Explained | Britain’s week of market turmoil and the tax cut reversal

The story so far: On Monday, October 3, recently elected United Kingdom Prime Minister Liz Truss was forced to reverse plans to bring in Britain’s highest tax cuts in 50 years, after a “minibudget” presented by her Finance Minister Kwasi Kwarteng set in motion a tumultuous week for the country’s markets. Announcing the reversal and acknowledging that the budget plan had become a “distraction” from the new government’s mission to “tackle the challenges” facing the U.K., Mr. Kwarteng said: “We get it, and we have listened.”

Notably, the International Monetary Fund (IMF) rebuked the government’s new tax plans last week, cautioning that they were likely to increase inequality and drive up inflation. The most immediate reaction to the plans was the plummeting of the pound to record lows and the increase in the government’s cost of borrowing to record highs, prompting an emergency intervention by the Bank of England.

Monday’s tax cut reversal announcement helped the pound sterling bounce back against the dollar. It was up 1.4% to the highest level since before the minibudget was announced.

What was announced in the minibudget and what happened after that?

On September 23, Kwasi Kwarteng, the U.K.’s Chancellor of the Exchequer (Finance Minister), in a “minibudget” statement announced the country’s biggest tax cuts in 50 years, worth £45 billion ($48.7 billion; €50.3 billion along with additional massive spending to “boost economic growth and generate increased revenue”. This was in addition to previously announced plans worth more than60 billion pounds to cap soaring energy bills for homes and businesses.

The problem, however, was that the announced plans were unfunded, or to be funded by further borrowing. When governments usually announce tax cuts to boost the economy, corresponding government spending reductions are also announced to ensure that borrowing does not spike, but instead, Mr. Kwarteng’s plan called for huge additional spending fueled by borrowing.

While inflation was already at record highs, the borrowing-heavy plan triggered a crisis of confidence in the government, with markets and investors worried that the tax cuts would drive up inflation and force the Bank of England to increase its interest rates at a faster pace. Investor mistrust further deepened since the plans were not accompanied by a forecast or assessment from the U.K.’s budget watchdog Office for Budget Responsibility (OBR). Moreover, in concurrence with the IMF, the British think-tank Resolution Foundation also said that the tax cut would unjustly benefit the richest Brittons.

After the minibudget on September 23, the pound plunged over 3% and two days later, briefly dipped as low as $1.0349 per U.S. dollar before rebounding to $1.0671. The British currency was trading at levels last seen in the early 1980s.

The slide of the sterling to the dollar further cemented inflationary fears in a country that imports a large part of its fuel, food and other products, at a time when imported Russian gas has already driven up consumer inflation to levels greater than in 1989.

While Britain posted almost stagnant growth since 2008, the government’s plan to borrow more was expected to increase the budget deficit to 4.5% of the gross domestic product (GDP), and the debt burden to a whopping 101% of GDP by 2030, according to a Bloomberg Economics analysis.

So, while large economies are usually trusted by investors for their ability to reservice debt, analysts said that owing to the radical tax plans to boost demand instead of supply, the market was now treating the U.K like an emerging economy. This meant a sharp increase in the country’s cost of borrowing.

Countries borrow money through the issuance and sale of bonds (or gilts, as they are called in the U.K.), which are debt instruments with different periods of maturity. In the case of bonds, their price is generally inversely proportional to the interest rates charged on them.

In reaction to the policy, the British bond market opened on September 26 in a rout- prices went down, triggering the largest sell-off of gilts in decades. Subsequently, the bond yields (the interest that the government is charged when it borrows) skyrocketed.

What made the Bank of England step in?

On September 28, against the backdrop of a sliding sterling and a bond market crisis, the Bank of England (BoE) launched an emergency intervention, announcing that it would buy around 65 billion pounds ($69 billion) worth of the government’s long-dated bonds. Incidentally, this came at a time when BoE was set to reduce its government bond holdings, in a phased sale worth 838 billion pounds ($891 billion.)

The Bank stated that its emergency bond buying was to stem potential risks to the stability of the country’s financial system and more importantly, to shield the impact on Britain’s large pensions funds which together hold around $2 trillion worth of assets, according to Reuters.

Britain’s pension funds invest in bonds to create assets, and a large proportion of these pension funds follow a strategy called liability-driven investing (LDI), which essentially involves maintaining the same amount of assets as future liabilities to shield schemes from exposure to swinging markets.

So, when gilt prices fell and yields went up, the value of pension fund assets started wiping out. This meant that the funds were getting margin calls by LDI managers to immediately raise collateral to offset liabilities and avoid collapse. As a result, pension funds started selling off their gilts in order to raise cash quickly, which lead to a further drop in gilt prices, described by some analysts as a “doom loop”. Hence, the BoE’s emergency bond-buying intervention to stabilise bond prices and lower yields to shield the financial system and pension funds.

How did analysts react to the tax plans? Is the crisis over?

Apart from the pound’s increase, it is yet to be seen how Ms. Truss’ U-turn on the tax plans helps with market stabilisation.

The outlook seemed grim while they remained in place. While yields or interest rates on bonds fell to below 4% for a brief period after the BoE’s intervention, signalling some respite, they were back on the rise the next day. The Bank planned to buy $69 billion worth of bonds through daily auctions till October 14. Analysts said that while that was enough to calm waters in the short run, if Mr. Kwarteng’s tax plans were not reversed, markets could become unstable again when the temporary intervention ended.

Both Ms. Truss and Mr. Kwarteng did not initially indicate a change in plans. Bloomberg reported that top London bankers urged the former last week to reassure the market then and not wait for his planned statement on November 23.

A BoE executive also warned that if kept in place, the tax cut plans would increase inflationary pressures, and force the Bank to significantly increase interest rates for borrowers in order to curb spending.

This meant that the crisis wouldn’t stop at financial markets but was also expected to have a cascading effect on the housing market. David Blanchflower, a former member of the BoE’s Monetary Policy Committee told DW that the huge instability in the system would lead to a “housing market collapse because interest rates are going to rise, people can’t get mortgages and the price of those mortgages is going up”.

“This looks like the U.K. is in great turmoil, headed into recession. This looks like an utterly incompetant economic policy by a Prime Minister who has been in place three weeks,” he added.

Bloomberg quoted Kallum Pickering, senior economist at Berenberg Bank, as saying that the BoE intervention had bought the “government time to fix its credibility”.

“Because the UK has damaged its once strong credibility with a poorly managed Brexit and persistent threats of a UK-EU trade war, it no longer enjoys the benefit of the doubt.” he said.