U.K. Faces Three Catastrophic Risks to Public Finances, Watchdog Says

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The U.K. faces three potentially catastrophic risks to its public finances, the government's budget watchdog said, underlining the challenge confronting Chancellor of the Exchequer Rishi Sunak to restore fiscal restraint.

Unfunded pressures on government departments total some 30 billion pounds ($42 billion) over the next three years as a result of the pandemic, the Office for Budget Responsibility said on Tuesday in its biennial Fiscal Risks Report. The OBR also flagged U.K. ambitions to eliminate net carbon emissions by 2050 and the country's record 2 trillion-pound debt pile.

The risks “are global in nature, with the potential for rapid contagion across countries,” the OBR wrote. “Governments seeking to manage these threats must thus weigh the known costs of early action to mitigate these risks against the uncertain costs of dealing with the fallout when they crystallize.”

The report brings into focus the fiscal tightrope Sunak must walk as he tries to spur an economic recovery from the U.K.'s worst recession in three centuries while keeping a close handle on the national finances.

The chancellor has said he has a “sacred” duty to manage the national finances responsibly, but he also has to work with a prime minister wedded to expensive election manifesto commitments and large infrastructure projects.

The OBR said unfunded departmental spending needs stem mainly from the National Health Service, and include funding Covid vaccination and test and trace programs going forward, as well as a backlog in operations delayed by the pandemic. There are also considerable pressures to spend more on transport and education, it said.

The government's promise to eliminate net emissions by 2050 could increase public debt -- already at around 100% of gross domestic product -- by another 21 % of GDP over the next 30 years, the OBR said. While an increased carbon tax could cover the costs of public spending to reach net zero, it isn't enough to cover the loss of tax receipts from revenue raisers such as fuel duty, it said.

The OBR said the government will find it more difficult to either grow out of or inflate away its debts, which have tripled since 2008. It set out a range of scenarios based on different paths for interest rates, inflation and economic growth, concluding that changes in any of the variables would quickly feed through to debt-interest costs.

The public finances are six times more sensitive to changes in interest rates than they were prior to the financial crisis, the OBR said. That reflects both increased debt and the huge amount of gilts now held by the Bank of England, which has shortened the effective maturity of government liabilities. Increased foreign ownership of U.K. government bonds has also made the public finances more susceptible to shifts in investors sentiment.

“In the end the chancellor is faced with a much tougher set of choices, which are really about tax and spending if you want to get debt down, rather than some of the tricks that previous chancellors have been able to use,” OBR Chairman Richard Hughes said at a media briefing.