Blow for Chancellor as bond rout prices hit £50bn

The Chancellor faces a £50 billion bill for higher debt interest payments after the bond market rout sent Government borrowing costs soaring – but the final sum could be much higher, City experts warned this weekend.

It means that unless conditions improve soon, Rachel Reeves will break her self-imposed fiscal rules – and may be tempted to bend them to avoid painful tax rises or spending cuts.

Reeves left a historically tiny buffer of £10 billion for this year in her Budget to meet her main rule that day-to-day spending be matched by tax receipts.

But that reserve has all but gone after the cost of Government borrowing soared to a 27-year high and the pound slumped against the dollar in a turbulent start to the year on financial markets.

The Chancellor, who is in China leading a trade delegation, has ruled out more borrowing or tax rises to fill any gap in the nation’s finances, while a public sector spending review is not due before June.

If the sell-off in bonds and sterling continues, experts fear that Reeves may not be able to hold the line until the independent Office for Budget Responsibility delivers its next outlook for the economy at the end of March.

‘Reeves has a big problem,’ said Sanjay Raja, senior economist at Deutsche Bank.

‘The razor-thin headroom left in the autumn Budget has likely all evaporated.’

He says if Government borrowing costs stay high, the interest paid on its debt pile – which stands at £100 billion a year – will jump by another £10 billion in each of the next five years, holing Reeves’ fiscal rules below the waterline.

This £50 billion hit from higher debt servicing costs comes before an expected cut in the OBR’s forecast of 2 per cent growth this year, which would further weaken the fiscal position as tax receipts would be lower.

The economy has flatlined under Labour and business confidence has collapsed after the Chancellor’s Budget hiked the year’s taxes by £40 billion, leading to fears of job losses.

The fiscal watchdog is also set to raise its inflation forecast, which would see the cost of servicing the public debt rise, as a quarter of all borrowing is linked to the retail price index.

Experts say that, having boxed herself in, Reeves is most likely to back spending cuts to make sure she does not break her own fiscal rules. But that would raise political problems as Labour promised no return to austerity, and to fix public services.

Another option for Reeves is to try to bend the new debt rules to allow even more borrowing without spooking the markets.

She could do this by moving forward the rolling target date for meeting her fiscal rules and apply them as a range from now.

But the OBR recently warned the Chancellor against using smoke-and-mirrors accounting tricks to balance the books. In an extraordinary rebuke, revealed in The Mail on Sunday, the OBR highlighted a number of ‘fiscal illusions’ that she may ‘exploit’ to make the public finances seem better than they really are.

These included the way student loans and National Wealth Fund investments are treated.

The Government could also be ‘tempted’ to bring the assets of funded pensions – such as the £400 billion Local Government Pension Scheme – on to its books while moving liabilities off the balance sheet, the OBR added.

It said pension liabilities for the likes of doctors and teachers worth £1.3 trillion – or almost half the UK’s annual economic output – do not appear on the state’s balance sheet.

‘If they follow international guidelines, markets won’t care much,’ said Raja. ‘The key now for the Chancellor is to show fiscal policy does not fall foul of the fiscal rules and there’s a credible plan for growth.’

Reeves could just cross her fingers and hope the storm passes. ‘Doing nothing is probably the most sensible thing,’ said economist Julian Jessop.

However, traders are braced for another volatile week on bond markets, especially if December’s inflation figure on Wednesday comes in above the expected 2.5 per cent rate. If it does the Bank of England may slow the pace of interest rate cuts.

The Treasury said meeting its fiscal rules was ‘non-negotiable’ and the Government would leave ‘no stone unturned’ in delivering economic growth’.