Chancellor constrained by Brexit hit to public finances

In the immediate aftermath of the EU referendum, with concerns about the near-term economic outlook at their height, the prospect of a sizeable fiscal stimulus package being included in the Chancellor’s Autumn Statement looked odds on. Certainly, Philip Hammond made all the right noises in the immediate aftermath of taking office, abandoning George Osborne’s previous target of balancing the budget by 2019-20.

But the subsequent performance of the economy, which grew by 0.5%Q/Q in Q3, well above most expectations, as well as an apparent desire by both the Chancellor and the Prime Minister to maintain at least the pretence of a commitment to fiscal rectitude, has seen repeated attempts to rein in expectations of a substantial stimulus package when the Autumn Statement is presented next Wednesday. Instead, a programme of infrastructure spending in the “low billions of pounds a year” is the line the media is now being fed.

Notwithstanding that the Chancellor is set to be more cautious than he initially indicated, the position of the UK’s public finances is significantly worse than anticipated at the time of the March Budget. For the first six months of the year public sector net borrowing was £45.5bn, well behind the improvement anticipated by the Office for Budget Responsibility (OBR) in its March forecast, and implying (if the trend of the first half of the year continues into the second) that the deficit will be a full £17bn above that expected.

Public sector net borrowing*Public sector net borrowing_18Nov16*Excluding public sector banks. Source: ONS, OBR, Thomson Reuters and Daiwa Capital Markets Europe Ltd.

And, looking further ahead, the position of the public finances is set to remain much weaker than expected before the EU referendum. While the economy has performed better than expected, there is no denying that Brexit has had a downward impact on growth, and one that is likely to intensify as (a) rising inflation increasingly eats into real income growth and (b) Brexit itself moves closer. Certainly, the BoE expects a significant slowdown in growth over coming months, something that the OBR will also have to do to a greater or lesser extent.

GDP growth forecastsGDP growth forecasts_18Nov16Source: BoE, OBR, Thomson Reuters and Daiwa Capital Markets Europe Ltd.

Slower growth, of course, means lower tax receipts and higher spending, with the upward pressure on expenditure compounded by higher inflation. The OBR will also have to take a longer-term view of growth than the BoE, forecasting out to 2022. This will force it to make assumptions about both the nature of Brexit (hard, soft, something in between) and its impact on the potential growth rate of the economy, not least as a result of the anticipated impact on net migration following Brexit. So there is no doubt that the OBR will forecast a significantly larger deficit, by up to £25bn, in 2019-20 than it did in March, with the debt stock falling (if indeed it is forecast to fall at all) at a much slower rate than previously expected. This will highlight both the damage to the public finances from Brexit and the Chancellor’s limited room for manoeuvre.

And it is this limited room for manoeuvre that will ultimately be driving his reticence to launch any meaningful fiscal stimulus. Indeed, fiscal policy, in aggregate, will continue to tighten over the next five years – the Chancellor will be willing to do little more than let the automatic stabilisers operate (whereby tax receipts fall and government spending on welfare automatically rises) as the economy slows. This, of course, will lessen the impact of the fiscal tightening, but will not fully mitigate it. As such, as the economic uncertainty surrounding Brexit intensifies with the triggering of Article 50, fiscal policy will be working to dampen, not boost, growth, whatever minor infrastructure spending Hammond announces next week. That, in turn, will put the pressure back on the BoE to act if growth slows more precipitously than it anticipates.

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