It took the new British Chancellor of the Exchequer, Kwasi Kwarteng, just 25 minutes to unleash havoc when he unveiled his mini-Budget on September 23. His speech was meant to announce help for the ongoing energy crisis in Britain and provide a plan for higher economic growth. It led to an unprecedented week in which the pound plummeted, the cost of borrowing soared and ongoing conversations about a cost-of-living crisis are now being replaced with tentative fears of a financial crisis.
Mr. Kwarteng announced a slew of ideologically-driven tax cuts that disproportionately favour high earners. In place of policies to boost the United Kingdom’s economy to achieve a promised 2.5% growth, the Chancellor offered promises of sunlit uplands simply as a result of reversing recent tax rises (meant to fund extra investment in the National Health Service and social care), abolishing the top rate of income tax and reversing a promised rise in corporation tax.
He failed to explain how the announced support on winter fuel bills to households and small businesses (estimated at £60 billion for this winter) would be funded, and how the shortfall generated by the tax cuts (of £45 billion) would be made up. Markets were spooked and the cost of the U.K.’s borrowing rose sharply, indicating a lack of confidence in the long-term prospects of the economy. Though the sterling’s precipitous fall grabbed headlines initially, it is the damage done to the U.K. treasury bonds that has the potential to cause turmoil globally. So much so, that the International Monetary Fund (IMF) issued a statement on the Chancellor’s mini budget.
To be clear: the IMF is not in the habit of criticising G7 countries on their domestic economic policies. The Fund, officially the lender of last resort and the organisation tasked with maintaining stability in the global economy, broke new ground on September 27 with its stinging rebuke which, moreover, was issued outside of a scheduled country review, global economic update, or a bailout. Noting that the tax cuts threatened to ‘increase inequality’, the Fund said that it was ‘monitoring … developments’ and remained ‘engaged with the authorities’. Observers could be forgiven for wondering if the Fund had accidentally issued a statement composed for a developing country facing a balance of payments crisis. There was more: cautioning against a fiscal policy that appeared to be ‘at cross purposes to monetary policy’ and which thereby risked stoking inflation further, it ended by urging the U.K. to ‘re-evaluate the tax measures... that benefit high income earners’.
Spotlight on pension funds
The IMF, however, has a duty to protect global financial markets, and to mitigate the risk of contagion. The Bank of England had to intervene the following day; warning of a ‘material risk to U.K. financial stability’, the Bank reversed its stance of bringing down its debt and instead pledged to buy back up to £65 billion in long-term Treasury bonds, or gilts, over the coming fortnight in order to stabilise the bond market. Despite the inflationary repercussions of this move, there was little choice in the matter as pension funds, which have invested heavily in gilts, suddenly found themselves facing a liquidity crisis brought about by the rising cost of borrowing, and compounded by the over-leveraged debt instruments that underwrite their future liabilities. However, the Bank has not solved the problem but only stabilised pension funds for now by buying them a little time.
It is not just U.K. pension funds that have exposure to gilts. The sterling is one of the five major reserve currencies, and is (still) ranked third, after the U.S. dollar and the euro, on a par with the yen and above the renminbi. Approximately 5% of global foreign currency reserves are held in sterling or sterling instruments, including gilts. The pound has already lost value. If gilts start looking like a bad investment, several economies around the world, including India, may reconsider their holdings.
Implications for household debt
A little ideology can be a dangerous thing. Prime Minister Liz Truss came to power promising to take on the ‘economic orthodoxy’ of the Treasury and economists. One of her first actions as Prime Minister was to dismiss the top civil servant in charge of the Treasury. Her Chancellor did not publish a forecast of his interim economic policies provided by the Office for Budget Responsibility, an independent body. When their ideology rubbed up against what they perceived to be orthodoxy, they belittled the experience, knowledge and institutional memory that go into providing independent, non-partisan advice. Britain could pay dearly for this. As the country stares into an economic abyss, the cost of domestic borrowing has risen, affecting household (and corporate) debt. Within days of the mini-budget, several mortgages were discontinued, and those paying a variable rate, or facing an imminent renewal of their fixed-rate loans, are anticipating calamitous increases in their monthly payments. Interest rates are expected to rise even further. Over the summer, discussion focused on whether people could afford to heat their homes over the winter. Now, people are asking whether they will be able to keep their homes after the winter.
Good debt may be turned into bad debt. And bad debt has a habit of infecting other economies, as was the case in 2008. Britain could be in for a rocky ride, and it may yet take others along with it.
Priyanjali Malik is a London-based commentator