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Why the UK needs to find a global solution to its economic crisis

In the long run, the main problem for Britain is growth stagnation. (file)

London:

Recent changes in the UK’s top job have had a positive impact on the pound sterling and long-term sovereign bond yields. But the financial market’s reaction in recent weeks has been muted compared to the financial turmoil over former prime minister Liz Truss and ex-chancellor Kwasi Quarteng.

After the mini-budget on 23 September, markets reacted to a poor policy: the strategy of a truce to make massive tax cuts without being sure how it would be funded. Conversely, bond yields fell below recent highs (essentially reducing the cost of government borrowing) and the pound appreciated. But overall, the market losses seen after the mini-budget have barely recovered.

For investors, solid and stable economic policies mean a lot more than the person living in No. 10. And that’s why, even with a new prime minister, recent market movements indicate that investors continue to see more significant issues with the UK economy, both immediately and over the longer term.

In the short term, yields on UK sovereign bonds have increased after a short budget, raising the government’s cost of borrowing. This negative reaction was exacerbated by the lack of a simultaneous forecast by the Office of Budgetary Responsibility (OBR).

Previously, the Bank of England was considering a bond-selling exercise to try to bring rising inflation back to its 2% target by reducing the supply of money in circulation (this is known as quantitative tightening). .

Instead, it had to change course quickly following the mini-budget. It not only postponed this tightening, but also restarted quantitative easing and bond buying, with pension funds pledging to buy up to £10 billion a day of gilts to address the associated crisis.

Two things will now determine future sovereign bond yield dynamics and determine government borrowing costs.

First, the Bank of England plans to continue its policy of quantitative easing (buying bonds to keep yields low) before quantitative tightening again. The markets are watching these actions very carefully and any suggestion that this support will be discontinued by the bank could upset traders and investors.

Second, the government’s medium-term fiscal plan, currently scheduled for October 31, will also impact bond yields. Unlike the mini-budget, the scheme will come with an in-depth evaluation from OBR, giving more insight to the markets. Also, the current chancellor, Jeremy Hunt, has put forward some fiscal planning measures to ease market concerns.

However, it is not yet clear what kind of plan this will be. Hunt’s debt-cutting strategy and the new government led by Rishi Sunak should reassure markets about the UK’s financial stability, but it is still unknown whether this will happen through higher taxes or less spending. Some evidence on what would be best for the economy supports raising capital income taxes (capital gains tax and inheritance tax) rather than cutting public spending or raising income taxes.

In the long term, the UK’s major problems are lack of growth and productivity. And if the new government addresses current problems by raising taxes and cutting spending – with higher interest rates from the Bank of England – there will be more economic pain.

Changes in the global economy Many countries are facing issues similar to the UK, contributing to a weaker global economic outlook in general. After a long period of historically ultra-low interest rates, growth – the so-called normalization of monetary policy – ​​was expected in most countries. But a sharp rise in inflation due to Russia’s invasion of Ukraine and pandemic-era supply chain issues have caused most central banks to scramble to tighten monetary policy even more by raising rates more quickly.

These rate hikes and policy tightening strategies by central banks can create significant financial and fiscal instability. For example, the US Federal Reserve has already opened its balance sheet from a peak of US$8.97 trillion (£7.9 trillion) in April 2022, causing the dollar to appreciate by more than 13% over the past six months. This has created challenges for emerging market currencies as well as major currencies – the yen, pound sterling and euro – which have all depreciated significantly against the US dollar.

This has added to inflationary pressures, particularly in the eurozone and the UK, but it also affects sovereign bond yields challenging economic stability in these countries. Since August, the cost of borrowing has more than doubled for many people.

But to offset rising inflation, even more central banks will want to shrink their balance sheets by selling bonds. The total size of the asset purchase programs of the main four central banks alone is approximately US$26.7 trillion. With a weak global economy and these other financial vulnerabilities, it is going to be a painful exercise for the global economy.

In fact, such strictures would further increase the cost of government borrowing, particularly for highly leveraged governments, and would pose major issues for those still paying pandemic-era support such as the UK and the eurozone.

The UK in particular is also dealing with a shift in the global economic center of gravity away from its economy. In less than two decades, the UK has shrunk from being a large economy to almost nine times smaller than China. And the pound no longer enjoys the same status as the US dollar, which means financial markets will punish it severely if it goes out of line.

This means the new UK government faces a difficult task in restoring global investor confidence in its economic stability, even with a new prime minister as a widely held steady hand. is seen.

(Except for the title, this story has not been edited by NDTV staff and is published from a syndicated feed.)

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