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

By Hanna Ziady, CNN

London (CNN) — The UK government went all out to prop up the economy through the Covid pandemic and the initial phase of Russia’s war in Ukraine. Now, the bill is starting to bite.

Interest payable on UK central government debt hoovered up £7.7 billion ($9.8 billion) last month alone, hitting a record for July, the Office for National Statistics said Tuesday. For comparison, that equals 11% of the United Kingdom’s defense budget for the entire financial year.

Since the pandemic struck in March 2020, UK government debt has surged more than 40% to almost £2.6 trillion ($3.3 trillion) — a level not seen since the early 1960s and roughly the same size as the nation’s annual gross domestic product.

While several countries owe even more as a percentage of their GDP — including the United States — Britain stands out for a different reason: Almost a quarter of its government debt is “index-linked,” meaning it’s tied to inflation.

That’s double the share in Italy, whose dependence on inflation-linked debt comes second only to that of the UK among advanced economies, according to Fitch Ratings.

As prices in the UK have soared over the past 18 months, so have the repayments and the interest owed by the government on inflation-linked bonds.

High inflation helped drive Britain’s debt-servicing costs to their highest level as a share of GDP in more than four decades in the latest financial year, decimating the country’s finances just as it grapples with feeble economic growth and draws closer to a general election.

According to Fitch, Britain now spends more to service its debt than any other developed economy, as a percentage of government revenue.

“The 2020s are turning out to be a very risky era for the public finances,” the Office for Budget Responsibility, the UK government’s fiscal watchdog, said in a report last month.

“In just three years, they have been hit by the Covid pandemic in early 2020, the energy and cost-of-living crisis from mid-2021, and the sudden interest rate rises in 2022.”

As an indication of how high borrowing has jumped, the UK government expects to spend £116 billion ($148 billion) on debt interest in the current financial year. That’s behind only social security (£341 billion), health (£245 billion) and education (£131 billion).

Credit downgrades looming?

The UK’s growing debt burden puts it on shaky ground ahead of upcoming assessments by the three main credit ratings agencies. A downgrade to its credit rating, which is a reflection of a country’s creditworthiness, could raise borrowing costs further still, although the impact may be limited.

“It is becoming clear that rating agencies are placing an ever-greater scrutiny on debt-to-GDP ratios when making their decisions,” wrote Ellie Henderson, an economist at Investec in London, in a note Tuesday.

When Fitch stripped the United States of its top AAA rating earlier this month, it cited the country’s high debt-to-GDP ratio as one of the reasons for the downgrade, she added. Fitch currently has the UK on a negative outlook, meaning it is at a higher risk of a downgrade to A from its current level of AA-. That would indicate a “high” rather than “very high” credit quality.

Moody’s and S&P are due to publish their updates on the UK on October 20, with Fitch following on December 1.

“We are not forecasting a downgrade,” Ruth Gregory, deputy chief UK economist at Capital Economics, told CNN, pointing to the fact that the UK economy and public finances have performed better than expected.

Even if a downgrade were to happen, “the consequences may not be particularly significant,” she added. “Whatever developed market you look at, bond yields don’t rise after credit [ratings] agency downgrades.”

Still, the overall state of UK public finances leaves the Conservative government with difficult choices heading into the next general election, which must take place by January 2025.

With official interest rates still rising and “a mild recession on its way,” finance minister Jeremy Hunt “will struggle to unveil a large package of permanent tax cuts” in the budget due to be announced in the fall, Gregory added.

In a statement Tuesday, Hunt said: “As inflation slows, it’s vital that we don’t alter our course and continue to act responsibly with the public finances. Only by sticking to our plan will we halve inflation, grow the economy and reduce debt.”

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