Chancellor Sticks to Fiscal Course, Looks Through Economy's Better-Than-Expected Near-Term Performance

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Wednesday, March 8, 2017 3:27 pm EST

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LONDON
"meet his target for structural borrowing in 2020-21 with room to spare, but not yet to achieve his goal of balancing the public finances"

It is notable that while the GDP growth forecast for 2017 has been revised up markedly (from 1.4% to 2.0%) and the expected budget deficit for 2016/17 has been cut by £16.4 billion (to £51.7 billion from £69.2 billion), the longer-term picture of the economy is essentially unchanged. The economy is still seen as the same size in 2020 as had been the case in last November’s Autumn Statement while an expected budget deficit of £16.8 billion in 2021/22 is little changed from the previously anticipated £17.2 billion 

  • A cautious, steady overall approach is essentially the defining feature of the budget. Chancellor Philip Hammond is clearly keen to keep fiscal ammunition up his sleeve – due to the major uncertainties and downside risks that the economy faces as it navigates its way out of the EU. Despite the resilience of the economy so far since last June’s Brexit vote, the Chancellor is very well aware that a challenging road lies ahead. Furthermore, an appreciable budget deficit is still seen existing in 2021/22 so there is still work to be done then on getting the public finances back to full health. The Chancellor stated that the only responsible plan is to continue to work to bring the budget deficit down.
  • There are limited targeted measures, most notably aimed at providing relief for small businesses suffering the most from changes in business rates and extra funds for social care for the elderly. As part of the government’s stated priority of lifting productivity, there are a number of measures aimed at supporting education, the development of technical skills and fostering Research & Development.
  • To help fund these measures, there is an increase in national insurance contributions from the self-employed. There is also a reduction in the tax free dividend allowance that directors can receive from their company.    
  • As expected, the Chancellor essentially stuck to the fiscal course that he had set out in last November’s Autumn Statement. The Office for Budget Responsibility (OBR) concluded that the budget is slightly stimulative for 2017/18 (between £1.7 billion and £3.1 billion depending on the basis calculated). There is a modest net takeaway from 2019/20 or 2020/21 again depending on the basis calculated.  
  • The OBR concluded that the Chancellor is on target to “meet his target for structural borrowing in 2020-21 with room to spare, but not yet to achieve his goal of balancing the public finances “at the earliest possible date in the next Parliament”. Specifically, the fiscal rules adopted by Mr, Hammond in November’s Autumn Statement included (1) the public finances should balance as early as possible in the next parliament (due in May 2021) and there must be a cyclically adjusted budget deficit (i.e. structural deficit) below 2% of GDP in 2020/21: and (2) net debt must fall relative to GDP in 2020/21. The OBR’s latest forecasts see a structural budget deficit of 0.9% of GDP in 2020/21, while net debt starts falling relative to GDP in 2018/19.
  • The Chancellor has a rainy day fund in case there are severe economic storms ahead as Brexit proceeds. The OBR calculates that the Chancellor has £25.8 billion spare to meet the structural budget deficit target in 2020/21. The Chancellor can also run a bigger deficit if the economy suffers a larger cyclical downturn than expected.
  • It is notable that while the GDP growth forecast for 2017 has been revised up markedly (from 1.4% to 2.0%) and the expected budget deficit for 2016/17 has been cut by £16.4 billion (to £51.7 billion from £69.2 billion), the longer-term picture of the economy is essentially unchanged. The economy is still seen as essentially the same size in 2020 as had been the case in November while an expected budget deficit of £16.8 billion in 2021/22 is little changed from the previously anticipated £17.2 billion.
  • While the OBR is more confident about the economy in 2017, the GDP forecasts for 2018-2020 have been trimmed.
  • While the projected budget deficit for 2016/17 was slashed by £16.4 billion (to £51.7 billion from £69.2 billion) compared to what had been expected in the Autumn Statement, this was attributed primarily to one-off factors and timing effects rather than structural factors. Indeed, the expected overall budget deficit was only then trimmed by a further cumulative £7.4 billion over the period 2017/18 to 2021/22.      
  • We suspect the upgrading of the 2017 GDP growth forecast to 2.0% will likely prove to be over-optimistic and we also believe that growth will come in lower than the OBR expects in 2018. This would put upward pressure on the fiscal targets.

Economic Forecasts

All the economic forecasts contained in the budget have to be considered in the context that there is massive uncertainty over how the UK’s relationship with the EU will develop over the next few years and what arrangements are eventually reached regarding trade, access to the single market and immigration. The growth forecasts for 2019 and beyond are particularly uncertain given that the UK would be due to leave the EU in April 2019 (assuming Article 50 is triggered by the end of March) and nobody knows what arrangements will be in place by then.

Growth

Reflecting the economy’s extended resilience since last June’s Brexit vote, the OBR sharply raised projected UK GDP growth in 2017 to 2.0% from the 1.4% expected in last November’s Autumn Statement.

Significantly though, this improvement is not seen lasting as the growth projections for 2018 (to 1.6% from 1.7%), 2019 (to 1.7% from 2.1%) and 2020 (to 1.9% from 2.1%) have been trimmed. Growth in 2021 is still seen at 2.0%.

While the economy ended 2016 better than expected, we believe the upgrading of the 2017 GDP growth forecast to 2.0% may be over-optimistic and we also suspect that growth will come in lower than the OBR expects in 2018. In particular, there are mounting signs that consumers are now starting to rein in their spending as their purchasing power is increasingly squeezed by rising inflation. Furthermore, we suspect that inflation will rise more than the OBR forecasts (they see it averaging 2.4% in 2017 and 2.3% in 2018) so the squeeze on consumers will be deeper than they expect.  

Consequently, we expect GDP growth to come in around 1.6% in 2017 and we see it slowing to 1.2% in 2018. We see growth picking up to a limited extent in 2019 (t0 1.5%) and 2020 (1.8%).

Fiscal Forecasts

The OBR now sees Public Sector Net Borrowing excluding banks (PSNBex) being £23.8 billion lower during 2016/17 to 2021/22 than it had at November’s Autumn Statement. However, this improvement is largely concentrated in 2016/17 (to the tune of £16.4 billion) due to one-off and timing factors, rather than perceived structural changes. In fact the 2017/18 deficit is seen rising from the expected 2016/17 shortfall and an appreciable shortfall is still seen in 2021/22.

Specifically, PSNBex is now seen coming in at £51.7 billion (2.6% of GDP) in 2016/17 then rising to £58.3 billion (2.9% of GDP ) in 2017/18 before coming down progressively to £40.8 billion (1.9% of GDP) in 2018/19, £21.4 billion (1.0% of GDP) in 2019/20, £20.6 billion (0.9% of GDP) in 2020/21 and £16.8 billion (0.7% of GDP) in 2021/22

In November, the PSNBex had been seen at £68.2 billion (3.6% of GDP) in 2016/17 then coming down to £59.0 billion (2.9% of GDP ) in 2017/18, £46.5 billion (2.2% of GDP) in 2018/19, £21.9 billion (1.0% of GDP) in 2019/20, £20.7 billion (0.9% of GDP) in 2020/21 and £17.2 billion (0.7% of GDP) in 2021/22.

If growth comes in less than the OBR forecasts as we expect, then the Chancellor will be highly likely to miss these fiscal targets. However, he has scope to do so under the fiscal mandate he adopted in the Autumn Statement.

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