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Economics Weekly - UK public sector debt set to rise sharply; Weekly economic data preview - Will the UK pre-Budget Report deliver growth?

Economics Weekly 24 November 2008

 

UK public sector debt set to rise sharply

 

A slowing economy & tax cuts mean that borrowing will rise

This is undoubtedly the toughest Pre-Budget Report (PBR) that labour has had to deliver since it took office in 1997. For a start, this is the first recession the government has experienced – although one was only just avoided in 2002, helped by increased public spending. But this time, the fiscal position is much less favourable, with a budget deficit of 3% of gdp compared with a surplus of 1½% of gdp in 2000 before the sharp economic slowdown began in 2001.

 

The UK and world economy face huge challenges, the likes of which the financial markets in particular have not seen since the 1930s. In normal circumstances, slower economic growth should lead to slower growth in tax receipts and faster growth in government spending, resulting in increased government borrowing, but with the current financial crisis the fiscal deficit will be even larger. This means that the deficit will worsen due to the deteriorating economic environment - and the announcement of additional measures to prevent the slowdown from being even more severe – and measures already announced to help offset the threat of the credit crisis. Hence, we focus on what the Treasury’s forecasts will be given the change in the economic environment and the additional fiscal measures that are likely to be announced.

 

Economic slowdown is worsening the fiscal position and will be acknowledged…

Slower UK economic growth is already impacting the government’s borrowing requirement. As chart a shows, tax receipts are rising more slowly than spending, and below what the Treasury forecast in the March Budget. Overall in October, receipts were rising by 0.3% in the year but spending was up by 5.1% (against expectations in the March 2008 Budget of 4.6% growth in receipts and 4.8% in spending). This gap is evident in net public sector borrowing, which in October was £37bn and £16.9bn higher than in the same period last year. This compares with a full official borrowing projection of £43bn for the fiscal year ending in March 2009, with five months remaining, see chart b.

 

We expect the reality of weaker economic growth to be acknowledged in the PBR, with cuts in the previous projections taking them into line with market consensus, or lower, in order to build in some scope for further bad news. Chart c illustrates the extent to which the economic situation has deteriorated since March. The chart shows that the market consensus is for UK growth of 0.8% this year and for a fall of 0.9% in 2009. We would not disagree with the current consensus view, although recent trends suggest that the bias of risks are skewed to the downside of this central view, there is also a wider than usual range of possible outcomes given the uncertainties. Inflation will likely be sharply revised higher for this year and lower for next. One key aspect of interest will be whether the Treasury view will be in line with that of the Bank of England, which is looking for growth to fall by around 1 ½% in 2009, and inflation to drop below 1% by the end of that year, see chart d

 

.…but a package of new measures will also be announced…

Although the scale of new measures to be announced is uncertain, what is certain is that the total will be large. The boost may be as much as 2% of gdp, which is the amount that was mentioned at the G20 meeting in the US recently. This would amount to about £28bn. This could be a combination of tax cuts aimed at small businesses and the low paid and spending increases, aimed at projects that produce a future return or enhance economic productivity. And VAT rates could be cut as part of the measures. A package of this sort should in theory boost domestic demand by 2%, though its overall economic effect will be less than this. That would help to mitigate the economic downturn. It would not be surprising if there were measures to help the housing sector and, like in the US, some measures to back mortgages or to subsidise the social housing sector.

 

But there are also the announcements over the last seven months to take into account, and these could come to about £93bn. In May, there was £2.7bn, reflecting an increase in the tax free allowance to offset the effects of the abolition of the 10% income tax band, and later the postponement of the October fuel tax increase and that stamp duty will not impact on properties worth less than 175,000, and the various plans to help the financial services sector through the credit crisis. However, some of these measures should not be included in government debt, as they are equity stakes and so should produce an income stream in future, so could count as investments, and are planned to be short lived.

 

…and changes in the fiscal rules…

As a consequence of these changes, we suggest that the golden rule, to borrow only to invest over the cycle, and the sustainable investment rule, to keep government debt below 40% of gdp, will probably be abandoned and replaced with strict guidelines to get the budget back into balance in the medium term, i.e. after the current economic crisis is over. This will result in a budget deficit in the current fiscal year of around £70bn in our view and possibly £90-100bn plus in 2010/2011. That would take the fiscal deficit to around 5% of gdp this year and to some 6½% in 2010/2011. But total UK debt is starting from a very good position relative to other countries, see table 1, even though it does exclude PFI projects. However, as chart d shows, it will get worse very quickly.

