Wednesday, November 6, 2013

UK Economy - Case Study

"Assume that the chancellor is able to sell the British Government's holdings in Lloyds Bank plc. and Royal Bank of Scotland to the extent that all the original investment is recouped. If the chancellor uses £40 billion to pay down Government's debt; £10 million to put into a new business bank, and the remainder to fund public infrastructure projects, discuss the prospects for growth in the British economy assuming all shareholdings are sold in 3 equal tranches through 2014- 2016"

Introduction and Assumption

The British Government pumped in total of £65.5 billion in 2008 for equity stake in Lloyd Banking group (LLOY) and Royal Bank of Scotland (RBS) (i.e. £20.5 billion to LLOY for 39.2% equity stake and £45.0 billion for 81% equity stake to RBS). Assuming the British government would sell off its holding at a price where it recovers its capital investment and earns amount equivalent to the opportunity cost of investment. To compute opportunity cost of investment, it is assumed that investment would earn return equivalent to bank base rate return of 2.5% p.a. [average bank base rate over 2008 (5.25% p.a) – 2013 (0.5% p.a.)] for 6 years. Thereby, the combined computed maturity value of investment is £75.0 billion.
Given that total investment is sold off in 3 equal tranches. Each tranche will generate £25 billion. Further it is assumed that all stakes in Lloyd and RBS is sold either to UK institutional investors or public at large. The spending by government has multiplier effect; therefore fund generated on sale of each trance will be utilized in following sequence.

  • The funds received on sale of first tranche in 2014 will be utilised to pay down government debt. 
  • £25 billion received in 2015 as part of second trance will be utilized to extent of £15 billion (£40 billion - £25 billion) to pay government debt and balance £10 billion will be used towards funding public infrastructure projects. 
  • Of the funds received in 2016, £10 million will be used to set up new business bank and balance funds be spent towards funding public infrastructure projects.
When the government implements its plan to recoup investment, the banks would regain its private and independent status. This will improve the customer and business confidence in banking system.

Impact on British Economy

Reduction in govt debt

Along with debt comes the fixed commitment of timely interest payment. In addition, high proportion of debt as percentage of GDP in the economy makes incremental borrowing costly and thereby affects the credit rating of the country, which would impact revival of economy. So, it is important that funds received from the first tranche (£25.0 billion) be utilized to pay off partial government debt. Thereby the government can reduce the cash outflow towards interest payment and improve its purchasing power. Fall in Government debt implies future taxpayers will not be burden with debt payment. With repayment of debt and improved business confidence, the likelihood of economic growth increases. For instance, on occurrence of this event, the economy grows by 2%, then government would receive incremental tax revenue and these receipts will be increasing sufficient to meet existing debt interest payment. In addition, the funds that would otherwise be used to make interest payment can now be utilised to accelerate public infrastructure spending (productive purpose) or as payment for social security, given the ageing population in Britain (non-productive purpose).

With large quantum of funds in hand, it is imperative that a balanced approach be adopted for allocation of funds towards productive and non-productive purpose. 

Public spending towards infrastructure

Of the total £25 billion funds received in second trance, £10 billion be utilised to pay down government debt and balance £15 billion will be utilized towards public spending in infrastructure. Since UK has most of its basic infrastructure in place – the investment is likely to be in rebuilding and upgrading existing infrastructure or towards setting up smart grids and green infrastructure. Expenditure towards public infrastructure would benefit the economy indirectly; as absence of quality infrastructure could lead to traffic congestion, which could have negative effect on productivity and thereby adversely affect economic growth. 

Public spending towards infrastructure is a fiscal measure to revive economy which has multiplier effect. For instance, the government spending towards building roads and highways would directly benefit construction industry and indirectly do good to steel and cement industry (raw material for building roads), major retailer players (smoothes supply chain) and other related industry. Thereby government spending on one area creates job opportunity in all sectors that are related to it. With increase in employment opportunity, the unemployment rate will fall and government’s spending towards job seekers allowance will also reduce. However, with median age of 39.7 years and 17% of the population in age bracket of 65 years and above, the country faces challenges in form of ageing demographic. So, to meet its demand for labour, it’s imperative that skill assessment of unemployed be carried out and if required, such labour be made productive by imparting skills and knowledge Further, to reduce its social security payment, the government may raise the retirement age.  On the other hand, high employment rate would increase the household spending power, which may in turn increase consumer spending. The improvement in consumer spending would provide initiate the process gradual recovery of economy. On parallel terms, more number of employees, greater working hours and improved productivity will increase the firm’s annual output. The incremental output would benefit the government in form of higher tax revenue and improved balance of trade if such goods are exported.

In addition to that, incremental money flow in the economy has likely effect to bring down the interest rate and encourage private player to borrow money. However, Monetary Policy Committee (MPC) has stated that it plan to retain interest rate at current level of 0.5% p.a. till unemployment falls below threshold of 7%.  This indicates that any changes in monetary policy would have little impact of revival of economy. So, fiscal measures are key players to generate economy’s growth.

New Business Bank

With boost in economy through reduction in debt, increases government spending and positive business atmosphere, many small firms would be interested in setting up or expanding its business operation. Normally, these firm faces problem in raising funds, thereby leading to lower growth potential. So if the government plans to set up new business bank targeting small firms and first time entrepreneurs, it would boost the economic growth.


Given the scenario where monetary policy has little impact to receive economy and high expectation are placed on fiscal measures, the impact of fiscal stimulus on economy depends on proportion of government spending towards investment and consumption or transfers. There is greater likelihood that given series of fiscal measure would go a long way in reviving economy, the overall impact of fiscal stimulus is also depended on state of business cycle and reaction of economy towards monetary policy.