Britain is facing the repercussions of its massive debt burden as its economy continues to languish. Since the onset of the pandemic, the country's public debt load has surged by over 40%, reaching almost £2.6 trillion ($3.3 trillion). This unprecedented level of debt amounts to more than the entire annual economic output of the country, a situation not seen since 1961. Additionally, the UK's heavy reliance on index-linked bonds during a period of high inflation means that it will have to allocate more funds to service its liabilities compared to any other advanced economy.
While the government's significant spending has helped cushion the impact of recent setbacks, such as the financial crisis and Russia's invasion of Ukraine, it also poses a threat to future investment and could lead the UK into a long-lasting negative spiral. The Office for Budget Responsibility recently warned that without appropriate measures, debt could balloon to over three times the gross domestic product over the next fifty years.
These circumstances have raised concerns about the UK's credit rating, particularly after Fitch surprised the financial markets by stripping the US government of its AAA status. A potential downgrade for the UK would undermine Prime Minister Rishi Sunak's efforts to rebuild the country's fiscal credibility after his predecessor, Liz Truss, triggered a bond-market crash a year ago by promising substantial unfunded tax cuts.
To compound matters, the Bank of England's aggressive interest rate hikes in an attempt to quell inflation have led to a sell-off in bonds. The yield on the 10-year benchmark recently reached its highest level since 2008, surpassing 4.70%. Consequently, the UK bond market has been one of the worst performers among developed economies this year.
Both Sunak and his main political rival, Keir Starmer, face limited options to address these challenges. Economic growth is projected to remain stagnant until next year, the National Health Service is under immense strain, and the tax burden is already at its highest point in 70 years.
Maxim Rybnikov, a lead UK sovereign analyst at S&P Global Ratings, warned that there is no simple solution to the current situation. The fiscal picture is weighing the country's credit rating down, making it increasingly precarious.
Over the next four months, the three major credit-rating agencies will update their assessments of the UK. Moody's and S&P Global Ratings are scheduled to announce their findings on October 20, with Fitch following suit on December 1.
The recent downgrade of the US serves as a reminder that concerns related to deficit spending and debt sustainability, which often lie dormant, can suddenly emerge and cause significant unease. Unlike the US, the UK does not possess an unblemished status to lose. A decade ago, Moody's and Fitch downgraded the country's top rating, with S&P doing the same in June 2016, shortly after Britons voted to leave the European Union. However, the UK still maintains an investment-grade rating with all three agencies.
Sunak has made reducing the country's debt burden one of his key pledges, despite persistent calls for tax cuts and increased spending to boost the sluggish economy. The upcoming autumn budget statement, expected in November, will provide Chancellor of the Exchequer Jeremy Hunt with an opportunity to address this issue.
In April, S&P revised the UK's outlook from negative to stable, representing a positive ratings action. However, Moody's and Fitch have maintained negative outlooks since Truss's "mini-budget" and highlighted the UK's inflation-linked debt predicament in a recent report.
Should the UK face another downgrade, the impact on its assets could be more severe compared to the consequences for the US dollar and US Treasuries, which are traditionally considered safe havens.
Sam Zief, the head of foreign exchange strategy at J.P. Morgan Private Bank, emphasized that the UK is more vulnerable to sudden debt-sustainability concerns since the pound does not hold the same status as the world's dominant reserve currency. He also highlighted that debt sustainability does not significantly affect the markets until it does.
The issuance of index-linked gilts began in the 1980s under Prime Minister Margaret Thatcher, as the country endeavored to recover from its reliance on an International Monetary Fund loan in 1976. Although officials at the time were aware of the risks associated with tying debt to inflation, these bonds accumulated over many years of low inflation.
Currently, index-linked gilts account for 25% of the UK's outstanding bonds, a share that is double the proportion held by Italy, the second-largest issuer among advanced economies.
The UK is faced with a debt-interest bill that amounts to 10.4% of its revenue this year, the highest share among developed nations, according to Fitch. Moreover, debt is projected to rise to 105% of GDP by 2025.
The severity of the situation will depend on whether inflation becomes entrenched. If expectations point towards a sharp decrease in inflation pressures next year, the debate surrounding index-linked gilts being an excessive burden on public finances may become less pronounced, according to Eiko Sievert, the director of sovereign and public sector at Scope Ratings.
A string of shocks over the past 15 years has led Britain to accumulate such a significant debt burden. Prior to the financial crisis in 2008, UK debt stood at a relatively modest 35% of GDP. Subsequently, the country faced bank bailouts, the pandemic, and most recently, Russia's invasion of Ukraine.
During the pandemic, the Conservative-led government expended £376 billion to support businesses and households, including a £70 billion furlough job-protection program and another £70 billion on energy bill subsidies as natural gas prices soared due to the conflict with Russia.
Although inflation has slowed down, the UK's public finances will remain strained. The state pension bill for next year is projected to increase by as much as 8.2% under the government's "triple lock" policy, which guarantees that benefits will rise at the same pace as wages or inflation, whichever is higher.
According to online investment service Interactive Investor, this will cost taxpayers around £10 billion. Additionally, the government's independent forecaster has stated that the growing number of working-age benefit claimants due to illness will result in an additional £15 billion in lost tax revenue and higher welfare costs.
The Bank of England's efforts to control prices through higher interest rates are exacerbating the situation. The central bank's reduction of its vast holdings of bonds accumulated during more than a decade of quantitative easing to support the economy is compounding losses. Over the next decade, losses are expected to surpass £150 billion, ultimately falling on the taxpayer.
One concern is that the Conservative Party, which is currently trailing Labour by double digits in opinion polls, might be tempted to loosen the purse strings. Some Members of Parliament are urging Sunak to implement tax cuts before the election.
The next two budgets, set for the autumn and spring, are crucial in determining the future course of action. If the Treasury attempts to substantially ease in the short term but promises medium-term cuts, credit rating agencies may view these plans as less plausible, according to Bruna Skarica, a UK economist at Morgan Stanley.
Hunt's previous budgets postponed difficult decisions by accounting for £30 billion in spending cuts that would only take effect after the next election. This sets a potential trap for Starmer and his potential chancellor, Rachel Reeves, who could be left with the choice of taking ownership of painful cuts or risking another investor backlash shortly after assuming power.
Starmer and Reeves have argued that Britain needs to grow its way out of this predicament. However, Labour has already acknowledged that it will have to delay the implementation of its flagship plan to transform the economy, a £140 billion investment in green industries over five years.
Looking ahead, the projections are grim, such as the warning from the OBR that debt could exceed 300% of GDP by the 2070s.
"In some ways, it's a rather depressing outlook," said David Miles, a senior OBR official. "Something will have to adjust here unless we witness a return to the kind of productivity growth experienced in the 80s, 90s, and early 2000s."