Friday, July 17, 2009

Still Heading For The Cliff Edge

This ain't no way to run a government

Yesterday the IMF published its annual Staff Report on the UK economy. It is an alarming read.

First, they are far gloomier than Darling about the depth and length of the slump. They say that GDP will contract by 4.2% this year, and will not recover its previous peak for more than four years. That's far worse than those Tory recessions Brown always used to go on about, and is the worst performance we've seen for 80 years:

Second, the IMF says that the disastrous state of our public finances makes us extremely vulnerable to an even worse outcome:

"The sharp increase in public sector borrowing and contingent government liabilities, together with continued financial sector fragility, are significant vulnerabilities. If there was a renewed and abrupt loss of confidence, possibly triggered from outside the UK, it could spark further financial sector instability, undermine faith in fiscal sustainability and unhinge inflation expectations, thus disrupting domestic and external stability...

...Should fiscal sustainability come into question, interest rates would rise despite monetary easing efforts, the ability of the government to provide support to the financial sector would be severely limited, and pressures on the currency could emerge."

That is what's known as a red flag. When the careful diplomatic wordsmiths at the IMF start talking about undermining faith in sustainability, and unhinging inflation expectations, it means we've run out of road. We don't have time to muck around hoping that isn't a cliff edge just ahead. We have to slam on the brakes now.

So just how bad is it?

Under current spending and tax plans, the IMF forecasts that public sector debt (gross) will reach 100% of GDP by 2014-15. And even in 2015-16, the government's so-called "primary deficit" (ie its deficit on day-to-day spending, excluding capital investment and interest payments) is still 1.4% of GDP.

That's almost certainly not good enough to retain the confidence of the markets, especially given the huge annual borrowing we will be doing:
"Gross financing needs in the near term are high—they are expected to reach 18 percent of GDP in 2010/11, driven by the high overall deficit, amortization, and an increased share of short term debt."
18% of our GDP is a lorra lorra of borrowing - about £250bn (or one-quarter of a trillion, or ten grand for every household). All in one year. And all to be followed by more or less the same again... year after year.

And the IMF also notes that their central debt ratio forecast of 100% of GDP could easily be too optimistic. Here are just three of things they reckon could happen:
  • Interest rates on government debt could move higher - they assume a rate of 1.2% pa (in real terms), which is low by historic standards - if rates moved back up to their longterm average, it would increase the debt ratio to 108% of GDP by 2014-15.
  • GDP growth could be even lower - 0.5% pa reduction would lift the debt ratio to 109%
  • Government bank guarantees could get called - the central forecast assumes no losses on the many guarantees the government has issued, but if we lost around a quarter of their value - entirely plausible - the debt ratio would rise to 113% (and that's on just £777bn of specific bank guarantees - not the implicit and very scary 100% guarantee given on all UK bank liabilities)

So to summarise, we are looking to borrow a shedload of cash, yet we are not proposing to bring our finances under control anytime soon. What's more, any more puffs of wind and we're likely to go over the edge.

Now, you're an international bond investor.

Do you like the sound of that?

Exactly.

So what does the IMF recommend?

Regular BOM readers will find its advice has a familiar ring:

"A strong commitment to reverse the sharp deterioration of public finances within a reasonable timeframe is crucial... implementing an ambitious fiscal consolidation plan will be essential. The focus should be on putting public debt on a firmly downward path faster than envisaged in the 2009 Budget...

... evidence from OECD countries shows that although changes in revenue and expenditure contribute to closing the fiscal gap, expenditure restraint brings about longer lasting and larger adjustment episodes, which are more successful in achieving a debt stabilizing fiscal position. Expenditure reduction demonstrates a firmer commitment to feasible and substantial consolidation, and may trigger lower interest rates and boost private demand... fiscal rules have been shown to contribute to successful adjustments..."

Ambitious fiscal consolidation plan - tick.

Focus on expenditure restraint - tick.

Fiscal rules - tick.

So at least we agree on what to do.

The trouble is, that cliff edge is looking awfully close, and this is no time to play chicken run with the markets.

We really do need you to get those brakes on, George.

Like, now!

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