Against the tide: Is the UK next in line?
Markets have focused on the woes of the peripheral eurozone member states and their sovereign debt crisis but we should remember that public finances in the UK, the US and Japan are in an equally bad, if not worse, state.
By the time you read this, the UK’s new finance minister will have presented his June 22 emergency budget. George Osborne has said that urgent action is needed to get the UK’s public finances under control and to start to reduce the country’s large deficit and public debt. He is right.
Markets have focused on the woes of the peripheral eurozone member states and their sovereign debt crisis but we should remember that public finances in the UK, the US and Japan are in an equally bad, if not worse, state. These three big sovereigns are running annual budget deficits in double digits of GDP, and public sector debt ratios are heading towards 100% of GDP by 2012. It’s already double that in Japan.
The UK debt level excludes off-balance-sheet liabilities such as the private finance initiative, where the public sector takes on the servicing of debt raised by private suppliers of infrastructure projects. If this were included in official public debt it would add another 15% of GDP to the public debt ratio.
The UK has experienced the largest swing in government deficit during this debt crisis. And its primary deficit (which excludes interest costs on the debt) has the highest structural component (that part of the deficit that cannot be improved by faster economic growth but requires deliberate fiscal action) among all the G7 economies.
The UK government’s gross financing requirement for this fiscal year and next will reach a post-war record of about 15% of GDP. Up to now, the gilt market has been artificially propped up by the Bank of England’s £200 billion quantitative easing purchase programme. This has accounted for all of the supply of gilts in the past year. But that programme is over. From now on, the private sector must absorb the large increases in long-term gilt supply.
The UK has a particular problem in that its household savings and thus its national savings rate is very low by international standards. With limited national savings, government borrowing will have to rely more on foreign investors to buy gilts. Already, non-residents hold 38% of all outstanding gilts.
Some argue that the new coalition will deal with the fiscal mess. But the present joint programme devised by the two governing parties does not make me optimistic. The government really needs to impose state-sector wage cuts for at least three years. But that appears politically impossible. Instead, it seems likely that it will opt to increase the value-added tax rate. But an increase in VAT will add to the UK’s already higher-than-average inflation rate – now at a 17-month high.
It will also change the balance of fiscal measures towards higher taxation and away from spending cuts – hardly a move towards smaller government. And remember, the UK has a bigger state sector (measured as a share of the GDP) than Greece, Portugal, Spain, or Ireland and has had the biggest rise in its public spending ratio in the past 10 years in the whole of the OECD.
The indicators of UK economic recovery are ambiguous at best. The UK’s real GDP growth still lags behind the eurozone, despite the latter’s debt crisis. Private-sector employment growth has never been so sluggish. Apart from financial sector bonuses, income from work remains very weak. And although house prices at the top end of the market have recovered, UK households are still reluctant to borrow more, so the mortgage market remains moribund. Worst of all, although business investment and manufacturing output have bottomed, they are still 12% to 20% below the peak before the crisis.
The one big advantage for the UK is that its debt maturity profile is benign, with an average maturity of nearly 14 years compared with five years for the US. So redemptions in gross issuance will be small and the impact of rising yields on government debt will not affect the budget deficit as fast as gilt market pricing.
But it still worries me that the UK, with its huge budget deficits and fast-rising debt burden, could be the next in line for a debt crisis.