Blow for Chancellor as bond crisis costs reach £50bn
- Reeves left £10 billion behind to meet the cardinal rule that spending must be matched by tax revenue
- That reserve has virtually disappeared
- Borrowing is at its highest level in 27 years and the pound has fallen against the dollar
The Chancellor is facing a £50 billion bill for higher interest payments on debt after the bond market pushed up the government’s borrowing costs – but the final figure could be much higher, City experts warned this weekend.
It means that unless conditions improve quickly, Rachel Reeves will break her self-imposed budget rules — and may be tempted to relax them to avoid painful tax increases or spending cuts.
Reeves has included a historically small buffer of £10 billion in her budget for this year to meet her headline rule that day-to-day spending must be matched by tax revenue.
But that reserve has all but disappeared after government borrowing costs rose to a 27-year high and the pound slumped against the dollar during a turbulent start to the year in financial markets.
The chancellor, who heads a trade delegation in China, has ruled out further borrowing or tax increases to plug any gaps in national finances, while a review of government spending will not take place before June.
If the sell-off in bonds and sterling continues, experts fear Reeves may not be able to hold the line until the independent Office for Budget Responsibility releases its next outlook for the economy at the end of March.
Nothing to cheer about: Chancellor has ruled out further borrowing or tax increases to plug any gaps in the country’s finances
“Reeves has a big problem,” said Sanjay Raja, senior economist at Deutsche Bank.
“The wafer-thin room for maneuver that remained in the autumn budget has probably all evaporated.”
He says if government borrowing costs remain high, interest on the debt pile – which stands at £100 billion a year – will rise by a further £10 billion over the next five years, pushing Reeves’ budget rules below the waterline to lie down.
This £50 billion hit from higher debt service costs comes ahead of an expected cut to the OBR forecast of 2 percent growth this year, which would further weaken the budget position as tax revenues would be lower.
The economy has flattened under Labor and business confidence has collapsed after the Chancellor’s Budget increased taxes by £40 billion this year, sparking fears of job losses.
The budget watchdog will also increase its inflation forecasts, which will increase the cost of servicing the national debt as a quarter of all loans are linked to the consumer price index.
Experts say that after she locks herself in, Reeves will most likely support the cuts to ensure she doesn’t break her own budget rules. But that would pose political problems as Labor promised there would be no return to austerity and that public services would be restored.
Another option for Reeves is to try to bend the new debt rules to allow even more borrowing without spooking the markets.
It could do this by bringing forward the rolling target date for meeting its fiscal rules and applying them within a certain range from now on.
But the OBR recently warned the chancellor against using smoke-and-mirrors accounting tricks to balance the books. In an extraordinary rebuke, revealed in The Mail on Sunday, the OBR highlighted a number of ‘budget illusions’ that it could ‘exploit’ to make the public finances look better than they actually are.
These include the way student loans and National Wealth Fund investments are treated.
The government could also be “tempted” to transfer the assets of funded pensions – such as the £400 billion local government pension fund – onto its books, while taking liabilities off the balance sheet, the OBR said.
It says pension liabilities for doctors and teachers worth £1.3 trillion – or almost half of Britain’s annual economic output – do not appear on the state’s balance sheet.
“If they follow international guidelines, the markets won’t care much,” Raja said. “The key now for the Chancellor is to show that fiscal policy does not conflict with fiscal rules and that there is a credible plan for growth.”
Reeves could just cross her fingers and hope the storm passes. “Doing nothing is probably the wisest thing to do,” says economist Julian Jessop.
However, traders are prepared for another volatile week in bond markets, especially if the December inflation rate rises above the expected 2.5 percent on Wednesday. If that happens, the Bank of England could slow the pace of rate cuts.
The Finance Ministry said meeting fiscal rules is “non-negotiable” and that the government will leave “no stone unturned in achieving economic growth.”
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