'Formidable' challenge facing Osborne pushes pound to lows

A warning from the Fitch ratings agency that Britain faces a "formidable" challenge to bring its public finances under control sent the pound and shares plummeting yesterday. The FTSE 100 index dipped briefly below the 5,000 mark and sterling shed 1 per cent of its value against the euro, a remarkable one-day fall.

While Fitch dropped no hint that it would alter its AAA credit rating for the UK, the scale of the task facing the Government was underlined in a report that gave little comfort to investors: "The scale of the UK's fiscal challenge is formidable and warrants a strong medium-term consolidation strategy – including a faster pace of deficit reduction than set out in the March 2010 Budget."

The warnings came as the Chancellor, George Osborne, outlined plans for how he will conduct his "once-in-a-generation" cuts to public spending. Two weeks before the emergency Budget, the Prime Minister has also come under pressure to resist EU "surveillance" over UK budget plans.

Fitch says that the existing plans, delivered by Alistair Darling in his last Budget in March, "render the UK vulnerable to adverse economic and financial shocks". The agency is also critical of the projections made for growth in the last Labour Budget, pointing out that they are "above consensus and arguably optimistic". The new independent Office for Budget Responsibility is due to present fresh forecasts for GDP growth on Monday.

The OBR is widely thought to be ready to downgrade Mr Darling's forecast of 3.25 per cent growth in 2011 to something closer to 2 per cent. Such a move would make even more urgent the need for cuts in public spending, as a smaller figure GDP implies a higher deficit in relation to that GDP. On current Treasury forecasts the deficit will reach 11.1 per cent this year, falling to 8.5 per cent next.

The current debate about fiscal retrenchment is unsettling markets and investor confidence. While the UK gilts market has generally benefited from the flight of funds from the troubled eurozone, a record sale of government securities to the Bank of England yesterday was taken by some observers to indicate a reduction in investor appetite for UK government paper.

It is part of a picture of gradually rising financial stress. This week the key three-month Libor rate for sterling hit a 10-month high, and euro borrowing rates rose on fears about contagion spreading from the eurozone to the UK via the banking system, and a second credit crunch. News about renewed problems in Hungary and Spanish workers' resistance to spending cuts have also added to the tensions.

Safeguards agreed by the UK in international forums such as the G20 on easing market fears through international mutual scrutiny of budget plans are now the subject of Tory disquiet.

Yesterday the EU's commissioner on economic and monetary affairs, Olli Rehn, said he expects the EU's 27 finance ministers to move "fast forward on reinforcing economical governance". The EU's president, Herman Van Rompuy, said most countries had agreed on more sanctions at talks on Monday, though the details still need to be finalised: "A government presenting a budget plan with a high deficit would have to justify itself in front of its peers, among finance ministers."

At a summit next week, EU leaders will be asked to take advice from the European Commission on their Budgets before putting these to the national parliaments, to identify overly optimistic growth or revenue assumptions.

Although this is very much in line with the thinking of the coalition, Tory backbenchers seem certain to urge Mr Cameron to resist such moves.

A British spokesman commented: "The UK would not be prepared to submit draft Budgets to the European Commission or peer review before putting them to Parliament. We will not support measures that undermine the role of Parliament."

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