The Dollar Balance, Revisited

OBR's Autumn Forecasts: UK on Track

By Melanie Baker, CFA & Cath Sleeman | London

Impact on our views: As expected, there are no major changes in the OBR's deficit forecasts from June. There are, however, some bigger changes in the net cash requirement in the later years of the projection, and the OBR's estimate of longer-term fiscal sustainability gives some cause for concern (although it will return to this issue in more depth next year). However, in our view, there were no major new implications for the UK's 'fiscal story'. In terms of our economic forecasts, we continue to think that the UK economy will struggle next year as fiscal consolidation picks up. We stick to our below-consensus forecast of 1.6% GDP growth in 2011.

What's new: The OBR set out its new economic and fiscal forecasts. This was followed by an 'Autumn Statement' from the Chancellor in parliament. There were only small changes in the deficit forecast: Public Sector Net Borrowing (PSNB) this fiscal year was broadly unchanged at £148.5 billion (we'd expected a £2 billion downward revision). For the next fiscal year, PSNB is £1 billion higher. There are some larger differences (increases) further out for the Central Government Net Cash Requirement (CGNCR) - £6 billion higher by 2015-16. Much of this appears to reflect increases in student loan projections. A bilateral loan to Ireland should also have further CGNCR implications.

UK 'on track': The OBR judges that the government still has a "better than 50% chance of meeting its mandate" and that the government has "slightly more margin for error in meeting the mandate" than it thought in June. At this stage, we continue to expect the government to be successful in achieving a sharp deficit reduction over the next few years. We still think that the OBR's central forecast is too optimistic on real GDP growth. But the effect of this on the public finances is offset somewhat by our assumption that the OBR's inflation forecasts are too low.

Further Detail

Borrowing Broadly Unchanged

The OBR's forecast for PSNB is broadly unchanged from June. The estimate is £0.6 billion lower in the current fiscal year (now £148.5 billion). In the following two years, it is £2 billion higher; in 2013/14 it is unchanged; over 2014/15 and 2015/16, it is £2 billion lower.

Lower Receipts Offset by Additional Spending Review Measures

Part of the slightly higher borrowing in the near term reflects lower house prices and lower oil prices that lower receipts. These are offset further out by additional measures announced in the Spending Review and an assumed fall in debt interest costs. 

Bigger Changes to the Net Cash Requirement

The Central Government Net Cash Requirement (CGNCR) is closely linked to the projection for gilt issuance. Following the OBR's Autumn Forecasts, the DMO released an updated remit for 2010/11 and illustrative gross financing projections for later years.

The changes to CGNCR are relatively small in the near years. But there are some larger increases further out (CGNCR is £6 billion higher in 2015-16). Much of this appears due to 'financial transactions'. According to the OBR, the main change here reflects the government's announcements on higher education funding (an increase in the projections of loans to students).

This increase in the net cash requirement feeds through into a higher illustrative 'gross financing projection' from the DMO, particularly from 2013-14 (up by £5 billion). For fiscal year 2014-15, the upward revision is £11 billion. As well as higher CGNCR, this reflects an £8 billion upward revision in redemptions. 

The bilateral loan to Ireland should have future implications for the net cash requirement.

Impact of Bilateral Loan to Ireland

In his statement today, Chancellor Osborne said, on support for Ireland, that "in principle our bilateral loan is for £3¼ billion". The OBR, while not yet incorporating an impact for this into its forecasts, confirms that it is likely that a UK bilateral loan "would raise the net cash requirement and net debt as it is disbursed. But, as it would be a financial transaction, it would normally have no direct impact on net borrowing". Lending by the IMF and EFSM is likely to have no impact on net debt.

OBR Optimistic on Growth

The OBR's fiscal outlook rests on its economic outlook, central to which is its forecast for growth. Although the OBR revised down its outlook for real GDP growth in 2011 and 2012 (by two-tenths in each year), they still look too optimistic, in our view. The OBR now anticipates GDP growth of 2.1% in 2011 and 2.6% in 2012; in comparison, we expect 1.6% in 2011 and 2.0% in 2012. The difference between our views stems primarily from the OBR anticipating stronger growth in real government spending and business investment. Upward revisions to the former reflect, in part, the additional welfare measures announced at the Spending Review. We use the OBR's forecasts for real government spending as the basis for our own forecasts. Hence, all else being equal, this suggests some upside risk to our GDP forecasts. However, we expect a higher GDP deflator than the OBR, and we also see some offsetting downside risk to our current forecasts from inventories and consumer spending in particular.

If the OBR were to adopt our current outlook on real GDP growth, it would, all else equal, raise the PSNB projection. However, we anticipate stronger growth than the OBR in the 'GDP deflator'. A stronger deflator has a greater (positive) impact on government revenues than it does on government expenditure (which is subject to nominal budget constraints). This provides some offset to our weaker real GDP growth forecast.

Risks to the Forecasts

The OBR's very detailed report does a good job of drawing out some of the risks to the central fiscal forecast.

1. Risks highlighted by the OBR: Two particular sets of scenario analysis in the OBR's report caught our eye. First, it simulated the effect of a rise in gilt yields in 2011-12. It includes the case of a 150bp shock (its base case for the weighted average market gilt rate at that point is 3.7%, up from an estimated 3.1% in 2010-11). The OBR highlights a lack of vulnerability to such shocks since the increase only applies to new lending and the UK has a relatively long average maturity debt (14 years). It also runs analysis for a scenario it describes as "persistent weak demand" where the real GDP forecasts, at least, look similar to our own. Compared to the base case, PSNB is 0.7pp higher (percent of GDP) by 2015-16 but, the OBR judges, the government would still have a better than 50% chance of meeting its objectives. 

2. Long-term risks highlighted by the OBR: There is some interesting analysis in the OBR's report on long-term fiscal sustainability. The OBR produces what it describes as a "simple illustrative extrapolation" for public sector net debt out to 2049-50, then augments this by taking account of demographic pressures. According to this exercise, the public finances would "not remain on a sustainable path indefinitely if these spending pressures were not offset". However, it describes the projection as "highly simplified". It also says that the projections do not reflect recent policy changes (such as the change to CPI uprating for public sector pensions). Further, it highlights that its results are similar to those from the IMF, European Commission and BIS (and that the UK is not unique in confronting these pressures). The OBR intends to look at long-term fiscal sustainability in detail in its 'Fiscal Sustainability Report' next summer. Still, its initial findings are a reminder of the significant longer-term challenges the UK fiscal finances face.

Chancellor Given Opportunity to View Forecasts

The OBR shed light on the process surrounding the creation of the Autumn Forecasts. It reveals that a preliminary summary of the economic and fiscal projections was given to Chancellor Osborne on November 18: "This gave him an opportunity to ask questions about the forecasts and to confirm that he did not plan to make any policy announcements that would need to be incorporated in them." The process implies to us that the OBR's Autumn Forecasts may, in future, incorporate imminent policy announcements from the government - particularly if the OBR's preliminary projections are expected to show that the government will miss its fiscal objectives.