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Election Pledges Heighten UK Fiscal Risks

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Tuesday, November 19, 2019 / 11:20 AM / Fitch Ratings / Header Image Credit: Daily Kos

Spending plans from the two largest UK political parties suggest that the period of budget deficit reduction is over, Fitch Ratings says. We anticipated fiscal loosening when we affirmed the UK's 'AA' sovereign rating in October but, while the scale and timing remains uncertain, risks to our fiscal projections have risen substantially.

Chancellor Sajid Javid and his opposition counterpart John McDonnell set out spending plans on 7 November as part of their election campaigns. The Conservatives' new fiscal rules would allow an extra GBP22 billion of public sector net investment annually, while the opposition Labour Party would allow an extra GBP55 billion. The announcements are consistent with our view in last month's rating review that 'austerity fatigue' and Brexit preparations are set to reverse the path of expenditure restraint seen since 2010.

December's election is unpredictable and could result in a majority government committed to take the UK out of the EU by the end-January, or a hung parliament or coalition and a second referendum. No-deal can't be excluded until the Withdrawal Agreement (WA) is approved by the UK Parliament and ratified, and the WA bill enacted. Trade 'cliff edge' risks would linger until the new UK-EU relationship is negotiated. Brexit is key to resolving the UK's Rating Watch Negative (RWN), which reflects the substantial economic disruption no-deal would cause the UK, as well as the potential for an agreed future UK-EU relationship to have an adverse economic impact.

The future direction of the UK rating will also reflect economic and fiscal policy choices and outturns. Post-election fiscal settings are hard to predict. Higher spending commitments are common in election campaigns but not always implemented in full, while large infrastructure projects take time to execute.

Neither party has abandoned the concept of fiscal rules. A Conservative government would target a current budget balance (i.e. excluding capex) within three years. Debt interest payments would be capped at 6% of revenues (from 4.5% currently) and public sector net investment capped at 3% of GDP. Debt-to-GDP would fall over the next parliament. Labour would also cap interest payments, but at 10% of revenues, and has replaced its target of falling debt-to-GDP with improving 'the overall balance sheet by the end of the Parliament'.

UK fiscal rules have been re-written frequently in recent years. These proposed new rules would allow for substantial fiscal loosening, increasing uncertainty around the fiscal outlook and risks to our projections. At last month's UK review, we used the government's 4 September spending round as the main indicator of likely spending increases (assuming slower implementation). These projections saw the deficit widening to 2.5% of GDP by 2021 from 2.3% in 2019, but general government debt would still fall slowly.

Our projections assumed that revenue-to-GDP ratio remained broadly stable, consistent with the fact that the UK's large fiscal adjustment has chiefly been through expenditure measures. We expect more clarity about revenue measures and spending plans in areas other than investment when the manifestos are published. This could shed further light on the credibility of fiscal plans.

Any surge in investment would likely boost GDP, but would need to be appropriately targeted to boost UK productivity and potential growth. Recent data revisions suggest the growth impact of Brexit uncertainty was less severe than previously thought, but we believe underlying economic momentum remains fragile.

We will continue to assess how far policy settings might reduce the UK's fiscal headroom at its present rating level beyond the election as part of our sovereign analysis, in the context of domestic political and Brexit outcomes.