OBR Forecast to Signal Increase in Bond Issuance

With the Bank of England steadily implementing its asset purchase programme, markets may shift their focus in the UK towards fiscal policy and, in particular, the new set of forecasts from the Office for Budget Responsibility(OBR) that will be published alongside the Chancellor’s autumn statement on 29 November. There are several interesting issues that will be addressed:

– Given the weaker prospects for growth, what the OBR’s new forecasts for the deficit in this and coming years will be;

– What the implications are for this year’s gilt issuance; and

– Whether that has led to a change in the OBR’s estimate of the structural deficit, implying that the government may have to impose further fiscal tightening in coming years.

– The government has also announced it will announce “credit easing” measures at the autumn statement.

There has been considerable focus on the potential for a revision to the OBR’s estimate of the structural deficit, which in large part would reflect changed assumptions about the amount of spare capacity in the economy. Although some change is likely – the economy now looks to have been well above potential before the recession, for example – the immediate impact of any change in this estimate may be more political than economic, as it would imply that there may be a need for further tightening in a few years’ time.

For markets, it may be that the key issue will be the revisions to the deficit for this and the coming few years. Back in March, the OBR forecast that public sector net borrowing would be £122bn (8% of GDP) in 2011-12, on the back of 1.7% GDP growth this year. With growth strengthening further next year (to 2.5%), the deficit was expected to shrink further, down to 2.5% of GDP by 2014-15.

Since March, of course, the prospect for growth has deteriorated. Given continued uncertainty over the Euroland debt crisis, a sharp and immediate recovery is unlikely. As such, the OBR’s growth forecasts are likely to be revised downwards. In turn, that should lead to higher deficit forecasts. Using simple rules of thumb for the impact of weaker growth on the public finances, the deficit should be revised up to 8.3%
of GDP in 2011/12 & 7.2% of GDP in 2012/13.

Although such a weaker growth profile suggests a higher deficit for this year, it is interesting to note that in the first half of the year net borrowing has continued its downward trend, and given the OBR’s tendency to be conservative, we could expect a deficit forecast of around £130bn (8.5% of GDP).

The fact that the public finances are performing so well given the weakness in the real economy indicates that the structural fall in the deficit is likely to be at least as large as planned. Indeed, given that the risks to the growth forecasts are likely to be the downside while the chances are that the deficit could end up slightly smaller than £130bn, it appears that the structural fiscal tightening this year should be considerable. And as such, the deficit may actually shrink faster than the OBR is likely to project.

A higher deficit forecast for 2011-12 will, of course, have implications for issuance and we may see gilt issuance for 2011-12 to rise by £10bn, to £177bn. We would expect that increase to be split between mediums and longs.

One issue that may affect issuance is the impact of any “credit easing” announcement by the government. Given Chancellor Osborne’s comment in his letter to Governor King that the government would make
interventions that should “complement the MPC’s asset purchases”, the scope of any credit easing could be substantial and there may be several aspects to any such policy. Thus, the government may attempt to set up a financing vehicle for small and medium-sized firms, potentially by buying and securitising loans to
those firms.

As that is unlikely to have an instantaneous effect, the government may choose to improve credit conditions more generally by financing the direct purchase of credit issued by firms. Indeed, we wouldn’t be surprised if the government were to announce the direct purchase of bank credit. It’s possible that the proposed scale of these purchases could be around £50bn. We would expect them to be financed by the issuance of bills.

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

Image courtesy of www.London-GB.com