Share the article
twitter-iconcopy-link-iconprint-icon
share-icon
Western EuropeMay 1 2020

How is the UK going to pay for Covid-19 recovery?

As the UK economy is hit by the coronavirus, the government has pledged massive fiscal support. But how sustainable is this in the longer term? James King reports.
Share the article
twitter-iconcopy-link-iconprint-icon
share-icon
BOE

Paul Volcker, a former chair of the US Federal Reserve, reportedly quipped that “every 10 years we have the greatest crisis in 50 years”. In the opening decades of the 2000s, these words ring painfully true.

A little over 10 years since the global financial crisis, the world is now contending with what the International Monetary Fund (IMF) has termed ‘the Great Lockdown’ – the fallout from the spread of the Covid-19 pandemic. The confinement of citizens and closure of businesses in response to the virus have afflicted nearly every country in the world and dealt a hammer blow to an already fragile global economy, which is now expected to contract by 3% in 2020, according to the IMF.

Faced with this unprecedented challenge, national governments have deployed an astonishing set of measures to safeguard their economies. The difference in this crisis, however, is that monetary policy will play second fiddle to fiscal policy as the go-to support mechanism, even if central banks are still playing a vital role. “Central banks can’t cut rates any further, and it means they cannot respond in the way that they did during the last financial crisis,” says James Smith, research director at economic think-tank Resolution Foundation. 

Whatever it takes

Nowhere is this more apparent than in the UK, where the Conservative government of Boris Johnson has announced it will do “whatever it takes”. By the end of April, the British authorities had promised to extend £400bn ($499.75bn) to both individuals and businesses in the form of tax relief, payment holidays and salary support, among other measures, representing the largest peacetime fiscal expansion in the country’s history, according to the Resolution Foundation. 

James Smith, developed market economist at ING, says: “What you have to remember is just how rapidly the economic crisis has manifested itself. It is a real challenge for the government. The [fiscal support measures] were surprisingly bold and, crucially, the speed at which they were announced was also impressive. I think they are generally regarded as being well thought through, particularly given the short notice.” 

This intervention will blow a gaping hole in the UK’s public finances at a time when economic growth is tanking. The Office for Budget Responsibility (OBR), the independent government forecaster, expects the UK economy to shrink by 35% in the second quarter of 2020, contributing to an annualised contraction in the region of 13%. Under the OBR’s scenario, in which the UK would be in lockdown for a period of three months, followed by three months of social distancing, government borrowing will hit £273bn, equivalent to 14% of gross domestic product. 

Furthermore, a swift economic recovery is unlikely. “The question is: how quickly can [the economy] recover? We think the recovery will be gradual. It will take a couple of years before the UK economy returns to its pre-virus size. This is because, despite the best intentions of the government, some firms are going to fall through the net. Even by the end of 2021, we expect the UK economy to be 3% to 4% smaller than it was before the pandemic,” says Mr Smith at ING.

QE returns

Against this economic backdrop, with risks tilted to the downside, questions have been raised as to how the UK government will finance its spending plans in the short term, while managing the public purse over the longer term. Crucially, the Treasury’s spending plans in 2020 are being supported by the Bank of England, with the apex lender announcing a £200bn quantitative easing (QE) programme over the coming months. 

“The Bank of England knows that it needs to provide large-scale support. The most obvious mechanism to achieve that is through the additional QE. The motivation for this is to stop financial conditions tightening in order to keep longer-term interest rates low and to provide support for  the economy through that channel. The upshot of that is that gilt yields will fall and that obviously helps the government indirectly by reducing the cost of borrowing,” says Resolution Foundation's Mr Smith. 

Even as falling interest rates over the preceding decade have left the Bank of England with little room for policy manoeuvre, it is still playing a vital supporting function during the current crisis. When British government gilt yields spiked in mid-March, discussions in the City of London turned to the prospect of monetary financing – the modern-day equivalent of printing money. Following the central bank’s announcement of its QE programme in March, it noted: “The Monetary Policy Committee will keep under review the case for participating in the primary market.” In this scenario, the central bank would buy bonds directly from the UK government.

Martin Beck, lead UK economist at Oxford Economics, says: “Monetary financing wasn't even mentioned in 2009 but now it is a live issue. Investors are aware of it, so they know that as a last resort the Bank of England will backstop the market.” 

Though Bank of England governor Andrew Bailey rejected the use of monetary financing in the Financial Times in early April, some analysts have interpreted these comments to reflect any sustained or open-ended use of the mechanism, which could contribute to runaway inflation. Moreover, the severity of the crisis has the potential to force a rethink of monetary financing, at least on a short-term basis, in the coming months. “The Bank of England has rejected the idea of buying from the primary debt markets because it thinks it would be inflationary. But a lot of eminent voices have come out in support of monetary financing,” says Mr Beck. 

Ways and means

In any case, the Bank of England has since taken measures to ease the government’s financing woes by increasing the size of the Ways and Means Account. This facility, which essentially acts like a government overdraft with the central bank, will reportedly be expanded by an unlimited amount to cover the UK Treasury’s short-term funding needs. Though it is typically £370m in size, the ways and means account increased to £20bn during the 2007/08 global financial crisis. 

“What the Ways and Means Account does is reduce the government’s need to go to the market with a really large financing request causing more ructions in the money market. So it allows the government to smooth that bond issuance over the year,” says ING’s Mr Smith. 

This will undoubtedly be a relief for the Treasury. In April alone, the British government had tripled the amount of debt it wanted to raise from an initial £15bn to £45bn. But with low interest rates in place, the cost incurred by this borrowing should be minimal. And, for now, demand for UK government debt remains healthy. 

“In terms of financing at the moment it doesn’t look like a problem. Gilt yields are hovering around record lows. [In mid April] the 30-year yield was below 1%. So borrowing costs are next to nothing. Given where gilt yields are, there’s clearly significant demand for UK sovereign debt. The crisis, which has generated higher borrowing, has also generated higher demand for government bonds,” says Mr Beck. 

Even so, the UK government will need to sustain the confidence of the markets to maintain this situation. And given how quickly global economic conditions are deteriorating, this will be no easy feat. Looking ahead, however, the authorities will be faced with another challenging task. Public debt levels are expected to exceed 100% of gross domestic product (their highest levels since the 1960s) in even the most optimistic Covid-19 scenarios, according to Resolution Foundation. Though the cost of servicing this debt will be low, it will remain vulnerable to rising inflation or interest rates. 

A question of sustainability

Ultimately, the UK government will need to address its fiscal stance before long to ensure the sustainability of public finances. “The problem is going to be that, with deficits rising, you are going to end up with a legacy of debt from this crisis. That is going to mean that the fiscal position will need to be tighter to remain sustainable,” says Resolution Foundation’s Mr Smith. 

“It is not obvious to me that spending can be cut much more across many government departments. So I think the government will look to increase the tax base and broaden tax revenues to help ensure that its debt levels remain sustainable,” he adds.

Clearly, there are no easy choices facing the UK government. And, if Mr Volcker’s quip remains true, the government, in common with many peers around the world, could be facing the next crisis with an elevated debt pile and an exhausted arsenal of monetary policy tools.

“We are going to have to find other ways to fight recessions if this experience is anything to go by,” says Mr Smith at Resolution Foundation. 

Was this article helpful?

Thank you for your feedback!

Read more about:  Western Europe , UK , Western Europe