UK PBR: fiscal austerity delayed until recovery becomes entrenched

By Trevor Williams, Chief Economist, Corporate Markets

Overview

In terms of the stance of fiscal policy there is little new in the chancellor’s 2009 Pre-Budget Report compared with Budget 2009. It confirmed that government borrowing would continue to bridge the gap between government revenues and government receipts opened up by the financial crisis and the recession. This means that the budget deficit will be close to 13% of gdp in the next financial year. In the last financial year, borrowing has been revised up by £5.4bn to £95.4bn. In the current financial year, the budget deficit has been revised up by £2.6bn to £177.6bn.

This is a little less than expected but nevertheless confirms a picture of continued government borrowing in order to ensure that economic recovery takes hold. Predictions for 2010-11 have also been revised up modestly to £176bn from £173bn in budget 2009. Projections further out are little changed, with the budget deficit in 2013-14 expected to be £96bn – a rough halving compared with borrowing for this year and next. Both this year’s and next year’s gdp projections are in line with the consensus. Beyond that, however, the economic growth projections are higher than the consensus.

Fiscal arithmetic

The UK government has a delicate balancing act between ensuring economic recovery takes hold, and therefore not tightening policy too soon, and yet giving sufficient confidence to financial markets that it is tackling the widening debt position in future years.

Even if the halving of the fiscal deficit is achieved in 2013/14, it will still leave the UK with outstanding debt to gdp of nearly double the level prior to the onset of recession in 2008. The actual debt to gdp ratio of around 80-90% will be in line with international norms for advanced economies. However, stabilising at that level, implies that the yearly borrowing that the PSBR shows will have to cease.

Economic outlook

The chancellor’s medium-term gdp projections were unchanged from those published in the April Budget.

After dropping by a revised 4.75% this year, the Treasury expects gdp to grow by 1-1.5% in 2010, and by 3.25-3.75% in both 2011 and 2012. While the forecasts for this year and next are in-line with the consensus of independent forecasters, they remain more upbeat further out.

Moreover, the recovery relies heavily on a rebalancing away from consumer spending towards investment and net exports. With little in the way of additional fiscal restraint announced, the anticipated improvement in the public finances requires a sustained economic recovery.

If this fails to occur, the government may be left having to tighten policy more aggressively to meet its stated target of halving the deficit by 2013/14.

Company impact

Further measures were announced in the PBR to support small and medium-sized companies, including the deferment of the planned increase in small companies’ corporation tax rate, and infrastructure and innovative industries. Employer national insurance contributions, however, will rise by a further 0.5% from 2011-12.

Financial market reaction

What has been the market reaction to the 2009 Pre- Budget Report (PBR)? Looking at the equity market, the reply has to be that, on balance, it has been negative. After the PBR, the FTSE 100 closed lower on the day, but was higher at Friday’s close. In which industry sectors did the largest declines occur? Using the FTSE All Share index breakdown by industry, it appears to have been largely in construction materials and in real estate investment trusts. Oil and gas and pharmaceuticals and biotechnology were also negatively impacted, though more modestly. This market reaction, however, should not be exaggerated: overall, the change has been small.

December’s PBR did little to alter the underlying arithmetic of the debt / borrowing nexus compared with what was in the 2009 Budget itself, and in financial market expectations of what was likely to be in the PBR.

The three month Libor rate was unchanged on Thursday after the PBR, after falling modestly on Wednesday. Commentary around the need for further fiscal tightening persisted, even after a PBR that starkly showed the intention for a sharp reduction in the level of borrowing, highlighting the likelihood that official short term interest rates will stay low for some considerable time. True, the level of debt does not fall, but the amount borrowed is planned to fall dramatically. In this scenario, it is clear that there will be pressure on monetary policy to offset some of the fiscal tightening that is planned.

Sterling was already trending lower before the PBR but continued its slide afterwards. Worries about the UK’s credit rating as the deficit climbs, and especially in view of Greece’s recent rating downgrade, seems to be putting selling pressure on the currency.

But the move has not been large, under 1%. Bond yields rose on the PBR, as gilt prices fell back.

However, gross bond issuance was not materially higher than already announced in Budget 2009.

Bond prices were falling ahead of the PBR and continued to do so afterwards. Of course, there was also turbulence in financial markets about the risks for sovereigns from rising debt and higher government borrowing. The PBR did not halt the rise but neither did it precipitate it.

All in all, the PBR seems to have been received as a work in progress in financial markets, with rising speculation about what will be unveiled in the next actual Budget, due in spring 2010.

 

* All charts are sourced to Lloyds TSB Corporate Markets Economic Research, Bloomberg, IMF and Datastream

 


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