Analysis: Emerging markets feel the heat of the ‘bondfire’

Just when developing economies were ready to bask in the post-COVID rebound in global growth, in sweeps a bond market blaze to scorch them again.

Most major investment banks were predicting a stellar 2021 for emerging market assets as long as one crucial snag – global borrowing costs rising too fast – was avoided. Well guess what, they are on a tear.

February saw their steepest monthly gain since Donald Trump’s shock 2016 U.S. presidential election win and, though the move comes from record low levels, for emerging markets now carrying nearly $80 trillion worth of debt it has been painful few weeks.

The widely-tracked JPMorgan Emerging Market Bond Index (EMBI) is having its worst start to a year for a quarter of a century, currencies have recoiled and MSCI’s EM stocks index has just suffered its biggest weekly drop since peak COVID panic last March.

The carnage has been described as a bond bonfire by ING analysts and prompted some of those bullish investment banks like JPMorgan and Morgan Stanley to curtail their bets.

Graphic: Worst start to a year for EM hard currency debt in 25 years –

Reuters Graphic

Rising developed market bond yields sting emerging markets in two main ways.

Firstly they push up borrowing costs. BofA estimates emerging markets will sell over three quarters of a trillion dollars worth of debt this year – $210 billion by governments and over $550 billion by corporates. Higher rates mean adding to government debt ratios that soared 15.5 percentage points across the top 60 emerging markets last year and have left 13 such countries with debt-to-GDP in excess of 100%.

Secondly, it cuts the premium existing emerging debt offers investors compared to ultra safe and liquid U.S. Treasuries.

If the risk-reward calculation no longer adds up, money managers can quickly sell as was seen during the 2013 ‘taper tantrum’ when the Federal Reserve’s hints at ending its easy-money policies triggered an estimated $25 billion emerging asset selloff in just two months.

The effects of that episode were particularly severe in the “Fragile Five” of Brazil, India, Indonesia, South Africa and Turkey that had built-up large current account deficits that were funded by short-term capital inflows.

Graphic: US yields and EM capital flows –

Reuters Graphic

BOOM TIME

This time, investors are worried about at least some of those.

“Brazil and South Africa are countries whose combination of persistent weak growth, rising public debt, very steep yield curves with very high long-term real interest rates has become a big source of concern,” said David Lubin, Citi’s managing director and head of emerging markets economics. “Mexico might also be on that list.”

Still, the alarm bells aren’t ringing as loud now.

For one reason, U.S. “real” yields, adjusted for inflation, remain low by historical standards, at about negative 80 basis points which keeps emerging market assets looking attractive.

By comparison, during the original taper tantrum, “real” U.S. 10-year yields rose steeply from negative 75 basis points at the end of 2012 to positive 50 basis points by mid-2013.

And despite the huge rise in debts, last year’s recessions have helped to mostly eliminate current account deficits, limiting many emerging markets’ reliance on capital inflows and acting as a shock absorber against rising U.S. yields.

A punchy recovery in global growth and fast-rising commodity prices should further help developing economies and even dig some out of a hole.

Moody’s last week cranked up its pan-EM growth forecast for the year to 7% from 6.1%, led by upward revisions to China, India and Mexico, and with $1.9 trillion of U.S. stimulus now coming most institutions are doing the same.

“We could be at the door of a big, big economic boom,” said head of Barings’ sovereign debt and currencies group Ricardo Adrogué. “Some of these countries that seem hopeless today could actually be ok”.

Graphic: Emerging market borrowing costs are rising again –

Reuters Graphic

FRAGILE FRONTIERS

Others will not be so lucky though.

Ethiopia is about to become a test case for the new G20 ‘Common Framework’ debt relief plan which stipulates private creditor debt must also be restructured, meaning the government has to default.

Others are expected to follow. S&P Global warned last week Belize was “virtually certain” to default in May. Laos and Sri Lanka have key payments in June and July, while JPMorgan lists 16 at-risk countries from Cameroon to Tajikistan sitting on a combined $61.4 billion of debt.

Tellimer’s senior economist Patrick Curran has dubbed the new group of vulnerable countries the ‘Fragile Frontiers’. It includes Jamaica, Tunisia, Ecuador, Sri Lanka, Belarus, Ethiopia, Laos, Bahrain and Oman.

