BondSquawk

The scale of the UK’s fiscal challenge is formidable and warrants a faster pace of medium term deficit reduction than set out in the April 2010 Budget. The rise in public debt ratios since 2008 is faster than for any other ‘AAA’-rated sovereign and the primary balance adjustment required to stabilise debt is amongst the highest of advanced countries. The primary deficit is nearly twice as large as that seen in previous episodes of fiscal deterioration in the UK in the 1970s and early 1990s.

Existing medium-term consolidation plans – set out most recently in the preelection

2010 budget but essentially unchanged since the March 2009 budget, despite a substantial decline in deflation risks since then – are un-ambitious. In particular, they only achieve public debt stabilisation at the end of the mediumterm horizon, are based on arguably optimistic growth assumptions, while planned spending cuts are not articulated in detail, undermining their credibility.

The new Conservative-Liberal coalition government has acted very quickly to establish fiscal consolidation as its top priority and has announced immediate additional tightening measures of 0.4% of GDP in the form of spending cuts and an emergency budget scheduled for 22 June 2010.

Given downward revisions to last year’s deficit outturn and the spending cuts now being implemented, it is highly likely that the deficit target for the financial year to April 2011 (FY11) will be lowered from the 11.1% Budget 2010 figure. Indeed, this must now be done to adhere to the recently passed Fiscal Responsibility Act, which mandates that borrowing must fall every year to 2014.

However, while likely, it is not completely obvious from policy statements that the new government will adopt lower deficit forecasts throughout the medium term. A clear agenda exists for tax cuts in a number of areas and it is possible that the new Office for Budget Responsibility will deliver a more pessimistic assessment of the economic outlook which offsets stronger discretionary tightening.

While a similar deficit path based on more realistic assumptions might be viewed as more credible, it would still run the risk of leaving the UK as something of a standout relative to the deficit targets of other advanced‐country sovereigns, the US notwithstanding. With other European sovereigns strengthening their consolidation plans and market concerns about sovereign risk in advanced countries increasing, both the size of the deficit currently projected for 2011 and the failure to reduce the deficit to 3% of GDP within five years are striking;

A more ambitious deficit-reduction path – with borrowing 1% lower than in Budget 2010 throughout the medium term – would result in an earlier peak in the debt/GDP ratio and a clearly declining debt path within the medium-term horizon, helping to go some way to restoring “fiscal space”, or a cushion against future shocks. Achieving such a path purely on the basis of further spending cuts would imply unprecedented real declines in primary spending.