OBR to drive final nail into the fiscal rules coffin - Capital Economics
UK Economics

OBR to drive final nail into the fiscal rules coffin

UK Economics Focus
Written by Ruth Gregory

Although the Office for Budget Responsibility won’t expose the full deterioration in the public finances when it updates its forecasts on Thursday, it’s clear that it is only a matter of time before borrowing smashes through the targeted level. That said, regardless of who wins the election, a new set of fiscal rules will probably allow a big fiscal expansion that supports the economy.

  • Although the Office for Budget Responsibility (OBR) won’t expose the full deterioration in the public finances when it updates its forecasts on Thursday, it’s clear that it is only a matter of time before borrowing smashes through the targeted level. That said, regardless of who wins the election, a new set of fiscal rules will probably allow a big fiscal expansion that supports the economy.
  • The Chancellor, Sajid Javid, may have been relieved to learn that on Thursday 7th November the OBR will not update its borrowing forecasts to reflect the spending pledges announced in September’s 2019 Spending Round and the worsening economic and fiscal backdrop. Instead, the OBR’s new forecasts will be more of a holding exercise in place of the full suite of fiscal forecasts that would have been published alongside the Budget on 6th November had it not been postponed. Indeed, the OBR will take into account only some methodology changes.
  • Even so, these revamped forecasts are unlikely to make for pleasant reading for the government on the first day of the official election campaign. We expect the forecast for public sector net borrowing excluding banking groups (PSNB ex) to be raised by a full £14bn in 2019/20 to £43bn (1.9% of GDP).
  • Admittedly, the forecasts will probably remain technically consistent with the main fiscal rule inherited from the previous Chancellor Philip Hammond – for the cyclically-adjusted budget deficit to be below 2% of GDP by 2020/21. But the margin for error against the rule, the “fiscal headroom”, could look much slimmer at just £10bn (0.4% of GDP), down from £27bn (1.2% of GDP) in March.
  • What’s more, when the next Budget is held, presumably soon after the election on 12th December, the forecasts published by the OBR will then undoubtedly look much worse. The deterioration in the economic and fiscal backdrop and the plans to boost spending by £13.4bn announced in the 2019 Spending Round in September mean that the OBR could add another £22bn or so to its 2020/21 borrowing forecast, leaving borrowing at £57bn (2.5% of GDP). As such, even in the absence of major new spending or tax measures after the election, the main fiscal rule looks set to be breached.
  • Given all this, it’s unsurprising that the Conservative and Labour Parties have signalled that they intend to alter the fiscal rules. And since both Parties seem aligned in their desire to increase investment spending, we suspect that they will couch their new fiscal rules in terms of the “cyclically-adjusted current budget deficit”, which excludes investment spending, accompanied by some form of guidance on the debt ratio.
  • Such rules would be less stringent. Not only would they allow for the deterioration in the fiscal figures that the OBR may announce on Thursday and in the next Budget, but they would also allow a further fiscal stimulus after the election worth up to 1.5% of GDP (or £32bn or so), focused mainly on investment. (See our UK Economics Focus, “Rewriting the fiscal rules”, 24th October 2019.)
  • Overall, regardless of the recent deterioration in the fiscal figures, a big fiscal loosening is likely after the election, whoever wins. This could mark the beginning of the biggest fiscal boost seen since the financial crisis and should act as a prop to the economy, whatever the Brexit situation.

OBR to drive final nail into the fiscal rules coffin

The Office for Budget Responsibility’s (OBR) revamped fiscal forecasts due to be published at 9.30am on Thursday 7th November will whittle away the margin with which the government is expected to meet its existing fiscal rule, namely that cyclically-adjusted borrowing is below 2% of GDP in 2020/21. And the OBR is all-but certain to drive the final nail in the coffin of the current fiscal rules when it publishes a full set of economic and fiscal forecasts alongside the next Budget.

But with both the Conservatives and the Labour Party signalling that they are prepared to tear up the fiscal rules in favour of some which are less binding, this will not prevent either Party from splashing the cash in their election manifestos. A significant fiscal loosening appears to be on the way regardless of who wins the election on 12th December.

Re-stated not re-modelled

With the Budget previously scheduled for today having been postponed, the OBR decided to publish some new fiscal forecasts at 9.30am on 7th November anyway. But the Chancellor, Sajid Javid, may have been relieved to learn that the OBR will not update its borrowing forecasts to reflect spending pledges in the 2019 Spending Round, the deterioration in the public finances so far in 2019/20 or any downgrades to its economic forecasts in light of the recent weakening in the data.

