Evercore Pan Asset

Cutting deficits is popular in the heavily indebted western world. Some countries are being forced to, as lenders decline to lend them more money at realistic interest rates. Greece, Ireland and Portugal have been in the spotlight as they seek to borrow from the EU and IMF to avoid the penal rates on world markets. Some countries are taking voluntary action to curb their deficits before markets become alarmed by their levels of borrowing. The UK has embarked on a five year plan for deficit reduction, and US political dialogue is dominated by the arguments for and against early and deep cuts in spending to curb the state’s appetite for loans.
 
It is generally agreed that deficits need to be cut and the level of debt brought under control if a country is to have a sustainable and prosperous future. The Credit Crunch exposed the dangers of too much lending to people and companies, and brought down banks which had geared themselves too heavily. Now it is the turn of the sovereign borrowers to be under the spotlight.
 
In the UK, whilst all the main political parties agree that the deficit has to be brought down, the commonly voiced fears are that the programme is too rapid and severe. This is a curious bias to the debate if you look at the figures. Current public spending is planned to rise by £73.9 billion a year, comparing 2014-15 with 2009-10. Whether this is an overall rise in real terms after allowing for inflation of course depends on how successful the government is at curbing public sector costs, and how successful the Bank of England is at getting general inflation back to target or below. Individual programmes and entitlements will be cut within the growing totals. The government’s priorities for increased spending include overseas aid, contributions to the EU, health and schools.
 
State borrowing over the five years of the deficit reduction programme will add £485 billion extra to total debt, or more than the total state debt in 2000.  The March 2011 budget revised both the extra borrowing levels and the level of public spending up compared to the first budget of the Coalition government in 2010. The Chancellor added £34billion of extra spending over the period up to 2014-15, and agreed to an extra £37 billion of borrowing over the same time period. In the first year of the programme current public spending increased by 5.1% in cash terms.
 
The central feature of UK deficit reduction is the £184 billion extra revenue they plan to collect in 2014-15 compared to tax receipts in 2009-10. This all depends on the economic forecasts, which point to faster growth from 2012 onwards. Over the six year period 2009-2015 the Office of Budget Responsibility forecast 15.5% growth in June 2010. They cut this to 14.94% in March 2011. They reduced the forecast growth rate by 0.6% for 2011, and cut 0.3% off 2012. They added 0.2% to 2014 and 0.1% to 2015. The growth pattern assumes the economy speeds up to 2.5% in 2012, and then to 2.9% in each of the following two years.
 
One of the risks of the strategy is that the economy will not grow this quickly. If the world economy slows down in 2012, as many now fear, the UK may not manage such a fast rate of growth. Revenue is very sensitive to growth rates, and could in those circumstances disappoint. That in turn means more borrowing, which in turn increases public spending on interest charges. The UK cannot afford many more budgets where growth is revised down, revenues are revised down, and spending revised up. The revenue forecasts already show a down year for both Stamp Duty and Capital Gains Tax as the higher rates have an impact on transactions. In 2012-13 the forecast revenues from Income Tax, CGT, Land Tax, NI and onshore Corporation Tax fell by £7 billion as a result of the downgrade of growth in the revised figures in the March 2011 budget. If growth does not come in on target over the next four years, we could see a bigger revenue loss knocking another hole in the deficit reduction plans.
 
In the struggling Euroland economies their problem of deficit reduction is made far worse by the lack of growth. Their inability to provide monetary stimulus and to devalue has placed them in a dangerous straightjacket. As they are forced to cut spending and raise taxes, this lack of flexibility makes it more likely they will stay mired in low or no growth. This makes them seek more borrowings, which in turn outs more pressure on public spending to pay the rising interest charges. The Euro crisis is by no means over.

As published in Investment Week