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Monday December 12, 2005 - 11:19:37 GMT
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UK Pre-Budget points to higher government debt for years to come

Economics Weekly: UK Pre-Budget points to higher government debt for years to come

There were a lot of announcements in the 2005 Pre-Budget Report (PBR), but the key changes were a major rise in government borrowing (expenditure remains well ahead of revenue, see chart A) and a sharp downgrading of growth projections for this year and next. We analyse the main changes in this week's briefing.

With regard to the public finances, the Chancellor announced that for the 5th consecutive year net borrowing would be more than was announced in the preceding Budget. The net borrowing requirement is now projected to be £37bn in the 2005/6 (current) financial year, up by £5bn from the Budget 2005 projection of £31.9bn. For 2006/7, net borrowing has been raised from £29bn to £34bn, so roughly maintaining the £5bn shortfall into next year as well.

Over the next three years, government net debt as a share of the economy stays at around 37% on average, leaving the Chancellor open to another rise in borrowing - just as this year – if the economy performs worse than the new Treasury forecasts suggest. On the Chancellor’s figures debt rises to 37% of gdp in 2006/7 and then to 38% in 2007/8.

Table 1 shows that £4.3bn of the £5bn of extra borrowing in the current financial year is due to forecasting changes (non-discretionary factors). The latter is referring to slower economic growth than forecast, owing to higher oil prices and a weaker than expected housing market that has hit personal sector consumption hard. Slower economic growth has hit VAT receipts, income tax receipts and excise duties. Non North Sea companies tax payments have also been lower than expected. But one positive major offset to poor tax receipts overall has been higher revenues from North Sea oil firms. The tax revenue to the exchequer from the North Sea is estimated by the Treasury to have risen from £5.2bn last year to £9.1bn this year and is then expected to be £11.7bn in 2006/7. A rise in tax on oil companies of 10%, means that the Treasury will now bring in an extra £2bn in 2006/7 and £2.2bn in 2007/8 of tax revenue. If not for this increase, then net public sector borrowing would have been £9bn or nearly 1% of gdp higher than forecast in Budget 2005. But the tax increase also runs the risk of reducing investment in the North Sea just as the oil is running out and perhaps therefore when it is most needed. Anti tax avoidance also featured heavily in revenue raising measures, and is projected in the PBR to total an estimated £600m in 2006/7, rising to over £1bn in 2007/8. In all, the tax raising measures amount to nearly 1/2% of gdp, mainly falling on the company sector, but also more wealthy individuals through the scrapping of tax avoidance vehicles. But the UK's net financial position is still very favourable, with outstanding debt at only about 35% of gdp, compared with over 50% in the US and over 60% in the euro area.

The main reason for the rise in net borrowing is a weaker economy. The Chancellor has had to revise his economic growth forecasts sharply lower, to 1¾% for 2005 (from 3 to 3.5%) and to 2 to 2.5% for 2006 (from 2.5 to 3%), thus leaving him in line with the consensus view of external forecasters. After 2006, however, official forecasts show growth rising back strongly to the 3%, in line with the estimated trend pace of growth of the UK economy.

Overall, the 2005 PBR was a positive for equities, based on increased government borrowing and continued public spending. It was neutral to positive for bonds, because it showed the Treasury's acceptance that the economy will grow below 2% this year and by between 2-2.5% in 2006, a rate below the long run average. For the currency, the PBR was probably negative, but only mildly so, as it suggests policy as a whole as being steady as you go. Although the government's growth forecasts were slashed, this was only to levels that were in line with views in the financial markets. If they had been below the consensus projection, then they would have led to a downgrading of interest rate expectations and possibly hit the currency though boosting bonds. The extra debt issuance of £2.6bn in 2005, see table 2, is not enough to overly concern the bond markets. With gilt yields low and demand from pension funds strong, the markets are likely to easily absorb the rise in government debt.

UK economic indicators
With interest rates on hold last week, the financial markets will be looking for signs that the MPC had good reason to keep them unchanged. But this week there will be interest rate hikes from the US and Swiss central banks. In the last month, Canada, New Zealand, the ECB, and Denmark have all raised interest rates, yet the talk in the UK is of cutting them. The reason of course is that UK interest rates were already high and growth has weakened in the last year. Data this week should show that inflation is still above target, as gas and electricity prices drive consumer prices up in November. Although producer prices on Monday may show that price pressure from raw materials are not being passed on by companies, the MPC is right to remain cautious. But wage inflation is still modest and retail sales growth is expected to be sluggish, so pressure for lower interest rates is likely to persist.

Trevor Williams, Chief Economist
trevor.williams@lloydstsb.co.uk
www.lloydstsbfinancialmarkets.com
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