U.K. Budget Deficit Is Forecast to Narrow Even as Pace of Growth Weakens

Britain has a bigger budget hole to fill than the previous Labour government forecast, the country’s fiscal watchdog said in an initial report that sets the stage for the deepest spending cuts in a generation.

Cyclically adjusted net borrowing, the part of the deficit that is structural, is forecast to fall from 8 percent of gross domestic product this year to 2.8 percent by April 2015 instead of the 2.5 percent predicted by the Treasury in March, the Office for Budget Responsibility said in London today. The economy will expand at a slower pace than forecast, it said.

Chancellor of the Exchequer George Osborne is set to outline the deepest spending cuts since the 1970s in his emergency budget on June 22. Fitch Ratings said last week that Prime Minister David Cameron’s coalition needs to step up the pace of reductions to protect Britain’s top credit rating.

“The problem may not be any bigger but the proportion of the problem that needs to be addressed with spending cuts or tax increases is greater,” said Danny Gabay, director at Fathom Financial Consulting and a former Bank of England and government economist. “The reason the U.K. has a fiscal problem is not to do with the crisis, it’s structural.”

Sterling climbed 1.5 percent to $1.4767 as of 5:42 p.m. in London. The 10-year gilt yield was 9 basis points higher at 3.55 percent.

‘Credibility’ Needed

“Credibility will be a key issue in next week’s budget,” said Hetal Mehta, senior economic adviser to the Ernst & Young ITEM Club. “Any hint that there is a lack of conviction in tackling the huge deficit will undermine market confidence and make it even more difficult to consolidate fiscal policy in the years ahead.”

The budget office, set up after the Conservatives formed a coalition with the Liberal Democrats following the inconclusive May 6 election, will release revised forecasts on June 22 to take account of the measures announced by Osborne.

The OBR, led by former Bank of England policy maker Alan Budd, forecast the overall deficit will be 22 billion pounds ($33 billion) lower over the next five years than the Treasury predicted in March.

That reflects the impact on tax receipts and spending of abandoning the deliberately “cautious” planning assumptions used by the Treasury under Labour’s Gordon Brown and Alistair Darling, Budd said.

‘Spread the Pain’

The deficit will narrow from 155 billion pounds in this fiscal year to 71 billion pounds by April 2015, or 3.9 percent of GDP. Net debt will increase to 74.4 percent of economic output, the OBR forecast.

The OBR forecasts would require a real-terms cut to departments’ budgets of 10.2 percent between now and 2015, or 39.3 billion pounds a year, the Institute for Fiscal Studies said. Given that Osborne has pledged to protect spending on health and foreign aid, the squeeze on welfare benefits would be so large that he may have to increase taxes to “spread the pain,” it said.

The six-week-old coalition is pinning the blame for the size of the deficit on Labour, which ruled Britain for 13 years. Cameron said last that the squeeze to come will “affect every single person in our country.”

“The structural deficit is larger than anyone realized,” Deputy Prime Minister Nick Clegg said in a speech in central London. Labour left the U.K. “very nearly bankrupt,” he said.

‘Forced by the Markets’

“We will not allow our hand to be forced by the markets,” Clegg said, citing the fiscal crisis engulfing Greece and other euro-area countries.

“The OBR couldn’t be clearer,” Osborne said in a statement released by the Treasury. “Growth lower in every year. The structural deficit -- that’s the borrowing which doesn’t fall even when the economy grows -- higher in every year, and that’s on what the OBR say are optimistic assumptions.”

While the OBR accepted the economy will grow about 1.3 percent this year, it said the Treasury had been too optimistic about future years. It forecast 2.6 percent growth in 2011 and 2.8 percent in 2012, compared with Treasury predictions of 3.25 percent and 3.5 percent.

The Treasury said a surprise 10 billion-pound improvement in the deficit will be eroded to about 3 billion pounds by 2015. Budd said the forecasts are based on market interest rates that have fallen since May because of expectations that the government will take steps to reduce the deficit.

Osborne created the OBR to provide forecasts that are independent of the government.

Labour fought the election on a pledge to maintain spending this year to sustain the nascent economic recovery. The new government has already announced 6 billion pounds of budget cuts to take effect this year.

“I’m extremely concerned that the fiscal conservatism that’s now so dominant in so many countries in Europe is going to result in there being less growth,” Darling told BBC News television today.

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

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