Britain’s Spending and Tax Cut Plans Worry Investors in Its Debt

Much of the outward business of government in Britain is grinding to a halt during 10 days of national mourning until the state funeral for Queen Elizabeth II, when schools, doctors offices and many shops will close.

But through it all, the financial markets have been grumbling with an unease about Britain’s economic outlook.

High inflation and low economic growth are expected to continue, joined by vast borrowing to finance the new government’s plan to freeze energy bills while it cuts taxes. There is still uncertainty about the fiscal plans of Liz Truss, who became prime minister just two days before the queen’s death. And investors remain concerned that Britain’s trading relationship with the European Union, its largest commercial partner, may founder over differences less than two years since Brexit became law.

Once again, British assets are out of favor. Bonds, equities and the pound have declined simultaneously in recent weeks — an unusual and foreboding confluence that could set the stage for escalating borrowing costs and stubborn inflation.

“The prime minister has got a lot of work to do to reassure markets,” said Jane Foley, a senior currency strategist at Rabobank in London. “Markets are not convinced that her policies will improve the investment environment for the U.K.”

Even in a challenging year for markets around the world, the weakness in British assets has been notable. The pound has tumbled about 15 percent against the U.S. dollar this year and last week reached its lowest level since 1985, while it has weakened more than 3 percent against the euro. The FTSE 250, a stock index that contains a large portion of domestic-focused companies, has dropped almost 20 percent this year. And falling bond prices have pushed 10-year yields above 3 percent, the highest level in 11 years. In August alone, the 10-year yield rose nearly a whole percentage point, the biggest monthly jump in Bloomberg records going back to 1989.

With near-double-digit inflation deepening a cost-of-living crisis, Ms. Truss, on her third day in office, announced in Parliament a major plan to freeze energy bills for households and offer businesses “equivalent” support for at least the next six months. Conspicuously lacking was an official estimate of how much it would cost.

“Truss’s package on energy bills was big enough to pass the political test, but has not yet passed the economic one” Mujtaba Rahman, a director at Eurasia Group, wrote in a research note. He described the policy as “a blank check funded by higher borrowing.”

The policy could cost about 150 billion pounds ($172 billion), according to Paul Johnson, the director of the Institute for Fiscal Studies, a nonpartisan think tank in London.

“It could turn out to be the biggest single fiscal announcement in peacetime,” he said. Calling it “a staggering quantity of money,” he added that it was a mistake for the government not to put its cost estimates into the public domain.

The government is also widely expected to announce a series of tax cuts this month, a promise that Ms. Truss made during the Conservative Party leadership contest this summer. The long-term hit to revenue could have an even bigger impact on Britain’s finances than the one-off freeze in energy bills, Mr. Johnson said. And the government will need to find more money for public services, like the National Health Service and pay raises for teachers, because inflation has eroded the value of previously announced spending plans, he added.

“There’s a more general issue about big fiscal expansions, which is what we’re likely to get this year, in an era of very high inflation,” Mr. Johnson said.

The problem of rising borrowing costs is underscored by the Bank of England’s efforts to bring down the highest inflation in 40 years and close the era of easy money. The central bank has dropped its practice of buying huge quantities of bonds, a policy that helped tamp rates down during the pandemic, when the government borrowed hundreds of billions of pounds to pay for health care, provide wages to keep people in their jobs and support businesses. The bank is preparing to make what amounts to a U-turn, and will sell bonds back to the market.

It will fall to private investors to buy up the new debt. While the Treasury’s recent auctions of British government bonds have shown healthy demand for the debt, bond sales by the central bank are uncharted waters.

Although British stocks have suffered since Brexit, further uncertainty and worries about economic growth and messy politics have made them “one of the first to be jettisoned” when investors move away from stocks, said Sue Noffke, the head of U.K. equities at Schroders.

Recently, bets against the pound have increased. Analysts have raised the alarm about its vulnerability to a steep decline because of Britain’s widening current account deficit. The deficit means the value of imported goods and services exceed Britain’s exports and other income from overseas investments; with energy prices so high, that gap is expected to stay wide. In the first quarter of the year, it was a record 8.3 percent of gross domestic product.

Britain’s budget and current account deficits mean it needs to borrow and is therefore increasingly reliant on what Mark Carney, a former governor of the Bank of England, called the “kindness of strangers.”

That kindness, or investor confidence, “cannot be taken for granted,” Shreyas Gopal, a strategist at Deutsche Bank, warned in a note just one day before Ms. Truss took office on Sept. 6. Without it, Britain would face a crisis.

In an analyst note, Mr. Gopal wrote that “a very large but untargeted spending package” risked exacerbating investors’ fears about the sustainability of the deficit. “If investor confidence erodes further, this dynamic could become a self-fulfilling balance-of-payments crisis whereby foreigners would refuse to fund the U.K. external deficit,” he wrote.

This “may sound extreme, but it is not unprecedented,” Mr. Gopal added. He pointed to the mid-1970s, when “a combination of aggressive fiscal spending, severe energy shock and a slide in sterling” forced Britain to seek a $4 billion loan from the International Monetary Fund.

For some, harking back to that 1976 financial crisis is a step too far. Analysts at Barclays dismissed “scaremongering” over a balance-of-payments crisis and said the real risk to the currency instead lay in a deterioration of British trade with the European Union.

But concerns remain widespread.

Britain’s economic background is “very disturbing,” said Richard Portes, a professor of economics at London Business School, citing the wide current account deficit, labor unrest, the Truss government’s decision to remove the top civil servant in the Treasury and a likely recession.

“The capacity now of the system to deal with crisis should it materialize is not very strong,” Mr. Portes said. “The governor of the Bank of England is in a very weak political position. The Treasury is headless. Where are the grown-ups?”

While few people expect a repeat of 1976, some of the similarities are hard to ignore.

“What worries me is that there will be a dash for growth — cutting taxes and increasing spending and so on — and that might look good for a year before the election, but it’s deeply unsustainable and potentially long-term damaging,” said Mr. Johnson of the Institute for Fiscal Studies.

Ms. Truss and her chancellor of the Exchequer, Kwasi Kwarteng, have said they will aim to generate economic growth of 2.5 percent.

But that goal may be hard to achieve anytime soon. Analysts say the economy could tip into a recession this quarter because the extra national holiday for the queen’s state funeral will bring many businesses and public services to a halt. The size of the economy has hardly changed this year, and last month the Bank of England forecast that the economy would shrink 1.5 percent next year.

“We are facing lower growth, higher inflation for some years until we can find a path to raise productivity.” Ms. Foley of Rabobank said. “It’s quite clear that that’s not going to be a quick solution given Brexit and then the energy crisis that we are in.”

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2022-09-15 21:01:08

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