UK's Debt Vulnerabilities: The Impact of Rising Interest Rates

High inflation and rising interest rates are causing a strain on the country's public finances, warning of the need for restraint on public sector pay.

While inflation is a global problem, its rapid ascent was largely out of the country's hands, the government will nevertheless take credit if it is halved by the end of the year.

However, the impact of rising interest rates is not uniform across economies.

The UK is suffering more acutely than other advanced economies, partially due to the way it has financed its borrowing.

Structural factors have made the country more vulnerable to rising interest rates than its G7 peers.

Britain has a higher share of inflation-linked debt than other G7 countries, with a quarter of its debt being inflation-linked.

This means that the cost of servicing its debt rises with inflation, which has put the UK in a more vulnerable position than other advanced economies.

The country has more than twice the proportion of inflation-linked debt than Italy, the second largest issuer at 12%.

The other major vulnerability dates back to the financial crisis, when the central bank launched a massive bond-buying programme, known as quantitative easing (QE), to prop up markets.

As part of its QE programme, the Bank of England created electronic money to pay for bonds and has been paying interest on this money, also known as central bank reserves, in line with the bank rate.

In an era of low interest rates, this arrangement allowed it to generate profits because the interest paid on the reserves was lower than the interest received on the bonds purchased through QE.

That money flowed back to the Treasury.

However, a sharply rising bank rate has reversed those fortunes.

As a result, interest rate changes propagate through to overall debt interest costs much faster than in previous decades, according to the Office for Budget Responsibility (OBR).

The UK government has seen a larger and more rapid rise in its debt servicing costs than other advanced economies, which is due to its larger rise in interest rates, larger share of inflation-linked debt, and shorter effective maturities.