LONDON (S&P Global Ratings) Oct. 31, 2024--S&P Global Ratings said today that it views the U.K.'s fiscal position as constrained following the policy announcements in the Autumn Budget 2024. The net fiscal impact of the Labour Party's first budget is to raise net general government borrowing over the medium term, underscoring the challenges in repairing the U.K.'s diminished fiscal policy flexibility in the midst of a multitude of public spending pressures. The new policy decisions, however, do not have an immediate impact on our headline budgetary forecasts for the U.K., because we already expected a weaker fiscal trajectory in our base-case scenario, reflecting some of these expenditure pressures (see "United Kingdom 'AA/A-1+' Ratings Affirmed; Outlook Stable," published on Oct. 18, 2024).

On Oct. 30, 2024, Rachel Reeves, the U.K.'s Chancellor of the Exchequer, delivered her first autumn budget, the net fiscal policy effect of which is expansionary. The budget follows the Labour Party's victory at the general election held in July 2024. The announced measures include a significant increase in spending, as projected by the government, of £76 billion annually by March 31, 2028, which is 2.5% of our projected 2027 GDP and is only partially compensated by policy decisions to raise government revenue (£39 billion annually by 2027 or 1.2% of GDP). About two-thirds of the decided spending increase covers public services, including the National Health Service (NHS), while about one-third is directed at additional public sector capital expenditure. On the revenue side, nearly two-thirds of the projected increase stems from higher employer national insurance contributions, while the remainder is mostly attributed to the abolition of the non-domicile tax status and expected improvements in tax compliance.

As we previously communicated, one of the key factors weighing on our unsolicited 'AA' long-term sovereign credit rating on the U.K. is its constrained fiscal position, characterized by elevated budgetary deficits and net general government debt level (see "United Kingdom 'AA/A-1+' Ratings Affirmed; Outlook Stable,"). We are currently maintaining our headline forecast that the U.K.'s general government deficit will gradually moderate to 3% of GDP by 2027 from 5.2% of GDP in 2024 with net general government debt slowly declining from almost 100% of GDP over this period. We have not changed our headline budget deficit forecasts as a result of the budget announcement, partly because our existing projections already contain wider deficits that reflect lingering public spending pressures.

Below we highlight four key takeaways from the Autumn Budget from a ratings perspective.

1) A key consideration for us is whether higher public investments and extra spending on public services will be effectively delivered, thus successfully addressing existing problems.   We note that public spending tends to be sticky and often difficult to roll back. Consequently, a hypothetical scenario in which public spending is permanently higher but the quality and accessibility of public services still doesn't improve enough, could further complicate policy trade-offs in the future. Conversely, a faster improvement in public services could yield greater dividends in terms of lower future pressures and positive growth repercussions. We also note that the government has established a new HM Treasury Unit (The office for Value for Money) tasked with ensuring effectiveness of public spending.

2) In our view, a change to fiscal rules represents a mixed message.   The switch to target a reduction in public sector net financial liabilities (as opposed to public sector net debt) is designed to give scope for the implemented additional public spending, which widens budgetary deficits under the government's projections. At the same time, a gradual move to a three-year, rather than five-year, timeframe (so that the current budget is in balance and public sector net financial liabilities are falling as a percentage of GDP in the third year of the forecast horizon) should in the future underpin a better focus on near-term fiscal consolidation. This is in contrast to the practice in recent years where fiscal consolidation has been typically backloaded toward the end of a five-year forecast, given that the current fiscal rules require debt to be falling as a percentage of the economy in the fifth year of the forecast. It remains to be seen, nevertheless, to what extent the administration can consistently adhere to the new rules in the future and whether the rules themselves could be subject to further changes as the shift to a three-year horizon begins in 2026.

3) Overall, strengthening the U.K. public finances will remain a challenging task, and we expect net general government debt to stay just below 100% of GDP through 2027.   A budget delivering a net fiscal loosening is not new in the U.K. context, given policy decisions taken in recent years. We note in particular the previous two budget announcements under the Conservative administration which relaxed fiscal policy via lower taxes as opposed to front-loading the repair of the U.K.'s public finances. One takeaway from this is that even though successive governments have recently aimed to bolster the U.K.'s public finances, they have often relaxed fiscal policy--either based on the electoral cycle or to address persistent spending pressures.

4) Most importantly, we consider that a key factor underpinning the government's ultimate success at strengthening public finances will be the U.K.'s growth outcomes.   The front-loading of spending will mechanically boost growth in the short term, but it's too early to tell how much this will add to potential output in the long term. On the positive side, investments in infrastructure and planning reforms should create a more business-friendly environment; an improved health service should help bring people back to work as current inactivity remains mainly linked to people who are off sick; and education and childcare investments should improve workers' skills in the long term. Nonetheless, reaping those potential benefits will also depend on whether the spending is deployed in an effective way.

In the short run, the boost in government spending will likely crowd out the private sector in favor of the state. As the demand side of the economy is still adjusting to a less dynamic supply side, a looser fiscal policy stance is set to result in a slightly tighter monetary policy than would have been expected otherwise. The increase in the minimum wage, a rise in spending in sectors, where vacancies remain well above historical average (e.g. health, education, and defense) and a labor market that is still tight by historical standards, are likely to add to current wage pressures, slowing the return to the Bank of England's inflation target of 2%. In turn, a higher interest rate, higher labor costs, and a higher tax burden could raise input costs for companies and delay the private sector investment recovery.

Beyond the Autumn 2024 budgetary announcement, we note that our ratings on the U.K. are still supported by its high income levels; its large, diversified economy and financial sector; its developed product and labor markets; the strength and independence of its key institutions; and the sterling's reserve currency status.