Budget commentary: Chancellor is trying to keep up his fiscal-guard ahead of the ‘Brexit’ vote

Neil Williams, Group Chief Economist at Hermes Investment Management, sets out his reaction to today’s UK Budget:rnrnWith the ‘Brexit’ vote looming, the chancellor was never going to wantonly let his fiscal-guard down today, and deviate widely from his aim of returning the underlying deficit ‘to the black’ by 2019/20. This target he has preserved. But, to do so, he has had to take leeway in the intervening years, as the “cocktail of risks” he’s been flagging takes its toll on the OBR’s growth and tax revenue assumptions. This means the cost of preserving the 2019/20 target-date is an even steeper glide-path to surplus before then.rnrnThe intervening slippage amounts to a meaty 2 percentage points of GDP, compared with his previous plans. This has been limited by the funds still in his ‘back-pocket’ from bank proceeds and the BoE’s deferral of asset sales.rnrnAnd, as usual, he managed to pull some ‘rabbits from hats’, such as on saving, over-indexing of personal allowances, and corporation tax. But, while helpful to longer term growth and competiveness, his measures short-term may have more micro than macro effects on the economy.rnrnSo, let’s not get carried away. The fiscal screw will have to stay tight if he is to hit his target of grinding down the underlying budget deficit and returning ‘to the black’ in 2019/20.rnrnFirst, the deficit is still high. Even including special items like bank sales, QE, and milder inflation and interest-rate assumptions, the 3.8%-of-GDP headline deficit for 2015/16 could be the G7’s widest after Japan.rnrnSecond, the recovery should have squeezed the deficit more than it has. While the headline deficit falls on sustaining growth, the structural, less growth-sensitive part will fall by less, begging further reform and consolidation.rnrnAnd, only in 2015/16 is the net-debt-to-GDP ratio expected to have peaked, at 84% – disappointing given real GDP is about 7% up on its pre-crisis peak. This 84% ratio is more than twice Japan’s was, when Japan limped into a ‘lost decade’ in the mid 1990s.rnrnFinancing this debt may become more troublesome if the UK has to deal with the effects of a ‘Brexit’. Should it occur, conventional gilts may benefit initially from the perceived hit to growth. But, this could be short lived, given about one third of the £1.3trn gilts outstanding is backed by international investors who will be sensitive to both currency and ratings risk.rnrnIn which case, it’s possible that dealing with a ‘Brexit’ and a hit to growth may need the BoE to reactivate its QE. And, with the main rating agencies already twitchy, an ever bigger fiscal loosening today would have added to the chance of a ratings downgrade in the event of a ‘Brexit’.