Adding to the risks, not all emerging markets have started rolling out COVID vaccines yet. In Africa, for example, only a minority of countries are currently vaccinating and more variants are still breaking out.

Countries like Mexico, Jamaica, Panama, Mauritius, Montenegro, Jordan and Fiji where tourism accounts for close to 10% of GDP will wonder whether vaccines will come quickly enough to save their busy seasons this year.

“Virus mutations are a real thing I worry about,” said Raza Agha, head of emerging markets credit strategy at Legal & General Investment Management. “There’s already been several and there’s no way of predicting how many more there will be.”

Graphic: Tourism as a share of GDP –

Reuters Graphic

Graphic: Most indebted emerging and low-income countries –

Reuters Graphic

Graphic: Interest payment pain –

Reuters Graphic

Analysis: Central banks will happily ignore inflation-mongers

After a decade of underestimating inflation, central bankers in the United States, Europe and Japan have every reason keep money taps open and policymakers are even rewriting their own rules so they can let price growth overshoot their targets.

If anything, central banks are more likely to nudge up stimulus, particularly in the euro zone, keeping borrowing costs depressed and ignoring the inflation hawks at least until growth is back to pre-pandemic levels — and not just fleetingly.

The Reserve Bank of Australia already launched a surprise bond buying operation while the European Central Bank has repeatedly warned investors not to push yields too high, unless they want to fight its 1 trillion euro war chest.

The argument behind the inflation warning is that once economies reopen, massive government stimulus will combine with pent up consumer demand, unleashing spending-fuelled price pressures unseen for decades.

Although top economists are weighing in on both sides of the debate, the voices that really count all seem to be downplaying the threat.

“Inflation dynamics do change over time but they don’t change on a dime,” Federal Reserve Chair Jerome Powell said.

“We don’t really see how a burst of fiscal support or spending … that doesn’t last for many years, would actually change those inflation dynamics.”

Even if inflation accelerates, a big if given that big central banks are all undershooting their 2% goal, tightening policy too hastily is seen as a bigger evil than moving too slowly.

First off, much of the inflation rise is temporary, driven by the rebound in oil, one-off stimulus measures and the base effect of tanking prices a year ago. So this is not the sort of sustained inflation policymakers are looking for.

Tighter policy could also choke off growth – a costly blunder with tens of millions still out of work after the biggest peacetime economic crisis in a century. In the worst case, higher borrowing costs would even raise debt sustainability concerns, particularly in heavily indebted southern Europe and across emerging markets.

And lastly, the Fed and European Central Bank both tightened policy too quickly in the past decade, forcing them into the type of credibility-damaging reversal they are now keen to avoid.

JOBS

The message from the Fed has been uniform and emphatic: its $120 billion monthly bond purchases will not change until the economy has more fully recovered, and any actual interest rate increase is even further into the future.

The Bank of Japan and the ECB are making similar noises: there will be no reversal of stimulus for a long time, possibly years.

Their central concern is employment.

There is still a 10-million-job hole in the U.S. economy while the euro zone unemployment rate is kept artificially low by government subsidies, pointing to huge spare capacity.

The Fed is already putting greater emphasis on job creation, particularly for low income families, and made an explicit commitment last year to let inflation overshoot its target after periods of excessively low price growth.

While the ECB and the Bank of Japan do not have employment mandates, policy framework reviews now underway could raise the emphasis on social considerations, particularly jobs.

The ECB is already debating the merits of letting inflation overshoot, a hint that overheating in the jobs market will not on its own trigger policy action.

“Labour markets tend to lag real activity by as much as six months, and we may yet see a wave of mergers, bankruptcies, and layoffs,” said Tamara Basic Vasiljev of Oxford Economics.

BIG MOVE?

While the rise in yields has caused a ruckus in markets, the moves are not excessive and may simply be a reversal of excessively low yields.

U.S. 10-year Treasury yields are up 56 basis points this year – to roughly their pre-pandemic record low – while Japanese yields are just 14 basis points higher. A 10-year German bond still yields a negative 25 basis points.

“We see a return of bond yields from ultra-low to still low levels as a consequence of, rather than an obstacle to, a strong economic rebound and solid gains in corporate earnings in most of the world,” Berenberg economist Holger Schmieding said.

Policymakers have also played down the moves.

