The pound has dropped to its lowest level in nine months after government borrowing costs continued to rise – leaving Rachel Reeves “on the verge” of breaking her self-imposed fiscal rules, economists warn.

It comes as UK 10-year borrowing costs rose to their highest level since the financial crisis of 2008. It’s thought the Chancellor could be forced into further tax rises or cuts to spending plans.

State borrowing costs hit their highest level for almost 17 years on Wednesday as a sell-off continues in the bond market and ongoing investor concerns over the threat of stagflation, PA reports.

The rise in the cost of servicing government debts could cut into Labour’s expected financial headroom in a potentially worrying sign of how investors see fiscal sustainability in the UK.

This contributed to Sterling dropping by as much as 1.1% to $1.233 against the US dollar on Wednesday.

The yield on the benchmark 10-year UK gilt, which reflects the cost of government borrowing, climbed by roughly 12 basis points to a peak of 4.81%.

After the autumn Budget, Reeves was left with only £9.9 billion of headroom to meet her revised fiscal rules. This came despite a £40 billion package of tax increases to fuel higher spending.

Higher debt interest costs may mean the Chancellor would need to trim spending plans or bring in more revenue than expected to meet the fiscal rules.

Kallum Pickering, chief economist at brokerage Peel Hunt, said: “If bond yields rise further, Reeves may be forced to make the economically damaging decision of further increasing taxes or cutting back on planned public spending to balance the books.”

The Chancellor committed last year to having only one fiscal tax-changing event a year.

On Wednesday, the Prime Minister’s official spokesperson said: “I’m obviously not going to get ahead… it’s up to the OBR (Office for Budget Responsibility) to make their forecasts and they’ll make their forecasts at the spring statement in the usual way.

“But I would say when the Government came into office, we made very clear why it’s so important to manage the public finances to deal with the £22 billion black hole that was in the public finances, because having stability in the public finances is precursor to having economic stability and economic growth.”

A Treasury spokesperson told The Telegraph: “No one should be under any doubt that meeting the fiscal rules is non-negotiable and the Government will have an iron grip on the public finances.

“UK debt is the second lowest in the G7 and only the OBR’s forecast can accurately predict how much headroom the government has – anything else is pure speculation.”

Eight distinguished economists have penned a letter to the Financial Times, arguing that the UK requires a significant increase in public investment to stimulate growth and address social and environmental issues. While there is some merit to this argument, it also carries many risks.

The authors rightly point out that a lack of investment has been a key factor in the UK’s subpar economic performance. In fact, there are three points that most economists would likely agree with.

Firstly, investment spending should be distinguished from current spending on everyday expenses. Specifically, borrowing for capital projects that provide long-term benefits for both the economy and future taxpayers makes more sense.

Secondly, there has been a chronic underinvestment in both the private and public sectors. Even worse, the Labour government has inherited spending plans that suggest substantial real-terms cuts in public investment over the current parliament as well, as reported by City AM.

To put some figures on this, the Office for Budget Responsibility predicts that public sector net investment will decrease steadily year by year, from approximately £70bn in 2023-24 to less than £50bn in 2028-29 (all in 2023-24 prices). This would result in public investment falling from 2.6 per cent of national income to just 1.7 per cent.

The current fiscal rules do not provide much scope for additional public investment without either offsetting cuts in current spending or significant tax increases, particularly as the main rule requires public sector net debt to fall as a percentage of national income by the fifth year of the rolling forecast period. This is too short a timeframe for the full benefits of investment to materialise.

Furthermore, the supplementary target that mandates public sector net borrowing not to exceed three per cent of GDP, also by the fifth year, does not differentiate between borrowing for investment or current spending.

However, there are some crucial caveats to consider.

One key point is that the state of public finances is currently worse than during the ‘austerity’ years following the 2008 global financial crisis. While it’s still valid to argue that severe cuts in public spending would be counterproductive, the risks of further government spending are heightened due to higher public debt, interest rates no longer being near zero and improved private sector balance sheets.

The competence of the public sector in managing large-scale investment projects is also questionable. There are certain areas where the state must take the lead, such as ‘public goods’ like the criminal justice system and environmental protection.

The previous government arguably underinvested in prisons and flood defences.

However, the issues with HS2 and other large-scale programmes highlight the challenges. Apart from some clear gaps in public service investment, there isn’t a ready list of projects that would be best handled by the state.

Moreover, we don’t need a massive shift to increase public investment to acceptable levels. The new Chancellor, Rachel Reeves, has suggested returning to a ‘Golden Rule’ which would balance everyday spending with current revenues.

The existing three per cent annual borrowing target would then permit the government to borrow an additional three per cent annually for further investment.

This might necessitate some adjustments to the debt rule, either redefining debt or extending the time frame. However, there should be scope for a minor increase in public investment without bankrupting the nation.

Julian Jessop is an independent economist and fellow at the Institute of Economic Affairs.