UK Pre-Budget Report: Modest Stimulus, Major Deficit

- Arguing that extraordinary times required extraordinary measures, the UK government duly announced a fiscal stimulus package worth a little above 1% of GDP. With official public sector borrowing projections soaring to £118bn, or 8% of GDP next year, the Chancellor set out how the government is to regain control of borrowing in the medium-term.

This will take the form of a combination of economic recovery, a reduction in the growth of public spending in real terms in later years to below 2% per year, public sector efficiency savings worth £5 billion a year, sales of government assets as well as deferred tax increases. With BoE Governor King already giving his blessing to a temporary, modest fiscal boost, we do not see any major impact on future monetary policy from today’s announcements. We continue to look for a 100bp cut to 2.0% in December with a trough in the Bank rate at 1.5% in early 2009.

With the UK economy facing its most serious downturn since at least the early 1990’s, the Labour government today carried through on its promise to support the economy via a fiscal stimulus package, as part of a ‘throw the kitchen sink at it’ approach by the macro-policy authorities to stem the rapidly deepening recession. The Bank of England (BoE) has already slashed interest rates 200bp since early October. More aggressive easing is likely to follow in coming months, in  our view. Concerns that the monetary transmission mechanisms is impaired, with banks still apparently unwilling to lend to each other, household and small businesses, has meant that the burden on fiscal policy to undertake some of the ‘heavy lifting’ has risen.

However, runway public sector borrowing has constrained the potential size of the fiscal stimulus to a relatively modest £20bn or close to 1.5% of GDP. Moreover, we are concerned that the centrepiece announcement of a 2.5 percentage point cut in the rate of value added tax (VAT) has diluted the potential impact from a given level of stimulus. All households benefit from a reduction in VAT, with those spending the most extracting the largest gains. By contrast, we believe the government could have got more ‘bang for its buck’ by concentrating the stimulus into targeted tax cuts for the most cash-constrained, low income households. From this perspective, we believe by far the most important potential economic stimulus will come from monetary policy, when spreads to LIBOR rates finally begin to ease more notably, a process which hopefully will become more apparent once the likely year-end funding squeeze is over.


Economy in Dire Straits

As expected, Chancellor Darling formally acknowledged the UK was in recession by taking an axe to the Treasury’s forecasts made back in March. Darling presented a scenario of a short, sharp recession with the economy contracting around 1.0% next year but bouncing back to growth of +1.75% in 2010 and then reverting to its past decade trend rate of 2.75% in 2011. On balance, we see the Treasury’s forecasts on the optimistic side. Next year, we believe the economy is likely to contract by at least 1.2%, with a 1.5% outturn a rising risk. While our 2010 forecast, at 1.6%, is not too dissimilar from the Treasury’s call, we believe that the recovery in later years will be far more muted. It is unlikely, in our view, that the UK economy will be able to achieve growth anywhere close to the 3% of recent years in the absence of robust financial services growth, a surging house market and easy credit. More likely, the UK will even struggle to reach the 2.5% average over the past 50 years as the economy rebalances away f rom leveraged household and public spending towards a greater weighting of exported goods and services under a weaker sterling exchange rate. We expect growth of at best 2.5% in 2011.


Borrowing to Soar

UK public finances have been under major pressure for some time now following the major public spending drive between 2002 and 2005 in health and education. Between these years, net debt rose 4 percentage points of GDP to 36% at a time when GDP growth averaged 2.5%, in line with its historical average. This included two years—2003 and 2004—in which GDP growth was well above trend at 2.8%.

With the UK economy slowing sharply already over 1H 2008, the strain on public finances has continued to grow. This situation is likely to be exacerbated enormously under recessionary conditions as tax revenues seriously disappoint and social expenditure rises sharply, an expected development reflected in the Treasury’s startling upward revision to public sector net borrowing (PSNB).

Having predicted in March that PSNB would peak at £43bn in the current 2008/09 financial year and then fall to £38bn in 2009/10, the Treasury now projects a leap in borrowing to £77.6bn this year. With the economy struggling with serious recession and the level of unemployment likely to spike up toward the 3mn level by the end of next year, borrowing is now expected by the Treasury to explode to £118bn next year, rocketing to some 8% of GDP from 2.5% in 2007/08. In today’s Pre-Budget Report (PBR), the Treasury has raised its projection for public sector borrowing in the 5 years between 2008/09 and 2012/13 by a staggering £295bn or 20% of GDP relative to the forecasts it made only 8 months ago in the March Budget.

