UK: Tax Cuts Raise Debt-sustainability Stakes; Growth, Inflation Challenges Intensify
The United Kingdom (rated AA/Stable by Scope Ratings) faces a prolonged period of widened budget deficits because of the government’s recently announced large-scale tax cuts and rise of public spending from a two-year cap for household energy prices.
We see the UK’s debt-to-GDP ratio rising back to pandemic-era levels by 2027 whereas we had previously expected it to decline over the forthcoming years. Keeping the debt ratio stable would require a sustained and significant increase of the economy’s growth potential, which would require time to materialise – if it materialises at all.
Expansionary fiscal policy will widen the budget deficit to circa 7% of GDP next year, only slightly below a 8% of GDP deficit reached during 2021 amid the pandemic crisis. This deficit is expected thereafter to steady to 5% of GDP, raising debt-to-GDP nonetheless to 95% by 2027, from 91% presently (Figure 1).
As for economic output, the government’s target of raising potential output growth to 2.5% a year is well above our present expectation of around 1.5%. To keep the public debt ratio stable, we estimate economic growth would need to increase at least a further 0.8pps above current expectations each year. This amounts to growth not seen for the United Kingdom since the decade before 2008, which, at the time, proved unsustainable.
Figure 1: UK debt-to-GDP expectations as of July 2022 compared with September 2022
% of GDP
In addition, upside pressure on public spending of the UK will remain considerable. Given volatile energy markets, there is significant uncertainty around exact costs of the government energy-price ceiling. While resulting one-off costs will push up UK debt, announced corporate- and income-tax reductions could become a longer-run drag on public finances as there is little room to curtail spending.
In isolation, the deterioration of the outlook for UK public finances is significant, but the UK’s fiscal situation still compares favourably against that of some similarly rated advanced economies. Take France (AA/Stable), for which debt-to-GDP would still be running around 20pps above the UK’s.
Much Riding on Labour-market, Other Reforms to Kick Start Growth
Finance Minister Kwasi Kwarteng has promised to match government reliance upon boosting economic growth with a raft of economic reform. Some of the tax cuts will help here and the government is set to give more details over coming weeks.
The government needs to focus especially on the labour market given well-entrenched productivity challenges of the economy. Since the pandemic, economic inactivity has remained elevated, so finding ways to raise employment and bolster labour-force participation are crucial.
Figure 2: UK current-account balance and sterling exchange rate
% of GDP, and USD to GBP (as of 28 September 2022)
For the present, risk of inflationary pressures stemming from the cumulative impact of growth-enhancing policy measures, coupled with Brexit-related uncertainty, has brought a >25% decline of the value of sterling against the dollar since mid-last year (Figure 2). UK government bond yields had risen sharply over recent days as well compared with those of other major economies (Figure 3), before declining upon the BoE’s intervention announced Wednesday in gilt markets.
However, the exceptionally long average maturity of the UK debt portfolio of almost 15 years – compared with around eight of peer sovereigns such as France and Spain – means average financing costs faced by the British government will rise only gradually.
Figure 3: 10-year government bond yields of select major economies
% (as of 28 September 2022)
Maintenance of the UK’s strong financial regulatory framework will prove crucial for shoring up credibility of economic policy and investor confidence. The BoE, Prudential Regulation Authority and Financial Conduct Authority play core roles in this.
Yet this poses an immediate and difficult challenge for the government in that the fiscal programme is at odds with monetary policy making. While headline inflation is expected to be much reduced by the energy-price ceiling, the support provided to businesses and households via tax cuts will place upward pressure on core inflation. With an eye on sterling weakness, the BoE will likely bring forward policy-rate hikes, which could put the brakes on the economy.
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Eiko Sievert is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH.