Investors took fright on Thursday at the timidity of the government's plans to balance the books with one of the biggest sell-offs of British gilts this year.
As economists digested Wednesday�s pre-Budget report, concerns grew both about the sustainability of the public finances and the government�s willingness to tackle yawning budget deficits.
Michael Saunders, an economist at Citigroup, said: The PBR seeks to create a fiscal fiction that the deficit can be resolved solely by tax hikes on a relatively small share of the population the few, not the many � and without painful public spending cuts. The revenue forecasts again look over-optimistic, and there are no public spending plans after 2010-11 only vague forecasts.
The Institute of Fiscal Studies estimated that public spending would have to be cut by as much as a fifth in areas such as defence, higher education, housing and transport during the next parliament under plans laid out in the pre-Budget report. This would amount to the sharpest cutback since the International Monetary Fund bailed out Britain in the 1970s.
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The IFS also calculated that the effects of population ageing would mean high public-sector debt levels for a generation or more unless taxes were raised substantially or public spending cut further. (See chart)
Amid these concerns, the yield on 10-year government bonds rose by 0.14 percentage points to 3.8 per cent, one of the biggest daily rises this year, signalling that investors are demanding a higher return for holding government paper.
More worrying for the Treasury is that the interest rate on gilts is now rising compared with German government bonds. The difference in the interest rate widened to 0.62 percentage points on Thursday, the highest in a year, and up from 0.46 percentage points on Monday morning.
With European bond markets in turmoil after Greece's downgrade this week, there are fears that unless Britain acts quickly to bring down its budget deficit, currently at 12.6 per cent of national income, a similar fate could befall gilts. The result would be that the costs of servicing the debt burden would rise rapidly and any planned tax rises or spending cuts would have to be tougher to compensate for the additional interest costs.
Huw Worthington, fixed-income strategist at Barclays Capital, said: UK bond investors should look at Greece, where the bond markets have crashed this week. The bond markets in the UK could crash too, unless the government starts to initiate serious debt reduction policies.
Greek two-year bonds have seen a startling fall this week. Yields on two-year bonds have risen 1.3 percentage points to 3.15 per cent, the most abrupt move in the eurozone�s history, as investors fear the country's public finances have fallen into disrepair.
The IFS on Thursday calculated that once the effects of population ageing were taken into account, public debt in the UK would remain at 60 per cent of national income until the middle of the century even if the Treasury's plans to wipe out structural borrowing were met.
The Treasury published a long-term public finance report on Wednesday that showed that it expected to return public sector net debt to the government's former 40 per cent of national income target by the mid 2030s. [On their plans they haven't a hope! -cs]
But Carl Emmerson, deputy director of the IFS, pointed out that the Treasury's estimates did not include the expected costs of population ageing from higher pension payments. Previously, the Treasury had published these estimates. He said that the bad news is that debt will become sustainable at 60 per cent of national income not 40 per cent. [This implies at best a permanent rise in the costs of debt servicing of around 50%! -cs]
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