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Great Britain lies at the edge of the Gulf Stream. But it is not these warm waters that can make it seem like a banana republic. It is the state of UK public finances. Like many emerging markets in the past, the UK is in the throes of a combined banking crisis and deep recession. Alistair Darling, the chancellor, would like to boost government spending to meet those challenges. But he cannot open the taps – markets will not let him.
Last year, the budget deficit hit 6.3 per cent of gross domestic product. This year, borrowing is set to almost double to 12.4 per cent. That would be the highest level among Britain’s developed economy peers. It is also three times the percentage deficits of Argentina and Indonesia.
The British government’s biggest challenge is to avoid a funding crisis. So far, barring one failed gilt auction, that has not been a problem. Investor demand for “riskless” assets remains high. But there is a chance investors will run scared if they can see only red ink stretching into the future. Such fears are only compounded by worries that UK public finances may be structurally weak, given that the now smouldering financial services sector once accounted for an eighth of all tax revenues.
Trying to address such fears, Mr Darling has forecast the budget deficit will start to narrow from 2011, falling to 5.5 per cent in 2013. By then, net debt, including the costs of the bank bail-out, will also start to fall from a peak of 79 per cent of GDP. Yet, while welcome, such projections lack credibility. It is not the spending cuts or tax rises of Mr Darling’s budget that should be doubted. They can be executed with the stroke of a pen. It is his forecast that the UK economy, in spite of the worst recession in almost 80 years, will grow 1.25 per cent next year and 3.5 per cent the year after. This is crucial as higher growth translates into smaller budget deficits and lower debt. The International Monetary Fund disagrees. It expects the economy to shrink next year, not grow. So too, it seems, do investors. Wednesday’s rise in gilt yields may be a sign of steeper debt costs to come.
Wednesday’s rise in gilt yields may be a harbinger of more to come.
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