Timothy Ash is an Associate Fellow of the Russia and Eurasia Program at Chatham House and Senior Sovereign Strategist at Bluebay Asset Management.
Imagine for a moment a country shaken for years by political instability. He has seen four prime ministers in just six years and three general elections in the past seven years. This country also held a referendum on its relations with its neighbors and voted to leave its main trading bloc, which led to a collapse in its trade volumes and slowing growth.
While this country calls itself a democracy, its new Prime Minister was chosen by members of an elite club comprising barely 0.2% of the actual electorate. And now this Prime Minister – who hasn’t even won a popular mandate to govern – has launched a pro-growth populist agenda: taxes on the top 5% must be cut in the hope of reviving growth and create a net…low feel-good factor.
Welcome to today’s Britain, a mature G7 country, where it all sounds like a very emerging market.
The UK economy suffers from deep structural problems and a fundamental lack of competitiveness, as evidenced by a current account deficit of over 8% of GDP. Years of underinvestment in public services, education, housing and transport have left an unskilled and immobile labor force in the region struggling to fill the voids left by the departure of foreign workers, which has been caused by the nationalist agenda of the ruling party.
Likewise, years of underinvestment in energy infrastructure have left the economy dependent on energy imports and, with low storage capacity, dependent on the vagaries of global spot prices. Inflation rises, living standards fall, and workers go on strike for higher wages. A wage-price spiral is emerging.
The UK government has responded to these challenges with bailouts and now tax cuts, which will further increase already bloated budget and current account deficits and increase public debt. Senior civil servants, who might have criticized such economic policy, have been expelled, and an Office of Budget Responsibility has been told to delay the release of updated economic forecasts, lest it show the government’s plans in a negative light. .
Meanwhile, the “independent” central bank governor has been undermined by constant beatings and whispers about his competence within the ruling party.
As expected, the market was not convinced by the new government’s rapid growth economic policy. The government’s borrowing costs have risen, making its macroeconomic forecast now seem unsustainable. Everything is collapsing, and there is talk of a crisis in the air.
All of the above sounds like a classic Emerging Market (EM) crisis country. And as an EM economist for 35 years, if you presented me with the fundamentals above, the last thing I would recommend right now is a program of unfunded tax cuts.
Sri Lanka tried to do just that between 2019 and 2022, and it ended in a currency crash and default.
For starters, there is little evidence to suggest that a set of wildly regressive tax cuts can successfully kick-start growth.
Moreover, with the starting point being a public debt-to-GDP ratio close to 100%, the obvious question is how will all of this be financed?
Markets will need to be convinced that the program will indeed generate real GDP growth and achieve competitiveness gains to address the large account deficit. Markets will also surely wonder what the UK’s fundamental structural problems are – is it high taxation and restrictions on bankers’ bonuses? Or are the problems much deeper?
I would argue that the UK’s problems start with Brexit, itself the result of years of underinvestment in education, housing and transport, which sparked a huge north-south divide and helped fuel racism, which fueled the Brexit vote.
Brexit signaled that foreigners were not welcome in the UK and as a result many skilled foreign workers have now left. But low taxation will not attract international companies if the country is not perceived as open to international labor, which it is not.
And even if tax cuts could generate growth, confidence in the UK is now so low that international financial markets have little faith in the ability of UK policymakers to deliver on their promises.
Instead, in reality, the tax cuts likely mean a larger current account deficit in the near term, which will require either a weaker currency or higher interest rates, or both, to reduce the external financing gap. Interest rate hikes will likely cripple the housing market and trigger a deep recession, running counter to the government’s growth agenda.
As in many emerging markets, in the UK the ‘independent’ central bank is now under pressure from the ruling party to hold rates, which only risks a collapse of the currency, fears of a sovereign debt crisis and eventually a banking crisis.
In the world of emerging markets, all of this would mean that funding gaps would have to be filled by some combination of fiscal or monetary tightening and/or monetary adjustment, perhaps delayed for some time by currency intervention (FX ) – but the Bank of England’s foreign exchange reserves are limited.
An alternative is to “call a friend”, namely the International Monetary Fund (IMF). However, in an emerging environment, if a country went to the IMF, it would also demand policy tightening, reversing the country’s growth agenda. However, fiscal tightening seems to have been ruled out by Chancellor of the Exchequer Kwasi Kwarteng’s desire to bet on growth.
The only option the UK has without the IMF, however, is for the pound to weaken further and UK borrowing rates to rise. But the harsh reality is that even this option would also stunt growth.
It’s time to recognize that the UK government’s growth agenda is just wishful thinking.