Amidst the furore over the prospects of a hard Brexit and President Trump’s immigration policies, the dry subject of our national finances has been overlooked. So may I have your attention please? Last year the United Kingdom’s national debt increased by £251 million every day.
Sobering news
The latest news on UK public finances is sobering. I’ve just gone through the latest public finance figures – complete with spreadsheets – released by the Office of National Statistics (ONS) on 24 January[i].
Total UK state debt excluding both public sector bank liabilities and Bank of England short-term liabilities stood at £1,698.1 billion (call it £1.7 trillion) at close on 31 December 2016. This is overwhelmingly made up of bonds and bills (“Gilts”) issued by the Treasury into the bond markets. That was an increase of £95.1 billion as compared with twelve months earlier.
According to the 24 January ONS publication, that yielded a national debt-to-GDP ratio of 86.2 percent. However, I note from the accompanying spreadsheet which can be downloaded from the ONS website that, when that ratio is calculated using GDP at market prices[ii], it rises above the psychologically important 100 percent mark to a colossal 102.4 percent. There are many ways to cut and splice the figures so one should always consult several sources.
Just to confuse us all further, the ONS is also obliged under EU law to produce an annual estimate of government deficit and debt for the European Commission in accordance with the Excessive Deficit Procedure (EDP) protocol under the Treaty of Maastricht (1992). These figures were released on 18 January and provide an estimated UK debt-to GDP ratio of 87.6 percent on 31 March 2016[iii]. This is the figure that is the best comparator with other EU countries, even though it is now ten months out of date (and the real figure now is almost certainly higher).
The budget deficit, also known as public sector net borrowing, decreased by £10.6 billion to £63.8 billion over the first eight months of this fiscal year (i.e. April to December 2016) as compared with the same period in 2015. That is likely to turn out to be around 3.7 percent of GDP for the fiscal year. That is much better than the 8.7 percent of GDP recorded in Q1 2010, according to my ONS spreadsheet, but still way above Mr Osborne’s target. (Remember that he originally set out to balance the budget by 2015 and that that objective was then put back to 2020 – and then abandoned altogether by Mr Hammond).
So the budget deficit is reducing (though much more slowly than planned by Mr Osborne) and the national debt is still rising – faster than economic growth. To be precise, I calculate that debt increased by 5.93% last year and the economy grew by approximately two percent, and therefore the debt-to-GDP ratio is still rising.
Extrapolating forwards
If we assume that debt continues to rise by 5 percent per annum and that GDP growth continues at 2 percent (which is optimistic since, as I have written recently, we are overdue for a downturn) then I calculate that the national debt by the end of 2020 will reach £2.064 trillion with a debt-to-GDP ratio of 96.8 percent[iv]. That will place the UK in the same dubious company of fiscal bad boys like France and Belgium.
The moment of truth
I know that I have said this before, but for debt to increase faster than growth is simply unsustainable over the medium term. True, up until now the gilt market has just shrugged off the UK’s level of debt. In fact, gilt yields have declined in recent years even as debt has risen because of the hunger for safe haven assets on behalf of institutional investors (principally pension funds). In the era of near-zero interest rates such investors have been quite forgiving of fiscal incontinence on the part of governments, particularly in Europe. But that could change quite quickly, in my view.
The markets know that, with interest rates at rock bottom, the government can raise money relatively cheaply. But the cost of debt is actually much more than the current market yield on, say, 10-year gilts (1.45 percent) because the government must pay the full coupons on bonds that were issued when market rates were higher. I calculate that the average cost of government debt in the current fiscal year is actually 3.37 percent.
If the average cost of government debt were to rise to 5 percent by 2020 then the interest cost could reach £105 billion.
According to the ONS data, interest cost on the national debt amounted to £38.1 billion for the first eight months of the year, suggesting that it will total over £57 billion for the whole year. This is already much more of a financial burden for the government than the defence budget, which will come in at £45.6 billion for the current year.
So what would happen if interest rates were to rise appreciably? (Given the amount of latent inflation in the UK economy right now as a result of the falling Pound and increasing commodity prices, it is quite possible to imagine that rates will start to move higher over the course of this Parliament.) If the average cost of government debt were to rise to 5 percent by 2020 then the interest cost could reach £105 billion. That would be much more than the education budget and would be politically toxic. And the markets might then reprice risk such that gilt yields rise, thus putting further upward pressure on interest costs.
Et l’heure de la vérité
As it happens, this kind of risk re-repricing is happening right now in Europe.
France has a similar debt-to-GDP ratio to our own, though historically it has been higher for longer. In fact, the French state has not run a budget surplus since the 1980s. It now looks probable that the run-off in the French Presidential election on 07 May will be a divisive contest between the Europhile M Macron and the Europhobe Mme Le Pen. As uncertainty about the outcome of the French presidential election has grown, so yields on French government bonds have swollen recently. Spreads on French 10-year bond yields over equivalent German Bunds have risen by about a third over the last four trading days to 62 basis points, a premium not seen since early 2013[v]. The market for Credit Default Swaps (insurance policies that banks take out on different types of asset) also suggests that France’s risk profile has been rising.
The spread on Italy’s 10-year bonds relative to Bunds has widened by 25 basis points over the last two weeks to 190 basis points. And Portugal’s spread is 380 basis points. All this suggests that investors do not regard all Euro denominated government bonds as equally risky (even though they are all theoretically supported by the same European Central Bank and stability mechanisms).
The fact is that political risk is rising rapidly in Europe at a time of extreme financial fragility. In comparison, UK gilts still look like a safe bet, despite the failure of the Coalition Government (2010-2015) and now this Tory one to address the deep-rooted problem of our fiscal immoderation. Unsustainable means that things cannot go on like this indefinitely – but Mr Hammond probably has enough rope for the moment to hang us with later.
The overwhelming question
We are so preoccupied with Brexit right now that we have almost forgotten that the overwhelming question of the day is what to do about welfare and healthcare budgets which are growing faster than the economy as a whole. Medium-term, either those budgets must be trimmed (politically problematic) or taxes must rise (economically negative). There is already talk of a compulsory insurance scheme to cover the cost of “social care” (caring for the elderly) – in effect a disguised tax.
The third approach is that of innovation. I have put the case before in these pages for a digital NHS (robot doctors, health monitoring apps on smartphones) which the millennials would love – and which would save us money. It’s a theme I’d like to return to shortly.
[i] See: https://www.ons.gov.uk/economy/governmentpublicsectorandtaxes/publicsectorfinance/bulletins/publicsectorfinances/dec2016
[ii] Current prices not seasonally adjusted (CPNSA) basis.
[iii] See: https://www.ons.gov.uk/economy/governmentpublicsectorandtaxes/publicspending/bulletins/ukgovernmentdebtanddeficitforeurostatmaast/julytosept2016
[iv] As ever, my spreadsheet calculations are available for review.
[v] See article by Ambrose Evan’s Pritchard in yesterday’s Daily Telegraph: http://www.telegraph.co.uk/business/2017/01/30/bond-markets-sniff-mounting-risks-france-italy/