Brown Goes ‘Full Circle’ as Debt Casts Doubt on AAA Bond Rating

By Gonzalo Vina

May 22 (Bloomberg) -- When Gordon Brown took over as Britain’s Labour finance minister in 1997 after 18 years of Conservative rule, he promised “sustainable public finances” to cut a debt load that was near the highest in more than decade.

Brown, prime minister since 2007, is leaving the next government -- either his own or one led by the Conservatives -- a mess similar to the one he inherited.

Standard & Poor’s yesterday highlighted the task facing the next finance chief, saying it may cut Britain’s AAA credit rating for the first time as debt heads to 100 percent of gross domestic product amid the worst recession since World War II.

“We have gone full circle,” said Danny Gabay, director of Fathom Financial Consulting in London and a former Bank of England economist. “Like then, there was a massive collapse in the fiscal position. Whoever is in government won’t have the luxury of waiting, because the situation is pressing.”

Debt costs will consume 6.9 percent of government spending by 2013, double the current rate, crowding out funds available for roads, schools and hospitals, according to the independent Institute for Fiscal Studies in London. The government expects to spend 60 percent more servicing debt next year. By 2014, it will be paying lenders almost as much as it spends on defense.

Britain needs to sell a record 220 billion pounds ($344 billion) of bonds in the fiscal year through March 2010. Chancellor of the Exchequer Alistair Darling says the budget deficit will reach 175 billion pounds, or 12.4 percent of GDP, the highest among the Group of Eight nations.

Pound, Stocks Slide

After S&P lowered the U.K. credit outlook to “negative” from “stable,” the pound fell the most in four weeks against the dollar, the FTSE 100 Index slid 2.8 percent and the cost of insuring U.K. debt against default rose by 8 basis points.

The move couldn’t have happened at a worse time for Brown, who trails in opinion polls and is struggling to overcome a scandal regarding expense reimbursements provided to lawmakers - - a controversy that toppled the Speaker of the House of Commons this week for the first time since 1695.

A BPIX Ltd. survey published May 17 showed Brown, who must call an election by June 2010, lagging behind the Conservatives by 22 points.

“Does this government in its current state have the steel and the authority to put through a painful program of tax increases and spending reductions and nurture the economy in a consensual way through a period of difficult economic adjustment?” said George Magnus, senior economic adviser at UBS AG. “ No. The politics just aren’t right.”

Higher Taxes

Regardless of whether Brown’s Labour Party or David Cameron’s Conservatives win the next election, Britain is headed for years of pain as the government raises taxes and slashes spending to restore credibility with investors, economists say.

“The huge deficit will still require significant and active tightening of fiscal policy,” said Ben Broadbent, a U.K. economist at Goldman Sachs Inc. in London.

A credit rating cut may drive government borrowing costs higher, eating further into what a Brown or Cameron government can spend on public services.

Fathom’s Gabay says the average interest rate paid by the government following a downgrade may rise to about 7 per cent. That rate was last seen in 1997 and, because of the size of the debt, servicing costs as a share of the economy would rise to their highest since 1946.

The government estimates it will devote 5.9 percent of spending to paying interest by 2011, jumping from a low of 4.1 percent this year, though still less than the 9.1 percent when Brown became chancellor in 1997.

Debt Costs

For now, the Treasury plans on paying an average interest rate on outstanding debt of 4.8 percent from April 2010. That compares with averages of 10 percent in the early 1980s and 7 percent in the 1990s.

With the economy shrinking, tax revenue is crumbling and the deficit ballooning. The government says debt may total 1.4 trillion pounds by 2014 from about 600 million pounds last year.

Darling has already announced a spending squeeze and higher taxes that will boost Treasury coffers by almost 27 billion pounds a year. The International Monetary Fund said yesterday those steps aren’t enough to restore the government’s finances and urged further action.

“Britain’s economic reputation is on the line,” said George Osborne, the lawmaker in charge of Treasury affairs for the Conservatives. “Unless Britain has a government with a credible plan to reduce debt, there will be a further downgrade, with all of the serious consequences for our prosperity that would entail.”

Britain’s debt next year will be 66.9 percent of GDP, exceeding Canada’s 29.1 percent and Germany’s 58.1 percent, according to April 22 forecasts by the IMF. The U.S. will be at 70.4 percent, and the 16-nation euro area at 68 percent, according to the Washington-based lender.

“We’ll get to 100 percent quite easily,” said Colin Ellis, an economist at Daiwa Securities SMBC Europe Ltd. in London. “The public finances are really in trouble.”

To contact the reporters on this story: Gonzalo Vina in London at gvina@bloomberg.net;