Atlanta Fed President Raphael Bostic argued that the increase in yields was of no concern and did not warrant any Fed response.

ECB policymakers have meanwhile said some rise in yields was a reflection of better fundamentals and they would not target any yield level.

“I don’t think the BOJ is too worried about the recent rise in yields,” Tomoyuki Shimoda, a former BOJ executive and Hitotsubashi University professor said. “The BOJ has plenty of scope to ramp up buying as needed. It can stem unwelcome yield rises 100%.”

By: Balazs Koranyi, Howard Schneider, Leika Kihara

China says ready to enhance exchanges with U.S. on trade – Economic front

BEIJING (Reuters) – China is ready to enhance exchanges with the United States on the trade and economic fronts, Wang Wentao, the country’s new commerce minister, said on Wednesday.

He looks forward to working with U.S. colleagues to focus on cooperation and manage differences, Wang told reporters in a news conference.

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Britain, EU edge forward with financial services forum plan

(Reuters) – Plans by Britain and the European Union to set up a new financial cooperation forum by the end of March have made some progress but this will not automatically lead to market access, senior officials said on Tuesday.

Britain’s trade deal with the EU that came into effect when it left the single market on Dec. 31 does not cover financial services, leaving the City of London largely adrift from its biggest export market. Trading in euro denominated shares and swaps has already left London for the EU and New York.

A forum for financial regulators from Britain and the EU to exchange views would help to improve relations. There is already a forum set up for EU and U.S. market watchdogs.

“We are in the process of exchanging texts and looking at that, and in due course we will come to a resolution,” John Glen, Britain’s financial services minister, told an insurance conference on Tuesday.

Separately, Mairead McGuinness, the EU’s financial services commissioner, said “informal engagements” regarding a memorandum of understanding on regulatory cooperation were now taking place.

“Once we agree on our working arrangements, we can turn our attention to resuming our unilateral equivalence assessments,” McGuinness, speaking at an online event at the European Parliament, said.

Glen said the EU’s equivalence assessments would not be part of the MoU. “That is a process we can’t control,” he said.

The EU can grant direct market access for foreign financial services companies if it deems their home market rules to be equivalent or aligned closely enough to the bloc’s own regulations.

The EU has only granted two temporary equivalence decisions for clearing and settling trades for Britain.

“We consider our interests and will only take equivalence decisions that are in the EU’s interests. There cannot be equivalence and wide divergence,” McGuinness said.

Explainer: U.S. Treasury’s cash drawdown – and why markets care

(Reuters) – The U.S. Treasury is due to run down a $1.6 trillion bank account at the Federal Reserve as government spending ramps up in the months ahead – a move some analysts warn may crush short-term money rates further and flood financial markets with cash.

The Treasury said recently it would halve its extraordinarily large balance at the so-called Treasury General Account (TGA) by April and cut it to $500 billion by the end of June.

Graphic: Treasury cash balance –

Reuters Graphic

Here’s what’s involved and its potential fallout:

1/WHAT IS THE TGA AND HOW DOES IT WORK?

The U.S. government runs most of its day-to-day business through the TGA – managed by the New York Fed and into which flow tax receipts and proceeds from the sale of Treasury debt.

When citizens or businesses receives a government cheque, they deposit it at their commercial bank, which presents it to the Fed. The Fed then debits the Treasury’s account and credits the bank’s account at the Fed – increasing its reserve balance.

The TGA sits on the Fed’s balance sheet as a liability, along with notes, coins and bank reserves.

But the Fed’s liabilities must match its assets. So a drop in the TGA must see a rise in bank reserves and vice versa. Last year’s reserves drain was masked by the Fed’s $3 trillion in asset purchases.

But when cash flows leaves the TGA, bank reserves rise – potentially increasing lending or investment in the wider economy or markets.

That’s why the government usually keeps TGA balances low. Today’s balance is more than four times year ago-levels. In the past four years, it has rarely surpassed $400 billion and prior to 2016, it never exceeded $251 billion.

Graphic: Fed assets and liabilities –

Reuters Graphic

2/WHY ARE WE TALKING ABOUT TGA NOW?

The TGA balance soared in 2020 because the Treasury ramped up borrowing to pay for an expected $1 trillion-plus in pandemic relief. But as stimulus was approved only in December, the accumulated monies were not all spent.

