A clutch of factors has triggered the recent financial crisis in the UK, but there’s one that has been nearly overlooked – UK’s fragile balance of payments. It all began on September 23, when Chancellor Kwasi Kwarteng announced £45 billion unfunded tax cuts, which led to the pound dropping to its lowest level in nearly four decades and interest rates spiralling out of control, amidst panic and a liquidity freeze. It’s worth asking why. After all, fiscal boosters during Covid did not lead to market mayhem. The difference is that investors now have serious doubts over UK’s fundamentals as well as its capacity to manage them. UK already runs a high budget deficit and current account deficit; a stimulus could lead to the former feeding into the latter, adding to currency pressure.
Basically, three factors are at play. First, UK’s current account deficit is really the elephant in the room. It is projected by OECD at 7 per cent of GDP in 2022, by far the worst among the G7, with the US’ CAD pegged at just over 4 per cent. UK’s CAD was at about 2.5 per cent of GDP in 2021 and 2020, which goes to show how badly the Ukraine war has damaged its economy. At this level of CAD, investments are not forthcoming, more so after the Brexit disruption. A slight shock is amplified under such CAD stress. Second, the immediate trigger was the implosion of the UK pension funds sector, which largely finances floating mortgages. UK pension funds sold gilts in a flurry as interest rates soared in anticipation of higher government borrowings and inflation. The reason: these funds had to suddenly cough up collateral to pay for their hedge against sudden market shocks, for which they liquidated their gilts. This led to a self-fulfilling spiral, with interest rates going all the way to nearly 4.5 per cent – till the Bank of England (BoE) intervened with buying bonds to cool the market and bring down rates. BoE’s intervention of buying bonds as against selling them in an inflationary climate was meant to restore financial stability. It revealed policy chaos unbecoming of an OECD country. Meanwhile, the pension funds episode also showed up the shallow market for gilts in the UK, as all its holders acted in concert. Other countries should take heed of the need to develop deep bond markets. Third, global currencies are under pressure anyway on account of the Fed’s aggressive rate hikes. Prior to the mini-budget, the BoE was expected to match the Fed and ECB in sharp rate hikes. It remains to be seen whether the central bank holds back till the bond sell-off scare is fully overcome.
The Truss government must accept the inevitable and roll back its tax sops. It could replace price caps on energy with targeted subsidies and provide similar relief to mortgage holders, so that the BoE can freely manage inflation. Broadly speaking, in prevailing currency market and inflationary conditions, the room for a fiscal stimulus does not really exist.