Higher interest rates and rising inflation pose a serious threat to the public finances because the national debt is unusually exposed to price fluctuations, the Office for Budget Responsibility has warned.
Of the £1.7 trillion of national debt, £386 billion is in index-linked gilts that move automatically with inflation. Another £371 billion is held by the Bank of England through its quantitative easing programme and is highly sensitive to changes in interest rates, which tend to follow inflation.
The analysis by the OBR has exposed a vulnerability in the nation’s debt that has been masked by record low rates and low inflation in recent years. Others risks to the public finances included Brexit, “austerity fatigue” and the prospect of a recession.
Against this backdrop, the OBR urged the government to use years of economic growth to cut the deficit. It said debt needs to fall as a percentage of GDP to build the “fiscal space” to respond to another crisis. The comments were a boost for the chancellor, who is facing calls to ease austerity.
“The public finances need to be managed prudently during more favourable times to ensure that when these shocks do crystallise they do not put the public finances on to an unsustainable path. This is all the more important, given the rise in the stock of debt in recent years, and the greater sensitivity of future debt interest costs to changes in interest rates and retail price inflation,” the OBR said.
To demonstrate the risk implicit in Britain’s high level of debt, which has doubled to 89 per cent of GDP since the crisis, the OBR conducted a stress test that assumed inflation hits 5 per cent and rates rise to 4 per cent. In its scenario, the cost of servicing the debt in 2021 soared from current projections of £44 billion to £110 billion, and added £266 billion to the debt pile over the next five years.
Britain’s debt is generally considered low risk because the average maturity is 15 years, roughly twice other G7 countries’, which means it does not have to refinance as often. However, a fifth of all gilts automatically rise with the retail prices index of inflation. The £371 billion held by the Bank is highly sensitive to interest rate rises because the effective borrowing cost for the state is base rate, which is currently just 0.25 per cent. As a result, 45 per cent of the nation’s debt is particularly “vulnerable”, Robert Chote, chairman of the OBR, said. RPI has risen from 1.4 per cent to 3.7 per cent in the past year, largely due to sterling’s devaluation since Brexit. The OBR pointed to several other risks.
Leaving the European Union poses numerous threats. A decline in trade could hit productivity and, consequently, growth. Even at €75 billion, the divorce bill from the EU “would not pose a big threat to fiscal sustainability”, the OBR said, but “if GDP and receipts grew just 0.1 percentage points more slowly than projected over the next 50 years, but spending growth was unchanged, the debt-to-GDP would end up around 50 percentage points higher”. Lower migration could deplete the working population and leave debt as percentage of GDP 31 percentage points higher than currently forecast in 50 years’ time. Brexit could also deliver a further sterling devaluation, which would make the national debt more expensive by driving up inflation and rates.
Britain is due a recession soon. Since the 1970s there has been one every decade but the last was in 2009. “The risk of a recession is one in two over any five-year horizon,” the OBR said. A stress test that saw the economy shrink 4.7 per cent, not as much as in 2009, with 5 per cent inflation and 4 per cent interest rates, would add £596 billion to the national debt over the next five years. Debt would end up at 1.13 times the size of the economy in 2022, rather than the 0.8 times currently forecast.
The country’s ageing population and technological advances are putting pressure on health and care spending. The OBR is projecting spending to rise from 6.9 per cent of GDP in 2021 to 12.6 per cent of GDP in 2066. The office identified the risk as one of the biggest “slow building fiscal pressures” alongside persistently weak productivity growth.
A number of potential liabilities do not show up in the debt figures at all. They include nuclear decommissioning costs of £161 billion, negligence claims against the NHS that could cost £100 billion, and about £10 billion in tax reimbursements over the next five years. The total value of provisions has risen from 6 per cent of GDP to about 16 per cent in the past seven years.