Category: #icaewchartoftheweek

Last year we published a policy insight ‘Analysing the EU exit charge’ explaining the likely elements of an exit charge payable by the UK on leaving the EU.

Our higher scenario of £30bn was based on contributions until the end of the EU budget period in 2020. With a formula similar to this scenario now agreed, the Treasury estimate is that the UK will pay £37bn (plus or minus £2bn). This is £7bn more than we expected, so we decided to look at the reasons for the difference.

As with any negotiation there were some ups and downs, additional commitments of £3bn are due to the transition period. A £1bn concession on EU operating assets was offset by £3bn in timing differences and a net £1bn from revisions to estimates. Nothing like £7bn though.

The difference is the UK’s puzzling agreement to accept the return of its £3bn original investment in the European Investment Bank, rather a share of its £10bn of net assets, including accumulated profits. This results in an increase of £7bn in the net financial settlement. We still don’t know why this was agreed, or what the UK got in return…

To find out more, read our press release (https://bit.ly/2tPM5lQ) and the policy insight update itselft (https://bit.ly/2pWbnL1).

On Thursday, the Chancellor Philip Hammond announced a £1.2bn capital injection into the Bank of England, which prompted us to take a look at its balance sheet.

As our chart this week shows, the Bank of England has equity of £4bn. This supports assets of £606bn, including £445bn in quantitative easing investments (principally government securities) and £127bn in Term Funding Scheme (TFS) loans to banks and building societies that are used to provide low cost finance to businesses and individuals.

The injection will increase the Bank of England’s capital from £2.3bn to £3.5bn (not all of the Bank’s equity counts as capital for this purpose). In turn the Treasury will no longer guarantee each TFS loan.

Initially these internal changes won’t alter the risk profile of the overall public finances. But, this will allow the Bank to take on more risk in the future, without needing to ask for permission first.

Fortunately, Treasury is still committed to recapitalising the Bank if it ever gets into trouble, ensuring that a deposit with the Bank the England remains, well, ‘as safe as the Bank of England’.

The announcement of a £20bn increase in funding for the NHS in England means a rise in the NHS England budget from £115bn this year to £149bn in five years’ time once inflation is taken into account. (This excludes £14bn of other health related spending in England in 2018-19 outside the main NHS budget).

This is equivalent to an average annual real-terms increase of 2.4%. As a consequence, per capita spending is expected to rise from £171 a month to £194 a month in five years’ time in 2018-19 prices. When Scotland, Wales and Northern Ireland are included, the total is £25bn.  

Around £8bn is expected to come from growth in the economy and there are indications that another £5bn will be made from savings elsewhere in the overall budget.  This leaves somewhere in the region of £12bn a year still to find, equivalent to a couple of extra pence on income tax. 

We leave you with a cliff hanger. Will the Chancellor put up taxes? Or will he increase his borrowing, moving his deficit reduction even further into the future?  We’ll find out in the November budget!

As an aside this increase is only enough to cope with the expected increase in the numbers of people aged over 60 and to give NHS staff the pay rises they expect…

A recent report by the Institute for Fiscal Studies and The Health Foundation concludes that annual real-terms increases of 4% in the funding for UK health and social care is needed, mainly to care for the growing number of older people.

Our chart this week shows that consequently, spending on health and social care is forecast to increase from 22% of the total to 28% over the next 15 years.  With the share taken by pensions and debt interest also expected to increase and ring-fences surrounding defence, international development and education, this means that either taxes must rise or spending on ‘everything else’ has to reduce significantly – from 40% to 30% over the same period.

Will it really be possible to deliver further substantial cuts in working-age benefits or in spending on police, prisons, the courts, transport and the environment? Not to mention to everything else? Can our creaking infrastructure really survive another 15 years of underinvestment?

Given the pressures on this and future governments, we suspect that it is more likely that any increase will have to be funded by higher taxes and greater borrowing. Unless we can come up with some radical alternatives: suggestions on a postcard to the Chancellor!

Deloitte Chief Economist Ian Stewart’s excellent Monday Briefing last week on ‘300 years of public spending’ made for a fascinating read. Over a relatively short period, we have gone from a very small administration to the highly developed welfare state that we have today.

Ian ends with the reassurance that: “Those who worry about the current level of indebtedness of the UK government might take some comfort from the fact that the UK ran far higher levels of debt through much of the last three centuries”.

Unfortunately, we are not comforted.

As our chart this week illustrates, while debt may have been much higher (as a proportion of GDP) in the past, once other liabilities are added in (the red line) things are less rosy. Accounting data only goes back to 2010, but we know that significant liabilities, such as those for employee pensions, have been built up since the 1940s.

In practice, we think the financial position of government is actually much worse than that shown in the accounts because of the even greater commitments made by government to pay for state pensions and other welfare benefits in retirement. Accurate valuations aren’t available, but it is likely that the UK government’s overall financial position is the worst that it has ever been.

Last month, the caretaker government in Italy proposed a budget which forecast the elimination of Italy’s fiscal deficit by 2021.

