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Chancellor navigates fragile UK public finances

As he prepares to deliver his second Budget, Rishi Sunak feels he has made his own luck by supporting the economy with £280bn of taxpayers’ money through the coronavirus pandemic.

But the UK chancellor will not celebrate when the Office for Budget Responsibility outlines an improved outlook with the publication of its official forecast alongside his speech, his aides said.

Instead Sunak’s sober tone will reflect the tightrope he is walking even though the forecasts for public finances will show about £40bn less borrowing this year than the £394bn predicted in November. Despite a smaller, longer-term hole in the books, the chancellor will still warn that tax rises are coming.

Some of this is raw politics. If the chancellor overachieves in repairing the public finances, he will have built a nest egg for tax cuts or public spending increases at the time of the next general election in just over three years.

But much of the caution is due to the official forecasts still being highly speculative. A lot could still go wrong, causing Sunak to have nightmares about the books slipping deep into the red over the longer-term and his Conservative party losing its reputation for prudence in managing the public finances.

Torsten Bell, chief executive of the Resolution Foundation, said the OBR’s improved assessment of the persistent hit to the economy from the pandemic could only be guesswork on the fiscal watchdog’s part.

“What actually matters for the public finances — and whether further significant tax rises will be needed in future Budgets — is what actually happens to the economy rather than what is forecast to happen to it,” Bell said.

It is not difficult to imagine scenarios for the economy or public finances that are much worse than the OBR is likely to predict in its central forecast. UK public debt is close to 100 per cent of national income for the first time since the early 1960s, so any small changes to individual assumptions have large effects on projected deficits and the cost of servicing government debt.

Animated chart showing how UK central government debt interest would rise rapidly under modest rate rises. A two percentage point rate rise on inflation, gilt yields and the Bank of England base rate would more than double debt interest in the years ahead

Sunak is acutely aware of this, telling the Financial Times last week that if the official interest rate rose by 1 percentage point alongside equivalent rises in the cost of longer term government debt and the inflation rate, it would add £25bn to the UK’s annual bill for debt interest payments.

This estimate is derived from the OBR, which has warned that public finances are now twice as exposed to the Bank of England’s interest rates as they were a year ago. If the bank rate rose from 0.1 per cent to 1.1 per cent, it would add £10bn a year to the debt service burden.

This remarkable increase in the sensitivity of the public finances to interest rates has occurred because the BoE has doubled the planned level of quantitative easing by the end of 2021 to £895bn.

In the QE programme, the BoE buys government bonds, so the interest on them is recycled within the public sector and is no longer paid out. But the central bank still pays its official interest rate on the electronic money it created to purchase the bonds — currently 0.1 per cent — to the banks which, in aggregate, have to hold these reserves and deposit them overnight at the central bank. As a result, a rise in the interest rate adds to public spending.

For the £1.95tn of government bonds issued, the rise in debt outstanding means that every 1 percentage point rise in gilt rates increases debt service costs over time by just over £7bn. On top of this, with a quarter of those gilts linked to inflation, a 1 percentage point rise in inflation adds another £6bn to the annual debt service bill.

Chart showing how, despite UK borrowing having surged to a 55 year high, it is currently relatively affordable debt, due to low interest rates

These potential increases in debt servicing costs are far from outlandish. Less than a month after the OBR finalised its forecasts based on February 4 prices, the gilts rate for 10 year debt has already risen 0.5 percentage points.

In a plausibly difficult scenario these rises in debt servicing costs could hit the government’s books at the same time. An inflationary shock combined with a rise in interest rates by the Bank of England, which some in the bond markets are predicting, would add close to £25bn a year to debt servicing costs in one go — about the equivalent of adding 5p to the basic rate of income tax.

Changes in market sentiment is far from chancellor’s only concern. Sunak’s assumption in November’s spending round that most of the money allocated to tackling Covid-19 would be temporary looks increasingly misplaced.

Sunak wants to cut £90bn a year from government spending totals by 2022-23. But if he were to struggle with half of this, that would immediately make the public finances more difficult. The need for ongoing funding of test and trace services, Covid-19 vaccines as well as increased resilience in acute care services demanded by NHS hospitals this week, looks increasingly likely.

The former head of the OBR, Robert Chote, has warned that the need to spend more on health and social care after the pandemic “to build more resilience into the system”, is the most likely reason taxes are going to have to rise in the years ahead.

Even with a successful vaccine programme, Ruth Gregory, senior UK economist at Capital Economics, said that the Tories’ ambitious pre-pandemic funding commitment may yet force Sunak to become a tax and spend chancellor. “It is a question of raising taxes to fund the government’s spending aims, rather than to pay for the crisis,” she said.

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