Instead, only methodological changes will be reflected in the OBR’s updated forecasts. These include the new treatment of student loans (see here) and unfunded public service pension schemes, a large correction by HMRC to corporation tax receipts and the ONS’s correction of an error found in the data relating to local government social benefits.

Even so, the updated forecasts are unlikely to make for pleasant reading for the government. Indeed, the forecast for public sector net borrowing excluding banking groups (PSNB ex) could be raised by a full £14bn in 2019/20, from £29.3bn (1.3% of GDP) to about £43bn (1.9% of GDP). Moreover, assuming there is a similar impact on the OBR’s borrowing forecast in 2020/21, these changes could raise it from £21.2bn (0.9% of GDP) to about £35bn (1.5%). (See Chart 1.)

Chart 1: Public Sector Net Borrowing, 2020/21 (£bn)

Sources: OBR, ONS, Capital Economics

Fiscal rule still met…but for how long?

Admittedly, the forecasts will probably remain technically consistent with the main fiscal rule inherited from the previous Chancellor Mr Hammond – for the cyclically-adjusted budget deficit to be below 2% of GDP by 2020/21. But the margin for error against the rule or “fiscal headroom” will look much slimmer, at just £10bn, down from £27bn in March.

What’s more, the full set of forecasts published by the OBR alongside the Budget that will surely take place after the election will undoubtedly look far worse due to the government’s commitment in the September 2019 Spending Round to a £13.4bn (0.6% of GDP) increase in spending in 2020/21 and the recent worsening in the economic and fiscal backdrop. While the OBR won’t be reassessing the economic and fiscal outlook on this occasion, we have done it below in order to provide a full picture of the fiscal situation.

A deteriorating economic backdrop

Much of the news on the economy since March has been unfavourable. Admittedly, the OBR’s real GDP growth forecast for 2021 may end up being a bit above its projection in March thanks to the boost from the 2019 Spending Round.

And the OBR Chairman, Robert Chote, has at least offered the government some encouraging news by suggesting that Boris Johnson’s Brexit deal – which is perceived as a harder form of Brexit compared with Theresa May’s deal – “is unlikely…[to make] a significant quantitative difference compared to our last forecast in March”. Indeed, there have been no changes to the transition period and financial settlement. As such, the OBR’s forecasts will still be based on a Brexit deal that incorporates a blend of external studies that assume import and export growth would slow over the next 10 years.

Even so, in response to the recent easing in actual growth, we suspect the OBR would need to slash its real GDP growth forecast for 2020 – perhaps from 1.4% to around 1.0%. (See Table 1.)

Table 1: Real GDP Forecasts (% y/y)

2019

2020

2021

2022

2023

OBR Mar.

1.2

1.4

1.6

1.6

1.6

OBR Nov. (CE est.)

1.3

1.0

1.8

1.6

1.6

Bank of England

1.3

1.3

2.3

Consensus

1.2

0.9

1.4

1.5

1.5

Capital Economics*

1.3

1.3

2.2

1.6

1.5

Sources: OBR, Bloomberg, BoE, HMT, *CE “deal” scenario.

The Chancellor would probably receive a more pessimistic outlook for GDP growth in nominal terms too. After all, nominal GDP also hinges on the OBR’s forecasts for prices, and CPI inflation was 0.3ppts lower than the OBR expected in Q3 2019.

As a result, the weaker economic outlook would flow through into higher borrowing over the coming years. The OBR’s rule of thumb is that nominal GDP of 1% lower increases borrowing by around 0.7% of GDP after two years. We think that the OBR’s forecast for the level of nominal GDP will be revised down by about 0.5%, which would add about £7bn (or 0.4% of GDP) to annual PSNB ex after two years.

Borrowing off track this year

In addition, the fiscal figures for 2019/20 so far have been pretty dire. Cumulative borrowing has been £40.3bn in the financial year so far. And if the recent trend were to continue into the final months of the fiscal year, PSNB ex would come in at £50.4bn in 2019/20 as a whole. That would be about £7bn more than even the upwardly-revised £43.2bn 2019/20 figure we expect the OBR to announce on Thursday. (See Chart 2.)

