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					The Green Budget

Funding issues and debt management
January 2005
Professor David Miles +44 20 7425 1820 david.miles@morganstanley.com

          Morgan Stanley does and seeks to do business with companies covered in its research reports. As a result, investors should be aware
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Overview:
   Much more government debt is likely to be issued over the next five years than
    over the last five. Demand from insurance and pension funds should be strong;
    UK issuance is likely to remain below that of the largest euro area countries.
   The Debt Management Office has pursued a simple, predictable and transparent
    funding strategy, issuing debt across the maturity spectrum to achieve a relatively
    smooth redemption profile.
   There is a strong argument for the government to issue a much higher proportion
    of long-dated and index-linked debt. The relative shortage of this sort of debt may
    be keeping long rates unusually low.
   The government might also find it attractive to become active in the options
    market and to encourage the issuance of bonds linked to life expectancy. But
    whether it should itself issue longevity bonds is much less clear.




                                                    Please refer to important disclosures at the end of this presentation
Public sector net borrowing

        £ billion          2003-4      2004-5       2005-6      2006-7         2007-8         2008-09        2009-10


        PBR                 34.8         34.2        33.4         29.0           28.0           24.0           22.0


        Base case 1         34.8         34.4        36.7         40.9           40.9           39.2           37.4


        MS central          34.8         34.4        39.6         42.9           41.1           39.7           38.1
        case

        MS Sharp rise
                            34.8         34.4        49.2         65.0           73.6           80.7           88.5
        in household
        saving



       1) Base case refers to IFS estimates based on PBR economic forecasts
       Source: IFS, Morgan Stanley Research estimates, HM Treasury




                                                                         Please refer to important disclosures at the end of this presentation
Public sector net debt
      % of GDP            2003-4        2004-5         2005-6        2006-7          2007-8          2008-09          2009-10


      PBR                   32.9          34.3           35.4          36.2            36.8             37.0             37.1


      Base case1            32.9          34.3           35.7          37.4            38.9             40.1             41.0


      MS central            32.9          34.3           35.9          37.8            39.3             40.6             41.7
      case


      MS worse              32.9          34.3           36.7          40.4            44.3             48.4             54.5
      case


     (1) Base case refers to IFS estimates based on PBR economic forecasts
     Source: IFS, Morgan Stanley Research estimates, HM Treasury




                                                                             Please refer to important disclosures at the end of this presentation
Gilt issuance: the DMO’s Pre-Budget Report projections
     £ billion                     2004-05           2005-06          2006-07          2007-08            2008-09             2009-10

     Central Government                 40               36               31                28                 25                 28
     Net Cash
     requirement1

     Redemptions2                       15               15               30                29                 15                 16

     Financing                          54               50               61                57                 40                 44
     Requirement3


     Illustrative Gross                 50               48               59                55                 38                 42
     Gilt Sales4


     Notes: 2004-05 estimate of gross gilt sales is from the PBR; other projections assume national savings and investments run
     at £2 billion a year and that other factors (e.g. changes in public sector net cash position and changes in the stock of Treasury
     Bills) have zero net impact.
     1, 2, 3: Source: DMO
     4. Source: Morgan Stanley Research Estimates based on DMO projections



                                                                                    Please refer to important disclosures at the end of this presentation
Outlook for gross gilt issuance
      £ billion                 2004-5          2005-6         2006-7             2007-8            2008-09            2009-10

      DMO/PBR                      50              48             59                 55                 38                 42
      illustrative gilt
      sales


      Base case1                   50              52             71                 68                 53                 57

      Morgan Stanley               50              54             73                 68                 54                 58
      central case

      Morgan Stanley               50              64             95                101                 95                109
      worse case



      1) Base case refers to IFS estimates based on PBR economic forecasts
      Source: HM Treasury, IFS, Morgan Stanley Research




                                                                             Please refer to important disclosures at the end of this presentation
Projections for net and gross debt issuance
                                   100
                                                                                   Net gilt issuance
                                       80

