Autumn Statement: Brexit forces extra government borrowing
Philip Hammond delivered his first public finances update since replacing George Osborne as chancellor, and provided the first update since the UK’s vote to leave the European Union. As had been widely expected, the Autumn Statement was dominated by the economic impact from the Brexit shock, but also the implications for the exchequer. In an attempt to “reset fiscal policy”, it appears that the government has decided to allow borrowing to rise, while only providing a small amount of relief.
Growth outlook downgraded as inflation is set to rise
The independent Office for Budgetary Responsibility (OBR) downgraded its growth forecast for 2017 from 2.2% to 1.4%, which is in line with our recently updated forecast, but close to the top of the range of consensus estimates. The OBR then expects growth to rise to 1.7% in 2018 (previously 2.1%), which is higher than our 1.5% forecast. Interestingly, the OBR then assumes growth will return to 2.1% from 2019 onwards, which matches its previous forecast from March. It seems the OBR has decided not to judge the outcome of Brexit negotiations by lowering its longer-run forecast. However, it has published a much wider fan-chart of growth, stressing the high degree of uncertainty with regards to the eventual timing and reality of Brexit.
The OBR also revised up its inflation forecast to reflect the fall in sterling. CPI inflation is expected to rise from 0.7% year-on-year in 2016 to 2.3% in 2017 and 2.5% in 2018, before falling back to 2% by 2021. The profile looks a little optimistic to us. Most forecasters (including ourselves) now expect inflation to approach 3% next year. An inflation overshoot will have negative consequences for the exchequer, as not only will it reduce the real disposable income of households, but also many government spending commitments are inflation linked (like the pensions’ triple-lock which incidentally will only be reviewed in the next parliament).
Public debt to absorb Brexit hit to finances
Given the downgrades to growth, the OBR now expects the government to borrow an addition £122 billion over the next five fiscal years. Public sector net borrowing is still expected to fall over the coming years, but rather than achieving a surplus of 0.5% of GDP by 2020 as previously planned, the chancellor now expects to run a deficit of 0.7% by 2021/22. Debt is forecast to continue rising and then peak in 2017/18 at 90.2% of GDP, before coming down to 81.6% by the end of the forecast period.
Of the cumulative five-year £122 billion1 borrowing overshoot announced in the update, £58.6 billion is attributed to the impact of Brexit. This includes not only a cyclical slowdown and higher inflation but also lower productivity growth and lower migration. Putting Brexit to one side, the OBR expects the government to spend more and receive less in tax receipts than it had previously expected (excluding new commitments). This is worth £25.6 billion and can be thought of as a revision to the previous revenue and spending forecasts.
The final key figure is £25.9 billion, which is the cumulative cost of the policy announced in the Autumn Statement. It is made up of £7.1 billion of extra welfare spending, £6.3 billion of extra departmental spending, £14.2 billion of additional spending on infrastructure, and finally a net tax gain of £2.3 billion. It is worth noting that the £14.2 billion of extra infrastructure spending is worth just 0.7% of GDP over five years (or 0.13% per annum).
As for departmental spending, the OBR reports that it is still due to fall by 7% per capita over the forecast horizon, and with the usual ring-fenced departmental budgets (health, defence, overseas aid and pensions) this means much deeper cuts in other “low priority” departments.
Fiscal policy will still tighten in coming years
At first glance, the new chancellor appears to have changed the direction of fiscal policy. However, upon closer inspection, it is clear that very little has changed and fiscal policy will still be tightened in coming years. When comparing the latest fiscal impulse2 with the same measure from March, the government will tighten fiscal policy by 0.7% of GDP per year over the next three fiscal years. This is just 0.2 percentage points less than in March. The main change is for policy in 2019/20: where Osborne had planned a 1.5% of GDP tightening of policy, Hammond has reduced this to 0.9% of GDP. While Osborne’s back-loaded austerity always looked unrealistic, Hammond has just re-assured his party that fiscal tightening will not be stepped up aggressively in the run up to the 2020 election.
Light touch policy changes
In terms of policy changes, the chancellor spent most of his speech re-affirming past announcements, having warned everyone that his hat was missing a rabbit. The changes that were announced were largely disappointing. For example, the National Living Wage will rise from £7.20 to £7.50 from next April, but this is 10 pence less than expected. Also, rather than undoing some of the cuts to support for low income earners, he announced no further savings. Tax savings and salary sacrifice benefits will be scaled back, while the insurance premium tax will rise from 10% to 12% next year. There was a ban on upfront fees charged by letting agents in England, but this will probably just internalise the cost of such services in rents.
We never believed the previous chancellor’s threat of a post-Brexit punishment budget; however, we expected greater support for the economy from Hammond given the overtures of a “fiscal policy reset”. Yes, Hammond is abandoning previous fiscal rules, but only after failing to meet all of them, and only to replace them with a less credible promise to fix public finances in the next parliament.
The chancellor has acknowledged the negative economic impact from Brexit (even if many in his party remain in denial), but he has decided to continue to tighten fiscal policy, which may prove to be a hawkish mistake in years to come. Even if he does not believe the cyclical slump that the OBR is projecting, he has a very rare opportunity to provide badly needed investment in public infrastructure at close to zero interest rates, yet his cautious approach means the additional spending announced barely moves the dial.
In terms of our GDP forecast, there is little here that would persuade us to make upward revisions. It appears that the largest change to the government’s fiscal plan is politically motivated, rather than in reaction to the changing economic outlook.
1. Note, £11.9 billion is attributed to classification changes. Therefore, £110.2 billion is a fairer like-for-like comparison with the March projection.↩
2. Fiscal impulse measured as the change in the cyclically adjusted primary balance. It is a fairer measure of the impact of fiscal policy on the economy as it strips out the economic cycle and the cost of past debt.↩
- How the ageing population could be a boon for investors
- Why “corporate karma” is crucial for your investment returns
- Environmental initiatives boost Stockholm's Global Cities index rating
- The cost of trying to time the market since 2001
- Is it time for inflation-linked bonds?
- What the end of LIBOR means for investors