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Government debt: index linking is backfiring for Britain

Higher prices in the UK will not only squeeze the pocketbook of the average Briton. It will also hit the government hard. Talk of double-digit inflation this winter — Citigroup now thinks the rate could surpass 18 per cent — comes as energy prices continue to soar. But the country’s over-reliance on inflation-linked debt will mean punitively higher financing costs too.

Britain pioneered the issuance of index-linked bonds, or “linkers”, in the 1980s with the rationale that the government’s commitment to reducing inflation directly lowers borrowing costs. This would remove any temptation to inflate away debt.

That premise has proved flimsy in 2022. UK government debt now equals its annual economic output, one of the highest proportions of any developed economy. Soaring inflation, through inflation adjusting, has exacerbated the pain of excessive debt.

Linkers make up almost a quarter of total UK central government debt of £2tn. Compare that with just 8 per cent in the US and less than 5 per cent in Germany. UK government interest payments in June more than doubled to £19.4bn this year. This increase was entirely due to the rise in semi-annual linker payments connected to a surging retail price index (which includes mortgage rates). This measured inflation rising at 12.3 per cent in July.

In March the UK’s Office for Budget Responsibility had forecast interest costs to hit £84bn this fiscal year, about double what it expected at the end of last year. That burden will continue to pile up. Capital Economics expects an extra £30bn to be paid on top of that. An average RPI rate of 15 per cent next year would boost the cost to almost £130bn, Lex calculates. And that does not include the impact of any additional interest rate rises by the Bank of England.

Even without these, borrowing costs alone would equal about 5 per cent of GDP. That could push spending on debt servicing above that of Europe’s most indebted country Italy if the latter’s interest costs rose by 3 percentage points, thinks S&P. Those kinds of numbers should send a message to UK policymakers to clamp down on inflation, and soon.

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