Why inflation makes Britain's debt the costliest among rich economies

London CNN

The UK government did everything it could to support the economy, including the Covid pandemic as well as the first phase of Russia's conflict in Ukraine. The bill is now starting to bite.

The Office for National Statistics reported Tuesday that interest on central government debt in the UK reached a record high of 9.8 billion pounds sterling ($7.7 billion) for last month, a new monthly record. Comparatively, this is 11% of UK defense budget in the whole financial year.

Since the pandemic hit in March 2020, UK Government debt has risen more than 40%. It now stands at almost PS2.6 trillion ($3.3 billion), a level that has not been seen since the 1960s. This is roughly equal to the country's gross domestic product.

While many countries, including the United States, owe more in terms of a percentage of GDP than Britain does -- almost a quarter is "index-linked," meaning that it's linked to inflation.

According to Fitch, this is double the amount in Italy. The country's dependence on debt linked to inflation comes second to the UK only among advanced economies.

In the UK, prices have increased over the last 18 months. The government has also owed interest and repayments on inflation-linked bond.

Inflation has driven Britain's debt service costs to the highest level in over four decades as a percentage of GDP during the last financial year. This has decimated the country's finances as it struggles with a weak economic growth, and is approaching a general elections.

Fitch says that the UK spends more on servicing its debt as a proportion of government revenues than any other developed country.

In a report published last month, the Office for Budget Responsibility (the UK government's fiscal monitor) said that the 2020s were a risky time for public finances.

In just three years they will be hit by the Covid Pandemic at the beginning of 2020, then the Energy and Cost-of-Living Crisis in mid-2021 and the sudden rise in interest rates in 2022.

The UK government is expected to spend PS116 ($148 billion) in debt interest during the current financial period. This shows how much borrowing has increased. This is behind only health (PS245billion), education (PS131billion) and social security (PS341billion).

Credit downgrades looming?

The UK is in a precarious position ahead of the upcoming credit rating assessments by three major agencies. The downgrade of its credit rating could increase borrowing costs, even though the impact might be minimal.

In a note published on Tuesday, Ellie Henderson, Investec's London economist, wrote that it is clear rating agencies are scrutinizing debt-to GDP ratios more closely.

She added that when Fitch downgraded the United States from its top AAA credit rating earlier this week, they cited the high ratio of debt to GDP as one of the main reasons. Fitch has given the UK a negative outlook. This means that it faces a greater risk of being downgraded to A, from its current AA- rating. This would mean a credit rating of 'high', rather than'very' high.

Fitch will follow on December 1 and Moody's on October 20.

Ruth Gregory, Capital Economics' deputy chief UK economist, said on CNN that they were not forecasting any downgrades, as the UK economy, and its public finances, have performed better than anticipated.

She added that even if there were a downgrade, "the consequences might not be very significant." "Whatever developed markets you look at...bond yields do not rise after credit [ratings] agencies downgrades."

The overall state of UK finances still leaves the Conservative Government with difficult choices as it heads into the next general elections, which must be held by January 2025.

Gregory said that with official interest rates rising and a'mild recession' on the way, finance minister Jeremy Hunt will struggle to unveil a substantial package of permanent tax reductions' in the budget to be announced this fall.

Hunt stated in a Tuesday statement: 'As the inflation slows down, it is vital that we do not change our course, and continue to be responsible with public finances. Only by sticking with our plan can we reduce inflation, grow the economic and reduce debt.