HOW CREDIT EASING WILL WORK

Q.WHAT IS THE NEW POLICY?

A.So-called “credit easing” is supposed to make it cheaper for small and medium-sized enterprises (SMEs) to borrow. The programme involves buying SME bonds on the secondary market with the aim of driving down yields so that it is cheaper for them to issue debt.

Q.WHAT'S THE RATIONALE?

A.Banks are cutting back on lending because they are being asked to hold more capital. Borrowing from the bond markets cuts out the bank manager. The Treasury hopes it can boost the size of the market quickly if it becomes a buyer.

Q.HOW WILL IT WORK?

A.The Treasury will issue gilts and use the cash raised to buy SME bonds on the secondary market. Details of what mechanism it will use were sketchy, but it could use the Bank of England’s asset purchase facility (APS), an existing facility designed to boost liquidity. Either way, a third party will act as an “agent” from the government, so it can’t be accused of picking winners and losers.

Q.HOW MUCH WILL IT COST?

A.All the Treasury will say is “tens of billions”. It isn’t clear how much it will have to spend to lower yields, but the market for SME bonds is pretty small. It is almost certain to incur losses when firms default – there is a high failure rate among SMEs – but it thinks it can recoup the losses by borrowing at 2.5 per cent and lending at a much higher rate.

Q.IS IT RISKY?

A.Very. The government will end up with a stash of potentially toxic corporate paper on its balance sheet. One reason that SME bond yields are so high is that lending to them is very risky. There is no guarantee that proceeds from the bonds will cover these losses: indeed, because the aim is to push the cost of risk below the current market price, the losses could well outweigh the revenues.

Q.WILL IT JUST AFFECT SMES?

A.No. The government is already suggesting it could scale up the programme to buy the bonds of big corporates in the event of a full-blown European credit crisis.

Q.HAS IT BEEN DONE BEFORE?

A.Yes, in the US with questionable success. It also has much in common with the European Central Bank’s purchase of junk sovereign bonds: if and when those sovereigns default, the ECB could be left sitting on huge losses.