This year, it plans to run down the balance, slashing first-quarter borrowing plans to a quarter of initial estimates.

That may send what Credit Suisse dubbed a “tsunami” of cash into depositary bank reserves.

What’s more, less Treasury borrowing is seen impacting its main funding avenue of recent years – T-bills and cash management bills, cash-like securities banks use as collateral for repo borrowing and hedging derivative trades.

“Fewer bills mean more cash looking for a home in liquidity land,” JPMorgan said, adding: “U.S. money market and short term debt market participants are knee deep in liquidity.”

Graphic: Liquidity –

Reuters Graphic

3/SO IT’S A MONEY MARKET ISSUE?

Money market imbalances have a habit of spilling over.

Even before the TGA rundown, U.S. banks are awash with cash. The Fed is buying securities worth $120 billion from them each month, aggregate household savings are $1 trillion above pre-COVID levels, and money-market funds are brimming, with assets $700 billion above pre-pandemic levels.

In short, the M2 money supply aggregate is growing at an annual 26% rate.

Citi’s global strategist Matt King reckons the rundown of the Treasury’s account will effectively triple the amount of bank reserves created by the Fed’s asset purchase scheme each month.

He noted a “surfeit of liquidity and a lack of places to put it – hence the rally in short-rates to almost zero, with the risk of their going negative and the complete lack of bids in recent New York Fed repo operations”.

One-year and six-month yields have halved since the end of 2020 to six basis points (bps) and four bps respectively – contrasting with rising 10- and 30-year borrowing costs.

Negative yields could see cash flee money market funds for other assets – longer-dated bonds, equities, commodities and so on, further inflating bubble-like markets.

And if relative ‘real’, inflation-adjusted Treasury yields fall, it could weaken the dollar sharply – meaning that “at the global level the TGA effect will indeed prove highly significant”, King added.

Graphic: US t-bill yields –

Reuters Graphic

4/SHOULD WE WORRY ABOUT ASSET BUBBLES?

Some such as King see clear risks.

Banks too don’t always welcome huge reserves. JPM for instance, saw deposit inflows rise 35% year on year in the fourth quarter and fears being slapped with an increase in the minimum capital it’s required to hold as a globally systemic bank.

But JPM market strategists say overall liquidity won’t much be affected by adding another $1.1 trillion to a system flush with $3.2 trillion in reserves, with effects limited to money markets or short-dated debt.

TD Securities analysts agreed, noting: “Reserves themselves don’t translate to equities. What matters for broader markets is QE and fiscal stimulus rather than growth in reserves.”

They argue the Fed can address falling T-bill yields or overnight interbank rates by hiking the IOER – the interest it pays banks for holding reserves above the required minimum.

And if Congress does approve President Joe Biden’s $1.9 trillion spending plan, Treasury borrowing will rise again, easing the T-bill shortage.

Ghana owed IMF, World Bank, others $7.9bn as of September 2020

Multilateral debt component of the external debt stood at $7.9 billion at the end of September 2020, data from the Bank of Ghana.

This is an increase of $117.31 million (1.5%), compared to the level of $7.81 billion recorded at the end of the second quarter of 2020. The debt was expected to have shot up in the full year of 2020 due to the covid-19 impact on the economy, which resulted in increased borrowing from the bretton wood institutions

The multilateral institutions include the World Bank, the International Monetary and African Development Bank.

According to the Bank of Ghana, the multilateral debt accounted for 32.7% of the total debt stock at the end of the third quarter of 2020.

However, debts owed the International Capital Market stood at $10. 2 billion, representing the highest percentage share of 42.1% of the total external debt stock as of the end of September 2020.

This is compared to 37.9% for the same period in 2019. This stock position depicted a marginal decline of $15.99 million (0.2%) compared to the level of $10.2 billion registered at the end of the previous month.

The bilateral component of external debt stock for the third quarter of 2020 was $1.23 billion and represented a share of 5.1 percent of the total external debt stock, compared with 5.9% for the same period in 2019.

On the other hand, commercial debts at the end of September 2020 totalled $2.2 billion, and constituted 9.4 percent of the total external debt stock.

This was $57.87 million, 2.6% higher than the level of $2.2 billion recorded in the second quarter.

