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PP RUEHAG RUEHDF RUEHIK RUEHLZ RUEHROV RUEHSR
DE RUEHLO #0871/01 1041439
ZNR UUUUU ZZH
P 141439Z APR 09
FM AMEMBASSY LONDON
TO RUEHC/SECSTATE WASHDC PRIORITY 1973
INFO RUCNMEM/EU MEMBER STATES COLLECTIVE PRIORITY
RUCPDOC/DEPT OF COMMERCE WASHDC PRIORITY
RUEATRS/DEPT OF TREASURY WASHDC PRIORITY
RUEHBL/AMCONSUL BELFAST PRIORITY 1284
RUEHED/AMCONSUL EDINBURGH PRIORITY 1114

UNCLAS SECTION 01 OF 02 LONDON 000871 
 
SENSITIVE 
SIPDIS 
 
E.O. 12958: N/A 
TAGS: ECON EFIN ETRD EINV UK
SUBJECT: FAILED BOND AUCTION RAISED CONCERN OVER UK'S BORROWING 
PROGRAM, BUT PICTURE SLIGHTLY BRIGHTER NOW 
 
LONDON 00000871  001.2 OF 002 
 
 
¶1.  (SBU) The UK is borrowing its way out of recession.  HMG aims to 
sell a record GBP 146.4 billion of debt this fiscal year and as much 
as GBP 147.9 billion in 2010 to pull the UK out of its worst 
recession since 1980. An undersubscribed gilt auction on March 25 
triggered great concern in the government about investor-readiness 
to support the government as it takes on record debt.  However, gilt 
auctions since then, both short-and-long-term, have been fully 
subscribed, easing, at least temporarily, government concerns. 
 
Borrowing to Recover 
-------------------- 
 
¶2.  (SBU) The UK's economic downturn has strained public finances. 
Lower tax revenues and higher spending on recession-related benefits 
have left a hole in the public purse that will be partly filled by 
borrowing.  HMG plans to sell a record level of debt in the next two 
years. A report by the influential Institute for Fiscal Studies 
predicted that the total burden of outstanding government debt may 
continue to rise for the foreseeable future.  It estimated the total 
stock of government debt, which already exceeds HMG's previous 
self-imposed ceiling of 40 percent of GDP, could double to more than 
80 percent by 2016. 
 
Bond Auction Fails 
------------------ 
 
¶3.  (SBU) Four months ago, the chief executive of the UK's Debt 
Management Office (DMO), which oversees auctions of UK government 
bonds (gilts), warned of the possibility of failed bond auctions, 
given the record amount of debt to be sold.  His prediction came 
true on March 25, when the UK government, for the first time in 
seven years, failed to find enough buyers for a GBP 1.75 billion 
gilt auction.  Investors bid for GBP 1.63 billion of the 40-year 
bonds, leaving a shortfall of GBP 120 million.  The last time a gilt 
auction received less than 100 percent demand was in 2002 when an 
inflation-linked auction failed.  There has not been an 
undersubscribed conventional gilt auction since 1995.  On news of 
the failure, gilt prices slumped and the pound weakened against the 
U.S. dollar and the euro.  Media commentators said the qilt failure 
further undermined the Prime Minister's reputation for economic 
competence and compared it to the 1995 gilt auction failure under 
John Major's struggling government. 
 
¶4.  (SBU) The lack of demand is partly explained by concern over the 
state of public finances as government borrowing rapidly increases. 
This concern over public finances was fuelled by comments by the 
Governor of the Bank of England (BOE), Mervyn King, who told the 
House of Commons' Treasury Committee that the UK's fiscal position 
would not support another round of significant fiscal expansion - 
putting in question how much the UK could borrow.  Prior to the gilt 
auction, CPI inflation figures were released, showing an unexpected 
uptick, and as a result, eroded the value of bonds.  Additionally, 
the 40-year bond fell outside the BOE's quantitative easing gilt 
purchase program, which will buy up to GBP 75 billion of gilts and 
corporate bonds in maturities between five and 25 years.  The price 
of gilts that fall under the BOE's program will be artificially 
supported by the Bank's purchases - making other bonds less 
desirable.  While newspapers and several economists called the 
failure of the gilt a blow to HMG's borrowing plans, HM Treasury 
denied that the auction's failure reflected any wider difficulty in 
funding the UK's budget deficit. 
 
One-Off Timing Mishap? 
---------------------- 
 
¶5.  (SBU) HMT has been right, so far. It has been business as usual 
since the March 25 auction, according to Steve Whiting, the Debt 
Management Office's policy adviser.  Whiting told us the DMO was 
reassured by the April 2 auction when all GBP 2.25 billion of 
30-year bonds were sold.  The sale had 1.59 times as many bids as 
securities offered.  He said the March 25 auction was no more than a 
failure of the market to find an appropriate clearing price for the 
debt on offer on a particular day.  He added that market conditions 
are very volatile, particularly following the introduction of the 
BOE's quantitative easing program, and that in these conditions, 
failures can happen.  He said the 40-year bond is one of the 
riskiest bonds the DMO sells and that this, combined with the record 
volumes of debt the DMO is auctioning, partially explains the 
failure.  He cautioned that while one or two auction failures will 
not raise any particular concerns, a series of uncovered auctions 
might require a revision of the DMO's plans. 
 
¶6.  (SBU) Comment:  While the failure of the UK gilt auction was 
surprising and raised fears about HMG's ability to fund its 
ballooning deficit, it may not have any long-term significance.  The 
UK bond market is unusually volatile at the moment and so is likely 
to throw up some surprises.  If the auction failure was repeated, 
 
LONDON 00000871  002.2 OF 002 
 
 
serious questions would be asked about the credibility of HMG's 
borrowing program.  However, this single auction should not promote 
concern about the country's ability to fund itself.  Similarly, a 
one-off auction failure is unlikely to seriously dent the Prime 
Minister's standing, but a series of failures could be damaging and 
would highlight a serious lack of investor confidence in the British 
government. 
 
LEBARON