Chancellor’s Autumn Statement and the OBR
0On December 5th, Chancellor Osborne will present his Autumn Statement and the Office for Budget Responsibility (OBR) simultaneously publishes the official fiscal projections.
In summary, we should expect upward revisions to the OBR’s deficit and debt forecasts given recent news flows that leave the OBR’s economic forecasts, particularly for GDP growth, looking optimistic, and recent public finance data have been worse than expected, leaving a higher than expected starting point for the government deficit projections.
That brings with it a high probability that the OBR will judge the fiscal rules as likely to break. However, the ongoing transfer of coupon payments from the APF does help and the amount of additional fiscal tightening required to avoid breaking the rules is plausible, albeit that the Chancellor has the unenviable task of choosing between yet more planned fiscal tightening risking the recovery and letting the rules break.
Looming in more detail at the OBR’s numbers, their existing economic forecasts are some way from consensus and we can expect the OBR to revise down its forecasts for GDP growth and not just for the present fiscal year. The Bank of England have revised lower their predictions for medium term GDP growth in the UK and the OBR may well revise down their medium-term forecasts too. Equally the OBR’s assumptions on inflation look low albeit not unreasonable, but this does not help the fiscal arithmetic unless they also revise higher their assumptions for wage growth, and there’s no evidence to support such a decision. Taken as a piece, the fiscal finances may look worse rather than better.
Incoming data on public sector net borrowing (PSNB), the UK’s main deficit measure, has shown an increase in borrowing of £5bn in the first seven months of FY2012-13 over the comparable period of 2011-12 and given the weakness of the economy, it’s not surprising that the disappointment has been focused on revenues. Central government receipts have risen by just 0.4%Y thus far in the current fiscal year, against the OBR’s full-year forecast of a 3.7% increase. There has been particular weakness in corporation tax receipts (particularly the Oil & Gas sector), whilst VAT receipts are also beginning to materially undershoot the OBR’s projections. In contrast, growth in total current expenditure of 2.3% is undershooting the OBR’s full-year forecast of 3%, due to lower than expected spending on public services. Spending on net social benefits and interest payments have moved broadly in line with expectations.
More recent data releases have served to highlight just how volatile and prone to significant revision public finance data can be. Nevertheless, the current trajectory of the public finances is consistent with a borrowing overshoot of around £9bn in the current fiscal year. This is broadly in line with what commonly used fiscal rules of thumb would suggest based on the likelihood of a GDP growth undershoot of around 1pp compared with March forecasts. The risk to this view is likely for a larger deficit, particularly if the OBR were to judge the current spending undershoot as unlikely to continue.
Whether the debt rule breaks is very sensitive to underlying assumptions and special factors that can help or hinder the fiscal finances include APF cash transfers (helps), re-classification of Northern Rock Asset Management and Bradford and Bingley (hinders) and Royal Mail pension asset transfer (helps).
On balance, a break in the fiscal rules does look to be on the cards, without about an additional £12bn 2015/16 tightening in fiscal policy. In particular, the debt to GDP ratio looks set to rise slightly in 2015/16 rather than fall. More details and speculation are provided on the next page.
Fiscal rules: digging into the details
1. The Government debt to GDP ratio (verdict: likely to be missed without additional fiscal tightening):
The supplementary target requires public sector net debt (PSND) to fall as a share of GDP between 2014-15 and 2015-16. In the March 2012 OBR forecasts, the government just about hit this target with PSND peaking at 76.3% of GDP in 2014-15 and falling back to 76.0% in the following year. Without additional fiscal tightening of around £12bn in 2015-16 (and taking into account all the assumptions mentioned earlier) our simple fiscal model projects that the Chancellor misses this fiscal rule by a year. In addition, the peak in PSND is significantly higher at 81.4% of GDP (even after including the coupons from the APF transfer).
2. The cyclically-adjusted current budget balance (verdict: this fiscal rule looks less likely to break):
The government’s fiscal mandate requires it to balance the cyclically-adjusted (structural) current budget at the end of a rolling five-year period, now 2017-18. The assumptions the OBR make on the current size of the output gap and the future outlook for potential growth will be extremely important in determining whether or not the government is likely to meet this target.
We suspect the OBR won’t change its view materially on the current output gap (-2.5% of GDP; i.e. anaemic demand growth has been matched by a similarly tepid supply performance over 2012). They may, however, make material downgrades to their forecasts for the growth of potential output over coming years with a return to its long-term average rate (2.3% according to the OBR) delayed until 2017-18.
With assumptions regarding the output gap and potential growth, we would expect the OBR to judge that the Chancellor will fail to meet his fiscal mandate without additional fiscal tightening (again £12bn in 2015-would do it). However, if the APF coupon payments are included, the Chancellor would be able to hit the target with an extremely modest fiscal correction. If the OBR were to leave its forecasts for potential growth unchanged, it would likely judge the government would meet its fiscal mandate in either case.
The Chancellor’s choices
1. More fiscal tightening? Recent media reports suggest that cutting welfare benefits will be one of the ways that the government will achieve the fiscal tightening already embedded in the forecasts from 2015-16 (and which so far haven’t been specified). On the revenue side, there is discussion about the further reduction in pension tax relief for higher income earners. However, this discussion appears to be before considering the case for additional fiscal tightening in response to new OBR forecasts
2. Letting the rules slide? The economy’s weak and the recovery will be fragile while the UK continues to transition towards a less levered, more export and investment-driven economy. Arguably to meet the debt/GDP part of the fiscal mandate, a lot of additional fiscal tightening is required in 2015-16 but this would imply that the government would go into the next election promising the electorate yet more fiscal tightening on their return to office. Current polls are already consistent with a change of government at the May 2015 election (and by some margin).
Additional unflattering OBR analysis likely: The OBR intend to do a more detailed assessment of the impact of the APF cash transfers alongside their main projections. They will do so over the full potential lifetime of QE (the longest maturity bond held by the APF is the 2060) and not just the usual five-year horizon. They intend to use alternative assumptions, including on when and how QE is unwound. Many of these scenarios are likely to paint an unflattering longer-term picture, where losses made on gilt sales will have to be met with payments to the Bank of England from the Treasury.
James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla
