UK public finances face pressure as Iran war impacts economy

City economists are warning that UK government borrowing is set to be driven higher by the Iran war, following this morning’s drop in the annual deficit in the last financial year.

Lindsay James, investment strategist at Quilter, says: “The conflict in the Middle East has shown the UK economy remains very exposed to geopolitical shocks. However, there are some encouraging signs that rigid fiscal rules have been having the desired effect thus far, as today’s public sector finance data shows borrowing was £12.6 billion in March. This is £1.4 billion less than the same month last year, and the lowest March reading since 2022.

“Borrowing had been expected to be lower this year as the government had front loaded a lot of its spending plans into its early years, but things could get more difficult from here on out. With inflation on the rise, debt interest climbing again and gilt yields also becoming elevated once more, the fiscal headroom Chancellor Rachel Reeves had established could very quickly run out once again. As such, tax is likely to feature prominently as the lever to pull to help keep the public finances on steady ground, and we have already seen the burden this places on growth.

Ruth Gregory, deputy chief UK economist at Capital Economics, warns that borrowing will probably rise in the current financial year. “March’s figures showed an unexpected undershoot of the OBR’s forecast for public borrowing in 2025/26. But we do not expect this improvement to last long. We think the energy price shock will mean that borrowing overshoots the OBR’s forecast by a huge £29bn for the 2026/27 fiscal year and by about £13bn in subsequent years.

Thomas Pugh, chief economist at RSM UK, predicts that March could be the last month of good news on borrowing for a while: “The good news for the Chancellor is that full year borrowing for 2025/26 came in at £132.bn, down from £151.9bn in the previous financial year, and in line with the latest OBR forecast. The bad news is that the war in Iran means the situation will deteriorate sharply over the rest of this year. That will limit her ability to offer households and businesses a significant bailout if energy prices move higher.

“Looking ahead, March will probably be the last month of good news on borrowing. Gilt yields are down from their 5% peak in March, but are still significantly higher than before the war. Borrowing costs will rise quickly from here though, as higher interest payments on index-linked gilts weaken the near-term fiscal position. At the same time, the economy will almost certainly slow, which could send the unemployment rate trending back up. That would lower income tax receipts and raise welfare spending.

Asos is shifting more production closer to home - to Turkey, Morocco and even the UK - as it tries to offset disruption to shipping caused by the Middle East conflict. José Antonio Ramos Calamonte, the chief executive of the online fashion retailer, said the group had seen an increase in freight costs and longer delivery times as a result of the conflict which has pushed up fuel prices.

“We are navigating the cost impact through flexibility of different manufacturing origins and shipping methods,” he said. He noted that about a third of its clothing was now made closer to home. Asos reported that sales fell 9% to £1.17bn in the half year to 1 March, but pre-tax losses narrowed to £138m from £241.5m a year before.

The surge in cost pressures hitting UK companies adds to the dilemma facing the Bank of England, which is due to announce its next decision on interest rates in a week’s time. Chris Williamson, chief business economist at S&P Global Market Intelligence, noted that while the economy gathered momentum in April, it was driven by a rush to secure purchases ahead of feared price rises.

Service sector companies have been hit with the biggest jump in cost inflation in at least 30 years, as the Iran war drove up petrol and diesel prices. Data provider S&P Global also found that overall input cost inflation this month has hit the highest level since November 2022. Meanwhile, economic output across the eurozone has fallen for the first time in 16 months, as the conflict pushed up prices.

London stock markets opened lower, with the FTSE 100 dropping 0.5% as the deadlock in the Middle East weighed on sentiment. Sainsbury’s, Foxtons, and WH Smith all issued warnings regarding the impact of the conflict on their respective businesses, citing uncertainty, weaker consumer confidence, and passenger numbers.