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Not unlike death and taxes George Osborne described last weeks budget as unavoidable, with the coalition Government reversing the direction of Government spending after years in which it rose significantly and finished accounting for 51pc of GDP in the dying days of the Labour Government.  The argument at the centre of the debate is not whether or not public spending cuts should occur as Labour had already ear marked significant sums (73bn over five years) but the speed they are undertaken and the overall size of them.  The coalition Government argues that with growing difficulties in the bond markets, where investors have now turned their back on Greece and where the Government depends on European Central Bank money to survive, that the UK cannot risk going down the same route.  They argue that it they continue along the lines of what the previous Government had done then International investors would turn their attention on Britain forcing interest rates significantly higher as they demands a higher premium for lending money to a Government whose finances are heading in the wrong direction and it is important to remember that even after the harsh coalition cuts, we will still in five years time still be borrowing more than we spend as a nation under the current plan. My fear is that with high growth forecasts included borrowing are likely to be higher than projected. Whilst the coalition cuts are significant they argue that whilst this will affect growth the impact will be significantly less than the nightmare scenario of a Sovereign debt crisis when instantaneously they would not be able to borrow money from investors leading to a Sovereign debt default or emergency loan from the IMF.  Whilst sovereign default is the extreme of the situation the more like is that investors will demand an ever increasing higher level of interest on their debt and this would significantly push interest rates up and this would have a much more significant dampening effect on the economy.  The Coalition hopes that by taking action now and continuing to receive the backing of its creditors then interest rates can stay low for a more prolonged period thus helping to offset the slowdown inflicting by the reduction in Government spending.  

 

In all honesty nobody knows the outcome although its success I believe significantly rests on the fortunes of our global trading partners and in particular our biggest trading partner Europe.  Here I remain concerned that the difficulties in the Euro zone will push the region back into recession and this will have a dramatic effect on our own growth.  If European debt problems push Europe back into a recession, then to have cut UK public spending now however painful, will have been the correct thing to do. As without the cuts, the future pain would have to be considerably worse as the adjustment would have to be larger.  With this scenario of a slowing European economy I do not believe that the growth forecasts predicted by the Office of Budget Responsibility will be achieved and with it much of the heavy lifting that the budget depends upon to achieve stronger revenues, which means less borrowing. Growth this year is now forecast to be 1.2pc as opposed to 1.3pc and next year it has been cut to 2.3pc from 2.6pc.  Thereafter and for the remaining three years that the Coalition hopes to remain in Government growth is forecast to be 2.8pc, 2.9pc and 2.7pc respectively.  This latter growth is above trend and I believe it will be very hard to achieve, due to difficult economic conditions with our main trading partners.  We should also remember that his March budget Alastair Darling was predicting a growth of 3.2pc next year and 3.5pc the following year, which as I commented upon at the time looked hugely unrealistic.  It should also be remembered that the budget does not balance the books over the life of this Parliament and in the last year the prediction is that the Government will be borrowing £37bn for 2.1pc of GDP.  Whilst this is heading in the right direction from the current £155bn or 11pc of GDP this is deficit reduction and not debt reduction.  The last balanced budget in the UK was in 2001 and whilst Keynes is entirely right by stating that Governments need to support the economy through borrowing in times of distress, he himself makes it plain that this should only be a short term remedy and that once the economy is on a more stable footing then this money should be paid back.  What we seem to have lost sight of in the UK is the fact that if we do not pay this money back in the better times an indeed even in the boom times, the UK was running a budget deficit of 3pc.  The volume of outstanding public debt will therefore continue to rise from £900bn to just below £1.4tn by 2015/16.  As a result of the budget total public sector debt is forecast to continuing rising from 62pc GDP to a peak of 70.3pc in 2013/14 before falling to 69.4pc in 2014/15.  It is also important to remember that whist we talk about the Government’s spending requirements that require to be funded because of the redemption of existing debt then the Debt Management Office believes that in 2010/11 Gilt issuance will be around £165bn of which some £48bn is already issued.  The encouraging element of this is that whilst this still remains huge, it is lower than the £185.2bn that they had previously forecast, if however growth fails to materialise as planned then this number will not fall as fast over the remainder of the Parliament as is expected.

