The International Monetary Fund issued a stinging statement which sharply criticized the tax plan tabled by the Liz Truss government to help British businesses with their bills this winter.
This is amid soaring energy prices which threaten to ruin many businesses by making their operations unsustainable. The British Standard reports that “Under the estimated £40 billion ($45 billion) plan, announced in a statement, the government will cap the wholesale energy prices that feed into gas and power contracts for businesses for six months.
Thereafter, a review will determine whether ongoing support is needed for specific sectors.” This intervention by the government according to the tabloid translates to a fifty per cent discount on current wholesale prices.
- The International Monetary Fund (IMF) has openly criticized the UK government over its plan for tax cuts, warning that the measures are likely to fuel the cost-of-living crisis.
- IMF warnings came as the British government under Liz Truss announced a very ambitious plan to address the stagnant economy and rising inflation.
- The plans by the British government which the IMF were critical of include lowering taxes and subsidizing energy for households and businesses to keep them from going under.
The intervention is meant to shield companies from the impact of rising energy prices since Russia tightened the supplies of oil and gas to Europe proving that it is an unreliable energy partner.
This package is estimated to cost anything from US$ 20.81 billion to US$ 41.62 billion during the next six months. It is important to note and understand that this energy plan is different and is in addition to the US$ 128.83 billion plan by the British government to help households with their energy bills. The new prime minister Liz Truss has defended her plans against the many critics saying that without the measures and interventions her government is making plenty of businesses risked going out of business.
The moves by the British government have the right basis. The government is intervening to avoid the economic fall-out of run-away energy prices which will have severe consequences for the most economically vulnerable.
As has widely been reported, the world is experiencing a particularly acute bout of stagflation. This economic phenomenon where economies experience low levels of growth and elevated levels of inflation is not desirable. The single most potent way to deal with inflation is to make supply-side interventions in the economy.
The British government is doing this in two ways. They have a plan to assist businesses at the cost of US$ 45 billion and another which is targeted at households which will cost US$128 billion. It is largely focused on subsidizing the cost of energy. This is very profound in that during periods of stagflation businesses experience rising costs of doing business whereas revenues either flatline or fall.
Suppose such a scenario is allowed to play out over a protracted period. In that case, the effects will be disastrous because it will result in a vicious cycle of declining economic performance.
Germany itself has implemented a similar plan for its businesses and households without attracting as much criticism from the IMF. Why the difference you may ask? Well, it depends on the finances of each country. Supply-side interventions like those mooted by Britain and Germany must be paid for and how they are paid for makes a world of difference in terms of how sustainable each measure turns out to be in the future. This recalls the premise of international foreign exchange reserves.
A country’s foreign exchange reserves are critical in that they determine how well a country can withstand a shock to its economy. Reserves can be used to strengthen a country’s currency in times of volatility and the following example will explain why the IMF has given the British government so much flak over their tax and economic plans.
- Britain’s economic plans are dependent on the economy making a rapid recovery from the shocks of rising energy and food prices. A rapid economic recovery is not likely since the rest of the world is also grappling with the same shocks as Britain which took the fortunate decision to leave the European Union.
- The announcement of the economic plans left British financial markets in a tailspin and the Pound reeling against other major currencies namely the United States dollar.
- Britain does not have sufficient foreign exchange reserves to meet the costs of its economic plans. The country will have to borrow at unsustainably high costs to meet the needs of its economic plans which will cost well over US$ 173 billion.
- Germany unlike Britain has sufficient foreign exchange reserves to meet the costs of its economic plan without having to borrow. Therefore, the IMF was mum.
In terms of foreign exchange reserves, according to HM Treasury, Britain has net official reserves of US$ 114 billion whereas it plans to embark on an economic plan to pull itself out of the stagflation quagmire by spending no less than US$ 173 billion dollars. If Britain were to use all its foreign exchange reserves to meet the cost of its economic plan it would run short of money and still have a deficit of US$ 59 billion dollars before fully implementing its plan.
Fair enough and granted, governments do not always have to spend cash that they have on hand. They can always borrow if they do not have sufficient cash to finance their operations.
Herein is the problem, the current economic environment does not support borrowing either by individuals, households, or governments. The cost of borrowing is just simply too high either by domestic debt or foreign debt. The Bank of England in acting against rising inflation has been raising interest rates. This translates to higher borrowing costs and reduced inflation.
If local borrowing fails HM Government can always borrow offshore or borrow in United States dollars, right? Wrong!
The United States dollar has been rallying this year as investors and market participants pile into it because of its safety status. The British pound has performed poorly against the greenback reaching levels last seen decades ago. The British Pound currently trades at GBP1.06 to the dollar. A near parity level. These are not conditions that support a decision to borrow money offshore… At least not rationally. You do not wish to be a sovereign or a government with debt on your books that is denominated in a currency rapidly appreciating relative to your own firstly and paying a princely fortune to service the same loans because interest rates in the United States have also been on the rise.
This scenario has the potential to create a wicked problem if left unchecked. If Britain decides to proceed with its economic plan despite the warnings from the IMF, not having the resources in terms of foreign exchange reserves and the wherewithal to borrow in a cost-efficient manner the consequences will be devastating. Several economic scenarios can play out which may not favor the economy of Britain. Firstly, it is not likely that the country will spend its foreign exchange reserves entirely to pull the economy out of stagflation. This means that its only viable route will be to borrow. Unless the country can access debt on concessionary terms from multilateral financial institutions like the IMF and the World Bank it will be forced to borrow from private players at high-interest rates.
Typically, loans must be repaid and if they are expensive in the first instance the greater the likelihood of financial distress and possible default. To meet the expensive loans the British government may have to hike interest rates in the future. Now it would appear that the Truss government is wagering that the economy will make a quick recovery which would mitigate the risk of having to raise taxes to meet the costs of borrowing. A quick British economic recovery though desirable may not occur as anticipated because the rest of the continent and the globe is struggling economically. What makes matters worse is the country’s decision to exit the European Union.
The difference between Britain and Germany.
Germany announced an energy plan like Britain. The German plan involves expenditures of EUR 65 or US$ 66 billion. This is not small change by any measure. It is a large sum of money. However, Germany has foreign exchange reserves reported to be in the region of US$ 287 billion. The country due to its vast foreign exchange resources can comfortably absorb the shock of increasing energy prices without having to borrow a single cent.
