Jim Power: The UK's fiscal woes could get worse

Here in Ireland, we can afford to look across the Irish sea with some amusement, but we shouldn’t get carried away.
Jim Power: The UK's fiscal woes could get worse

Prime Minister Liz Truss and Chancellor of the Exchequer Kwasi Kwarteng. 

The events of the past weeks are not quite as dramatic as when sterling was forced out of the European Exchange Rate Mechanism (ERM), but without the aggressive intervention of the Bank of England, the situation could have turned extremely nasty.

Following the introduction of a mini-budget with a tax-cutting package worth around £45bn (€51bn), including a very controversial measure to abolish the higher 45% tax rate, the financial markets reacted in an apoplectic and pretty dramatic manner.

The markets basically decided that chancellor Kwasi Kwarteng’s unfunded tax cuts would lead to higher interest rates and that a deterioration in the public finances would undermine the UK’s long-term growth prospects.

Massive borrowing

The Institute for Fiscal Studies warned that borrowing will top £190bn (€216bn), which would represent the third highest peak since the second world war.

Following Kwarteng’s budget offering, sterling fell to its lowest ever level against the dollar and even lost significant ground against the euro, which is a currency that doesn’t exactly have a lot going for it at the moment. And government borrowing costs, or gilt yields, shot up across the yield curve.

The Bank of England was forced to intervene to push long-term gilt yields down to the extent of around €65bn. This intervention was necessitated by the fact that the market losses were threatening the solvency of pension funds which were about to be subjected to massive margin calls that could have triggered a financial crisis of monumental proportions.

The relationship between 30-year gilt yields and the solvency of pension funds is extremely complicated, but suffice to say that the central bank recognised the deep peril arising from the market turmoil

Following the budget there has been a surge in interest rate expectations and the base interest rate is tipped in some quarters to rise to 5% or higher, compared to 2.25% at the moment. This would translate into mortgage rates of at least 6%.

While a high proportion of mortgages are fixed, some have predicted there will be a lot of those fixed rate mortgages maturing over the coming months. This is not likely to bode well for the housing market or the overall economy.

Turmoil

The UK economy and its political system are in a state of turmoil at the moment. Already the heads of the prime minister and the chancellor of the exchequer are being sought and Rishi Sunak’s policy pledges, which did not please the Tory grandees, look positively appealing to sensible people.

The notion of having such a massive unfunded fiscal expansion package, at a time when the Bank of England is increasing interest rates in an effort to bring inflation under control, is bizarre beyond belief.

The UK economy is the only G7 economy that is still smaller than it was before the pandemic tells us all we need to know.

Also, the decision to push ahead with Brexit is having a fundamentally destructive impact on the UK economy. 

Irish concern

In Ireland, we can afford to look across the Irish sea with some amusement, but we shouldn’t get carried away. The UK accounted for almost 11% of Irish merchandise exports in the first seven months of this year and nearly 38% of food and live animal exports.

Sterling weakness will damage the competitiveness of those exports and will just compound the difficulties caused by Brexit. For UK tourists, the weak pound will make Ireland less attractive, but at least the same will apply to our competitor countries in the eurozone.

The UK economic performance and financial markets, including sterling, are likely to remain extremely volatile, uncertain and weak for the foreseeable future. For Irish companies with business interests in the UK, this will just provide an additional challenge in an already challenging and very uncertain overall business environment.

It is worth mentioning that the Irish government announced a massive fiscal stimulus, but unlike the UK, is was funded from buoyant tax revenues and a budget surplus.

Jim Power is a leading Irish economic analyst

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