Greek lessons for UK debt

Greece's collapse into a borrowing crisis this week has been swift. As Sarah Arnott reports, it is a precedent that the Chancellor must heed
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The Independent Online

It is becoming a familiar story: bond markets in crisis, gilt yields soaring, the government struggling to convince international creditors that it can bring down spiralling budget deficits.

But the City's wobbly response to the Chancellor's pre-Budget report this week was a pale shadow compared with the carnage in Greece.

After a week that saw the Greek sovereign debt downgraded below the prized A-rating for the first time in a decade, and the worst bond market collapse in the history of the eurozone, Athens was scrabbling to restore confidence yesterday. At a two-day EU summit in Brussels, the Prime Minister, George Papandreou, promised far-reaching cuts in his country's bloated bureaucracy and an assault on its rampant corruption.

Like Britain, Greece's problem is its debt – currently running at €300bn (£270bn), the highest since democracy was restored in 1974, and expected to hit 113 per cent of GDP this year and more than 120 per cent next.

The latest crisis started on Monday when Fitch Ratings downgraded Greece by one notch to BBB+, and Standard & Poor's put it on a "negative" outlook. Fears that it might become the first eurozone government to default on its debts sent yield spreads on 10-year bonds shooting up to an eight-month high above German equivalents, and by Wednesday the Athens stock market was down by nearly 12 per cent.

Greece is not Europe's most indebted nation – that accolade belongs to Italy. But, unlike Italy, its annual deficits are still rising and its reputation for fiscal prudence is poor. Greece's credit is already rated lower than many other eurozone governments because it has persistently flouted Stability and Growth Pact rules banning deficits of more than 3 per cent of GDP.

Its standing then took a further battering when Mr Papandreou's government came to power two months ago and discovered this year's deficit to be a whopping 12.7 per cent of GDP, more than twice its predecessor's estimate.

Greece's troubles offer some uncomfortable parallels with the debt-laden British economy. Though not on the scale of the Greek sell-off, the Chancellor's pre-Budget report (PBR) this week prompted a worryingly sharp dip in gilt yields as investors spooked at the gaping hole in public finances. The markets proved chary of Alistair Darling's predictions that the economy will grow by 1.25 per cent next year and a healthy 3.5 per cent in the following two, helping to cut the deficit in half by 2013/14. Further, Mr Darling's failure to spell out where the necessarily brutal spending cuts will fall fuelled doubts that the government has a coherent strategy, whipping up speculation that the UK Government's Aaa credit rating could be under threat.

Optimists will argue that the situations are different: while Greece's debts are already way beyond its total output, the UK's will be "only" a manageable 69 per cent this year. But the numbers are rising. The European Commission predicts Britain's gross debt will hit 80 per cent in 2010, dangerously close to the level at which investors start looking for premiums.

More worrying is the similarity between the UK and Greece in the scale of their structural debt. High structural debts mean the country was already spending more than output in the good times, so it will take more than just a return to economic growth to bring borrowing back down. Michael Taylor, a senior economist at Lombard Street Research, says: "There are distinct similarities – in structural terms – in the scale of the fiscal mess in the UK and in Greece."

The situation is not improving. The OECD puts the UK's structural budget deficit at around 10 per cent next year, even higher than the just over 6 per cent forecast for Greece. "The UK will probably have the worst budget deficit next year among all the major economies, both in absolute terms and in cyclically adjusted terms," Mr Taylor said.

The sharply rising trajectory is a matter of politics. In his PBR speech, the Chancellor talked explicitly of "competing visions", of Labour's commitment to keep spending until growth is certain while the Conservatives would cut too soon and endanger the recovery.

In this regard, Greece may have the edge. Although the markets may be adopting a wait-and-see approach to this week's hastily announced plans from Mr Papandreou, the Greek government is at least able to lay out a clear strategy. Its membership of the eurozone might also be a political blessing, giving Socialist ministers someone else to blame for unpleasant cuts likely to raise the wrath of their core left-wing support.

In contrast, Mr Darling is faced with a looming general election, the opposition leading the polls, and a Prime Minister adamant he must not endanger the party's electoral heartland. "We are at an unfortunate stage in the political cycle," Mr Taylor says. "What we need is a clear plan to cut the deficit, but we are within months of an election and a Labour government just cannot talk about cuts."

Uncertainty over the UK's fiscal stability is unlikely to tip into catastrophe before the election. But there will be little leeway afterwards. "The market will need serious action straight away," Mr Taylor says. "If there is a sense of political paralysis, or an unwillingness to take much tougher decisions than we have seen so far, then we risk a crisis that is on the Greek scale."