It is unfair to say that UK chancellor Kwasi Kwarteng’s dash for growth through unfunded tax cuts has sacrificed his credibility with the foreign investors on whose kindness the country depends to finance its deficits.
He had very little to begin with.
The fall in sterling on Friday afternoon and Monday morning – that has further impoverished the population and grabbed all the headlines – is merely a continuation of the trend since June 2016.
Over the six years since the Brexit vote, the currency has lost 25% of its value against the dollar.
So, what’s another 4% decline between friends? And the pound is only down 3.5% against the euro since Friday.
However, the swift repricing of UK risk – partly in recompense for the possibility of further currency falls, partly in recognition of policy incoherence – was remarkable and potentially much more damaging.
Yields on developed country bonds are not meant to rise 50 basis points in a single day. Unless that rise in borrowing costs is reversed rapidly – it almost certainly won’t be and could get worse – then it will effectively annul any boost from the growth plan.
UBS calculates that, with the Bank of England no longer the marginal buyer of gilts and now into quantitative tightening, the volume of new UK government bonds the private market will have to buy over the next 18 months is equivalent to the volume they bought in the previous 54 months.
A gamble
Kwarteng’s tax cuts won’t sacrifice too much revenue, but they focus on the size of the energy price relief bill to UK households and businesses, which Kwarteng puts at £60 billion over just the next six months and which most banks have calculated at £150 billion.
Could it be higher? That will depend on wholesale energy prices.
Mark Dowding, chief investment officer at RBC BlueBay Asset Management, points out: “The fiscal gamble is huge in scale and could just work if the conflict in Ukraine is short lived and gas prices fall.”
Well, let’s hope so.
But Societe Generale points out that a simple pro rata of that £60 billion number suggests £240 billion over the two years for which the UK government says it will cap prices, or 10% of UK GDP.
A lot of investors now appear to expect gilts to get even cheaper.
“Investors seem inclined to regard the UK Conservative Party as a doomsday cult,” says Paul Donovan, chief economist of UBS Global Wealth Management.
After other central banks with lower inflation raised policy rates last week at 75bp increments, the BoE’s mere 50bp hike, on a split decision, looks weak, given the much higher levels of inflation that the UK central bank predicts
In theory, a weaker currency and weaker planning restrictions could eventually make the UK a more attractive place to invest.
“However, the timing of these tax cuts could not have been worse,” says Azad Zangana, senior European economist and strategist at Schroders. “With inflation near double digits, the Bank of England is raising interest rates in an attempt to slow demand in the economy and bring inflation back to its target of 2%. While the chancellor stated that the independence of the BoE was 'sacrosanct', his tax cuts conflict with the central bank’s objectives.”
And it is the BoE’s credibility as much as the chancellor’s, that is now in question.
After other central banks with lower inflation raised policy rates last week at 75bp increments, the BoE’s mere 50bp hike, on a split decision, looks weak, given the much higher levels of inflation that the UK central bank predicts.
The market is now pricing in a terminal rate of 5.5%, more than double the current level, suggesting this is not a great time to buy gilts even at the new higher yields.
There is even excited talk – probably over-excited – of an emergency inter-meeting rate hike to stop the fall in sterling, offering a distant echo of Black Wednesday in 1992 when sterling devalued.
Cost benefits
While the costs of Kwarteng’s growth plan are enormous, the consensus among economists is that the benefits will be much smaller.
Some of the tax giveaways are merely cancellations of rises that had been planned by previous chancellor Rishi Sunak.
No economists that Euromoney can find give any credence to the Reagan/Thatcher era notion of trickle-down economics. Will those earning over £150,000 rush out to spend the extra income they retain from a cut in higher rated tax from 45% to 40%? They might be better advised to save it for when these tax cuts are reversed.
Investment zones have been tried before as enterprise zones; they don’t do much to boost the productivity of an economy with a poorly educated workforce that has ended freedom of movement from the EU and is suffering from labour shortages as well as lack of investment.
Even if the UK government performs another U-turn and seeks to encourage immigration, why would enterprising workers want to be paid in a depreciating currency?
Brian Hilliard, chief UK economist at Societe Generale, and his colleague Sam Cartwright point out that even if the UK’s real growth rate were raised by 1 percentage point each year for five years as a result of the plan, then tax revenues would rise by £47 billion, or just under £10 billion a year.
The Treasury’s own estimate of the cost of the plan is £44.8 billion a year by 2026/27, that is five times the boost to revenue from faster growth. That is why concern is now growing that the UK could be downgraded, further raising funding costs for the sovereign and for all other issuers in the sterling bond markets
Zombie economics is one of the politer terms being used for the mini-budget, though we should tip our hats to Dario Perkins, managing director of global macro at TS Lombard, for coining the term 'moron economics'.
