The problem that should be keeping Liz Truss awake at night

Speaking of her arrival in Downing Street, Truss said she would “ride out the storm”, promising help with energy bills and tax cuts. But the incoming prime minister is in a bind. If his government borrows too much money, he risks further stoking inflation and raising fears among investors that the country’s finances are becoming untenable

That could send the pound into a tailspin, pushing prices even higher and making it harder to pay for essential imports.

In other words, the UK could withstand the kind of collapse it suffered in the 1970s, when the combination of an energy shock, rising prices and heavy government spending forced the country to turn to the International Monetary Fund for a big bailout, an alarming prospect for a G7 economy.

Not long ago, this type of scenario would have sounded extravagant as a topic of conversation. But as Truss mocks a huge energy relief package and talk of tax cuts, and the pound remains stuck near its lowest level in decades: some analysts warn a “balance of payments” crisis cannot be ruled out.

“Ultimately, whether these risks materialize comes down to the credibility of the new government’s policy in the coming weeks and months,” Deutsche Bank strategist Shreyas Gopal said in a note to clients on Monday titled “Time critical for sterling”.

What is a balance of payments crisis?

Former Bank of England Governor Mark Carney once observed that the UK relies on “kindness of strangers”. That’s because it has a large current account deficit, which means it needs foreign investors to keep pumping money into the economy so it can pay for imports and meet other important obligations.

If they lose confidence, the turmoil in the financial system can quickly snowball. As traders dump the country’s currency, its value plummets, fueling inflation and forcing the central bank to raise interest rates even higher to try to control the situation. That can worsen recessionary conditions, and so the spiral continues.

Investors often look for these circumstances to arise in emerging markets, especially those that have dollar debt. When your currency falls, that makes it even more expensive to pay off your obligations. The most hyped example these days is Argentina, which signed a $44 billion debt deal with the IMF. in March.

However, there is a precedent in the UK. When the pound rapidly lost value against the US dollar in the mid-1970s, the country was forced to ask the IMF for $3.9 billion, Gopal said. At the time, that was the largest amount ever requested.

The pound is on the ropes again now. It dipped briefly on Monday to around $1.14, its lowest level since 1985. It has lost nearly 15% of its value against the US dollar so far this year. That’s even worse than the euro, which is down less than 13%. UK government borrowing costs are also rising at a rapid rate as investors dump the country’s bonds.

Investors are fleeing British assets due to concerns about the economy. UK inflation is the highest in the G7 and could soar further next year if natural gas prices remain high. The Bank of England has been raising interest rates since last December and may be forced to take even more aggressive action.

“UK assets are not wanted right now,” said Paul O’Connor, head of the UK-based multi-asset team at Janus Henderson. “The main reason, of course, is that the UK is facing a really acute cost of living crisis and a lot of political uncertainty around that.”

That’s a major problem for the UK because it has a record current account deficit, according to Gopal, meaning it spends more on goods, services and investments abroad than it brings in at home. Years of anemic growth and a post-Brexit hit to trade have not helped.

“Sterling requires large capital inflows on the back of improving investor confidence and falling inflation expectations,” Gopal wrote. “However, the opposite is happening.”

The United Kingdom is not Argentina, but…

The currency rose slightly on Tuesday as Truss officially began her tenure as prime minister.

Investors were encouraged by early reports on its plans to tackle the energy crisis, which are expected to be announced this week. It is expected to announce a cap on energy bills through a 100 billion pound ($115 billion) loan. That would exceed even the 95 billion euros ($94 billion) the German government has committed to tackle similar problems.

“Investors see this as a pretty decisive way of alleviating recession risks in the UK,” O’Connor said.

But questions could resurface about how he plans to pay for that relief package and other campaign promises, such as increasing defense spending and reversing proposed payroll and business tax increases, and whether investors will worry that the Kingdom’s loans Kingdom get out of control.

“Having a real financial crisis, and the fall of the pound, if that accelerates, is a very serious problem for real people, day in and day out,” former UK finance minister Ken Clarke told the BBC on Tuesday. . He has criticized Truss’s plans to cut taxes, which she says will help finance spending increases by boosting economic growth.

Viraj Patel, global macro strategist at Vanda Research, believes the fears are overblown. He puts the probability of a balance of payments crisis in the UK at less than 5%.

“A lot has to go wrong to get to this point, and one could imagine the UK government pivoting quickly before then on any policy that raises concerns,” Patel said, adding that tax watchdogs such as the Office for Budget Responsibility are keeping a close eye on the situation.

Deutsche Bank’s Gopal acknowledged that the UK is different from countries like Argentina in one key way: it issues debt in its own currency, which means that when the pound falls, it faces no additional worries about paying down liabilities. Still, he continued, it’s not a given that investors will start to come back.

“With the global macro backdrop so uncertain, investor confidence cannot be taken for granted,” Gopal said.

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