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      UK: tax cuts raise debt-sustainability stakes; growth, inflation challenges intensify
      TUESDAY, 27/09/2022 - Scope Ratings GmbH
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      UK: tax cuts raise debt-sustainability stakes; growth, inflation challenges intensify

      The UK government’s ‘mini-budget’ risks reversing the country’s debt-to-GDP trajectory in the medium term unless growth-enhancing policies can transform the economy’s potential output despite surging inflation and tighter monetary policy.

       By Eiko Sievert, Director, Sovereign and Public Sector Ratings

      The United Kingdom (AA/Stable) faces a prolonged period of widened budget deficits because of the government’s recently announced largescale tax cuts and the rise in public spending from the two-year cap on household energy prices.

      We see UK debt-to-GDP returning to pandemic-era levels by 2027 whereas we had previously expected it to decline. Keeping debt-to-GDP stable would require a sustained and significant increase in the economy’s growth potential, which will take some time to materialise – at best. Expansionary fiscal policy will widen the budget deficit to around 7% of GDP in 2023 only slightly below the 8% deficit reached in 2021 at the height of the pandemic. The deficit is then expected to steady at 5% of GDP, raising the debt-to-GDP to 95% by 2027 from 91% currently (Figure 1).

      As for economic output, the government’s target to increase potential GDP growth to 2.5% a year is well above our current expectation of around 1.5%. To keep public debt-to-GDP stable, we estimate that economic growth would have to increase by at least 0.8pps above current expectations every year. This will amount to growth not seen in the UK since the decade before 2008 which proved to be unsustainable.

      Figure 1: UK debt-to-GDP expectations in July 2022 compared with September 2022
      % of GDP

      Sources: IMF, Scope Ratings

      In addition, the upward pressures on public spending in the UK will remain considerable. Given volatile energy markets, there is some uncertainty around the exact cost of the energy price cap. While the resulting one-off costs will push up UK debt, the announced corporate and income tax reductions could become a longer-term drag on public finances given there is little room to reduce public spending.

      In isolation, the deterioration in the outlook for UK public finances is significant, but the country’s situation compares favourably with some similarly rated advanced economies. Take France (AA/Stable) whose debt-to-GDP would still be running around 20pps above the UK’s.

      Much riding on labour-market, other reforms to kickstart growth

      Finance Minister Kwasi Kwarteng has promised to match the government’s reliance on boosting economic growth with a raft of economic reforms. Some of the tax cuts will help and the government is set to give more details over the coming weeks.

      The government needs to focus in particular on the labour market given the well-entrenched productivity challenges in the UK. Since the pandemic, economic inactivity has remained elevated so finding ways to increase employment levels and raise labour force participation will be important.

      Figure 2: UK current account balance and Sterling exchange rate
      % of GDP, and USD to GBP

      Sources: UK Office for National Statistics, Bank of England, Scope Ratings

      For now, the risk of inflationary pressures stemming from the cumulative impact of such growth-enhancing policy measures, coupled with Brexit-related uncertainty, has led to a 10% fall of the value of sterling against the dollar (Figure 2). UK government bond yields have risen sharply in recent days too compared with those of other major economies (Figure 3). However, the UK’s exceptionally long average maturity of its debt portfolio of almost 15 years – compared with around eight in France and Spain – means that average financing costs faced by the government will increase only gradually.

      Figure 3: 10-year government bond yields in selected major economies
      %

      Sources: Macrobond, Federal Reserve, Scope Ratings

      Maintenance of the UK’s strong financial regulatory framework will be crucial for shoring up the credibility of economic policy and investor confidence. The Bank of England (BoE), Prudential Regulation Authority and Financial Conduct Authority play central roles at assuring financial stability.

      Yet this poses an immediate and difficult challenge for the government in that fiscal policy is at odds with monetary policy. While headline inflation is expected to fall significantly due to the energy price cap, the support provided to businesses and households through tax cuts will put upward pressure on core inflation. With an eye on sterling’s weakness, the BoE will likely bring forward policy rate hikes which could put the brakes on economic growth.

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