of certain very long-maturity instruments that the private sector for a variety of reasons does not issue but that would be extremely value assets for a number of key financial intermediaries and other financial institutions, including pension funds and life insurance companies. The instruments in question are long-maturity nominal and inflation index-linked treasury bonds (index-linked gilts in UK parlance), and nominal and index-linked longevity or mortality bonds.

Governments can issue long-dated instruments more easily that private institutions. While individual government administrations come and go, the institutions of government are pretty permanent. Given the strong convention that governments assume (accept responsibility for servicing) the debt left by their predecessors, government debt can have a maturity equal to the expected survival period of the state. Governments can establish important benchmarks for private asset pricing by issuing significant quantities of gilts at maturities of 10, 20, 30 and 50 years. Indeed perpetuities, or consols (government debt with an infinite maturity) should be issued again after a long interlude.

Index-linked debt is even scarcer than nominal long-dated debt. For pension funds, index-linking to a range of indices (RPI, CPI and Earnings) would be most helpful. Index-linked consols would not only be welcomed by economists trying to figure out what the truly long real rate of interest is, it would be welcomed by the markets too.

The absence of longevity bonds or mortality bonds (bonds whose interest rate varies with the life expectance of a given age cohort or collection of cohorts) is a major disadvantage to defined benefit pension funds whose liabilities are effectively index-linked annuities and index-linked deferred annuities. Index-linked longevity and mortality bonds (linked to the RPI, the CPI or to Earnings) would be a great boon for defined benefit pension funds and life insurance companies. They would at last be able to actively manage their exposure to longevity and mortality risk. The government is the natural issuer of such liabilities, because of their ability to tax, to vary transfer payments and benefits and to change eligibility requirements for benefits.

The government would also be doing the tax payer a favour by issuing these highly popular and in some cases somewhat innovative securities. Their marginal borrowing costs would be lower than it would be were they to issue shorter maturity nominal debt instead. It failed to do so even in January 2006, when the real yield on the newly issued 50-year index linker touched 0.38 percent. I tried to get a 50-year index-linked mortgage at those rates from my bank, but was told such an instrument does not exist (indeed, index-linked mortgages of any maturity are notable for their non-existence).

When the joys of issuing long-dated index-linked longevity bonds are put to the Debt Management Office the reply invariably is that if they were to issue more of the fancy new stuff they would have to reduce their issuance of the conventional gilts. The DMO wishes to remain present ‘in strength’ in all conventional market segments, to continue to establish important benchmarks. As indeed they should! And here comes the news: balance sheets have two sides: assets as well as liabilities. You can issue any amount of new liabilities without running a larger financial deficit and without retiring any existing conventional liabilities if you are willing the use the proceeds from the issuance of the new liabilities to invest in a portfolio of financial assets. Yes, says the DMO, but we only do liabilities. Yes, I answer, and that’s why you should become the Office of Asset and Debt Management or, more concisely, the Office of Portfolio Management.

The asset side of the OPM should probably be invested in a globally diversified portfolio of financial instruments, preferably mainly equity and other equity-like assets. Of course, we don’t want the British state to get involved in a managerial role in any of its financial investments; they would be in it for the income, not for the control. This OPM is different from a Sovereign Wealth Fund in countries like Norway, Singapore, Kuwait, Russia or China. The OPM is simply a by-product of the desire to issue liabilities to meet a market need, not an instrument for achieving intergenerational equity in an economy with a significant dependence on exhaustible resources.