The loan and the market
Nicholas Davenport
Last week I found the City in a sultry mood, rather like a carnivore which has been
robbed of its succulent prey. It had been keyed up to expect a cut of at least £3,000 million in government expenditure at the behest of the IMF bailiff men and it had been told that Chancellor Healey was prepared to acquiesce. But alas, it did not come off. In the critical Cabinet debate the Chancellor was apparently defeated and the 'softies' had won. The City told me who the 'softies' were. This surprised me, for members of the Cabinet do not usually leak to the City, until I realised that the Economist and the Observer must had had taperecorders under the Cabinet table—the latter, naturally, having the best technical equipment from its American owners—and were able to give the names of the rival protagonists. This was a shock to the old boys in the City who were inclined to regard the 'softies' as the extreme Left—Benn, Foot and Shore—but were amazed to find that the opponents of the deflationary line were the moderates like Crosland, Lever, Hattersley and Mrs Williams who took the sound economic view that cuts must be matched by relief of direct taxation so that there would be no net new deflation. This happily was the economic view expressed in this column. I was never in sympathy with the City carnivores.
As 1 write, the final outcome of the Cabinet-IMF ball game is not known. The latest rumour is that the IMF and the Treasury experts have reduced their estimate of the PSBQ by £500 million and that the Chancellor has agreed to expenditure cuts of £1,000 million and financial tricks of £500 million, bringing the PSBQ for 1977-78 to £9,000 million. The Cabinet has not yet agreed but the gilt-edged market has res
ponded to the better prospect of the loan and the long-dated 'tap' stock—£600 million of Treasury 151 per cent 1996--was exhausted on Monday. The whole of the 'long' and 'medium' market immediately rose by over half a point.
For me the only pleasing thing about this infernal wrangle is the revelation that the Cabinet is seriously hoping to bring down the rate of interest. This should whet the appetite of the bulls in the gilt-edged market, but we must wait and see for another week. In the meantime, as the IMF loan hangs fire, we will have to repay the 81,600 million drawings on the stand-by credit due this week by drawings on our own reserves which at the end of November stood at 85,156 million. This is exactly what I urged in this column some time ago.
Another thing which pleased me but not the City carnivores or the young monetary experts who feed them with the rotten flesh of our stinkingly bad financial statistics is that the negotiations for the funding of the official sterling reserves are going ahead in a friendly and co-operative spirit. This is due not only to the financial adroitness of Mr Harold Lever but partly to the American fear that if any tragedy happens to sterling there will be repercussions in the dollar world—the amount of dollar deficit finance is still huge—and partly to the desire of the German Chancellor to see Britain play a bigger role in the EEC and eventually to bring sterling into the European monetary union. The capitalist world is one and the power of a big debtor to persuade big creditors to help is compelling. We are too large and important to be allowed to go under.
I hope that the City will soon get rid of its sulks and respond to the more realistic financial stance of Mr Callaghan. His government knows that it has got to stop living on borrowed money; it knows that it has got to cut public expenditure over the next few years; it has already made cuts and the cuts are beginning to hurt because it is insisting on the application of cash limits for the local authorities. The rate support grant in the next financial year is to cover only 61 per cent—a cut of £250 million—of their relevant expenditure. What is surely more reassuring for the City is the conversion of the Chancellor to financial realism— that income tax is too high and the gap between work and the dole too small. He told his constituents last week that he intended to cut income tax and meet the cost out of further spending cuts. He is well aware that it does not pay a man to work extra hard. 'It is impossible to justify a situation,' he said, 'in which a family man has to get more than the average earnings to be more than £5 better off in work than he would be unemployed. Unless something is done about it next year the family man will get only half that advantage by working.' Surely that is encouraging for the gilt-edged market, for it suggests that the Chancellor will remove the dole advantage of getting benefits increased (indexed) in line with price increases. Whether he will go so far as to impose a tax on 'dole earnings' is another matter but it was significant that the prime minister attended Mr Healey's constituency annual dinner and stressed the importance of regenerating manufacturing industry.
My interpretation of this financial drama for the City is that the gilt-edged market stands on the eve of a boom, that is, if the present loan negotiations and the stabilisation of the official sterling balances are brought to a successful conclusion and, I should add, if the Callaghan government survives its attacks from the extreme Left and holds the social contract with the trade unions.
A gilt-edged boom will spill over into the equity share market but here I must add a word of caution. The new inflation account
ing will have a very varied effect upon company profits and dividends. As one broker put it : 'There is a danger of total confusion over dividend policy—with some
companies paying dividends out of capital and others cutting their dividends unnecessarily.'
If you allow for the current costs of replacing stocks and plant at present prices the return on capital in British industry falls from around 16 per cent to 3.9 per cent. The worst hit will be the commercial banks. As they lend more than they borrow the decline in the real value of their lendings will alwaYs exceed the decline in the real value of their borrowings, so that while inflation lasts
and it is not going to fall much this year they will have to make good out of profits this erosion of their capital base to preserve their margins. Further, the expected fall in interest rates and continuing rise in bank branch expenses will cut into their profits. So I don't need the scare of nationalisation to make me sceptical of bank shares.
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