YESTERDAY, chancellor George Osborne produced the most fiscally austere and severe budget in post-war UK history. Britain is embarking on its sharpest budget deficit reduction crusade since the 1940s with the aim of cutting the structural deficit by 8 per cent of GDP over the next five years. The fiscal shortfall will be cut from 11.1 per cent of GDP in 2009-10 to 4 per cent in 2014-15.

Market reaction has been positive so far with sterling rising and UK bond markets welcoming the budget with confidence – yields on long-term UK government debt moved lower following Osborne’s speech.

The rise in VAT to 20 per cent and consecutive decreases in corporation tax are the main features of the Budget that should help UK markets.

Although the hike will put further pressure on inflation measures and expectations, the revenue generated will allow the coalition government to avoid deeply unpopular cuts to healthcare budgets. The progressive reduction of corporation tax should act as an incentive to invest in the UK and thus increase capital inflows over the next five years.

But the lower GDP growth projections for the next two years were perceived by market participants to be a threat to the recovery and UK asset classes. Previous estimates in the March budget and from the Office for Budget Responsibility (OBR) have been revised lower; down to 1.2 per cent in 2010 and 2.3 per cent in 2011. The severe cuts to public spending are likely to weigh on UK output and create the possibility of further budget cuts and more tax rises at a later date should growth fail to meet current projections.

It is important to note that fiscal austerity is directly correlated to growth. If GDP estimates are revised lower and/or actual GDP growth rates undershoot projections, then the size of the fiscal adjustment will increase in real terms.

The key indicators for continued recovery and what investors will be scrutinising over the medium- to long-term is whether government borrowing, GDP growth rates and, in turn, budget deficit figures meet the sanguine expectations set out by the chancellor yesterday.

We’re not out of the woods yet but at least the international capital markets have received this emergency Budget with relative confidence which should induce a gradual inflow back into UK assets over the course of 2010. Britain remains heavily indebted while the path to fiscal balance is drawn out and faces several risks given the fragility of the broader global economic recovery.

But overall, it was a strong Budget that has removed a lot of uncertainty and appeased the bond markets for the time being. But the prospect of the UK managing to return to a sound fiscal footing within the next five years is still far from certain.