The Treasury’s medium-term fiscal forecasts appear to rest on optimistic assumptions about future borrowing costs. On reasonable alternative assumptions, public sector net interest payments could rise to 3.9% of GDP by 2013-14 versus an official projection of 3.0%.

The Treasury’s forecasts for debt interest have received limited scrutiny partly because they are buried within the detail of the Budget documents. Medium-term projections for public sector net interest as a percentage of GDP can be derived from Table C2 of the Financial Statement and Budget Report (FSBR) as the difference between public sector net borrowing and the “primary balance”. These forecasts can be converted into nominal terms using money GDP assumptions from Table C1.

To derive the Treasury’s unpublished assumptions about future borrowing costs, it is necessary to put these public sector net interest numbers onto a general government gross basis by adding back estimated interest receipts and adjusting for public corporations. The gross interest projections can then be compared with published numbers on gross government debt to derive an average interest yield.

According to the FSBR, public sector net interest will rise from 1.6% of GDP in 2009-10 to 2.6% in 2010-11 and 3.0% in 2011-12 – see first chart. A further small increase to 3.1% in 2012-13 is then reversed in 2013-14, when the proportion returns to 3.0%. This stabilisation raises suspicion, since general government gross debt is projected to rise by 17% in the two years to the end of 2013-14.

To generate this profile, the Treasury must be assuming a fall in the interest yield on government debt in 2012-13 and 2013-14. The FSBR projections are consistent with the yield averaging less than 4% in the three years to 2013-14, far below projected money GDP growth of more than 6% per annum over this period – second chart.

The bulk of outstanding debt consists of fixed-coupon gilts. The interest yield in a particular year is a weighted average of the rates on existing debt and new borrowing – not just to cover the budget deficit but also to finance gilt redemptions and roll over the stock of Treasury bills. For the average yield to fall after 2011-12, as implied by the FSBR forecasts, the interest rate on new borrowing in 2012-13 and 2013-14 would have to be well below 4% – a rough calculation suggests an average of about 3% over the two years.

The charts present an alternative scenario for the average yield and net interest as a percentage of GDP based on the assumption that the interest rate paid on new borrowing in 2011-12, 2012-13 and 2013-14 is equal to the projected rate of money GDP growth in each year (i.e. 6.0%, 6.2% and 6.1% respectively). This generates a gradual rise in the interest yield to 4.9% by 2013-14. While significantly higher than the 3.8% implied by the Treasury’s forecast, this is below the 5.2% average between 2004-05 and 2007-08 (when money GDP grew more slowly than projected for the three years to 2013-14).

On this alternative scenario for the average yield, net interest as percentage of GDP rises to 3.9% of GDP by 2013-14 against the Treasury’s projection of 3.0%. More pessimistic scenarios are clearly feasible, based on investor concerns about inflation and / or solvency pushing new borrowing costs above the rate of money GDP growth.

A higher interest bill would imply either a greater squeeze on non-interest spending or, more likely, further fiscal slippage. According to the Treasury’s forecasts, real current spending will rise by 0.7% per annum in the three years to 2013-14. Stripping out interest costs, however, the rate of growth is just 0.2% pa. On the alternative scenario presented here, real non-interest spending would need to fall by 0.7% pa over this period to make room for higher debt-servicing costs, assuming no further upward revision to plans.