Of course, the overshoot might be smaller than this. The increase in borrowing has largely been driven by faster-than-expected growth in spending by government departments. Central government spending was up by 5.4% for the year to date, well above the OBR’s March forecast of a 3.3% rise for 2019/20 as a whole.

Chart 2: PSNB Ex (Cumulative, £bn)

Sources: Refinitiv, OBR

But the OBR has argued that since it would be highly unusual for departments to spend more than the annual limits set by the Treasury, spending growth may soon start to slow. What’s more, the receding chances of a no deal Brexit should relieve the pressure on government departments to boost spending. As such, in our forecasts we have not assumed that this year’s overshoot in borrowing is repeated in later years.

The worsening economic and fiscal backdrop, taken together with the plans to boost spending by £13.4bn announced in the 2019 Spending Round, mean that the OBR could add another £22bn to its 2020/21 borrowing forecast in a post-election Budget, on top of the £14bn increase in borrowing likely to be unveiled on Thursday. That would raise borrowing in 2020/21 from £21bn to £57bn. (See Table 2.)

Table 2: PSNB ex. Public Sector Banks (£bn)

2019/20

2020/21

2021/22

2022/23

2023/24

OBR Mar.

29

21

18

14

13

OBR Nov. (CE est.)

43

35

32

30

30

OBR (post-election Budget, CE est.)

58

57

53

50

51

Capital Economics*

56

49

37

32

32

Sources: OBR, *Capital Economics “deal” scenario excluding any further fiscal stimulus.

As such, the main fiscal rule, namely that cyclically-adjusted borrowing is below 2% of GDP in 2020/21, looks set to be breached even in the absence of major new spending and tax measures after the election. In March, the Chancellor had a fiscal headroom of around £27bn. These forecasts imply that he could now overshoot the fiscal rule by £8bn. (See Chart 3.)

Chart 3: PSNB Ex (£bn, 2020/21)

Sources: Refinitiv, OBR

And since this excludes the effect of the as-yet unspecified fiscal loosening that is widely expected to kick-in after the general election, there is a clear risk that borrowing comes in even higher. Our deal forecasts include a fiscal stimulus worth £20bn, or 1% of GDP. As a result, we expect PSNB ex in 2020/21 and 2021/22 of around £70bn (3.1% of GDP) and £58bn (2.4% of GDP) respectively. (See Table 3.)

Even if a fiscal stimulus is not forthcoming, a higher borrowing figure is certainly possible. Given the possibility that politicians are hamstrung by a hung Parliament, we have not built a further fiscal stimulus into our repeated Brexit delay scenario. But our lower forecasts for GDP growth and inflation in that scenario suggest that borrowing nonetheless moves up to 2.6% in 2021/22 and remains close to this year’s levels further ahead.

Table 3: PSNB ex. Public Sector Banks

£bn (% of GDP)

2019/20

2020/21

2021/22

2022/23

2023/24

CE deal*

56 (2.5)

49 (2.1)

37 (1.5)

32 (1.3)

32 (1.2)

CE deal plus fiscal stimulus

56 (2.5)

70 (3.1)

58 (2.4)

53 (2.1)

53 (2.1)

CE “Repeated Delays”

56 (2.5)

56 (2.5)

62 (2.6)

62 (2.5)

61 (2.4)

Sources: OBR, *Capital Economics “deal” scenario excluding fiscal stimulus.

A new fiscal framework

Given all this, it’s unsurprising that both Parties have signalled that they would change the fiscal rules. And given that both Parties seem aligned in their desire to increase investment spending, we suspect that they will couch their new fiscal rules in terms of the “cyclically-adjusted current budget deficit”, which excludes investment spending, accompanied by some form of debt guidance.

Such rules would be less stringent. Not only would they allow for the deterioration in the fiscal figures that the OBR may announce in the next Budget, but it would also allow a further fiscal stimulus after the election worth up to 1.5% of GDP (or £32bn or so), focused mainly on investment. (See our UK Economics Focus, “Rewriting the fiscal rules”, 24th October 2019.)

Conclusion

Overall, then, regardless of the deterioration in the fiscal figures, a big fiscal loosening is likely after the election, whoever is at the despatch box at the time of the next Budget. This could mark the beginning of the biggest fiscal boost seen since the financial crisis and should act as a prop to the economy, whatever the Brexit situation.


Ruth Gregory, Senior UK Economist, +44 20 7811 3913, ruth.gregory@capitaleconomics.com