The coronavirus crisis means that the government’s budget deficit will soon explode to above the 10% of GDP peak seen in the financial crisis and debt could spiral from about 80% of GDP now to over 100%. However, if we are right in thinking that the economy will bounce back quickly from the coronavirus hit, the government will find it easier than after the financial crisis to bring the deficit back down.
- The coronavirus crisis means that the government’s budget deficit will soon explode to above the 10% of GDP peak seen in the financial crisis and debt could spiral from about 80% of GDP now to over 100%. However, if we are right in thinking that the economy will bounce back quickly from the coronavirus hit, the government will find it easier than after the financial crisis to bring the deficit back down.
- In recent weeks the Chancellor has announced a wide range of measures to cushion the blow to the economy from the coronavirus crisis. (See Table 1.) And more measures are expected in the coming days, such as some support for the self-employed. The influence on the public finances depends on three things.
- First, the size of the government’s direct tax and spending measures. So far, barring the government’s £330bn loan guarantee, all the measures have direct, one-off costs. Adding them up shows that the measures announced so far will cost about £110bn (4.9% of GDP) in 2020/21. (See Table 2.) On its own, that’s enough to increase the budget deficit in 2020/21 from the Office for Budget Responsibility’s (OBR) Budget forecast of 2.4% of GDP to 7.3% of GDP.
- Second, the hit to the economy from the measures taken to contain the virus will lower government tax receipts and raise government spending. Using the OBR’s rule of thumb, the 7% fall in GDP that we expect in 2020 (see here) would mean that the deficit in 2020/21 increases by a further 3.5% of GDP. (See Table 2 again.) That would leave it at 10.8% of GDP, just above the peak of 10.2% in 2009/10 following the financial crisis. (See Chart 1.)
- These first two influences are likely to raise the ratio of government debt to GDP from the OBR’s Budget forecast of 77.4% to at least 90% in 2020/21.
- Third, while other measures, including the government’s loan guarantees and the Bank of England’s emergency policy measures (see here), are unlikely to influence the budget deficit, they will raise government debt. As far as the government’s £330bn worth of loan guarantees go, it is not clear how this will be treated in the public finances and it will depend on the future judgement of the OBR and the Office for National Statistics (ONS). For the moment, we are assuming that it will be treated as a “loan” rather than a “grant”, which means it will not influence the budget deficit but it will add to government debt.
- That said, only a small part of the £330bn will make it onto government debt. That’s because loan guarantees are a contingent liability, so only the portion that the government actually pays out will be added to debt. And that depends on what share of the loans that banks make go bad.
Table 1: Size of Fiscal Package
Size £bn (% of GDP)
110 (4.9) Plus 330 (14.8) of guarantees
Sources: HMT, Capital Economics; *CE estimate
Table 2: Indicative Cost of Fiscal Measures £bn (% of GDP)
Impact on deficit?
Impact on debt?
1. Direct measures
2. Economic effect
3. Loan guarantees called upon
4. BoE emergency measures
5. Airline bailouts and nationalisation of railways
Excluded from ex. Measure?
Source: Capital Economics
- For what it’s worth, Standard & Poor’s have estimated that default rates for non-financial corporates in Europe could rise to close to 10% over the next year. Given that bank loans to all UK non-financial businesses stood at £489bn in 2019 (about 22% of GDP), that suggests the government could be on the hook for around 2.2% of GDP. (See Table 2 again.)
- Other policies, such as the Bank of England’s Term Funding Scheme with incentives for Small and Medium-Sized Enterprises (TFSME), will entirely feed through to government debt. The Bank initially suggested the amount borrowed through the TFSME might be £100bn before it doubled the size last week. So that could add another £200bn (9% of GDP) to government debt.
- In contrast, only a small part of the £200bn of assets that the Bank of England has said it will buy in its quantitative easing (QE) programme will increase government debt. That’s because the Bank has said it will buy mostly gilts. And when the Bank buys gilts, it just changes who owns them rather than the amount of gilts or debt outstanding. That said, any corporate bond purchases by the Bank would add to government debt. And any difference in the valuation of the gilts purchased by the Bank (i.e. at market value) and the value at which the government issued them (i.e. at par value) does add to debt. A good rule of thumb for these effects is that government debt rises by the equivalent of a sixth of the Bank’s total asset purchases. This means the Bank’s QE may add another £30bn (1.3% of GDP) to government debt. (See Table 2 again.)
- So far then, we estimate that the budget deficit will rise from 1.9% of GDP in 2019/20 to 10.8% of GDP in 2020/21 and that government debt could rise from 77% to 104%. That would take the budget deficit to above the levels seen during the financial crisis and it would leave the debt ratio at its highest since the 1960s. (See Charts 1 & 2.)
- Finally, government debt could rise further if more drastic action is taken, such as a bailout of the UK’s airlines. By suspending the normal financial mechanisms of rail franchise agreements for an initial period of six months, the government has already effectively nationalised the railways. And should the government eventually be forced to bailout the UK’s airlines, that could add more to government debt. For example, the chairman of Virgin Group proposed a government equity injection worth £7.5bn (0.3% of GDP).
- However, we suspect that the ONS might exclude the effect of any such bailouts or equity injections from the headline budget balance and debt figures. The ONS would probably assume that these liabilities would eventually be reversed, just as it did after the government’s bailouts of the banks in 2008/09. So such figures are not included in our borrowing or debt forecasts. In any case, while the government’s initial cash outlay to bailout and nationalise the banks in 2008/09 was £136.6bn (8.7% of 2008/09 GDP), the OBR estimates that the eventual net cost was just £27.3bn (1.7% of GDP).
- Overall, the government’s budget deficit and debt ratio are on track to explode above the levels seen in the financial crisis. We doubt that this will worry the gilt market too much, meaning that the government is still able to benefit from very low debt servicing costs. Indeed, the spike in 10-year gilt yields last week to just over 1% last week was driven by stresses in the financial markets rather than fiscal worries – it has since fallen back to just 0.44%. And if the economy bounces back quickly, then the government will find it quicker and easier than it did after the financial crisis to bring the deficit back down.
Chart 1: Public Sector Net Borrowing Ex. (% of GDP)
Chart 2: Public Sector Net Debt (% of GDP)
Sources: OBR, Capital Economics
Sources: OBR, Capital Economics
Ruth Gregory, Senior UK Economist, +44 7747 466 451, firstname.lastname@example.org