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How will the Chancellor repay debt?

• Robert Peston
• 29 Oct 08, 05:21 PM

The Chancellor has said that he needs the flexibility in the looming recession to spend and borrow more than would be possible if he adhered to the fiscal rules.

These are the strictures on how much the Government can borrow that were introduced in 1997 by Alistair Darling's predecessor as Chancellor, Gordon Brown.

The positive gloss Mr Darling put on this admission that those rules would be breached is that - with recession looming - only spending by government can compensate for a slump in spending and investment by businesses and households.

And more government spending would mean more borrowing and an increase in the national debt.

But Mr Darling also conceded in an interview with me - to coincide with his Mais lecture on "maintaining stability in a global economy" - that there's a negative side to the inevitability that the ratio of the national debt to our economic output is set to explode through the 40 per cent ceiling.

The current contraction in our economy means companies and households are paying less tax.

Stamp duty receipts have all but evaporated with the collapse in house sales.

And the appalling plight of banks and other financial firms is endangering 25% of all revenue from corporation tax.

So there's less revenue coming into the Exchequer just as it has to find extra money to pay benefits to those losing their jobs.

The criticism of the government therefore from the opposition is that it allowed the national debt to grow far too much in the boom years.

And it is a serious criticism, because when Gordon Brown introduced the fiscal rules all those years ago there no suggestion that they were only to be applied when the going was good.

Nor is this an academic criticism.

If investment institutions controlling billions of dollars aren't to shun sterling and the debt being sold by the Treasury - with the horrid consequence for the Government of a sharp rise in the cost of servicing that debt - the Chancellor has to explain how the fiscal rules would be changed to remain credible and how the national debt can be reduced to some kind of tolerable level after it rises significantly.

So what slightly surprised me when I interviewed Mr Darling is that he wouldn't even confirm that the fiscal rules will be reformed, rather than simply being conveniently ignored for a while.

There can be no doubt that he will have to reform the fiscal rules in a matter of weeks, and come up with a convincing plan to reduce the national debt as and when economic growth resumes - because in this economic age of anxiety, failure to do so would bring the risk of a dangerous run on the pound.

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Hedge funds and VW: what a pile up!

• Robert Peston
• 29 Oct 08, 08:46 AM

If ever there were a country and a people that signalled their distaste for hedge funds, private equity and the self-defined alternative investment industry, that country and people were Germany and the Germans.

It was this famous quote of April 2005 to the German popular newspaper, Bild, by the then Deputy Chancellor of Germany, Franz Munterfering, that didn't exactly represent a "come-in-and-make-yourself-comfortable" message to the rocket scientists of financial services:

"Some financial investors spare no thought for the people whose jobs they destroy. They remain anonymous, have no face, fall like a plague of locusts over our companies, devour everything, then fly on to the next one."

There will be some pathologists of the economic mess we're in who'll argue that Munterfering was spot on. But we can have that debate tomorrow or the next day.

Today let's ponder the marvel of the €22bn (£18bn) loss incurred over just two days by hedge funds and other short-sellers of .

We know there is a loss of that magnitude, because the aggregated short positions in VW - or the sum of all those bets on a fall in VW's share price - have been equivalent to 11% of the business at a time when the shares have been soaring.

In fact on Monday and Tuesday, VW shares rose an extraordinary 348% - which is enough to burn to a frazzle anyone wagering that the stock would decline - after Porsche disclosed it had taken out financial contracts that would give it a controlling stake in VW.

Shares in a company tend to rise, when a corporate bidder arrives on the scene. But in this case the increment was way beyond normal human experience: at one point yesterday VW became the most valuable company in the world, worth more even than Exxon.

You may ask why VW's shares have risen quite so much in so short a time. And the explanation is that there are very few of its shares available to trade, as the German state of Lower Saxony controls more than 20% of VW stock with voting rights.

When the share price started to rise, those who had bet on it falling had to scramble to buy, to cover their short positions and limit their losses (they had borrowed shares, and had to buy them so as to be able to repay these loans).

Which hedge funds have been wounded, possibly mortally?

Not, in spite of widespread press reports to the contrary, Marshall Wace of the UK.

It has incurred a tiny loss on VW, of just €5m, and the value of its core fund is up a tiny bit on the month.

So the hunt is on.

Those in the somewhat stressed hedge fund world say those most likely to have been seriously burnt are the so-called quant funds that try to replicate the performance of stock-market indices by buying and selling a few representative shares - because they are more likely than others to have taken out short positions in a mechanistic way, unmitigated by human judgement ("computer says yes").

Inevitably some traders and investors are calling foul.

They're furious with Porsche - because the astonishing surge in VW's share price was precipitated after the maker of the City traders' favourite vroom-vroom disclosed on Sunday that it had acquired financial contracts (cash-settled options) to buy more than 30% of VW.

If it exercises those options, it would have almost 75% of VW.

What annoys the hedgies is that they feel Porsche has been less than clear about its intentions towards VW - since in March Porsche said that the probability it would take its stake in VW to 75% was "very small indeed".

Some of the hedgies are therefore complaining to the German regulator, BaFin.

Which, in view of German attitudes to hedge funds, may represent the supreme triumph of hope over experience - and a slightly surreal postscript to the years of super-boom for debt-fuelled investment.

UPDATE, 09:38AM: More mayhem in the shares of German car makers this morning. VW's price fell as much as 56% at one stage, while Porsche's rose by more than a third. And Daimler's climbed by a fifth.

Why the rollercoaster?

Well Porsche said it would be helping out the squeezed hedge funds by settling "hedge transactions in the amount of up to 5% of the Volkswagen ordinary shares" - which has the effect of releasing 5% of VW's stock on to the market for trading.

But it added that it was still "committed" to raising its stake in VW to 75% - and would buy VW shares at prices that were "economically justifiable".

Does Porsche's decision to offer respite to the hedgies amount to an admission that it had somehow behaved improperly in the way it released information about its intentions towards VW?

No hint of that.

Porsche said allegations of price manipulation by it were "without any foundation" and that it denied "all responsibility for these market distortions and for the resulting risks to which the short sellers have exposed themselves."

And, with that, it pressed down on the accelerator and vroomed off.

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