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Tackling the budget deficit will be a hard pill to swallow post-election

RESEARCH DIRECTOR, FOREX.COM
JANE FOLEY

ACCORDING to the minutes of the last Monetary Policy Committee (MPC) meeting at the start of April, the Bank of England concluded that for many committee members, concerns about the outlook for the UK economy had eased. The market appears to agree – the consensus expectation is that first quarter GDP, due out at 9.30am this morning, will show a respectable quarterly expansion of 0.4 per cent.

Over the past few weeks, UK data has showed continued expansion in purchasing managers surveys, industrial production, retail sales and exports. It appears that the UK economy is finally moving out of recession, which is just as well because things are going to get a lot tougher after the election.

Yesterday’s official public finances data showed the budget deficit for the 2009-10 fiscal year had come in a little less than projected but with the government in the red by a mammoth £163bn on its preferred measure of borrowing, this is clearly not something to celebrate.

Also out yesterday was the European Union’s 2009 deficit data. The UK’s budget deficit last year was 11.5 per cent of GDP; by comparison, Germany’s deficit was 3.3 per cent of GDP. But the impending election has meant that most politicians have held the issue of deficit reduction at arm’s length. The electorate has been led to believe by some politicians that there is a choice between growth and deficit reduction, while last year’s warnings from Standard & Poor’s about a ratings downgrade have been shrugged off. The reality is that the delays in tackling the budget deficit cannot be postponed for much longer and that Britons are unlikely to escape the impact. Budget reform is difficult to stomach and a shrinking of the public sector, wage freezes, spending cuts and tax increases (stealth or otherwise) may all be part of the medicine. Like it or not the country will have to swallow this pill, and swallow it soon, because the alternative is even more unpalatable.

HUGE BILL
The UK is not the only country that has rung up a huge bill as a result of last year’s recession. The US’s budget deficit to GDP ratio is also likely to be in double digits this year, as will that of Spain, Greece and Ireland. Japan’s may be around 8 per cent of GDP. Sovereign funding requirements are huge and this is likely to bid up the associated costs of raising capital for all but the best managed governments.

If the UK delays in reducing the budget deficit, the risk of a credit ratings downgrade will increase. If that happens, some investors will no longer be able to invest in UK gilts, which will force the costs of maintaining the debt up even further. As the costs of maintaining the debt build, more and more taxpayers’ money will be funnelled away from public services into debt maintenance. If the budget deficit is not dealt with soon, budget reform will only become more painful.

If the UK electorate needs a reminder of this, it needs to look no further than Greece. Due to concerns over a debt default or restructuring, Greek bond yields have risen so high that Greece can no longer afford to raise money on the open market and simultaneously hope to reduce its budget deficit to its targeted 3 per cent of GDP by the end of 2012.

Email Jane Foley with your comments at researchemea@forex.com Read daily market commentary and analysis from Jane Foley and the FOREX.com global research team at www.forex.com/uk

SOVEREIGN DEFAULT | AN ISSUE WHICH WON’T GO AWAY

“Risk of sovereign default” is a phrase that is likely to stay at the front of the market’s mind this year. Within the industrialised world, those governments which had already got to grips with budgetary reform and which had well structured banking sectors have managed to avoid the largest budgetary fall-out from the financial crisis.

The UK has had to foot the bill created by badly managed banks and Ireland has had to transfer debt created by a property bubble from the private to the public sector.

According to EU data, the 2009 budget deficits of these countries rose to 11.5 per cent and 14.3 per cent of GDP respectively. Greece, by contrast, is presently paying the price of having a very poorly managed budget.

It has been living well beyond its means for years and this is reflected in the size of its cumulative debt which, according to the EU, could top 120 per cent of GDP. The EU has estimated Greece’s budget deficit to be 13.6 per cent of GDP and there is a chance that this could be revised higher to 14 per cent.

Greek and Eurozone authorities have been playing down the risk of a Greek default for months, but the market no longer has blind faith in the coherence of the single currency union and in its leaders’ rhetoric. Member states’ bond yields are currently being determined on the basis of each country’s fundamentals and may never again be traded as proxies to German bunds.

Debt restructuring and default are still possible in Greece – as a consequence, 10-year Greek bonds are now yielding well over 8 per cent. With so many funding hurdles still facing Greece, the euro could fall further.