 

The Chancellor was true to his promise of accelerated deficit reduction financing by committing to an additional debt fiscal tightening of £40bn or 2pc of GDP over and above the £73bn already penciled in by Labour over the next five years.  This is less than some had hoped for as it does not balance the books over the course of Parliament but I believe it strikes a reasonable balance between austerity and economy recovery. Importantly the actions have received the backing of the all important credit rating agencies and the removal of an immediate downgrading has been avoided. Moody’s said that the proposals were “supportive” of Britain keeping its coveted top notch AAA rating and Fitch said that if delivered upon, the budget would “materially strengthen confidence in UK public finances and its AAA status”. The majority of the tightening will occur through public spending cuts rather than tax increases and the ratio between these two rises from 60:40 under the previous administration’s plan to 80:20 by 2014/15.  Though the public spending cuts will be difficult to implement and there is likely to be a public sector backlash the reductions in current spending rather than capital investment is I believe a sensible move.  Dave Prentis, General Secretary of Unison, said this is the most draconian budget in decades.  "This budget signals that the battle for public services has begun with the Government declaring war.  Public sector workers will be shocked and angry that they are innocent victims of job cuts and pay freezes."  He was of course responding to the fact that due to election promises and the ring fencing of the National Health in particular most Government departments are likely to see a 25pc cut by 2014/15.  This represents one of the most dramatic spending freezes in any advanced economy in recent times.  The budget proposal that the tightening with equate to around 60,000 jobs looks in my opinion to be very much on the light side and there is every likelihood that unemployment will peak at around 3 million before falling back. For the restructuring of the economy the coalition hopes that the private sector and exports offset the weakness created in the public sector. The VAT increase to 20% on the 4th January should ensure a buoyant retailing Christmas but thereafter trading is expected to drop off quickly. The delay will ensure that consumer facing companies can adjust their businesses ahead of this, bearing in mind many have lead times of 6 months, ensuring that they do not over order and are therefore not left with losses in the early part of next year as they have to sell excessive stock cheap.  A number of retailers expressed relief that the scope of VAT had not been extended to areas such as food and children’s clothes, in spite of some calls for the government to consider this as an alternative to raising the headline rate. Also the Coalition has confirmed it has recruited ex-Labour Cabinet Minister John Hutton to look at state employee retirement funds and that another former Labour Cabinet Minister Frank Fields has been recruited by the Government to examine anti-poverty policies.  The budget also includes high capital gains tax, a levy on banks, a two year public sector pay freeze and less generous benefits.

 

Whilst George Osborne described the VAT increase as unavoidable the highly regarded Institute of Fiscal Studies believes that the single largest revenue raising measure in today’s budget could have been avoidable if the Chancellor had not decided to cut other taxes.  For over a year I suggested that whichever Government came into power VAT would rise to 20% as from an administration point of view it very quickly brings in additional revenue through an existing collecting system, at no cost to the Government and is very largely unavoidable.  It should also be remember that the UK has one of the lower rates of VAT in the European Union, even after the rate increase. The IFS also stated that the reform of capital gains tax was a missed opportunity to set out a long term vision on how savings should be taxed and the reform of capital allowances was ill judged and not a simplification. The national insurance break for start up firms was complicated and highly likely to be abused and it thought and that the bank levy lacked a clear rationale. They praised the long overdue publication of policy costing details as this would increase understanding of and trust in policy decisions and welcomed a switch in the direction of Labour’s complex and inefficient pension tax changes. The Chancellor has moved the tax-band threshold to counter the increase in personal allowances, which will free 880,000 of the lowest earners from paying any income tax. For those under the age of 65, personal allowance, the income you can receive without being taxed, will be increased by £1,000 to £7,475 in April 2011. The move will see 23 million basic-rate taxpayers pay £200 less in tax each year.  More than 700,000 will be dragged into the higher tax net because from next April the threshold for the 40pc tax rate will be reduced by £1,500 to £42,375 and over the next five years wages growth is expected see a further four million people become higher-rate taxpayers. The UK faces the "longest, deepest, sustained period of cuts to public services spending at least since World War II", said the respected Institute for Fiscal Studies (IFS) and it is the first time that six years of consecutive spending cuts will have been endured. They also suggest that if they had spread the planned departmental cuts across all departments, including health, they could have limited the real terms squeeze over the next five years to an average 14 per cent. By protecting health, the biggest spender, they increase the pain to 25 per cent for other departments. Education and defence are also to escape the worst of the squeeze. On the basis of the inflation forecasts included in the Budget, the IFS reckons that the decision to up rate most benefits in line with the CPI measure of inflation will amount to a 5% cut in these benefits, in cash terms, by 2015. The IFS pointed out, the reason the measures looked so fair was because they took into account the announcements made by Labour in its last few budget statements. By the end of the parliament, the IFS found that the total cost of Mr Osborne's budget was to make the poorest section of society 2.6% worse off, while leaving the richest only 0.6% down.

