May 28, 2012 / 12:35 PM / 5 years ago

REFILE-Odds lengthen on Osborne's UK debt reduction gamble

9 Min Read

* UK recession makes harder to reach debt cutting target

* Govt under pressure to reinflate economy

* Public sector borrowing now forecast at 75 bln stg in 2015

* Bond markets say policy makers need to retain credibility

By Mohammed Abbas and Matt Falloon

LONDON, May 28 (Reuters) - In George Osborne's office, a framed cartoon shows Britain's finance minister being crushed by an elephant labeled debt.

The irony may be choking for Osborne: his bet on Britain growing out of its debt addiction is in doubt and the $2.5 trillion economy is bracing for what Prime Minister David Cameron has warned could be the breakup of the euro zone.

On inheriting Britain's biggest peacetime deficit, Osborne gambled he could charm bond investors by slashing spending, but that growth rates of between 2.0 and 3.0 percent would kick in from 2013 to lift the mood of voters ahead of the 2015 election.

Britain has however slipped back into recession, making the task of reducing borrowing much harder, while spending cuts have upset millions of voters.

"I thought, you know what, I am convinced that George Osborne is cutting as deep as he can now so that when we come to 2014 and it has worked, he can do the budget and say ... 'Here is a thank-you budget for four years of austerity'," Mark Garnier, who sits on parliament's Treasury Select Committee and is like Osborne a member of the Conservative Party, said.

"I am now convinced that won't happen," Garnier, who said external factors such as the euro crisis and high oil prices were to blame, told Reuters. "It's the worst possible outcome."

Cameron, who staked the reputation of the Conservative-led coalition government on reducing Britain's debts, is now under pressure to close Osborne's bet and reinflate.

Even the International Monetary Fund (IMF) has told Britain and the Bank of England to do more to stimulate demand, though bond investors say reducing the deficit remains essential to preserving government credibility.

"Those that argue for a lot of government spending underestimate the need to be able to (sell) ... your bonds to bond markets," said Jamie Stuttard, fixed-income portfolio manager at Fidelity, which manages $231.6 billion in assets.

"In this government bond market that is bifurcating into ... the haves and have-nots, the UK is still in the haves. But it is important for policy makers to continue to retain credibility in terms of keeping inflation low and a conservative approach on the fiscal side," Stuttard said.

"No Money Left"

Since the coalition came to power, the bond market has been distorted by the Bank of England's 325 billion pound bond purchase facility, pushing down the yield on the benchmark 10-year gilt to a record low of 1.74 percent.

But Britain's Maastricht treaty deficit - the standard EU measure of borrowing - is forecast by the European Commission to reach 6.5 percent of GDP in 2013, higher than any other EU state bar Greece with 8.4 percent and Ireland at 7.5 percent.

Osborne was just 38 when he took the job in 2010, becoming the youngest Chancellor of the Exchequer since the appointment in 1886 of Winston Churchill's father Randolph.

But when he arrived at the offices of the Treasury, his deputy had been left a note by departing Labour treasury chief secretary Liam Byrne saying: "I'm afraid there's no money left".

Osborne faced a budget deficit of 11 percent and the UK gilt market was, in the words of Pimco's Bill Gross, the manager of the world's biggest bond fund, "resting on a bed of nitroglycerine" because debt was far too high.

Initially dismissed by some - including Bank of England Governor Mervyn King - as too wet behind the ears to cope with the situation, Osborne went for the jugular and silenced many doubters with an ambitious emergency budget.

He proposed cutting budgets across Whitehall by a fifth, eliminating the "structural" current deficit by fiscal year 2014-2015 and forecast public sector net debt would fall from a peak of 70.3 percent of GDP in 2013-2014.

Osborne said Britain had no choice: if it did not cut spending, it could lose its prized AAA credit rating.

Investors seemed pleased by his audacity; here was a politician who seemed to speak their language. "He's a risk taker, but in a positive way," said one source who works closely with Osborne but who spoke on condition of anonymity.

"He realises that without taking some calculated risks, the chance that you'll achieve your goals is a lot less."

Submarine Attack

Another adviser to Osborne describes his decision to put Britain in the vanguard of the Western world's deficit reducers as one of political courage, though enemies say his choice would be more akin to political suicide if growth proves elusive.

Aides to the Conservative leadership were sanguine in 2010, admitting in private that it all hinged on the economy recovering. Asked at a reception shortly after the emergency budget what would happen if the economy tanked instead of flourishing, one admitted it would be catastrophic.

The lack of growth so far has torpedoed the government's debt projections, while voter anger at spending cuts has raised concerns in the Conservative party that Osborne's bet may lose it the next election.

If the economy remains stagnant but nominal debt projections remain accurate, public sector net debt could soar to over 90 percent of GDP in 2016/17, instead of the 74 percent forecast.

Public sector borrowing, forecast two years ago by Osborne to fall to 37 billion pounds ($59.5 billion) in 2015, is now forecast to be around double that at 75 billion, roughly the original estimate of the previous Labour government.

Only Greece, Italy, Ireland, Portugal and Hungary in the EU will spend more than Britain on interest payments in 2013 as a percentage of GDP, according to European Commission forecasts.

Nicknamed "the submarine" for his habit of working quietly in the background and surfacing only for major strategic interjections, Britain's economic woes have dragged Osborne into the harsh glare of a deeply critical local media.

Rupert Murdoch's Sun newspaper has ridiculed Cameron and Osborne as "dipsticks" and mocked their privileged backgrounds.

Osborne's 5 pence in the pound income tax cut for the wealthy cemented the image of a government out of touch with millions of voters struggling to cope with recession. One disgruntled Conservative lawmaker even branded them as "arrogant posh boys" who "don't know the price of milk".

Osborne went to one of Britain's top fee-paying schools and then to Oxford University. His father, Sir Peter, earned a fortune from the Osborne & Little wallpaper firm he co-founded.

Though Osborne is feted by allies as one of the most courageous and ruthless men in British politics, the charge that a risk-taking millionaire was gambling with the economic future of 62 million people has stuck.

"The voters were promised that all the pain ... would be worth it to get the deficit down," the opposition Labour Party's shadow chancellor, Ed Balls, said in an article this month.

"The government won't now meet its key pledge to balance the books by 2015 and is set to borrow an extra 150 billion pounds."

Difficult Decisions

A recent poll showed the Conservatives losing their image of economic competence and local elections showed many Conservative voters staying at home rather than vote for the government.

"This is always going to be the time when the difficult decisions were coming to fruition. So I would describe him as resolute," Osborne's former adviser turned Conservative lawmaker Matt Hancock told Reuters.

"As chancellor what you've got to do is make the big calls. And you're judged not by tomorrow's headlines, but where it leaves you in coming years," Hancock said.

Conservative governments have come back from the brink before, for example Margaret Thatcher's election victory in 1983 after the 1980-81 recession. And if Osborne does catch growth in his sails, he could claim credit for a possible victory.

But with no growth, an election in just three years and his flagship five-year austerity plan already extended by two years, Osborne has little room for manoeuvre.

He declined to be interviewed. A spokesman for the Treasury said: "There is a false distinction between having a credible deficit reduction plan and having a plan for growth: the first is a vital part of the second.

"But despite our progress, Britain still has one of the highest budget deficits in the world, which is why it's right that we continue to deliver on that fiscal consolidation plan."

But in what amounted to proposing a "Plan B" alternative to Osborne's bet, IMF Managing Director Christine Lagarde told him this week that growth was too slow and Britain should bolster demand before low growth became entrenched.

For that to work, Osborne would have to hope he can charm both the bond market and British voters.

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