Other concessional debts totalled $1.62 billion at end of the third quarter and constituted 6.7% of the external debt stock.

This indicated a decline of $26.69 million (1.6%) compared with the previous quarter’s position of US$1.65 billion.

Covid-19 spending pushes Ghana’s debt to GH¢286bn

Ghana’s public debt stock jumped from GH¢274.1 billion in September 2020 to GH¢286.9 billion in November 2020, according to the latest Bank of Ghana’s Summary of Economic and Financial Data.

This is equivalent to $50.2 billion and represents 74.4 percent of Gross Domestic Product (total value of goods and services produced in an economy within a period).

According to the data, the external component of the debt stood at ¢139.6 billion ($24.4 billion), about 36.2% of GDP.

Source: Charles Nixon Yeboah

U.S. consumer spending falls for second straight month in December

U.S. consumer spending fell for a second straight month in December amid renewed business restrictions to slow the spread of COVID-19 and a temporary expiration of government-funded benefits for millions of unemployed Americans.

Consumer spending, which accounts for more than two-thirds of U.S. economic activity, slipped 0.2% last month after dropping 0.7% in November.

Economists polled by Reuters had forecast consumer spending decreasing 0.4% in December.

COVID-19 Pandemic: Effects on global economy

The coronavirus pandemic has reached almost every country in the world.

Coronavirus economic graphic

Its spread has left national economies and businesses counting the costs, as governments struggle with new lockdown measures to tackle the spread of the virus.

Despite the development of new vaccines, many are still wondering what recovery could look like. 

Here is a selection of charts and maps to help you understand the economic impact of the virus so far.

Global shares in flux

Big shifts in stock markets, where shares in companies are bought and sold, can affect the value of pensions or individual savings accounts (Isas).

The FTSE, Dow Jones Industrial Average and the Nikkei all saw huge falls as the number of Covid-19 cases grew in the first months of the crisis.

The major Asian and US stock markets have recovered following the announcement of the first vaccine in November, but the FTSE is still in negative territory.

The FTSE dropped 14.3% in 2020, its worst performance since 2008.

Stock market chart - Jan 2021

In response, central banks in many countries, including the UK, have slashed interest rates. That should, in theory, make borrowing cheaper and encourage spending to boost the economy.

Some markets recovered ground in January this year, but this is a normal tendency known as the “January effect”. 

Analysts are worried that the possibility of further lockdowns and delays in vaccination programmes might trigger more market volatility this year.

A difficult year for job seekers

Many people have lost their jobs or seen their incomes cut.

Unemployment rates have increased across major economies.

Unemployment rate chart - Jan 2021

In the United States, the proportion of people out of work hit a yearly total of 8.9%, according to the International Monetary Fund (IMF), signalling an end to a decade of jobs expansion.

Millions of workers have also been put on government-supported job retention schemes as parts of the economy, such as tourism and hospitality, have come to a near standstill.

The numbers of new job opportunities is still very low in many countries.

Job vacancies in Australia have returned to the same level of 2019, but they are lagging in France, Spain, the UK and several other countries.

Job vacancies - Jan 2021

Some experts have warned it could be years before levels of employment return to those seen before the pandemic.

Most of countries now in recession

If the economy is growing, that generally means more wealth and more new jobs.

It’s measured by looking at the percentage change in gross domestic product, or the value of goods and services produced, typically over three months or a year.

The IMF estimates that the global economy shrunk by 4.4% in 2020. The organisation described the decline as the worst since the Great Depression of the 1930s.

Majority of countries in recession - Jan 2021

The only major economy to grow in 2020 was China. It registered a growth of 2.3%.

The IMF is, however, predicting global growth of 5.2% in 2021.

That will be driven primarily by countries such as India and China, forecast to grow by 8.8% and 8.2% respectively.

Recovery in big, services-reliant, economies that have been hit hard by the outbreak, such as the UK or Italy, is expected to be slow.

Travel still far from taking off

The travel industry has been badly damaged, with airlines cutting flights and customers cancelling business trips and holidays.

New variants of the virus – discovered only in recent months – have forced many countries to introduce tighter travel restrictions.

Data from the flight tracking service Flight Radar 24 shows that the number of flights globally took a huge hit in 2020 and it is still a long way from recovery.

