Sunday, October 10, 2021
Sunak on tenterhooks over a rise in borrowing costs
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on This is an excerpt. Not to be reproduced without permission.

In the elegant Court Room of the Bank of England’s Threadneedle Street headquarters, there ls one of the most famous weathervanes in the world. Installed more than two centuries ago, its function was to tell the Bank which direction the wind was blowing, and thus when cargo ships were likely to arrive at the Port of London. This was information vital to controlling the supply of credit.

I am not aware of such a weathervane at the Treasury, though it sometimes employs a hawk to keep the pigeons at bay. Its electronic equivalent, however, monitors closely what is happening in the markets; the financial wind blowing from the east, the City and Canary Wharf.

For Rishi Sunak, who has racked up more debt for every month of his tenure than any of his predecessors – an average of nearly £24 billion a month since February last year - what happens to the east of SW1, in the financial markets, is crucially important.

The Bank, if it raises interest rates, will add to the cost of servicing that debt. It currently stands at £2.2 trillion (£2,200 billion) and is at its highest relative to gross domestic product – 97.6 per cent – since 1963, when it was still coming down after the war.

Even if the Bank does not act in the face of the inflationary shock the economy is facing, the gilt market may do so. Indeed, the reaction in the gilt market – the market for UK government bonds – could be greater if traders were to perceive that inflation was being allowed to get out of control.

There was a taste of this a few days ago, when gilt yields – the market interest on them – spiked higher in response to a surge in international gas prices. Yields, and thus the cost of borrowing, remain remarkably low, however. The yield on 10-year gilts, roughly 1.1 per cent, sometimes a little higher, is above the 0.1 per cent last year, but lower than typical levels of between 3.5 and 4 per cent in the early 2010s when David Cameron and George Osborne embarked on their austerity programme, fearful of what the markets might do it they did not.

In his speech to the Tory conference in Manchester, the chancellor took a rhetorical hard line against debt. “I believe in fiscal responsibility,” he said. “Just borrowing more money and stacking up bills for future generations to pay, is not just economically irresponsible. It’s immoral.” He sounded, rarely at the Manchester gathering, like a traditional Tory, and even praised his Tory predecessors.

His big fear is not just what he sees as the immorality of high debt. It is the cost of servicing that debt. Current very low interest rates, and the Bank’s extensive quantitative easing (QE), mean borrowing is cheap. By the end of the year significantly more than 40 per cent of the gilt market will be owned by the Bank, and that is as close as it can be to free borrowing for the government.

In 1963, when government debt was last this high relative to the size of the economy, the government’s debt interest bill was 3.2 per cent of GDP. Now it is 1.1 per cent. Were it now to rise to that 1963 level, it could add nearly £50 billion to the government’s debt interest bill.

Could that happen? Bank rate was 4 per cent in 1963, and it has not been above 1 per cent since early 2009, though these things can change.

The chancellor, in his budget on October 27, is likely to set out some revised fiscal rules. These were promised in the March budget, “provided economic uncertainty recedes further”. He may surprise us, but I would expect the new rules to be quite conventional. The government will be only borrowing to invest by the end of the parliament and that, by then, debt will be falling as a percentage of GDP, though it is likely to be above 100 per cent.

Fiscal rules are, recent history tells us, made to be broken, and all have been, so they alone will not do much for market confidence.
What will help is that the Treasury appears to be winning most of the battles over tax and spending. I did not like the national insurance (NI) hike announced last month but the fact that it was done in the run-up to a Tory conference, when it could have been left until the budget, showed a certain determination to grasp the nettle.

Had we got to this point in the year without any sense of how the government was intending to repair the public finances after the pandemic, the markets might have had reason to panic. But this has been a record year for tax hikes from a supposedly low tax political party. Corporation tax is going up a lot, from 19 to 25 per cent, and income tax is increasing by the stealthy route of freezing allowances and thresholds for four years from April.

When you see tax increases like this, you get an insight into Treasury thinking. My sense is that the official Treasury did not much like toe policy of continually raising allowances to “take people out of tax” and that money could have been better spent than by cutting corporation tax.

I shall return to the October 27 budget soon, but will a new set of fiscal rules and the announced tax hikes be sufficient to persuade markets that the government has a grip on the public finances? They may well be, though there are battles yet to fight, particularly over a levelling-up agenda that so far appears to be little more than an infrastructure programme. It sounds, however, that despite an absence of squeals emanating from Whitehall, that the spending round will be quite a tight one.

The Treasury, then, looks to be doing its best to reassure the markets. As was a common theme at the “don’t blame us” Tory conference, however, some of these things are outside its control. The only way is up for interest rates, even if the Bank is not itching to do so. In recent days Poland’s central bank has raised official rates for the first time since 2012, and rates have also been raised in New Zealand, which has not happened for seven years.

More than that, as we have seen in recent days, a surge in international gas prices, and in energy more generally, has the scope to spook the markets and push up the cost of borrowing. The future of them is in the hands of Vladimir Putin and international markets, not the UK government.

High inflation used to be of benefit to a government sitting on large debts, allowing them to be inflated away. But times have changed, and a high proportion of the debt stock is index-linked, and thus inflation pushes up borrowing costs. This is going to be a nervous autumn for the chancellor.