Rising borrowing costs batter UK government and threaten to derail its left-leaning program

[January 16, 2025]  By DANICA KIRKA

LONDON (AP) — Britain’s new government, which is already facing anger over higher taxes, unpopular spending decisions and political scandals just six months after taking office, is now being battered by rising borrowing costs that threaten to derail its left-leaning program.

The yield on the U.K.’s 10-year bonds, a reflection of the price investors demand for financing the country’s debt, has risen by more than 1.1 percentage points since Sept. 16 on concerns over sluggish economic growth and stubbornly high inflation. That has pushed Britain’s borrowing costs to the highest level since the 2008 financial crisis.

As borrowing costs rise, the government has less money to spend on the country’s creaking National Health Service, military, emergency services and schools. Though officials got a brief respite when the rate of inflation dropped slightly in December, if things don’t turn around quickly Prime Minister Keir Starmer may have to rethink promises to boost spending and avoid tax increases on “working people” that helped his Labour Party win a landslide election victory in July.

The problems are partly due to the return of U.S. President-elect Donald Trump, whose pledge to increases taxes on imported goods has sent shivers through the world economy and boosted global bond yields. But the problem is partly of the government’s own making, as Treasury chief Rachel Reeves built her economic plan on the assumption that economic growth would boost tax revenue.

Here’s a closer look at Britain's economy and the possible implications.

What has sparked the recent turmoil?
Bond investors around the world have been spooked by concerns over Trump’s plan to impose high tariffs on imported goods will push up U.S. consumer prices, prompting the Federal Reserve to keep interest rates higher for longer, said Susannah Streeter, head of money and markets at the U.K. investment firm Hargreaves Lansdown. Higher prices tend to lead to higher borrowing costs as bondholders seek to ensure that their investment isn’t eroded by inflation.

Only a few months ago, investors were betting the Fed would approve multiple rate cuts this year. Now they’re anticipating just one.

“The rise in gilt yields since the early autumn appears to largely be the result of global factors, rather than any decision the U.K. government has taken in recent weeks or months, and appears to largely reflect market expectations for higher central bank interest rates in the years ahead,” the Institute for Fiscal Studies, a think tank that focuses on U.K. government policies, said last week.

Gilts are a type of bond issued by the U.K. government that are traded on the London Stock Exchange.

Is Britain alone?
No, borrowing costs are rising in many countries, including the U.S.

But Britain is particularly exposed because of the state of its economy and high levels of government debt.

Consumer price inflation dipped to 2.5% in the 12 months through December, from 2.6% the previous month. That's still some ways away from the Bank of England’s 2% target.

The British economy has basically flatlined in recent months. The latest government statistics showed that gross domestic product was stagnant in the three months through September, after growing 0.7% in the first quarter and 0.4% in the second.

Britain's Prime Minister Keir Starmer, center right, and Chancellor of the Exchequer Rachel Reeves, center left, host an investment roundtable discussion with BlackRock CEO Larry Fink, right, and members of the BlackRock executive board at 10 Downing Street in London, Thursday, Nov. 21, 2024. (AP Photo/Frank Augstein, Pool, File)

That’s partly due to the government’s decision to boost payroll taxes paid by employers and increase workplace regulation, causing some companies to curtail investment and hiring.

“The U.K. is also now in the eye of the storm,’’ Streeter said, adding that “stagflation fears are taking hold.”

“With concerns that there’s a stagnating economy, inflation has veered away from the Bank of England’s target. And that’s also made investors nervous about holding U.K. government debt,” she said.

How much debt does Britain have?
U.K. government debt stood at more than 98% of economic output in November. That's the highest level since 1963, when Britain was still paying down its debts from World War II.

Reeves was counting on economic growth to help reduce debt as a percentage of GDP. She also introduced new fiscal rules that will bar the government from borrowing to fund day-to-day spending by 2030, while pledging not to raise taxes on “working people.”

Higher borrowing costs will make meeting those goals more difficult. Even so, it would be difficult for Reeves to abandon her promises, said Paul Johnson, the institute’s director.

″She’s really nailed her colors to the mast there and we’ve seen that the markets are pretty concerned about the U.K position,’’ Johnson told the BBC last weekend. “That's partly because we are so dependent on international flows of finance to finance our debt and indeed to finance things like our trade deficit with countries like China.’’

What is being done?
All this means the new Labour government has had to take risks, such as reaching out to China to boost trade and business ties despite critics raising national security concerns.

Reeves recently made a three-day trip to China, seeking investment rather than staying home and trying to calm the markets. While some derided the trip, Reeves insisted that China offered Britain an opportunity to drive growth that it cannot ignore.

“Choosing not to engage with China is therefore no choice at all,’’ she wrote in the Times of London.

What's likely to happen next?
Reeves may run out of options if borrowing costs stay high, curtailing the amount of money she has to spend.

A policy shift could come as early as March 26, when Reeves is due to update Parliament on the country’s financial position and the Office for Budget Responsibility will update its economic and fiscal forecasts.

“Ultimately, investors shouldn’t panic,’’ Streeter said. “Financial markets can be wracked with volatility, but over the longer term, that does tend to even out.”

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