As the chancellor’s Spring Statement approaches much of the discussion has centred on the potential for Rachel Reeves to alter the fiscal rules, which act as the parameters for the UK government when it comes to borrowing and spending.
Fiscal rules to guide the UK government have been around since Gordon Brown introduced a set as chancellor in 1997, and have been amended 10 times since then, by various governments.
Many in the political world associate the current rules with the decision of the government to reduce welfare spending by £5bn a year by 2030, and to end the universality of the winter fuel payments.
The rules that will help define Reeves’ speech are that the budget for current or day-to-day spending must balance by the 2029-30 financial year, and that the total of government debt must fall as a percentage of GDP by the third year – 2029-30 being the crucial year is why the welfare cuts are targeted within that timeline.
But the rules that will frame the chancellor’s statement have actually changed since she came to office.
In her first Budget in October, Reeves tweaked the first of those rules, so that it applied only to current budget expenditure; under the previous government it applied to all spending, including capital spending.
Current spending is the money spent on the day-to-day functions, while capital spending is for infrastructure, or other large scale, less frequent projects.
Gabriella Dickens, G7 economist at Axa Investment Managers, says: “I think it is unlikely the chancellor will break the rules. The issue is the rules have been changed so many times, each time you change them, they become less credible.
“I think if they are changed now, there would be a backlash in the gilt market. The market would want to punish the UK, especially when you consider where yields are already. The OBR will likely be revising down its growth forecast for this year and next.”
The growth forecast is relevant to the fiscal rules as, if the forecast level of growth does not happen, then the level of tax revenue will be lower than forecast, creating the need to raise revenue from elsewhere, or cut spending by more than planned.
The chancellor, in October, left headroom of about £9.9bn more than was expected to be needed in order to meet the fiscal rule around current spending.
Since October, UK gilt yields have risen, increasing the cost of the interest payments on the government’s existing debt, money which comes from the current budget, and the expected cut in GDP growth.
This is why the chancellor’s ‘headroom’ against the targets has vanished.
Dickens view is that it will not be the existence of the rules, but rather the potential for the gilt market to sell-off, that will constrain the chancellor.
Welfare spending is almost entirely from the current budget, while some defence spending, such as the building of new ships or military planes, would count as capital spending, so there is scope to increase defence spending, without violating the rules, based on the chancellor’s altering of the rules in her October budget.
But Phil Milburn, fixed income fund manager at Liontrust, says that regardless of the rules, “there isn’t the capacity for the UK to borrow in the way Germany has, the gilt market wouldn’t tolerate it.
“If there is a significant moving of the goalposts, then there will be a sell-off in the gilt market. Yields rose quite a bit in January, that wiped out a lot of the buffer the chancellor had, and the market will want to see the buffer rebuilt.”
Despite his scepticism around the health of the UK economy, Milburn is presently quite positive on the investment case for gilts, describing them as “cheap”.
If the chancellor decides to tweak the fiscal rules and run a current budget deficit, the way to fund this would be via issuing new gilts, increasing the supply of the asset at a time when demand for the asset class is less certain.
Marcus Jennings, fixed income strategist at Schroders, agrees that there would be a strongly negative bond market reaction if the rules are changed in the forthcoming Spring Statement, but adds that there is scope for the rules to change in future.
He says the challenge is that Germany’s decision to issue new bonds to fund extra spending, plus the continuing fiscal deficit in the US, “means gilts are competing with German bonds, and US bonds for investor interest. UK gilt yields are 20 basis points higher now than they were in October, which means the chancellor has less room for manoeuvre.
“Since October, gilts have outperformed relative to German bonds, but underperformed relative to US bonds. That’s because the UK is in an unenviable position – the word stagflation is often used – where inflation is proving stickier than in other countries, but the growth outlook is lacklustre.”
Jennings notes that while altering the fiscal rules in the Spring Statement would be a mistake, longer-term there may be justification. He says the bond market will not view all borrowing to increase spending in the same way, and that if the borrowing is for capital expenditure, rather than to fund day-to-day spending, the market may be more content, and yields may not spike.
The concept of separating borrowing for capital expenditure from borrowing for current expenditure is something already embedded in the rules, it is the change made by the chancellor in the last Budget.
Jennings says that while that separation has happened, another change in the Spring Statement would be viewed as too soon by the market, and that is why he feels a delay is needed.
Gerard Lyons, chief economic strategist at Netwealth, has served on government committees or advisory roles for both Labour and Conservative administrations.
His view is that while it would be much better to be changing the rules at a time when the economy is performing strongly, he believes the numbers-based approach to policymaking is harming the prospects for the UK economy, and instead believes the government’s focus should be on the sustainability of the debt level over the longer-term, that is, on whether the country can continue to find buyers for the debt.
He says increased spending for capital investment would lead to higher economic growth, and therefore generate the revenue to pay the higher debt costs.
Bryn Jones, head of fixed income at Rathbones, outlined the scale of the borrowing, with official figures showing the government borrowed £10.7bn in February, compared with the forecast of £6.5bn, while on a financial year to date basis the borrowing is £20bn more than forecast.
He says a challenge for the government going forward could be that defined benefit pension schemes, which have been big buyers of long-duration gilts in recent years, have now possibly reached their desired allocation, taking a buyer out of the market.
David Thorpe is senior investment editor of FT Adviser