The arrival of a radical new coalition government with plans to cut taxes and increase spending changes all that.

Debt investors have seen their concerns reflected in sovereign debt markets, with the yield on Italian government 10-year bonds jumping to 2.43% compared to 1.79% at the end of April, and a further widening in the premium over German government 10-year bunds, which currently yield 0.50%. 

The real issue is the scale of Italy’s accumulated debts. At €2.3tn, or 132% of GDP, Italy’s gross public sector debt is one of the largest in the developed world and is almost three times annual government revenues. Tackling that debt mountain has been the main focus of recent Italian governments, under the watchful eye of the other Eurozone finance ministers and the European Central Bank.

Although not good news from a public finance perspective, there is a silver lining for the UK. Philip Hammond’s plan to eliminate the UK’s fiscal deficit may have slipped to the ‘mid-2020s’, but at least the prospect of being beaten to that achievement by his Italian counterpart appears to have receded.

Our chart this week provides an insight into why Stagecoach and Virgin decided to ‘hand back the keys’.  

The East Coast franchise generated £247m in 2016-17, before a franchise payment to the Department of Transport of £272m. A net loss of £25m. The losses were likely to grow in the future because the payment for the franchise was due to increase significantly over the new few years at the same time as revenues are stalling. 

Franchise revenue of £820m in 2016-17 included £741m from passengers at an average fare of £34.23 per journey or 13p per km travelled, while direct costs of £573m comprised £158m in staff costs, £117m in track access charges, £93m for rolling stock, £22m on fuel, and £183m in other costs. 

The problem for the government is that this is supposed to be one of the financially viable rail franchises.  However, the government’s subsidies and losses on the East Coast routes were £289m in 2016-17, more than the £272m it received as a franchise payment from Stagecoach and Virgin.  It really needs this particular franchise to generate more money than it does. 

The challenge for government is whether it can make do and mend, or whether the entire franchising model needs to be revisited.

This week’s chart is perhaps the most interesting, if more complex ones, from our recent report ‘The debt of nations’.

https://www.icaew.com/about-icaew/regulation-and-the-public-interest/policy/public-sector-finances/debt-of-nations

Out of the 12 most indebted countries, it shows the UK has had the greatest growth in general government net debt in proportion to government revenues, up from 0.86 in 2001 to 2.20 times in 2018. This is a concern as the UK will be much less resilient to economic shocks. 

At the other end of the scale, Canada has seen its indebtedness rise more slowly than its government revenues, with net debt going from equivalent to a year’s revenue in 2001 down to 0.59 in 2018. 

While admiring Canada’s fiscal rectitude (albeit supported by a natural resources boom) the continued growth in public debt for the major developed economies raises question about whether this is sustainable in countries such as the US and the UK. 

This is particularly a worry for the US, where general government net debt has increased from 1.05 times government revenue to 2.55 times this year, even before taking in account recent tax cuts and additional spending pledges. 

The news that interest rates in Argentina have just hit 40% should give policy makers in the major developed nations some pause for thought about the risks they are running by borrowing so much.

Our chart this week again comes from our recently published report: The debt of nations – definitely worth a read. 

The usual measure used to compare borrowing between countries is the ratio of net public debt to GDP.  We do not think this is a good measure: there are problems with the way GDP is calculated and GDP also fails to reflect the financial positions of different governments. 

We prefer the ratio of net public debt to the government revenues actually available to service that debt. Our chart this week shows this ratio for the 12 most indebted nations – ranging from Canada with a ratio of 0.59 (less than one year’s revenues) through to Japan, which owes 3.73 times the revenue its government expects to receive in 2018. 

This ratio also takes into account different fiscal approaches.  E.g. France’s net debt to GDP ratio of 89% is greater than the UK’s 81%, but it has a significantly lower net debt to revenue ratio of 1.69 times compared with 2.20 for the UK. The UK’s lower level of tax as a proportion of the economy means it has less money available to service its public debt. 

Why isn’t Japan bust? Negative real interest rates means it is expected to have an interest bill of close to zero this year.

Our chart this week is from our report ‘the debt of nations’ published last week which we hope will be a ‘must-read’ for anyone affected by how our governments manage public debt; in other words everyone. 

Low interest rates mean that nominal interest on the UK’s almost £2tn of public debt is expected to fall to 1.8% over the next few years as existing debt is refinanced. With yields on 10-year fixed-interest gilts at the end of March of 1.35%, this forecast seems quite reasonable based on current refinancing plans. 

However, over a quarter (28%) of the UK’s public debt is index-linked. If inflation increases then the cost of borrowing will rise accordingly.

And although the UK Debt Management Office has been issuing debt for longer and longer maturities to lock-in low rates, a substantial proportion has been swapped by the Bank of England into variable rate debt as a result of quantitative easing. 

A return to 5%, the base rate in 2008 before the financial crisis, would cost an extra £20bn a year, roughly half the defence budget.

This poses a dilemma to the Bank of England. Unwind QE too quickly and interest rates could rise significantly. But, don’t unwind QE and the public finances will remain exposed for many years to come.