Pound collapse erodes international trust in United Kingdom

Britain thought it had the trust of markets — until it didn’t. Now homeowners and businesses will pay the price.

Britain is in a self-inflicted financial crisis that threatens to accelerate the economy’s dive into recession — and the country’s new prime minister is coming under intense pressure to blink.

In the week since the government unveiled the biggest tax cuts since 1972 with scant detail of how they will be financed, the pound has crashed to its lowest-ever level against the dollar, the cost of insuring British government debt against the risk of default has soared to the highest since 2016, and the Bank of England has been forced to intervene amid concerns about the nation’s pension funds.

What happens next will determine just how deep the looming recession proves. Central to that question is whether Liz Truss’s three-week old administration can restore its credibility with investors.

Last Friday’s mini-budget has become a flashpoint for not just investors’ short-term concerns about unfunded tax cuts at a time when inflation is running close to a four-decade high, or the Bank of England’s failure to contain price growth. It has given sharp focus to their long-held fears about Britain, its current-account deficit, its fractious relationship with its closest trading partner and, above all, a mistrust of what successive politicians promise.

“It’s the latest in a long line of self-imposed economically illiterate decisions,” said Peter Kinsella, global head of FX strategy at Union Bancaire Privee UBP SA in London. “It started with Brexit, and now we’re seeing the latest iteration.”

As markets tumbled, the Bank of England was forced into action to prevent a gilt market crash — and deployed a variant of a policy tool Truss spent recent months criticising. It promised to buy whatever long-dated gilts were needed to restore order to the market. That set off a rally in long-dated gilts — but increases two risks: that the bank will have to raise rates even further within weeks, and that investors could take fright at whether the BOE is bankrolling the government. For now, though, the BOE has bought the “government time to fix its credibility,” according to Kallum Pickering, senior economist at Berenberg Bank.

How they use that time will be crucial. Top bankers in the City of London this week urged Chancellor of the Exchequer Kwasi Kwarteng to reassure markets before a planned statement on November 23.

The International Monetary Fund, which came to the UK’S rescue in 1976, has already urged the government to reconsider its tax cuts. Famed economists are lining up to warn the UK is displaying the hallmarks of an emerging market.

The problem for Truss is that she made the tax cuts the centrepiece of her programme for government. An about-turn so early into her tenure would be politically fatal: She only won office thanks to the backing of grassroots party members. Most MPS in her own party voted against her, leaving her exposed to a backlash if they sense her policies will lead to defeat. While Britons wait to see if her gamble on “trickle-down” economics pays off, they face a dramatic increase in borrowing costs — something that could trigger a housing crash and deepen any recession — or a round of swingeing public spending cuts.

“Between Brexit, how far the Bank of England got behind the curve and now these fiscal policies, I think Britain will be remembered for having pursued the worst macroeconomic policies of any major country in a long time,” said former US Treasury Secretary Lawrence Summers, now a professor at Harvard University.

The Treasury declined to comment for this story.

BREWING CRISIS

The crisis of confidence had been brewing for years. Dubious claims from the ruling Conservatives together with the recent ousting of the Treasury’s top official and the side-lining of the country’s budget watchdog meant investors didn’t believe the Chancellor when he promised to stabilise the public finances.

Nothing illustrates it better than the slide in the pound. It’s fallen from a high of more than US$2 in 2007, just before the financial crisis, to US$1.50 at the time of the Brexit referendum, and is now on the brink of parity with the dollar.

Nevertheless, Friday’s act of fiscal largesse — being unfunded — marked a major break from the economic traditions of Truss’s Conservative Party. The government still needs to set out how it will cover the additional borrowing required to fund its £45 billion of tax cuts and further £60 billion-plus for its programme to offset the recent surge in energy bills.

The UK, then, faces a grimmer outlook than what Truss promised in her summer campaign to succeed Boris Johnson, when she talked of upending the “business-as-usual economic strategy.” Her own survival in office is even in question. She faces an election in 2024 and one opinion poll this week showed the opposition Labour Party’s lead widening to 17 points, the most ever recorded by Yougov.

The last week has tested confidence; the next could stretch it to breaking point.