Is the UK on the Brink of a Financial Precipice?

Over the past week, the UK's long-term borrowing costs have surged to levels not seen in decades, prompting Chancellor Rachel Reeves to dismiss claims that the heavily indebted nation is heading for a financial crisis. Most economists currently agree with her view – but only for now. Economists say that with industrialised nations' debt levels hitting record highs and debt servicing costs steadily climbing, the UK could become a "canary in the coal mine" (a metaphor for a risk warning signal) in financial markets, an early indicator of potential crises in other indebted countries like the US and France. "The UK is not the only country facing this situation," Ruth Gregory, deputy chief UK economist at Capital Economics, pointed out. "There is a common problem across many G7 nations: the conditions that give rise to a potential fiscal crisis seem to be in place, although that doesn't mean a crisis is imminent or inevitable."

Underlying Causes for Concern

Last year, the UK Labour government announced the largest tax increase in a generation, calling the move a "one-off measure" aimed at filling a widening public finance gap and demonstrating Britain's commitment to fiscal balance to investors. But now, Reeves is expected to once again ask British taxpayers to pay billions of dollars in additional taxes in November. The reason behind this is: the UK's continued rising borrowing costs, economic growth falling short of expectations, and despite the government having a stable majority in parliament, it remains difficult to cut ever-expanding welfare spending. Economists fear that this cycle could repeat itself over and over. Over the past 20 years, governments have indulged in a “borrowing binge” fueled by low interest rates. Now that interest rates have risen, investors fear that Western governments are unwilling to make politically difficult decisions to cut public spending, leading politicians into a “vicious cycle of continuous tax increases.” The French government may fall in the next week due to its plans to cut spending and abolish two public holidays (by adding two working days to increase tax revenue) which have met with political opposition. According to data from the International Monetary Fund (IMF), debt in developed economies as a share of annual economic output (GDP) has doubled since 2007, reaching approximately 80%. The IMF says that by the end of this decade, global public debt may approach 100% of GDP, partly due to rising borrowing costs. In the past year, net interest payments on government debt worldwide increased by 11.2% to $2.72 trillion, partly due to persistently high inflation pushing up interest rates.

Unique British Vulnerabilities

The UK is not the Western country with the largest debt, nor does it have the slowest economic growth. But unlike the US, the UK does not have a major reserve currency; and unlike its European neighbors, the UK is not part of a monetary union with a “large central bank” – the European Central Bank has helped debt-laden member states develop bailout plans. In addition, the UK has experienced market turmoil in recent years: in 2022, after then-Prime Minister Liz Truss launched a policy of “unfunded tax cuts + large-scale borrowing,” the pound's exchange rate collapsed, and Truss was forced to resign just weeks after taking office. Today, investors are asking the UK to pay a "small premium" for borrowing – UK borrowing costs have risen sharply in recent years, partly due to persistently high inflation. Last week, the yield on the UK's 30-year bonds rose to its highest level since the late 1990s, surpassing that of more indebted France. The UK's 10-year bond yield is currently the highest in the G7, surpassing the US. "Some countries have higher debt or deficit ratios, but when you see the proportion of debt servicing costs, the problem stands out," said Mark Dowding, chief investment officer of fixed income at RBC BlueBay Asset Management. Data from the UK's Office for Budget Responsibility shows that UK debt interest payments are expected to reach £111.2 billion (approximately US$150 billion) next year, twice the country's defence spending; UK government debt is currently less than 100% of GDP, but driven by population aging and increased spending on healthcare and pensions, it is expected to rise to 270% by the early 2070s. Gregory of Capital Economics said that these factors combined make the British debt market a "potential tinderbox" – whether a domestic or overseas market crisis could trigger a further surge in its bond yields.

Opportunity in Crisis?

Some believe that precisely because the Bank of England is independent and unlikely to provide financial assistance to the government, the UK will be the “first” to face the reality of post-pandemic debt overhang. "The process will be messy and painful, but the UK will at least face the problem," said Robin Brooks, a senior fellow at the Brookings Institution. "Other countries may wait until a crisis breaks out before taking action." On the other hand, Francis Diamond, head of European interest rate strategy at JPMorgan, believes that the UK is unlikely to repeat the market collapse of the Truss era. The pound's exchange rate against the US dollar has risen over the past year, in stark contrast to the sharp declines under Truss or when the UK accepted IMF assistance in the 1970s. But the overall trend is not positive. The Labour government elected last year pledged to assume more “fiscal responsibility,” but its first attempt this year to cut the growth of welfare spending failed due to opposition from members of its own party. In July, Reeves shed tears in parliament over “giving up a slight cut in welfare” – after Labour members threatened to “rebel,” a plan to cut fuel subsidies for the elderly was suspended. Economists say this leaves Reeves in a "difficult balance" when she announces spending plans this fall: finding ways to increase taxes without stifling economic growth.