 

On Friday the Bank of England said in its half yearly Financial Stability Report that the UK’s economic recovery is at risk if the nation’s banks do not move swiftly to raise the £750bn-£800bn needed to refinance their borrowings due by the end of 2012 as UK banks have greater refinancing needs over the next two years than lenders based in the US, Germany, France or Italy. “There’s a risk banks alleviate their own funding pressures by further constraining credit conditions for customers,” the Bank said. “That would dent economic recovery and so raise credit risk for all banks.” Moreover, the Bank said banks needed to cut their pay-outs in the form of bonuses and dividends still further. If the ratio of bonuses to profits fell to pre-crisis levels and banks held dividends steady they could add £10bn in fresh capital. That would allow them to lend an extra £50bn to UK households and businesses. Britain’s banking system is particularly vulnerable because of its reliance on short-term borrowing to finance its long-term investments. UK banks will need to refinance £204bn next year, about twice this year’s needs and also twice their long-term borrowing average. This would require borrowing of about £25bn a month, more than twice the £12bn a month they have managed this year. The Bank of England also warned that lenders are writing off record quantities of credit card borrowings as thousands of individuals spiral into insolvency. The report showed in the year ended March 2010 banks wrote off more than 10 per cent of their credit card loan balances. This was a record rate, up from 7 per cent in 2007 and amounted to £1.25billion of defaulting debt in the first quarter of 2010 alone. Over the past 12 months banks have written off more than £4.5billion of credit card loans, with the Bank warning that the burden of interest payments could become even more crippling if official interest rates were to rise from their current ultra-low levels. At the start of 2008 it was 14.8 per cent, according to Bank of England data, but it now stands at 16.5 per cent. Last year £24billion went into deposit accounts while £20billion came out in new loans and this is the first time since 1988, when records began, that savings have overtaken new borrowing.

 

The last minutes from the Bank of England’s Monetary Policy Committee meeting when rates were kept on hold showed a surprise split of 7 to 1 on interest rates as Andrew Sentance voted for a rise from the record low, which would have pushed rates up to 0.75pc.  In a possible foretaste of things to come the CBI’s monthly survey of retailers showed that high street sales fell for a second month running in June and warned that retailers will face harsh times ahead as George Osborne’s budget dampens consumer spending.  According to the British Bankers Association mortgage lending continued its spring rise in May with the number of mortgage approved for house purchases rising to its highest level so far this year.  A total of 36,709 loans were approved by the major banks for people buying a property during the month.  This is the third month in a row of rising mortgage approvals and left the amount outstanding 4.3pc higher than in May 2009.  The BBA represents high street banks who account for around 75pc of mortgage lending.  We should however note that the rate of growth is almost half that of 2008 when mortgage lending was increasing by around 8pc a year and the number of mortgages approved is about half the number seen before the financial crisis hit.  Re-mortgaging accounted for the lion’s share of loans approved with 24,626 taking out new or replacement loans on their existing property.