Commercial flights - Jan 2021

Hospitality sector has shut its doors worldwide

The hospitality sector has been hit hard, with millions of jobs and many companies bankrupt.

Data from Transparent – an industry-leading intelligence company that covers over 35 million hotel and rental listings worldwide – has registered a fall in reservations in all the top travel destinations.

Global tourism industry - Jan 2021

Billions of dollars have been lost in 2020 and although the forecast for 2021 is better, many analysts believe that international travel and tourism won’t return to the normal pre-pandemic levels until around 2025.

Shopping… at home

Retail footfall has seen unprecedented falls as shoppers stayed at home.

New variants and surges in cases have made problems worse.

Pedestrian numbers have fallen further from the first lockdown, according to research firm ShopperTrak, 

Huge drop in shoppers - Jan 2021

Separate research suggests that consumers are still feeling anxious about their return to stores. Accountancy giant EY says 67% customers are now not willing to travel more than 5 kilometres for shopping.

This change in shopping behaviour has significantly boosted online retail, with a global revenue of $3.9 trillion in 2020.

Pharmaceutical companies among the winners

Governments around the world have pledged billions of dollars for a Covid-19 vaccine and treatment options.

Shares in some pharmaceutical companies involved in vaccine development have shot up.

Moderna, Novavax and AstraZeneca have seen significant rises. But Pfizer has seen its share price fall. The partnership with BioNTech, the high cost of production and management of the vaccine, and the growing number of same-size competitors have reduced the investors’ trust in the company to have bigger revenue in 2021.

Pharmaceutical companies are the winners - Jan 2021

A number of pharmaceutical firms have started already distributing doses and many countries have started their vaccination programmes. Many more – such as Johnson & Johnson and Sanofi/GSK – will join the vaccine distribution during 2021.

By Lora Jones, Daniele Palumbo & David Brown

The UK economy remains in rescue mode

Today’s Spending Review is not a Budget. The numbers have not added up, tens of billions were announced in new spending, but nothing on taxation.

But it was the first full assessment of the economy from the government’s independent forecaster, the Office of Budget Responsibility, since March that took centre stage.

It confirmed not just that the pandemic would hit the UK economy this year by the biggest amount in three centuries, 11.3%, but that Britain was set to be the hardest hit of all the G7 major industrialised nations.

It also said that government borrowing in this year was 19% of the size of the economy, a peacetime record at just under £400bn.

And yet the paradox is that next year the amount of money it costs to fund that debt will also reach a post-war record: a record low.

Since World War Two, our debts have never been bigger. And yet they’ve never been cheaper.

How long this situation will last is the fundamental judgement for this chancellor.

So Rishi Sunak has made some down payments on budget consolidation, aid and public sector pay, while claiming there is no return to austerity generally.

The much bigger, tougher decisions that will be needed arise from the assumed persistence of the economic hit, and therefore of levels of government borrowing above £100bn a year for the next few years.

By 2025 the economy will still be 3% smaller than anticipated in March. The pandemic will have a long economic shadow.

Mr Sunak says employment is the number one priority, with overnight confirmation of £400m next year to start a £3bn Restart scheme to channel one million long term unemployed back into work.

The theory here is to take action on a likely rise in long-term unemployment pre-emptively.

The chancellor is proud of the fact that the UK’s unemployment rate is still comparatively low, even as it is set to rise to 2.6 million.

But the public sector pay squeeze for more than a million above average earners outside the NHS will hurt.

Huge sums were allocated to fighting the pandemic and protecting the health system.

This is an economic intervention as much as it is a health one.

The OBR document shows that if test and trace continues to underperform, or if vaccine distribution is delayed, there will be a direct impact on much worse public finances.

A no-deal Brexit will, say the OBR, be a further hit to the economy of 2%, and the public finances. 

There are many uncertainties, not all of them bad.

The big decisions on shrinking the deficit or indeed stimulating the economy further, as has been seen in France and Germany, await some of this fog lifting.

The nation remains in rescue mode, and for now funding it remains cheap.

Faisal Islam
Economics editor

Sunak begins planning for a post-Covid economy

On Wednesday, Chancellor Rishi Sunak begins setting out plans for what he hopes will be an economy beyond Covid-19. This Spending Review – detailing the money government departments will get for things like the NHS, education, roads, and police – only covers the financial year 2021-22. It will also set out money for the devolved administrations Scotland, Wales and Northern Ireland.

