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     - Scenarios imply explosive debt paths for UK that are unsustainable long-term
     - Government revenue and spending risks abound
     - Huge amount of Gilt issuance likely. BoE role? Brexit?

Latest UK public finances (for June) might have shown borrowing a tad below the Office for Budget Responsibility’s (OBR) July forecasts from its Fiscal Sustainability Report, but the record borrowing levels do nothing to assuage the concern that borrowing is on an explosive path.

The OBR's scenario analysis suggests at least one of three things needs to happen to place the nation’s public finances on a sustainable path (and this applies to many countries). Government spending will have to fall, taxes go up or the most preferable, the economy grows quick enough to avoid the previous two. Given the scale of the spending to mitigate the impact of the virus induced lockdown, the latter is unfortunately the least unlikely.

The 3-scenarios are;

Upside - activity rebounds relatively quickly and recovers to the pre-virus peak by Q1 2021

Central - output recovers more slowly and doesn't recover to the pre-virus peak until end-2022. This will still leave real GDP 3% lower in Q1 2025 vs the OBR's March forecast

Downside - output doesn't return to pre-Covid levels until Q3 2024 which means more business failures, higher unemployment, significant restructuring and real GDP 6% lower in Q1 2025 than the OBR forecast in March.

Even the 'upside scenario' results in relatively explosive debt profile in the longer-term.

 

IGM FX and Rates 

 

There are also risks to both receipts and expenditure.

On the receipt front, a smaller and probably restructured economy will offer a narrow tax base and different composition of tax receipts. Current more heavily taxed sectors and those with large consumption (change in behaviour) may not recover for many years if at all (tech companies may want to take note as they could be a revenue raising target). Loss relief rules are likely to hit corporation tax take and large-scale unemployment will impact income tax/NICs and VAT. Less travel impacts fuel duty and air passenger duty will take many years to recover. There will be less stamp duty in the immediate term, this may persist if the housing market fails to sustainably pick-up. Business rate income will fall with widespread company closures. Compliance may fall too. Local authorities will need to draw on reserves to the tune of Gbp 6bn although since the report was put together another central government support package has been agreed.

On the spending side, there is highly likely to be pressure to raise the share of GDP spent on public health services. Will the country tolerate another 'flu season' which results in a large number of deaths ... and there is concern that a second coronavirus wave will emerge in the winter. Some of the temporary economic support measure may become permanent and the government has increased its potential liabilities by fully backing some business loans (explicit guarantees) that will fail. Welfare spending will rise. This will be a function of how high unemployment becomes and how long it remains there. Unfortunately, significant redundancies are already crystallising the need for some of the measures to get people back into work announced last week. More will probably be required. The longer unemployment remains high, history suggests there will be an increase in chronic health conditions which will impact the health spending and local authority spending. If crime rises, more will have to spent on prevention.

Get Ready for More Gilts

There are obvious implications for the Gilt market. Over the next 5-years, the OBR estimates that Gilt issuance will need to rise a further Gbp 602bn (upside scenario), Gbp 910bn (central) and Gbp 1.2tn (downside). This on top of the Gbp 344bn forecast in March. Currently, the BoE is expected to soak up just about all of 2021's extra issuance.

 

IGM FX and Rates 

 

With all this in mind, the government's relationship with the BoE will remain critical. The Bank's current QE program is in relation to its inflation target, which the OBR chief noted is a long way from direct monetary financing and is therefore independent. This raises an obvious question as to what happens when the current program runs out or, if the government ramps up Gilt issuance later this year. So far, the market has accepted the need for the financing in a rational manner. The BoE had to step in earlier this year to prevent a disorderly market, resulting in a failed Gilt auction.

The implication of all this is that the 'scenarios' will be used by the Treasury for future reference. There is a spending review later this year, where 'difficult decisions' will be made. The PM has already said that there will be no return to austerity. Those areas hit worst by the last bout of austerity have also been promised 'levelling-up'. It sets the scene for much discussion about tax rises (included a wealth tax - that the government has ruled out so far). Of course, raise taxes too much and there is a risk that consumption is choked-off. And all this assumes that come 2021, the UK is in a conventional free-trade agreement with the EU. If on WTO terms, the OBR notes, downside risks will be posed to already challenged growth prospects.

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