How do we finance it?
Besides the terrible human cost, Coronavirus in 2020, the Napoleon wars and the South sea bubble company in around 1720 and the 1914 first world war all share this common factor.
We have all heard our political leaders evoking the spirit of war towards the Coronavirus by using language and metaphors relating to force and combat. While the fight is still ongoing, it is also now time to think about the financial costs of such a war. In response to a massive surge in demand for cash, the various governments and central banks have used a combination of very low interest rates and billions of financial support to help their economy during confinement. The confinement’s rules will slowly be released and the various economies will re-start, albeit at a slow pace, but what about the cost and repayments of all these initiatives and how to deal with it?
- Raise Tax: The most obvious, but the most damaging solution when you want your damaged economy to return to growth. Definitely a solution to be avoided and very risky for any government.
Applying debt ceiling rules: For example, the EU rules have 2 key elements which are to limit the nominal budget deficit to 3% of GDP and a ceiling on public debt of 60%. We all know that those rules have been bent several times by different European countries. Today, it is clearly time for those rules to be simplified or just cancelled to help make public finance more sustainable while stabilising the various economies throughout business cycles.
So, what is available?
Perpetual bonds: A solution which starts to be discussed and has successfully been used by different governments, among others by Britain, to finance war efforts. Hard to remember but those first bonds stretched as far back as the 18th century. In essence, a perpetual bond has many advantages that will avoid massive tax increases, ease fiscal pressure and will help the governments to rebuild their economic strengths as it recovers. Although we all agree that a debt has to be repaid, it is less obvious for a government whose economic life is technically unlimited and will continue to generate revenues through productivity.
So, what is a perpetual bond?
- It is a fixed income security and yes you guessed it, It has no maturity date and it pays a coupon or interest forever. It is similar to a stock dividend payments with return for an indefinite period of time
- A 4% perpetual bond will represent a 100% return of capital after 25 years
- Government as issuers, can potentially repurchase or redeem its bonds at face value and refinance it through existing debt. The government bond memorandum will have proper wording to allow redemption on suitable notice and /or will need proper legislation or parliamentary approval to exercise redemption
- Redemption at par (100) is profitable for original bond holders, if the outstanding bonds trades at a premium or above par (over 100) giving them a capital boost
- Most if not all perpetual bonds issued by banks (strengthening of their capital base) will have a relatively short call option (5 to 7 years) to compensate for potential drop in interest rates
Are perpetual bonds a competition to fixed rate deposits?
First we need to make a difference about short term callable perpetual bonds issued by banks and government’s perpetual bonds.1. Bank callable perpetual bonds:
- Financial institutions are more fragile
- Their bonds are subordinated to senior bonds in case of liquidation and will be paid after depositors
- Interest is not paid when there are no free reserves
- Interest not paid one year will not be accumulated
- The bonds have relatively short callable options of around 5 to 7 years
- Liquidity risks due to the relatively small size of the issue
To conclude, those bonds are real securities with very obvious risks and should never be compared to fixed rate deposit but rather to an equity investment.2. Government perpetual bonds
- Governments are more stable and have technically an unlimited life and generates revenues through productivity
- Perpetual bonds will be just like another government bond and will default when and if the government defaults
- Interest is paid
- Although redeemable, it is very unlikely for many years as they have been issued with a proper purpose and not for capital strengthening
- Government perpetual bonds can also be tapped / increased regularly to achieve the amount required to support the economy and improve its liquidity and meet investors demand
- The bonds will fit perfectly in the government asset purchase programmes
To conclude partially but:
- Government perpetual bonds are a proven tool that has been successfully used in the past
- Government perpetual bonds are easy to issue and many institutional investors are bound by their mandates from pension funds and insurance companies to buy government debt
- The government “market maker” structure and the size of the bond will ensure liquidity for investors
- They have long term purpose and fit well with the original motto: “if you cannot fight , you can help your country by investing”
For other analysis on bank deposit please refer to our previous paper: Coronavirus and the market crisis