The UK’s newly minted chancellor of the exchequer, Kwasi Kwarteng, presented his maiden mini-budget, the “Growth Plan”, on September 23. It was ostensibly designed to give much-needed assistance, via fiscal transfers, to businesses and households negatively affected by an energy price shock. It also included lower taxes for high-income earners and corporates. The intention was to protect the UK economy from the ravages of higher energy prices, and to raise the potential growth rate of the country, still struggling with Brexit drag.
These objectives look reasonable enough, though the ideological foundations of the plan can be debated. However, Kwarteng failed to outline how these tax cuts and new outlays would be financed. Economists immediately calculated that the “Growth Plan” would mean the UK government would have to borrow 1.7% of GDP in the coming fiscal year. This, on top of the planned rollback of central bank balance sheet holdings, implied a material rise in the supply of government bonds. Yields rose, and sterling fell.
This might have been the end of the story, but then came the idiosyncrasies caused by financial engineering. Pension funds found themselves at the receiving end of margin calls on some gilt derivative contracts, which generated a doom loop. Yields moved higher, margin calls increased, and yields moved higher still. Liquidity dried up and the Bank of England had to interfere to restore market function. The 30-year gilt rose more than 150 basis points, the 10-year more than 100bp and the two-year more than 100bp before the Bank of England intervened.
The pound lost more than 7% of its value relative to the dollar over 24 hours and panic spread throughout global financial markets. The BOE, which had been reducing its holdings of gilts since the beginning of the year, has now had to start buying them. The bank did not have a choice. It was either let the market break or intervene. The “Growth Plan” delivered higher inflation, higher borrowing costs, an outraged polity and anything but growth.
Spending pressures
The lesson to take from Kwarteng’s experience is that the current market environment is not one for policy adventurism. The same announcements from the chancellor 18 months ago would have solicited maybe a deep frown from the markets. After all, we were gorging on unrestricted liquidity in a no-inflation environment. Markets must now adjust to overshooting inflation, slimming central bank balance sheets, rapidly rising rates, and an ever-increasing cost of capital. They have little to no tolerance for risk and will clearly punish a lack of orthodoxy harshly.
Which brings us to SA. National Treasury will publish its medium-term budget policy statement, our version of the mini-budget, in three weeks. Revenues are expected to again overrun relative to February estimates. The fiscal deficit should be materially narrower than February estimates, but spending pressures remain high. Upward pressures from public sector wages, support for state-owned entities and social transfers persist. Calls for expansion in expenditure ignore the fact that SA is still on an unsustainable debt path.
Treasury has split the spoils from unexpected corporate taxes almost evenly between the market, via lower borrowing and expanded social support. Yet, the costs of funding barely budged, reflecting that government borrowing remained elevated, fiscal risks high, and appetite for emerging market bonds depressed.
I support policy experimentation and think SA’s challenges can only be solved by doing things differently. However, as we go into the mini-budget, officials must know that the terrain is more hostile than ever before, and that there is little room for adventurism. When the US Federal Reserve hikes rates, markets become fragile, and things break. The gilt market broke. Emerging market bond markets are breaking. We should do our best to safeguard our markets and our economy in these treacherous times. That is an argument for policy conservatism.
• Lijane works in fixed-income sales and strategy at Absa Corporate & Investment Banking.
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