The UK's Spending Review - Dealing with a Deficit of £390bn

James Penn
December 1, 2020

Last week the severity of the UK’s economic situation was spelt out by the Chancellor of the Exchequer, Rishi Sunak, in his Spending Review.

The Spending Review is a periodic assessment outlining public expenditure priorities and the government’s plans to finance these. Usually, they are given over a five-year period. However, the present lack of visibility means this one was only for the next twelve months.

The outlook was not pretty, although the delivery by the suave Sunak was as polished as one would expect.

Quentin Letts in The Times described the experience as follows: ‘Sunak speeches are warm, relaxed, a bubble bath with Schubert on the wireless. There is something aromatherapeutic about the voice with its honeyed inflections. He started his statement at 12.45pm but soon one was feeling drowsy. Which was perhaps as he intended when it came to the two trickier moments: the pay freeze for civil servants, and the overseas aid haircut.’

Some of the figures alluded to were astounding, even mind-boggling, though we already had a vague idea of the scale. The budget deficit this year will be £390bn, or 19% of GDP, about double the deficit in 2008 after the financial crisis.

The UK economy will fall by -11% in 2020/21. The debt to GDP ratio is expected to be 104% - in other words the amount of debt will be bigger than the size of the economy. Under the optimistic scenario this could be 94%, but under the pessimistic scenario – with lockdowns persisting and no swift rollout of the vaccines – this could be as high as 124%.

The budget deficit is still likely to be £100bn per annum in 2024/5, or double the deficit in the previous 2019/20 fiscal year. To reduce this to £50bn per annum (the amount that debt can rise on an annual basis without the debt to GDP ratio increasing), tax rises or spending cuts of £48bn a year will be needed.

Nothing was said about tax rises or spending cuts at this stage, and thankfully they aren’t immediately necessary.

But there was some bad news in the public sector pay freeze, and the cutting of foreign aid from 0.7% of GDP per annum to 0.5%. Also, some £10bn also seems to have been lopped from departmental spending plans.

Despite positive news on defence and infrastructure spending, overall it looks like the first signs of another period of austerity appearing.

Tucked away in the small print was a change to the Retail Price Index (RPI), the old method for calculating inflation, that will be of interest to investors.

The plan is to change the main inflation index to CPIH, or the Consumer Price Index adjusted for Housing, that includes owner occupiers' housing costs.

The RPI measure has tended to be 0.8% per annum higher than the CPIH measure over time, mainly because the former is an arithmetic rather than a geometric calculation. RPI is used for calculating student loan interest, pensions, benefits and the interest on index linked Gilts, so the change will affect many people.

In future, owners of index linked Gilts will get increased interest and redemption values calculated on the lower CPIH measure. However, the Chancellor will only introduce the change from 2030, or ten years from now. There had been fears that the change could be introduced as early as 2025, so there was a degree of relief.

What is changing is the methodology. There will still be something called RPI, but from 2030 it will use the methodology of CPIH, and from that date both measures will in effect be the same, rather than RPI being higher each year.

It seems that for index linked Gilts maturing up to that date there was something in the small print restricting any change to the methodology of calculation. Nevertheless, the change means there may be Court litigation on the part of linker owners ahead.

The DMO, or Debt Management Office, has said it will continue selling RPI linked debt in future, so as to avoid a splintered market where some of the index linked debt is tagged to RPI, and some to CPIH.

Index linked debt was first sold in the early 1980s after the inflation splurge of the 1970s, and now comprises about a quarter of total UK government debt.

Doubts about the future calculation of RPI have seen sales of linkers drop to just 6.8% of total debt sales this year, compared with an average of 22% over the previous 20 years.

Whether the new-found clarity, and slightly lower long term returns in prospect, result in continued diminution of appetite for linkers remains to be seen.

But one would have thought that they will continue to prove a useful hedge against unexpected inflation for many people – even after 2030.

Disclaimer: The views, thoughts and opinions expressed within this article are those of the author, and not those of any company within the Capital International Group (CIG) and as such are neither given nor endorsed by CIG. Information in this article does not constitute investment advice or an offer or an invitation by or on behalf of any company within the Capital International Group of companies to buy or sell any product or security.

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