Thoughts on the Spending Review

The Chancellor of the Exchequer today delivered his Spending Review. The focus was only on government departmental spending, which constitutes a significant part but a minority of overall public spending.

This note summarises the economic and market implications of the Chancellor’s speech. As had been made clear in recent weeks, this Review was to focus on only one year ahead, as opposed to the multi-year review previously planned.

A big rise in department spending

As financial markets were expecting, the Chancellor took advantage of the fiscal headroom he now has to unveil a significant rise in department spending. It was a credible fiscal expansion.

Recent financial market attention has been largely directed by the domestic political environment, and also by the global economic slowdown. The latter has been exacerbated by the deteriorating trade dispute between the US and China, which has contributed to a significant deterioration in global manufacturing and to a collapse in global bond yields.

This collapse in yields was of particular importance to today’s Spending Review. As the Chancellor touched upon, UK Government borrowing yields have recently fallen below 1% across the yield spectrum. That is, the UK Government can now borrow very cheaply.

That, in particular, strengthens the economic case for a more expansionary fiscal stance. This includes, in particular, increased infrastructure spending, some of which was announced today.

A credible fiscal expansion, backed by the numbers

In his Statement, the Chancellor focused on a £13.8 billion increase in ‘real terms’ (allowing for inflation), a rise of 4.1%. The Review thus put figures to many commitments already announced. The bulk of this pot is linked to current spending, thus ending the spending squeeze (or austerity) on a number of areas, but also £1.7 billion was focused on capital spending.

The numbers allow it to be viewed as a credible fiscal expansion. Ahead of the Review, the market’s expectation had been that there was scope for the expansion announced.

In his speech the Chancellor stated that he would revisit the fiscal rules in future. Today’s review is still within current fiscal rules: that is, a structural deficit below 2% of GDP in 2020-21 and a falling ratio of government debt to GDP.

In addition, the large planned rise in day-to-day departmental spending should help domestic demand and economic growth.

Low borrowing costs and domestic backdrop give room to manoeuvre

The associated documents released by the department state spending is to rise from £330.8 billion to £352.3 billion over the next year. This was the focus of today and is the rise of 4.1% mentioned.

To put this in the context of overall public spending, Treasury figures show that gross investment was to rise from £88.1 billion to £94.8 billion, a rise of 5.6%, from 2019/20 to 2020/21. Current spending, meanwhile, is planned to rise from £754.7 billion to £783.8 billion over the same period, a 2.0% rise. Thus, total managed (Government) expenditure is to rise from 38.3% to 38.6% of GDP.

Alongside low borrowing rates, the domestic backdrop to the Spending Review justified the more relaxed fiscal stance that was announced. Since the global financial crisis, the UK’s trend rate of growth has been revised down. The pace of economic and productivity growth is modest. Over that period the policy focus was on an easier monetary policy, as the UK, like other western economies, had to address a surge in government debt in the wake of the 2008 financial crisis.

That being said, in recent years, the fall in the budget deficit and a more recent turnaround in government debt to GDP, having peaked, gave the Chancellor the ability to choose – whether to let borrowing and the deficit to fall further, or to adopt, as he has done, a more balanced approach, allowing the debt to GDP ratio to ease gradually, while also permitting spending to rise.

The Brexit factor

Brexit currently impacts all aspects of UK politics and policy planning. There were two aspects relevant to this Review. One is that the Chancellor increased spending for Brexit preparation, with an additional £2.0 billion for next year, after £2.1 billion had already been allocated.

The second aspect (which is more relevant in how the markets will view the headline numbers) is the impact of Brexit on future economic growth. This will be reflected more fully in how the UK exits the EU and in the official economic forecasts that accompany the Budget later this year – and which may now follow an election. There was not an updated forecast of the economic outlook today from the Office for Budget Responsibility; that will accompany the Budget.

Recent economic growth has been erratic, up strongly in the first quarter, down in the second, and since then consistent with a global slowdown. As we have made clear recently there is scope for a credible fiscal relaxation. The impact on Bank of England policy is likely to be neutral. We would also expect bond yields to remain low.

Please remember that when investing your capital is at risk.

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