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The big question facing Rishi Sunak as he delivers his second Budget

Russell Lynch
·5 min read
Rishi Sunak - Stefan Rousseau /PA
Rishi Sunak - Stefan Rousseau /PA

Rishi Sunak’s face was a "complete picture of shock" when Boris Johnson offered him the job of Chancellor in February last year, according to the Treasury's glitzy video trailer for Wednesday's Budget.

So just imagine his expression had he known that, in a matter of weeks, he would be on the way to racking up the UK's biggest peacetime deficit.

The numbers from the Office for Budget Responsibility watchdog are likely to confirm borrowing of around £360 billion and a debt pile heading towards £2.3 trillion, more than 100 per cent of GDP and the highest since the 1960s. The Chancellor is a polite and articulate man, but even he might have reached for something a little more Anglo-Saxon than "oh gosh".

The enigma is that even as the UK's debt burden swells, the cost of servicing it has tumbled to an all-time low. As of January, the UK's net debt stood at £2.1 trillion, but in the same month the Government paid just £1.8 billion in interest, less than half the amount paid 12 months earlier.

The bill is also at a record low as a share of the Treasury's revenues, at just 2.2 per cent.

The key question for Mr Sunak as he steps up to deliver his second Budget is how long that state of affairs can last.

Squalls in global debt markets pushing up the cost of borrowing have raised concerns that the low rates needed to service Covid debt mountains may not last forever. The Chancellor himself has warned of an extra £25 billion interest bill by the end of this Parliament from a one percentage point rise in Government debt costs.

Politically, it suits Mr Sunak to begin making small down-payments on Covid borrowings through targeted measures such as corporation tax, even though he will almost certainly be spending tens of billions more than he gathers in this year: the extension of furlough until September, for example, and other support measures such as business rates relief, will see to that.

The move chimes with the focus grouping of the public mood about "paying the bills" for the pandemic.

Economically, however, it makes less sense. With the signalling of raising taxes, the Chancellor is pandering to the so-called "household fallacy" – governments do not have to behave like belt-tightening households, and it can be counter-productive if they do.

In any case, even before the virus struck there were big structural forces pushing down long-term interest rates around the world, making a sudden debt interest rate shock less likely. Swollen debt piles may alarm some fiscal hawks, but the factors at play include an ageing global population wanting to hold more savings, as well as weakening productivity trends as firms seek out less capital for investment.

Those trends have been exacerbated by the virus as innumerable governments crank up their deficits to pay for pandemic support.

The supply of new debt has been more than matched by investors hunting for safe assets during the turmoil of the past 12 months, as well as central banks buying up the bonds through quantitative easing (QE) to bring down interest rates and pour on economic stimulus.

That pressure has driven down debt costs further, but economists and credit ratings agencies also suggest that the Chancellor has little reason to fear a sudden debt spike.

The UK has had its share of banking crises over the decades, but it is one of a select group of countries to have never defaulted on its debt. In the Bank of England, it also has a credible, independent central bank. The strength of those institutions, as well as the position of sterling as one of the world's major reserve currencies, make it a safer bet in the eyes of global investors.

The debt market ructions triggered by inflationary concerns over President Biden's outsized $1.9 trillion (£1.4 trillion) stimulus plans should also be put into context. Even after a sell-off, the UK's own benchmark cost of borrowing for 10 years remains extremely low by historical standards; at just under 0.7 per cent, it is roughly where it stood in January 2020.

Sir Robert Chote, the former head of the OBR until October, told an Institute for Government event last week that "given the funding conditions at the moment, there doesn't seem to be a pressing requirement" to start chopping at the deficit. The former International Monetary Fund chief economist Olivier Blanchard has stressed that as long a nation's economic growth is faster than the rate of interest on its borrowing, debts will stabilise or fall over time anyway.

That said, the Bank of England's chief economist, Andy Haldane, fretted over "letting the inflation cat out of the bag", while the OBR has also flagged that the Bank's £875 billion holdings in QE bonds, funded by short-term bank reserves, make debt servicing costs more vulnerable when interest rate rises do eventually come.

But the Institute for Economic Affairs' Julian Jessop points out that by the time the Bank feels ready to raise rates it will be due to recovering inflation and growth. "On balance the combination of that is still going to leave the public finances in a better state than if we remain in a position where the economy is in recession and inflation is too low," he said.

This all bodes well for Mr Sunak despite his determination to "level with" the public about taking on the pandemic bills.

Politically, it suits him to draw dividing lines with Labour and slap down cash-hungry spending departments by sounding tough on "sustainable" finances. In reality, the UK's debt dynamics look stacked in his favour for some time to come.