Massive debt raises risk of interest rate shock, OBR warns

Sunak

Ballooning government debt meant the UK was increasingly exposed to the risk of interest rates rising in the coming years and decades, the new Office for Budget Responsibility chief has warned.

Richard Hughes told MPs that the Government should not rely on borrowing costs staying at record lows forever when drawing up tax and spending plans.

“We are clearly in exceptional times at the moment, with very low interest rates,” said Mr Hughes.

“It is a big question how long that will last. It is not something you would want to base government policy on in the longer term, if you look back at the broad sweep of history.”

This year the Treasury is likely to borrow £370bn, more than doubling the £158bn deficit in the peak year of the financial crisis.

It has already taken the debt to more than 100pc of GDP for the first time since the 1960s, when the cost of the Second World War was still being paid. Yet markets are happy to lend at negative interest rates.

Mr Hughes added that the Government had deliberately tried to borrow for longer time periods in financial markets, locking in low interest rates for years to come. However, quantitative easing, under which the Bank of England buys bonds, effectively shortens the average maturity of public sector debts, increasing the risk from rising rates.

“The level of debt is higher and the maturity of debt is getting shorter, so our debt stock is getting more sensitive to interest rate shocks, so there are reasons for us to be more concerned,” he said.

Mr Hughes, who took over from Robert Chote at the OBR this month, said that recessions typically increased government debt by about 10pc of GDP while financial crises add 20pc - roughly similar to the pandemic’s impact.

To tackle these effectively, borrowing must fall in the good years to make room for borrowing when a crisis strikes.

Sir Charlie Bean, a former deputy governor of the Bank of England who is now at the OBR, said Rishi Sunak did not have to start slashing spending or hiking taxes yet, as the pandemic was still ongoing, but that tackling the debt would be crucial in the years ahead.

“It is entirely appropriate, given the large and unusual shock the economy has been subject to, for the Government to run a large deficit so long as the virus emergency persists," he said.

"But as one goes beyond the emergency, then it will be appropriate to stabilise the public finances and potentially start building in fiscal space to recognise that there will be future bad shocks further down the road.”

Otherwise, the result could ultimately be a serious fiscal crisis: “If you leave the debt-to-GDP ratio at a high level, along comes another bad shock requiring fiscal action, it ends up ratcheting higher and higher, and in a worst case scenario you may find it becomes difficult to finance the debt on the markets. So that is when you see countries finding themselves cut off from the capital markets.”

Typically through recent history, governments have reduced debts either by running budget surpluses, growing economies or inflating away those debts. Sir Charlie said the latter was not likely to be a sensible answer.

“The ability of the Government to sell debt rests on the confidence of the buyers of that debt that it will be repaid in full at its expected real value, ie it won't be inflated away,” he said. “The key thing is that the UK preserves its reputation for honouring its debt when it falls due.”

Pressures on public spending could intensify as the recent rise in Covid infections and restoration of some restrictions on behaviour “will put the recovery on hold for a while”, Sir Charlie said.

All of this was taking place against a backdrop of an ageing population that will put serious pressure on public finances in coming decades because of healthcare and social care costs.

Traditionally Governments have given more resources to the NHS while squeezing other areas of public spending such as defence, said Mr Hughes, but this may no longer be an option as the ability to cut elsewhere becomes more limited.