                      £ billions       60

                                       40

                                       20

                                        0

                                   -20

                                   -40
                                            1990-1     1992-3    1994-5   1996-7     1998-9 2000-1        2002-3    2004-5      2006-7   2008-9
                       120                                                         Gross gilt issuance
                       100

                            80
         £ billions




                            60

                            40

                            20

                                   0
                                       1990-1        1992-3     1994-5    1996-7     1998-9      2000-1    2002-3      2004-5     2006-7     2008-9

                                                 Past actual                                                        PBR/DMO
                                                 Base case 1                                                        Morgan Stanley central case
                                                 Morgan Stanley weaker near-term

                            1) Base case refers to IFS estimates based on PBR economic forecasts
                            Source: IFS, Morgan Stanley and DMO



                                                                                                                   Please refer to important disclosures at the end of this presentation
The Scale of Gilt Issuance:


     The projections are based on an assumption of no change in tax rates and
      spending plans – so they exaggerate the likely scale of gilt issuance.


     But more debt is likely.


     It is helpful to put that in the context of demand from UK institutions and with
      an eye on the size of bond issues from other European governments.




                                                    Please refer to important disclosures at the end of this presentation
The Scale of Gilt Issuance:
   UK insurance companies and pension funds hold gilts with a market
    value of around £220 billion – almost two-thirds of all outstanding gilts.
    These bonds make up around 14% of the financial assets held by
    pension funds and insurance companies
   On the basis of our projections, net new issues of gilts over the next few
    years will average somewhere around £40 billion a year. This would be
    about 2.5% of the gross financial assets of UK insurance companies and
    pension funds.
   If there were to be no growth at all in the overall assets of insurance
    companies and pension funds and if such institutions were to buy all net
    new gilt issues – both extreme assumptions – their holdings of gilts
    would rise from around 14% of all their assets today to between 19%
    and 21% by 2007–08.

                                                Please refer to important disclosures at the end of this presentation
EMU4 government bond issuance
                    700        Gross Issuance                                              EUR bn
                               Redemptions
                    600
                               Net Issuance
                    500

                    400
    Billion euros




                    300

                    200

                    100

                     0




                    E = Morgan Stanley Research estimates
                    Source: National Treasuries, Morgan Stanley Research




                                                                           Please refer to important disclosures at the end of this presentation
 EMU 4: Government Bond Issuance, 1999-2010e

                       1999      2000 2001              2002   2003   2004 2005e 2006e 2007e 2008e 2009e 2010e

Across Countries
Germany                  100      101         97        142    154    154    157        166           177         194         196         192
France                    81      90          90        101    118    122    111        132           110         123         144         114
                         205      157         183       194    214    190    168        166           193         177         222         191
Italy
                          38      32          35        35      34    38     38         28            24          25          37          32
Spain

Gross Issuance           423      380         405        472   520    504    475        492           503         518         599         529
Redemptions              271      270         309        332   388    340    338        363           364         367         436         357

Net Issuance             152       110         97        140   133    165    137        128           139         151         164         172


 E = Morgan Stanley Research estimates
 Source: National Treasuries, Morgan Stanley Research




                                                                            Please refer to important disclosures at the end of this presentation
Optimal Debt Management:
    At present, the remit from the government to the Debt
     Management Office (DMO) is that it should seek ‘To minimise
     over the long term the costs of meeting the Government’s
     financing needs, taking into account risk, whilst ensuring that
     debt management policy is consistent with the aims of monetary
     policy’
    To meet this remit, the DMO has pursued a relatively simple,
     predictable and transparent funding strategy that has not
     explicitly involved targeting issuance at types of debt where there
     appears to be strongest demand. Gilts have been issued across
     the maturity spectrum and with an aim that there is a relatively
     smooth redemption profile. There has been little use of
     derivatives.
                                           Please refer to important disclosures at the end of this presentation
Average lives of stocks of government debt
              13
                              US Treasuries        Gilts             Euroland Governments
              12