In normal times, reviews cover three or four years. But such is the economic uncertainty that this look-ahead has been limited to the next 12 months. 

Even so, Mr Sunak will point to the direction of travel for spending (and possibly tax rises) for future years. Few reviews can have been so anticipated. Here’s what to watch out for.

Presentational grey line

The difficult financial backdrop

The economic shock has left the UK a poorer country. The economy is expected to be at least 10% smaller than expected before the pandemic. 

Alongside the Spending Review, Mr Sunak will disclose latest forecasts for the economy and public finances from the independent Office for Budget Responsibility (OBR).

Earlier this year, the OBR forecast a 13% contraction. While it is not expected to be that bad, the shrinkage will still likely be in the double-digits, and with public borrowing topping £350bn – something not seen in peacetime. 

A difficulty for the chancellor is that big tranches of public service spending have already been made. Despite that, some areas will reportedly get more: NHS England, schools and defence. According to the Institute for Fiscal Studies (IFS), some two-thirds of public service spending has been pre-determined. 

The key question is whether the remaining third is enough to go round. The answer is almost certainly not. The IFS thinks “unprotected” services such as the courts, prisons or local government are vulnerable to cuts. The overseas aid budget is also in the line of fire.

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Classroom
image captionTeachers are among workers who could face a pay freeze

Squeezing public sector pay

Saving, not spending, will dominate Wednesday’s agenda. And one of the biggest savings could be a public sector pay free. It would be hugely controversial. Media leaks last week claimed Mr Sunak wants a freeze for everyone except frontline NHS staff.

That won’t go down well with the police, teachers, civil servants or anyone who thinks they’ve done their bit to ensure the public sector keeps going in tough times. Even a return to a 1% cap is likely to be fiercely resisted.

Some commentators think the media reports were Treasury kite-flying. Even so, in the summer, Mr Sunak suggested that as private sector pay had taken a huge hit, in the “interest of fairness” the public sector’s 5.4 million workers should share some pain.

Trouble is, relative to pay in the private sector, public sector pay has fallen to its lowest level in decades, according to the IFS.

Only during the pandemic has public sector pay performed more strongly than in the private sector. Union leaders have already warned of industrial action to ensure members’ pay does not fall further behind.

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UK Treasury building
image captionThere is speculation some government operations could be relocated from London

‘Levelling up’

Many promises have been thrown off-course because of the pandemic, and the government will be keen to get its north-south levelling up agenda back on track as soon as possible. Infrastructure spending is key to this.

The north has long complained that the Treasury methodology used to calculate the cost-benefit of spending money on big projects is inherently biased towards London and the rest of the south east. So, expect some changes to these calculations. And watch out for whether any spending promises are new money, or simply projects brought forward.

To underline his commitment to spend on big long-term projects, there is talk that Mr Sunak could publish details of a National Infrastructure Strategy and a Research and Development Strategy.

And in a symbolic move that levelling up is more than a question of infrastructure, the Financial Times has reported that the chancellor could also announce that parts of government could relocate from the capital – with the Treasury leading the way.

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Money
image captionTax hikes are inevitable, but rises too soon will choke off recovery, economists say

What happens next?

While Wednesday will be about spending and borrowing, at some point the chancellor will have to decide how it will be paid for. He will start to address this in next March’s Budget, although most economic commentators feel the economy will still be too fragile for major tax rises.

It is possible that, with the success of a Covid vaccine, the economy could bounce back, limiting the need for big rises. However, Paul Johnson, director of the IFS, told the BBC that four or five years down the road he still expects the economy to be about 4%-5% smaller than before the pandemic.

Rein in spending and raise taxes too early, and recovery will be choked off. Leave it too late, and the public finances will spin out of control. 

“It’s a fine judgement,” said Mr Johnson. Both the chancellor and Prime Minister Boris Johnson have, however, said they don’t want a return to austerity. 

There have been reports the Treasury could raise money from changes to Capital Gains Tax, pensions relief or self-employment taxes. But this is tinkering. 

Mr Johnson believes £40bn of tax rises are necessary over the short-term, and that sort of money cannot be raised without touching the Big Three: income tax, VAT or national insurance. These bring in almost two-thirds of government revenue.

Source: BBC