Exciting: How hard will the UK budget hit the pound?

Currency markets are holding their breath for the financial plans that British Chancellor of the Exchequer Rachel Reeves will announce next week. A rapid rise in the budget deficit could severely impact the pound. A higher VAT rate would actually benefit the currency.

On November 26, the British government will unveil its preliminary budget plans for next year. A difference from Budget Day in the Netherlands is that the impact on financial and currency markets is often much greater. Recent years have shown that a poorly substantiated budget significantly impacts confidence in British finances and the pound.

The specter is the budget presented by Chancellor of the Exchequer Kwasi Kwarteng in 2022 during Liz Truss's extremely short term. The prospect of rapidly rising national debt instantly ripped the rug from under the British bond market. Many investors sold off British bonds, causing interest rates to soar and the pound to plummet. Within a few days, the currency lost almost 3% against the euro.

Budget deficit
Slowly but surely, concerns about the UK's budget plans are growing again. Chancellor of the Exchequer Rachel Reeves had long been adamant that raising income tax would ensure that government revenue and expenditure wouldn't get too far out of line. However, it appears she's being rebuked by her Labour Party. Tax increases don't sit well with voters. The good news is that Reeves likely won't be the first Chancellor of the Exchequer in 25 years to raise taxes. The bad news is that this will create an additional budget deficit of £7,5 billion. Fortunately, a solution seems obvious.

An additional 2% tax on wealth over £10 million would generate £25 billion annually. This would not only be sufficient to offset the budget shortfall, but would also create additional room for investment in education, housing, training, and infrastructure. Moreover, polls indicate that the vast majority of wealthy Britons are open to such a levy. Nevertheless, it's likely that Reeves won't want to get involved in raising income and wealth taxes. A VAT increase would be less politically painful. But in other ways, Reeves would be doing the British economy a disservice.

Higher VAT is making itself felt
A higher VAT rate is reflected in inflation figures, which the Bank of England (BoE) uses to determine its interest rate policy. In recent months, the inflationary surge that had been building since the autumn of 2024 seemed to have finally come to an end. This creates room for the Bank of England to lower its policy rate somewhat further. The current level of 4% is double the European interest rate, making it worthwhile to hold assets in pounds rather than euros. Despite the risk that Reeves's budget will temporarily cause some market unrest, it's premature to write off the pound for the coming months. The mere possibility that the BoE cuts interest rates later than expected could keep the currency afloat.

Joost Derks

Joost Derks is a currency specialist at iBanFirst. He has over twenty years of experience in the currency world. This column reflects his personal opinion and is not intended as professional (investment) advice.

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