 

I continue to remain very worried about the state of Europe and during the week rating agency Fitch warned that the global crisis has revealed weaknesses in the Euro zones economic framework which left it particularly vulnerable to the downturn.  Whilst it thought a breakup of the Euro zone was low over the short to medium term further periods of extreme market volatility were likely to persist until the recovery and debt reduction were secure in the region.  According to figures released in the week, banks in Greece, Portugal, Ireland and Spain accounted for more than two thirds of the increase in lending to Euro zone financial institutions by the European Central Bank since the summer of 2008 as many struggle to access financial markets.  The heavy reliance of these banks on the ECB for funding is a sign of the growing stress in the Euro zone as investors and banks refuse to lend to what they saw as increasingly troubled institutions.  According to the Royal Bank of Scotland banks in the four countries have borrowed €225bn of the €332bn increase in lending since June 2008 and report that the Central Bank has lent a total of €815bn to Euro zone banks at the end of May compared with €483bn in June 2008.  Outstanding loans to Euro zone banks by the Central Bank currently stands at €844bn.  Greece is the most reliant on the ECB having taken €78.1bn of increased lending followed by Ireland at €54.3bn, Portugal at €34bn and Spain at €58bn.  Germany has taken an extra €17.8bn.  Separately in the week the Bank of Portugal revealed that its banks had borrowed €38.5bn from the ECB in May compared with €17.7bn in April as investors and creditors grew increasingly reluctant to lend to it. The pound hit a 19-month high as debt concerns weigh down on the euro, last week as it touched 1.2222 Euros on Thursday; it’s highest since the financial crisis in November 2008, before dropping back as Markets continue to worry about the European debt crisis, with the risk of a default by Greece hitting sentiment. A weaker Euro does not help the Governments export growth strategy.

 

Crude-oil and gasoline futures settled more than 3% higher on Friday, as investors worried about a potential tropical storm brewing in the Caribbean. Light, sweet crude for August delivery added $2.35, or 3.1%, to $78.86 a barrel on the New York Mercantile Exchange, arriving at a weekly gain of 2.2%. It was oil's largest one-day gain since June 9 and oil's third consecutive weekly rise. Oil and natural gas markets are set to remain oversupplied until 2015, the International Energy Agency said on Wednesday, forecasting in its annual medium-term outlook report “comfortable spare capacity” for both energy commodities. The overall tone of the report was a reverse of with earlier years, when the western countries’ energy watchdog had warned about potential shortages. Nonetheless, it said: “We should not be complacent. Developing new supplies of oil and gas is in general a long-term undertaking.” For oil, the IEA revised upwards its forecast for rises in global crude consumption to 1.2m barrels a day per year, taking it by 2015 to a total of 91.9m b/d. But it also marked up its projection of global supplies in five years’ time to 96.5m b/d, leaving an ample cushion of spare capacity. But the IEA warned that supply risks abound. “First, there is the ever-present threat of geopolitical disruption surrounding a number of key OPEC producers. Second, the potential of the recent Deepwater Horizon disaster in the US Gulf of Mexico [risk delaying] substantial deepwater developments which underpin much of the expected supply growth,” it said. Even so, the IEA projected that the OPEC oil cartel’s spare capacity would remain at a relatively high level of 3.6m b/d by 2015, down from today’s 5.8m b/d.

 

It has been said for quite some time that the UK has lived beyond its means for far too long believing that the future would look after itself.  The future arrived in the week and the pain has become abundantly clear to all, unfortunately there is no quick fix to our or western economic troubles.  Whilst pain will be felt across the whole population it will I believe get worse because of troubles elsewhere within the world.  This will mean that the heavy lifting from economic growth that would boost Government revenues will not occur to the extent that is currently being forecast.  On the 20th October in the detailed Government spending review the exact level of individual department cuts will be revealed and whilst 25pc is an average some departments are thought likely to attract cuts of nearer 30pc as the pressure to lessen elsewhere demands harsher cuts for some. Difficult times are just starting and are unlikely to abate for a good year or two at the earliest. Markets in the UK were in selling mode last week amid a series of bearish updates from the US, leading to a weekly decline of 3.9% in the FTSE 100, which closed less than 50 points above the key 5,000 level. Having constantly talked about this level, I now think we are heading to 4700 and probably lower.

Leeds Solicitors Leeds Financial