Markets would allow government some leeway to ease its grip on austerity

LONDON (Reuters) - Chancellor George Osborne has nailed his colours to the mast of austerity, but as recession deepens investors see some room for Britain to slow the pace of spending cuts and allow stimulus without becoming the bond market's next pariah.

While investors and analysts welcome Osborne's commitment to balancing the books over the next five years, there is a growing feeling that he could afford to go easier on deficit reduction, even if it led to the loss of Britain's top notch credit rating.

"Some modest easing of austerity or lengthening of the time over which it occurs would be seen as reasonable, but certainly any more material U-turn would be taken badly," said John Stopford, head of fixed income at Investec Asset Management, which holds some 471 million pounds in British government debt.

With the interest rates, or yields, Britain has to pay on new borrowing at record lows, Trevor Greetham, director of asset allocation at Fidelity Worldwide Investment, said Osborne should borrow to invest in projects to stimulate the economy.

"If the economy responds to the stimulus, the increase in tax revenues could more than offset the additional cost," he said. "The markets are sending a clear signal that there is substantially more headroom on government borrowing than we are sometimes led to believe."

The Bank of England's readiness to buy up British debt under its quantitative easing programme, and safe-haven inflows which are being spurred by the euro zone crisis, would also support demand for gilts.

Yields on benchmark 10-year gilts are only slightly above their record low of 1.408 percent hit on July 23 and far below the 3 percent seen two years ago. Over the same period, yields on Spain's debt have risen to nearly 7 percent, from 4 percent.

Sticking to the original austerity plan still has prominent supporters. Angel Gurria, who heads the Organisation for Economic Cooperation and Development, said late last month that markets would come down on Britain "like a ton of bricks" if it wavered on deficit reduction.

And a majority of economists polled by Reuters in July, after news of the economy's unexpectedly sharp contraction in the second quarter, said the government should not loosen fiscal policy.

Markets, however, are increasingly worried that Britain's economic slump is reducing tax receipts, making it harder for the government to bring its spending in line with its earnings.

Treasury Secretary Danny Alexander said on Monday that the country's triple-A credit rating was not the "be-all and end-all", remarks analysts said could be aimed at preparing investors for a potential rating downgrade as deficit-reduction targets become more difficult to reach.

Many investors say they would accept a temporary rise in Britain's public sector net debt-to-GDP ratio above the peak of 76.3 percent forecast by the independent Office for Budget Responsibility. The ratio stood at 67.3 percent in the 2011-12 fiscal year.

Some would prefer stimulus measures that do not show up on the government's balance sheet such as investment guarantees, similar to those announced recently in infrastructure.

Others would be happy for the authorities to directly fund projects, such as construction of affordable housing or schemes to improve power supply and transport.

On balance, analysts are less keen on steps such as temporary tax cuts, aimed at giving the economy a quick boost.

CREDIBILITY AT STAKE

Market watchers agree, however, that any fiscal loosening would be a tough balancing act for the government.

"Credibility is easy to break but very difficult to form," said Anthony O'Brien, fixed-income strategist at Morgan Stanley.

Britain's credibility is made more precarious by the fact that its budget deficit - at 8.6 percent of GDP according to the International Monetary Fund's latest figures for 2011 - is among the highest in Europe, noted Melanie Bowler, economist at Moody's Analytics, a sister company to the ratings agency.

On the other hand, Britain has its own central bank, prepared to buy the government's debt and hold the benchmark interest rate at a record low of 0.5 percent.

In comparison, euro zone member France pays 2 percent on its 10-year debt despite a budget gap of just 5.2 percent of GDP.

The IMF noted in its recent assessment of Britain that borrowing costs in rich countries with their own central banks were only weakly related to deficit and debt levels.

The fund also pointed to the muted market reaction after Osborne said last November that it would take until 2017, two years longer than initially forecast, to wipe out Britain's budget deficit.

Rating agencies may be less lenient, however. Both Moody's Investors Service and Fitch already have a negative outlook for Britain's triple-A debt rating, warning that it could lose it if the government relaxes its fiscal stance.

But many doubt a downgrade would be very damaging in practice as few countries still have the top rating.

Britain's credit rating is also of less importance to the dominant buyers of gilts - domestic investors - who buy the bonds to hedge their liabilities in local currency, said Moyeen Islam, fixed-income strategist at Barclays.

"If the triple-A rating were to be lost, it may be more of a symbolic than market event," he said.

Indeed, domestic investors, such as pension funds and insurance companies, would welcome higher returns on long-dated gilts. A rise in 30-year yields to around 3.35-3.40 percent from the current 2.90 percent would attract buyers, according to Islam. That would in turn keep a lid on yields.

(Editing by Susan Fenton)

Source: http://news.yahoo.com/markets-allow-government-leeway-ease-grip-austerity-154411758--business.html

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