It may start a fight with the Bank of England and a trade war with the EU, which would affect the pound
The new British prime minister faces a test of the markets. If Liz Truss only planned big energy grants, investors wouldn’t worry too much. She but she also plans tax cuts, and she may start a fight with the Bank of England and trigger a trade war with the EU. If so, the pound could be affected.
In many ways, the UK faces similar challenges to other European countries: high inflation, rising rates, rising energy prices and a looming recession. As long as he stays in the pack, the markets won’t pay much attention to him.
But Britain also faces additional risks. Inflation is especially high, Brexit has hurt the economy and the country runs a chronic current account deficit, meaning it relies on foreign investors to pay its bills. Also, Truss doesn’t want to be part of any package. He believes that bold supply-side reforms will launch the country onto a new path of higher growth.
Although not a bad ambition, it has not presented a convincing strategy. She looks more like a populist prime minister who enjoys confrontation. According to the media, she is willing to declare China a “threat” and has questioned Britain’s “special relationship” with the US She is also taking a hard line with the EU. Meanwhile, she has said that she wants to change the mandate of the Bank of England, which is to provide price stability.
Until now, the UK has been in the middle of the European herd on tax matters. Public debt was 100% of GDP at the end of the first quarter, not much above the EU’s 88%. Since September, Britain has allocated 1.6% of annual GDP to cushion the energy crisis for consumers and businesses, about the same as Germany and France, according to the thinktank Bruegel, based in Brussels.
It’s unclear what extra help Truss will give to support people with energy bills this winter. But it will be expensive. The support to households alone could exceed 60,000 million euros throughout 2023, that is, 2% of GDP. Helping businesses would require another megaproject. If gas prices remain high, the government could face similar costs next winter and beyond.
This rescue may end up being more or less in line with the rest of Europe. Germany announced over the weekend an energy package of 65,000 million. The difference is that Truss will simultaneously cut employment taxes and reverse a planned corporate tax hike, which will cost at least $35 billion a year. And he doesn’t seem to want to cut spending to compensate.
He is also adamantly opposed to financing his aid package through extraordinary taxes on energy companies. It’s a missed opportunity, as the sector will post $200 billion in excess profits over the next two years, according to a UK Finance Ministry estimate reported by Bloomberg.
High inflation could help the government by lowering the debt/GDP ratio. But it’s not a get-out-of-jail card like it is for other countries, because a quarter of Britain’s public debt is linked to inflation, and just over a third has been bought by the Bank of England.
One of the ways in which Britain is already an outlier is that prices are rising faster than other G7 countries. Inflation shot up to 10.1% in July, and analysts at Citigroup have just predicted that it could reach 18.6% in early 2023.
Therefore, the Bank of England will have to raise rates a lot to restore price stability. It is also ready to start selling government bonds at the end of the month. These measures are unlikely to satisfy Truss. Not only will they deepen the recession and hurt their top voters, they will make it harder to finance a fiscal windfall.
That could lead to a further showdown between Truss and the Bank of England. Although many investors agree that the central bank has been slow to nip inflation in the bud, the priority now is to control prices. The markets will not like anything that looks like a manipulation of the Bank’s independence.
Truss may also spark a trade war with the EU over Northern Ireland. The 2019 agreement allows control of goods crossing from the island of Great Britain to Northern Ireland. London has since tried to change the protocol, but the EU has insisted it is a basic part of the Brexit deal.
While Boris Johnson used to kick the issue forward, Truss seems to want to bring it to a head. Although he opposed Brexit in the referendum, he now has the enthusiasm of a convert. To become prime minister, he too has had to court his fellow Brexit hardliners.
It would be sensible for both sides to negotiate a settlement. But they are so entrenched ideologically that it will be difficult. There won’t be much goodwill, after Truss recently said she was undecided whether Emmanuel Macron, who is the most powerful voice in the EU, was friend or foe.
The saga will likely take months to unfold, and Truss may tone down his rhetoric now that he is in power. But if she suspends parts of the protocol, the EU is likely to do the same to the trade deal, further hurting exports and fueling inflation.
Until recently, investors viewed the UK as part of the European package. Both the pound and the euro have fallen sharply against the dollar this year, and government bond yields have risen around the world. But now there are the first signs of nervousness focused specifically on Britain. The spread between British and German 10-year debt has widened by 0.3 percentage point in the last month. In the last 10 days, the pound has fallen about 2% against the euro.
A cocktail of particularly loose fiscal policy, central bank attacks and conflicts with the EU could make the UK look like an outlier. Investors could then hit hard on both the pound and the gilts.
