The UK's new Labour government will probably push investors' tolerance to a degree in its first Budget at the end of the month. But it is aware of the risks associated with increased borrowing. However, It should not forget that investors also care about how that capital is deployed.
It is fair to say that the new UK government has promised the electorate a lot. While carving out a budget that plans for debt to fall as a percentage of GDP in its fifth year of forecast, Rachel Reeves, chancellor of the exchequer, must also work towards making the UK the fastest growing country in the G7.
Together, these targets seem ambitious, not least because Reeves seems hot on investment-driven policies and Labour has promised not to touch key tax levers, but also because it claims that the previous Conservative government left a gaping "black hole" in the UK’s public finances.
The public spending gap was initially said to be just under £22bn, but recent reports suggest that Reeves is looking to fill a £40bn chasm.
It is likely that Labour will increase borrowing to find this cash. While doing so, the government should be able to meet its commitments on falling debt levels through a redefinition of the targeted measure of debt.
The bond market has a right to be worried about the upcoming budget. The lack of transparency around Labour’s incoming policies, and how much debt they will require, is strange.
However, it is likely that the 2022 Gilt market crisis , when the prime minister Liz Truss and her chancellor Kwasi Kwarteng threatened to fund tax cuts with extra Gilt proceeds, is still too fresh for Labour to forget about. Certainly, prime minister Keir Stamer’s rhetoric indicates that it is on his mind.
“What I’ve said to my team is Liz Truss had unfunded commitments for tax cuts,” he said in September. “Unfunded commitments for spending are just as bad and likely to have the same impact on the economy.”
So, Reeves might push bond investors, but she will be careful to tread the line with the level of extra borrowing. But that should not be the only lesson learned from the short, inglorious reign of the UK's most briefly employed premier.
When Kwarteng delivered that disastrous mini-budget a little over two years ago, the Gilt market broke under the prospect of an additional £72bn of issuance. But it also broke due to a loss of confidence in the government’s economic policy.
For a more recent lesson, the spiralling French budget deficit and accompanying cheapening of OATs is another bit of guidance that the UK government would do well to take heed of.
The UK’s debt is accelerating — public borrowing exceeded the government's official forecast in September, it said on Tuesday. If Reeves wants to add to this, she needs to convince investors of her policies.
An £11.6bn chunk of the claimed gap in the public finances comes from public sector pay increases of 5%-6% that Labour has negotiated, according to HM Treasury. This number represents more than the 2% budgeted by the previous government.
Rightly or wrongly, investors on the whole do not appreciate money spent on public sector wages and the idea of a Labour government harking back to policies so reminiscent of its more socialist past will make many of them twitchy.
The bond market will act as a handy brake on Labour's potential for excessive or unproductive spending. If Reeves is to achieve her aims as chancellor, she must convince it that she will deploy responsibly what she borrows.