Even Outside Emu, New Gilts Market Would Boost City

Even if the UK decides to stay out of European economic and monetary union, having a modern system in line with that used within the single currency area strengthens Londons chances of remaining one of Europes main -perhaps pre-eminent - financial centres after 1999.

The gilt repo market - for the sale and repurchase of UK government bonds, or gilts -began life in January this year, allowing the bonds to be bought and sold more easily and more widely between private banks and investors.

Bank of England figures published this week showed that by the end of August the market had grown to 60billion in size, compared with 35billion in May, with a daily turnover of15billion.

 

This rapid growth raises the prospect that the Bank may soon use the repo market to manage the UKs monetary plumbing. At present the Bank guides UK short-term money market interest rates by buying and selling Treasury bills from and to the Citys discount houses.

This adds money to or drains money from the market. But the system has its critics. They say it has become dominated by one or two big clearing banks and been responsible for volatility in short-term interest rates.

But the Bank has signalled that it may soon use the repo market to guide short-term interest rates. Under this system, used widely in other countries, the Bank would add or drain money by buying or selling gilts, through repo, to banks and institutions. The Bank is preparing a paper on how this might work.

It is awaited eagerly by the City. Such a change would mean that the UK could more easily adapt to the system of monetary policy likely to be used in Emu. Central bank officials across Europe are feverishly trying to work out how monetary policy would work after 1999.

A German model is likely to be adopted in which short-term money market interest rates, guided by repo operations, would move within an interest rate corridor bounded by a lower deposit interest rate and an upper lending rate.

Under a single currency, the proposed European Central Bank in Frankfurt would decide changes to interest rates. But each change would be implemented through each of the national central banks.

The Bank of England, for example, would intervene under instruction from the ECB in the repo market in the UK. The ECBs aim in changing interest rates would be price stability.

Whether this would be achieved through direct targeting of inflation - as in the UK - or by the targeting of an intermediate measure - such as the money supply - is still unclear. There may be problems in constructing an aggregate Emu money supply measure. Without a long track record, this measure could be difficult to interpret. The question of which securities would be eligible to be used in the proposed European-wide repo is still a contentious one. In some countries, only government-backed bonds can be bought or sold through repo.

But in Germany, for example, other high quality non-government debt is eligible. Some big US banks have complained that if the German system is adopted, it could give German banks -which already own a relatively big share of non-government debt - an unfair advantage.

Some non-German banks fear they may lack a sufficiently large stock of eligible debt to be able to compete with banks used to the German system. Another issue currently dividing officials is whether strict rules on government bond auctions would continue under Emu.