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Investors have warned that loosening the UK’s borrowing limits to fund more spending on defence would risk a bond market backlash and a self-defeating rise in borrowing costs, as the government struggles to fill a looming black hole in its armed forces budget.
Officials are examining ways to fund billions of pounds more spending as part of a repeatedly delayed defence investment plan. Sir Keir Starmer, the prime minister, has said the UK needs to “go faster” on raising defence spending to meet its security challenges.
Among the options officials have discussed is a proposal to allow additional borrowing for defence outside the UK’s self-imposed borrowing limits. Chancellor Rachel Reeves has, however, repeatedly insisted she will stick to her “ironclad” rules.
The gilt market would be likely to balk at any such loosening, investors have warned.
The idea “sounds like a ruse to borrow more”, said John Stopford, head of multi-asset income at asset manager Ninety One. “I’m not sure the bond market would like it.”
Fredrik Repton, senior portfolio manager at US fund manager Neuberger Berman, said the market would be “sceptical [about] a carve-out”.
“Even if a carve-out is structured to be time-limited, observers may equate it to fiscal slippage, as it will be painful to reverse the measure later on,” he added.
The UK’s 10-year borrowing costs, at just less than 4.4 per cent, are the highest in the G7. This is in part due to anxiety over the demand for near-record levels of sovereign debt issuance, which is set to exceed £300bn in the fiscal year to the end of March.
Reeves has been striving to keep interest rates under control by pledging to maintain fiscal stability, after doubling the “headroom” — the amount by which tax revenues exceed government spending — in her key fiscal rule last November.
Nevertheless, Whitehall is being forced to explore potential options to overcome a defence funding black hole of up to £28bn over the next decade. Britain and its Nato allies have promised to increase defence spending to 3.5 per cent of GDP by 2035 but the UK’s tight fiscal position means it has yet to lay out a pathway to achieving that goal.
The trade union Unite is among the voices calling for Reeves to relax the fiscal rules to boost investment, including in the armed forces. Defence firms have also been pushing for higher spending.
One defence industry source called the UK’s approach to defence spending “flat-footed”, adding: “The chancellor should stop harming her own growth strategy and take inspiration from our European allies by amending her fiscal rules to enable more defence investment immediately so we can create more British jobs, innovation and [intellectual property], whilst also defending our continent.”
Last year, the EU temporarily loosened its fiscal rules to allow countries to spend more on defence in response to growing US pressure on the bloc to invest more in its own security.
A Treasury spokesperson said the fiscal rules were “non-negotiable” and would “get borrowing down and support investment while we back defence with the largest sustained increase in defence spending since the end of the cold war, including an extra £5bn this year alone”.
Reeves has repeatedly stood by her fiscal rules, set after Labour took power in 2024. They require her to balance the current budget, excluding investment, by the end of this parliament and to have public debt falling as a share of GDP by then.
Other options under consideration by officials include funding the extra spending through public-private partnerships that could require less borrowing and be more acceptable to the market. Alternatively, the UK could seek to do a deal with its European allies to create a multilateral lender to fund rearmament.
The discussions come at a time when investors are nervous about the outlook for the UK’s fiscal regime given the leadership turmoil that has surrounded Starmer in recent weeks, with analysts anticipating a shift to the left.
Mark Dowding, chief investment officer for fixed income at RBC BlueBay Asset Management, said in theory there could be a tweak to fiscal rules if the market could be assured that “spending plans are not on an unsustainable trajectory”.
But he added: “Trust in this Labour government is currently very low and fears for a lurch to the left, and more profligate spending to go with it, mean that this is currently a very difficult moment to engineer this.”