Oct. 8 (Bloomberg) -- The U.K. government may need to increase borrowing by 50 billion pounds ($87.6 billion) to fund its bank rescue plan, limiting the amount it can spend on tax cuts and extra spending to spur the economy as it slips into a recession.

The Treasury will sell 25 billion pounds of bonds, known as gilts, to buy preference shares of Royal Bank of Scotland Group Plc, Barclays Plc and at least four other banks by March 31 under the emergency package announced today. A further 25 billion pounds is open to other banks that need capital infusions.

The sales may add to a 633 billion-pound debt burden, which soared after Prime Minister Gordon Brown borrowed heavily to pay for investment in schools and hospitals during his decade as finance minister. His successor, Alistair Darling, may find it hard to offer a fiscal stimulus to counter the economic impact of the worst financial crisis since the Great Depression.

``The public finances are in a dreadful state,'' said Jonathan Loynes, chief European economist at Capital Economics Ltd. in London. ``The downturn will be deeper than if the government had been able to cut taxes significantly. Fiscal consolidation will be needed when we get through this period of extreme weakness.''

The Treasury is losing tax revenue as the credit freeze worsens a housing slump and hammers the earnings of financial firms. The International Monetary Fund yesterday said it expects the U.K. economy to shrink 0.1 percent next year after forecasting growth of 1.6 percent six months ago.

Debt Ceiling

Debt is already above the ceiling of 40 percent of gross domestic product set by Brown when his Labour Party came to power in 1997.

Including the liabilities of Northern Rock Plc, the mortgage lender that was nationalized in February, net debt stood at 43.3 percent, or 633 billion pounds, in August. Six years ago, it was 30 percent.

Michael Saunders, chief Western European economist at Citigroup Inc. in London, says the budget deficit may reach 57 billion pounds, or 3.9 percent of GDP in the fiscal year through March 2009, among the highest in Europe. In his March budget, Darling forecast a shortfall of 43 billion pounds.

Today's part-nationalization of U.K. banks formed the centerpiece of a 500 billion-pound package designed to unfreeze credit markets and pull the financial system from the brink of collapse.

The plan also guarantees about 250 billion pounds of loans and doubles the amount the Bank of England makes available for banks to borrow against impaired assets to at least 200 billion pounds.

`Clear Concerns'

A Treasury spokesman said that the government debt agency is unlikely to raise the cash in a single sale, and will instead sell gilts as needed to pay for the equity stakes. In March, the Treasury said it expected to sell 80 billion pounds of gilts in the current fiscal year.

``There are clear concerns over the fiscal implications,'' Loynes at Capital Economics said. ``This prospect could put some upward pressure on long-term bond yields.''

The 10-year gilt yield today rose 5 basis points to 4.29 percent after the Bank of England joined central banks around the world in cutting interest rates to ward off a collapse of the financial system. Bond yields move inversely to prices.

The government statistics bureau will now decide whether to classify the investment in banks as current or capital spending, the Treasury spokesman said. It means borrowing may rise by a similar amount unless the extra spending is netted off against the assets purchased.

Off the Books

Other elements of the rescue package will stay off the government books for now. The loan guarantee will be classified as a contingent liability, and the expanded Bank of England lending facility will be funded through Treasury Bills, the spokesman said.

Taxpayers may benefit from the insurance premiums, based on credit default swap rates, charged on the loan guarantee. They may gain or lose on the value of the equity stakes taken in the banks.

The impact on the public finances ``will be exceptional and mostly temporary,'' Darling told Parliament in London today. ``The public is entitled to share in the upside of our proposals.''

To contact the reporters on this story: Gonzalo Vina in London at gvina@bloomberg.net

Last Updated: October 8, 2008 13:58 EDT