              11

              10
      years




               9

               8

               7

              6
              Jan-95          Jan-97      Jan-99       Jan-01              Jan-03                 Jan-05

      Source: Thomson Financial




                                                           Please refer to important disclosures at the end of this presentation
Composition of outstanding gilts 1999-2004
      At end-March               1999     2000   2001    2002              2003              2004

       Conventional

       0-3 years                   16     17     17        18                16                16
       3-7 years                   22     22     22        18                19                19
       7-15 years                  24     19     16        17                18                19
       Over 15 years               15     16     17        20                19                21
       Total                       76     75     73        73                73                74
       Index-linked*               21     23     25        26                27                25
       Undated                      1      1      1         1                 1                 1
       Floating rate                1      1      1         0                 0                 0


       * including index-linked uplift;
       Source: DMO




                                                        Please refer to important disclosures at the end of this presentation
Debt Management:


     On risk grounds there is a strong argument for the government
      issuing long debt and with a high proportion in index linked terms.


     This is probably what the optimal tax smoothing policy looks like
      (Barro).


     Fortunately there is no conflict with the aim of minimising expected
      cost since long gilts look expensive (to buy) and cheap (to sell).



                                              Please refer to important disclosures at the end of this presentation
Real yields on 20 year UK government index linked bonds

        1986        3.95           1991            4.49           1996            3.62             2001              2.31

        1987        4.16           1992            3.85           1997            3.05             2002              2.13

        1988        3.97           1993            3.01           1998            2.05             2003              2.01

        1989        3.80           1994            3.87           1999            1.86             2004              1.50

        1990        4.38           1995            3.56           2000            1.89



        Source: Bank of England estimated real spot yield curve (end year levels of yield)




                                                                             Please refer to important disclosures at the end of this presentation
Long dated real and nominal yields
                   10
                    9                               30 yr Nominal Gilt Rates
                    8                               Long Dated Real Gilt Rates
                    7
       Yield (%)




                    6
                    5
                    4
                    3
                    2
                    1
                   0
                   Dec-92 Aug-94 Mar-96 Nov-97 Jul-99 Feb-01 Oct-02 Jun-04
                                             Date

                   Source: FinCad/Reuters




                                                            Please refer to important disclosures at the end of this presentation
Forward rate on euro and sterling government bonds:
December 2004

                    5.5%

                    5.0%                                                 EUR 6M forwards

                    4.5%
         Rate (%)




                    4.0%
                                                                                      GBP 6M forwards
                    3.5%

                    3.0%

                    2.5%

                    2.0%
                      Dec-2004               Nov-2015   Oct-2026       Oct-2037               Sep-2048

                    Source: FinCad/Reuters




                                                                   Please refer to important disclosures at the end of this presentation
GBP and EUR 15year ahead 15year forward Rates
                8                                                                                   8

                                                     GBP, annualised
                                                     EUR (DEM pre-EMU)
                7                                                                                   7
       % rate




                6                                                                                   6



                5                                                                                   5



                4                                                                                   4
                Jun-97          Feb-99   Nov-00         Aug-02                    Apr-04

       Source: Morgan Stanley




                                                  Please refer to important disclosures at the end of this presentation
Use of New Instruments? Options and Longevity Bonds
   If it were able to provide liquidity to the long-dated options market by
    issuing calls or swaptions (an option to enter into a swap transaction),
    government could be smoothing the costs of its own funding.
   A call, or a swaption that gives the holder the right to receive a flow of
    fixed-rate payments at some point in the future, is an instrument whose
    value to the holder rises the lower are interest rates on bonds.
   The issuer of such options receives a premium and then only faces a
    future cost if bond yields fall below some given level in the future.
    Government would be issuing securities whose net profits are positively
    linked to the cost of its own future debt issuance, which is likely to be a
    risk-reducing strategy.
   It would help in hedging fix rate mortgages and generate securities in
    short supply for those seeking long bonds ultimately backed by real
    assets.

