Brexit Reshapes UK Budget Rules as Borrowing Poised for First Significant Increase Since 2010, According to Reuters

By David Milliken

LONDON (Reuters) – The UK is projected to borrow nearly £65 billion (approximately $85 billion) more than previously anticipated over the next couple of years, as new Finance Minister Philip Hammond aims to "reset" the government’s budget policy in response to the economic impact of last month’s Brexit vote.

Economists and ratings agencies widely expect a significant rise in borrowing next year, marking the first increase since 2010, as Hammond temporarily shifts away from the austerity measures that characterized the tenure of his predecessor, George Osborne.

In his first two weeks in office, Hammond acknowledged that the uncertain post-Brexit economic climate necessitates a change in the Conservative government’s fiscal strategy, which has been in place since 2010. Economists are beginning to quantify the potential implications of this shift.

Speaking to reporters on Sunday, Hammond indicated that the extent of any fiscal stimulus would depend on the pace at which the economy slows before the Autumn Statement, the semi-annual budget update typically delivered in late November or early December.

"There is going to need to be a rethink," stated Paul Johnson, director of the Institute for Fiscal Studies, a non-partisan think tank that evaluates public finances.

Continuing with Osborne’s March budget plans risks borrowing exceeding targets by tens of billions of pounds, driven by declining tax revenues and increased spending on social welfare for low-income individuals and the unemployed, according to Johnson.

Several economists, using guidelines from the UK’s budget watchdog, estimate that total borrowing for the current tax year and the next could exceed forecasts by nearly £65 billion, even if the economy avoids a recession. Uncertainty surrounding the economy and government’s budget strategies has deterred predictions beyond this timeframe.

In the fiscal year 2015/16, total public borrowing stood at £75 billion, representing a substantial 4% of GDP. The Office for Budget Responsibility had forecast a decrease to £55.5 billion this year and £38.8 billion in 2017/18.

In contrast, economist Sam Hill from the Royal Bank of Canada predicts that weakened growth alone will prevent a decline in borrowing this year, expecting it to rise to £85 billion next year—double the March prediction.

"The numbers could be even larger than that, and I believe there is a strong chance they will be," Hill remarked.

Hammond has indicated that the Bank of England may lead with stimulus measures if necessary, potentially as early as its upcoming meeting, although the finance ministry may also face heightened pressure to initiate action.

Unlike during the previous recession in 2008, both interest rates and government bond yields in the UK are already at historic lows, restricting the Bank of England’s ability to stimulate growth through interest rate cuts or quantitative easing.

Bank of England policymaker Martin Weale mentioned that even if rates were cut next week, substantial impact on the economy before the year’s end would be unlikely.

The current economic climate bears some similarity to Japan, where Prime Minister Shinzo Abe has ordered significant government spending to stimulate investment amid low interest rates.

Stimulus Choices

Should Hammond decide to introduce additional stimulus, he will have to carefully consider how to allocate the funds.

Research by the Office for Budget Responsibility indicates that long-term public investment yields the highest economic return per pound spent, providing three times the return of tax cuts and 50% more than general public expenditures. However, the downside is that investments require more time to implement compared to the immediate effects of tax cuts or public-sector pay rises.

Johnson and Hill argue that the rationale for public investment is stronger in this situation than during regular economic downturns, given the prolonged uncertainty about the UK’s EU relations potentially impacting economic performance for years, due to likely lengthy exit negotiations.

Public investment has been constrained, declining from £51 billion in 2009/10 to just £34 billion last year. The government highlighted £425 billion worth of projects requiring private investment in March, covering areas from offshore wind farms to high-speed rail links.

If immediate action is necessary, tax measures that incentivize business investment would be more effective than repeating the temporary VAT cut from 2009, as business expenditure is currently lagging behind consumer spending.

New Rule, Old Rule

Currently, there is no clear indication that Hammond or his ministry has a predetermined threshold for acceptable borrowing levels. Earlier this month, he expressed that the attractiveness of low borrowing costs for funding investment must be balanced against the signals sent to the financial markets.

He also affirmed that he seeks a clear plan to achieve "fiscal balance" within a reasonable timeframe. Hammond might consider reverting to the rule established by Osborne in 2010, which earned him a reputation for fiscal conservatism, even though it allowed for some flexibility during the recovery struggles of 2011 and 2012.

This rule required the government to aim for a budget surplus within five years, excluding investment spending, a loophole Osborne rarely utilized. This framework could potentially provide Hammond with over £40 billion annually for discretionary spending—equivalent to a 2% annual stimulus—while still maintaining a conservative fiscal image akin to his predecessor.

"Such a strategy could appeal politically," noted Hill, indicating that financial markets are unlikely to resist funding a sizeable budget deficit, especially when UK gilt yields remain higher than those for Japanese and German securities.

However, higher borrowing is expected to be a temporary remedy until the longer-term ramifications of leaving the EU become clearer, as Johnson from the IFS pointed out.

"If you increase borrowing now, it will ultimately need to be repaid, extending austerity measures albeit with a break in between," he cautioned.