In terms of the total UK debt picture, the need for radically higher borrowing due to economic recession, the inclusion of the £50bn bank capitalization plan and the nationalisation of Northern Rock and Bradford & Bingley looks set to push the debt-to-GDP ratio to just under 70% in coming years from just 36% prior to NR’s nationalisation at the end of last year. At this level, the UK would clearly breach the European comparable Maastricht limit of 60%. It is worth noting that, since the ONS will likely not offset the liabilities from the government's bank recapitalization plans or from the nationalized institutions against their non-liquid assets, i.e. their mortgage books, the deterioration in the debt/GDP is somewhat overstated but still alarming nonetheless.


Policy Details

The centrepiece of the government’s stimulus package was a reduction in the rate of VAT from 17.5% to 15.0% for a period of 13 months. It is estimated that this will cost the Treasury around £12bn, constituting by far the largest element of a fiscal stimulus package worth £20bn or 1.5% of GDP. The main attraction of a VAT reduction is that it can be implemented efficiently in a timely fashion in time for the start of Christmas season shopping. Also, by virtue of its temporary nature, the hope is to encourage spending that otherwise would not have taken place.

The main drawback, in our view, is that, against the backdrop of a given level of stimulus (i.e., roughly 1% of GDP), a VAT reduction benefits all households, potentially diluting its impact on spending. If one assumes an average £650 spend per person over Christmas, the VAT reduction will only save an individual £16.25, arguably not a major incentive to spend against fears of rapid increases in unemployment. Also, to some extent the effect of the tax cut is ‘hidden’ in the final selling price, making it difficult for individuals to appreciate the discount especially when prices are so volatile at present with retailers offering discounts of up to 30%. By rather concentrating a given stimulus into targeted tax cuts for low income households, the Government may have provided the greatest ‘bang for its buck’, in our view. Even though temporary tax cuts run the risk of finding their way into savings rather than spending, by directly putting money in the hands of those households which are most cash constrained w ould likely help offset any propensity for higher savings, in our view.

Targeted help for low incomes households was still feature in the PBR. Chancellor Darling announced an extension of the £2.7 billion package announced in the summer to compensate low income households who had lost out from the March 2008 Budget decision to abolish the starting 10p income tax rate by increasing the personal allowance before income tax kicks in by £600. The original rebate, worth £120 a year to basic rate taxpayers, was due to come to an end next April, but was today made permanent. A further increase in the personal allowance by £130 in 2009/10 implies a benefit of £145 for per year to tax-payers, according to Treasury figures, a stimulus of around £3.0bn per annum.

Significant previously proposed increases in vehicle excise duty for larger family cars will be  postponed until the economy recovers at a cost to the Treasury of around £500mn per year. Darling also announcement that lenders had agreed to a minimum grace period of 3 months between mortgage payment failure and the start of repossession proceedings.

On the business side, Darling announced a tax exemption for foreign dividends as well as a deferral of an increase in corporation tax from 21% to 22% for small businesses until 2010. As part of the fiscal stimulus package, the Treasury announced plans to bring forward capital expenditure worth around £3bn from 2010/11 plans into mainly fiscal year 2009/10. Strictly speaking, as this is simply shifting expenditure between financial years, it does not qualify as a genuine new stimulus, implying the degree of total stimulus, announced at £20bn, is a little overstated, in our view.


Regaining Control of Runway Borrowing

Darling’s statement also set out how the government is to regain control of borrowing in the medium term—in our view a fundamentally crucial element of the Pre-Budget speech. This will likely take the form of a combination of:

• economic recovery,
• a reduction in the growth of public spending in real terms in later years to below 2% per year,
• public sector efficiency savings worth £5 billion a year,
• sales of government assets; as well as
• deferred tax increases:

As covered in the press this morning, the Chancellor announced an increase to the upper threshold for income tax from 40 pence in the pound (£) to 45 pence for those individuals earning above £150,000. This tax increase will apply from 2011 onwards, netting the Treasury just above £650mn per annum. An unexpected development was the announcement of a 0.5% increase for all rates of National Insurance Contributions (NICs) for both employers and employees from April 2011 onwards. This is estimated to net the Treasury close to £5.5bn per year.


Implications for Monetary Policy

With BoE Governor King already giving his blessing to a temporary and modest fiscal boost, we do not see any major impact on future monetary policy from today’s announcements. We continue to look for a 100bp cut to 2.0% in December with a trough in the Bank rate at 1.5% early next year. While there still remains a chance that the Bank of England could be forced to cut rates even lower to a trough of 1.0% during 2Q 2009, the size of today’s fiscal stimulus—a little above 1% of GDP—implies that the chance of a 1% trough in the Bank rate has diminished somewhat, in our view.