Evercore Pan Asset

One of the neglected figures from the UK government’s last Budget book is the figure for total borrowing between 2010 and 2015. The government plans to borrow an extra £485 billion. That is more than the total UK state debt in 2004. People have not concentrated on this figure because there has been so much talk of spending cuts. Some have even thought that cutting the deficit means repaying the debt. That’s why telling them the UK is going through another substantial credit dependent period comes as a surprise.

The government has to undertake a difficult turn round of the public finances. That much is agreed between the main political parties in the country. The argument is not over whether to bring the deficit down, but how to do it and how quickly to proceed. We can safely leave that argument to Parliament, and the media, who are fascinated by it. Investors need to ask themselves how well is the deficit reduction strategy going, and what will the markets think of it?

The assumptions behind the strategy include the rapid acceleration of the UK’s current rate of growth. The five year forecasts assume a near doubling of the rate to 2.9% in both 2013 and 2014, with high growth continuing in 2015 at 2.8%. If by any chance this did not come true – owing perhaps to disappointment in global growth, or continuing struggles to sort out the banks – revenue will fall short of the target and the deficit will be proportionately higher. The government might still hit its target of eliminating the structural deficit, but overall borrowing could be higher as the cyclical deficit would be permitted to be higher under the rules.

The strategy also assumes that the squeeze of public spending tightens a bit in 2012-13 and subsequent years. In the first year of the programme current spending rose by a little over 5%. This year is in the budget for a 3.8% increase, falling to 2% the following year and staying below 2% up to the election. As this year has seen a £5.6 billion increase put in the March budget compared to the June 2010 budget, we do need to ask how realistic are these much tighter targets for the years closer to the election.

It seems likely that as the government gets closer to May 2015, its preferred election day, it will find good cause to spend more. If this coincides with any further downgrades of the Office of Budget Responsibility’s growth forecasts, lowering the tax estimates, then the deficit will come in higher than presently planned.

The markets will be watching progress carefully. This is a feasible plan which all would like to work. It is however a set of stretching targets on revenue, with substantial borrowing built into the targets. Were there to be much slippage from the forecasts the price of government borrowing could start rising. Then it gets more painful, as the deficit goes up simply to meet the extra interest burden. Bond prices do not allow much for slippage.

As published in Investment Week