 

…and greater gilt issuance

These measures will mean a big increase in gilt issuance. We estimate that it could rise to nearly £140bn this year and £160bn the year after. This may have implications for the slope of the yield curve. Although much of this is already expected in the financial markets, so should not lead to a dramatic effect in the shorter term. There will be immense interest about the duration of the debt, short, medium or long and index linked or not. Gilt yields may not necessarily rise, depending on demand from the private sector for funds and on inflation trends. But the issue of whether this will in the long run lead to ‘crowd out’ private sector borrowing will be a key one for some, as it implies weaker long term growth. Whatever the outcome, this is one PBR that will not be boring.

 

Weekly economic data preview W/c 24 November 2008

 

Will the UK pre-Budget Report deliver growth?


UK Chancellor Alistair Darling presents the pre-Budget Report today at 15:30. There is speculation that public borrowing could rise to £120bn over the next two years, with the knock-on effect of pushing public sector net debt up from the current level of 43% of GDP to possibly as high as 50% over the period. This year the PBR will attract unprecedented attention as the impact of measures to tackle recession are fully absorbed. On Wednesday, the European Commission is expected to announce its own fiscal growth package, potentially totaling €130bn. The focus of economic data lies with second estimate Q3 GDP growth, for the US due on Tuesday and for the UK on Wednesday. Also, the key German IFO business survey for November is released on Monday. There are unlikely to be any surprises in this data. As global economic growth weakens and oil prices fall below $50 a barrel, CPI inflation is falling sharply - the US core PCE deflator and the flash EU-15 CPI for November are published this week. The rising risk of deflation is giving central banks further reason to deliver more interest rate cuts over the coming weeks.

 

The outcome of the UK pre-Budget Report and its implications for households, businesses and financial markets are likely to take up a large part of the week as tax and public spending measures to avert a deeper recession are assessed. As the week pans out it may become evident that the stimulus package is not by itself a panacea for the economy and attention is likely to soon switch back to the likelihood of interest rate cuts the following week. UK data releases include the Q3 GDP second estimate which is expected to remain unchanged on the initial release of a 0.5% quarterly contraction, representing a 0.3% increase annually. The Nationwide house price index for November is expected to decline by 1.7% on the month and fall by 15.1% on an annual basis from -14.6% in October, adding to unease about the UK housing market.

 

The US has an abundance of data releases up until Thursday's Thanksgiving holiday. The second estimate of Q3 annualised GDP is widely expected to be confirmed at -0.3%, S&P/Case-Shiller annual house prices may exceed the August fall of 16.6%, while existing and new home sales for October may register monthly declines. The US consumer confidence index is likely to stay around or fall below last month's record low level of 38.0, while personal spending could contract 0.7% in October compared with 0.3% in September. So all in all, still a very negative economic backdrop, which together with tumbling oil prices, have contributed to consumer price inflation falling sharply. This is a good thing for now and will be reflected in weaker growth of the October core PCE deflator, the Fed's preferred inflation measure - 0.1% growth on the month compared with 0.2% in September - increasing the scope for a Fed rate cut to 0.5%.

 

We may get clarification of the size and content of the European Commission's proposed fiscal growth package on Wednesday, although objections by Germany may modify the initial proposal. That aside, economic data includes the important German IFO business survey index, which came out earlier this morning at 85.8 in November down from 90.2 in October and well off the high of 108.8 just over a year ago, highlighting how much German business confidence has deteriorated. EU-15 industrial orders are likely to show a 1% contraction in September after a 1.2% fall in August reflecting the current difficulties manufacturing firms in the region face. In addition, EU-15 consumer and industrial confidence for November, also published, will continue to be weak. The flash consumer price index for November should fall - we expect annual growth of 2.8% compared with 3.2% in October, giving justification for more ECB interest rate cuts.

Nichola James, Senior Economist

 

Economic Research,
Lloyds TSB Corporate
Markets,
10 Gresham Street,
London EC2V 7AE
,
Switchboard:
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www.lloydstsb.com/corporatemarkets

 

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