                                                Please refer to important disclosures at the end of this presentation
Sample Contract Terms — Indicative 10yr – 20yr
Swaption Terms

    Option Buyer:                                                                                     Counterparty
    Option Seller:                                                                                    HM Treasury
    Trade Date:                                                                                       11 Jan 2005
    Option Maturity                                                                                   11 Jan 2015
    Swap Maturity                                                                                     11 Jan 2035
    Strike:                                                                                           At The Money (4.475%)
    Notional:                                                                                         £1,000,000,000
    Option Type:                                                                                      European Receiver
    Upfront Premium:                                                                                  £55,340,000
    Current forward starting swap rate (10yr – 20yr):                                                 4.475%
    Breakeven swap rate:                                                                              3.85%


                i.e. as long as the 20yr swap rate in 10 years time remains at or above 3.85% HM Treasury will not face any
                net all-in expense.
                Source: Morgan Stanley




                                                                                Please refer to important disclosures at the end of this presentation
20yr historical GBP swap rate
                   6.5


                   6.0


                   5.5
       Yield (%)




                   5.0


                   4.5


                   4.0                         breakeven swap rate


                   3.5
                     Jan-99       Jan-00    Dec-00   Dec-01    Nov-02        Nov-03          Oct-04
                   Source: FinCad/Reuters




                                                                     Please refer to important disclosures at the end of this presentation
Use of New Instruments? Options and Longevity Bonds
   Willetts (2004) and King (2004) have argued that there is likely to
    be a role for the government in providing longevity bonds.
   Is the government already substantially exposed to longevity risk
    so that if life expectancy rises in an unanticipated way, its fiscal
    position worsens because pressure on spending rises relative to
    tax revenues? This is an issue that the tax-smoothing arguments
    of Barro suggest is crucial.
   Is the scope to spread longevity risk across different cohorts alive
    at the same time (something that private financial markets can do)
    so limited that the greater part of risks have to be handled by
    government if they are to be spread much more evenly?


                                            Please refer to important disclosures at the end of this presentation
Use of New Instruments? Options and Longevity Bonds
   The UK government relies much more on taxes on labour income than
    on taxes on capital income and spends a large amount on healthcare; it
    also has substantial obligations to pay public sector pensions. This
    suggests vulnerability to increase in life expectancy if that raises the
    proportion of time people spend out of employment and raises the
    demands upon the health system.
   While the ability of financial markets to spread longevity risk across the
    population is limited to those alive, this still presents scope to spread risk
    much more widely than it now is. Currently, much longevity risk is
    concentrated in particular places.
   Risk sharing between the relatively old and the relatively young is
    potentially highly advantageous. In principle, it can be achieved through
    trading in financial markets.


                                                 Please refer to important disclosures at the end of this presentation
Use of New Instruments? Policies

   There are a number of areas where the government could
    potentially provide assistance to get a private market in longevity
    bonds going:
   At the moment, there are estimates from the Government
    Actuary’s Department (GAD) on life expectancy, but these are
    updated relatively infrequently. They have also in the past
    severely underestimated longevity.
   The Financial Services Authority could consider a policy of
    allowing for regulatory capital relief to those who have exposure to
    longevity risk but hold longevity bonds to hedge it.
   Pension Protection Fund relief could be provided for funds that
    hedged their mortality risks.

                                           Please refer to important disclosures at the end of this presentation
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                        Coverage Universe           Investment Banking Clients (IBC)
                                            % of                      % of    % of Rating
Stock Rating Category       Count           Total     Count      Total IBC      Category
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                                                                                                                            Please refer to important disclosures at the end of this presentation
Disclaimers
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                                                                                            Please refer to important disclosures at the end of this presentation
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                                                                                             Please refer to important disclosures at the end of this presentation
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                                                                                            Please refer to important disclosures at the end of this presentation