Since UK chancellor Kwasi Kwarteng unveiled his “mini” Budget involving £45bn of debt-financed tax cuts last Friday, sterling has fallen to its lowest level ever against the US dollar, the cost of government borrowing has surged and households are braced for big rises in mortgage payments.
People inside and outside the UK could be forgiven for wondering whether the UK is in the middle of an economic crisis.
The similarity with emerging economy travails — especially the combination of surging gilt yields and a currency plunge — has not been lost on respected commentators.
Larry Summers, former US Treasury secretary, slammed Kwarteng’s fiscal statement as making the UK appear “a bit like an emerging market turning itself into a submerging market”.
Olivier Blanchard, former chief economist at the IMF, said the statement had been a “textbook example of how not to design and not to sell a fiscal expansion”.
The idea the UK suddenly looks like an emerging economy in crisis was prevalent in financial market commentary too.
Analysts at ING bank said “volatility levels for the pound are those you would expect during an emerging market currency crisis”.
Highlighting the phenomenon that international investors can suddenly stop wanting to fund a developing country’s budget and trade deficits without a large premium via high interest rates, Krishna Guha, vice-chair of Evercore ISI said this was a good description of the UK since Kwarteng had “squandered” the credibility of running prudent public finances.
“Currency lower, yields higher reeks of an emerging market-style sudden stop with foreign investors demanding deep price concessions to continue funding the UK’s twin deficits and applying risk premia for policy uncertainty and loss of credibility,” added Guha.
Following Kwarteng’s fiscal statement, the Institute for Fiscal Studies, a think-tank, estimated UK public borrowing would top £190bn this year, the third-highest level since the second world war — with debt rising as a share of gross domestic product into the medium term.
The UK government’s borrowing costs have increased from levels close to Spain and Portugal at the beginning of August towards the higher rates of Italy and Greece now.
Many economists and financial market commentators thought Kwarteng had taken very large risks and put the Bank of England under severe pressure to restore some calm.
On Monday the central bank said it would “not hesitate to change interest rates” to keep inflation under control. Kwarteng also promised a new strategy to put debt on a downward path in the medium term.
On Tuesday Huw Pill, BoE chief economist, said the government’s tax cuts would require a “significant monetary response” in the form of higher interest rates.
Sterling was trading flat on Tuesday afternoon in London at just under $1.07, after giving up earlier gains. The gilt sell-off intensified, with 10-year yields rising by 0.26 percentage points to 4.5 per cent, the highest level since 2008.
Economists attempting to stand back from the turmoil of recent days concluded the UK’s economy had been damaged by Kwarteng’s fiscal statement, but rejected the view that Britain was experiencing something akin to an emerging market crisis.
Jagjit Chadha, director of the National Institute of Economic and Social Research, a think-tank, said the higher interest rates now needed “will imply a deeper and longer downturn than was necessary” before the chancellor stood at the House of Commons despatch box last Friday.
He added he was worried the gains from BoE independence — which could be seen in lower long-term interest rates since 1997 — had been squandered. “I am concerned that we may have just witnessed the reverse,” added Chadha.
But the prospect of higher government borrowing costs would be significantly less serious than a sudden stop in foreign funding for the UK’s budget and trade deficits.
Many economists raised their forecasts for interest rates, but suggested that financial markets expecting the BoE to push them over 6 per cent had gone too far.
Analysts at Capital Economics and Goldman Sachs estimated the BoE would have to increase the bank rate to 5 per cent to control inflation, while those at Nomura predicted 4.5 per cent. Economists at Pantheon Macroeconomics thought the precarious nature of the UK mortgage market meant BoE rate-setters could probably stop at 4 per cent.
Financial market repricing of future interest rates has left lenders pulling mortgage products at speed this week. Millions of households face big rises in their fixed-rate home loan payments in the coming years.
But economists said the risk of severe financial pain for many does not equate to a full-blown economic crisis.
Allan Monks, economist at JPMorgan, noted the “measured” response from the BoE and Treasury which he thought would help calm the market situation, along with possible government efforts to put a tighter lid on spending to shore up the public finances.
“This would probably carry a large political cost,” he said, but was likely to be seen as better than a U-turn on the fiscal statement’s contents.
Andrew Goodwin, economist at Oxford Economics, said he thought “the scale of the [market] reaction is out of kilter with the UK’s structural position”, although he added that Kwarteng would have to work hard to regain credibility with financial markets.
If that means future spending cuts, the problem would not be an economic crisis but a political one over deteriorating public services.
“We’re sceptical that large spending cuts would be feasible in the current political situation,” said Goodwin.