Universities are facing their "greatest challenge for a decade", with the prospect of a ?400 million black hole in next year's budget.

The warning from Phil Willis, chairman of the House of Commons Universities Select Committee, follows this year's government grant letter, which he said set out "plenty of hard choices".

Adding to the gloom was Philip Harding, chairman of the British Universities Finance Directors Group, who said that cuts and redundancies would be increasingly common.

On the face of it, the grant letter from the Universities Secretary, John Denham, to the ÖйúAƬ Funding Council for England outlined a healthy increase in funding.

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For 2009-10, recurrent grants will rise by 3.2 per cent for teaching, 4.5 per cent for research, and overall funding will increase to more than ?7.8 billion. But for Mr Willis, the figures have set the alarm bells ringing, particularly because capital funding has been brought forward from the following year's budget.

He said: "The funding letter represents perhaps the greatest challenge to our universities for a decade ... The increase in funding contains a worrying drawdown of ?200 million from (the) 2010-11 science and research capital budget, building a potential ?400 million deficit for next year unless the (Government) provides more money or future projects are axed."

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Universities UK shares his concerns. The fear is that with the Government using future funding now to kick-start the economy, the sector will pay the price in years to come.

The letter also confirmed restrictions on additional student numbers, which were ordered after Whitehall discovered a hole in its student support budget last year.

It had originally planned to add 60,000 more places between 2008-09 and 2010-11, but the extra 15,000 places mooted for 2009-10 has been cut to 10,000. Extra numbers for 2010-11 are on hold, subject to a review later this year. If the freeze is not lifted, the total number of additional students over the period will be only 30,000 - half the figure originally proposed.

Mr Denham also told Hefce to "bear down" on institutions that over-recruit and warned that grants may be clawed back to pay for unexpected costs.

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Mr Willis said Mr Denham had called a halt to expansion "just at a time" when the economy needs "a greater emphasis on graduate workers and when many young people have been encouraged to seek new routes into ÖйúAƬ".

While much of the concern focuses on the prospect of hard times ahead, Mr Harding, who is also finance director of the University of Westminster, warned that for many, things were already tough.

"We still bear the scars of the (8 per cent pay) settlement (for 2008-09), which ended up being more generous to staff than anybody expected at the time it was settled in 2006," he said. "It has put the finances of a significant number of institutions under pressure.

"We are seeing that pressure now with the announcement of job losses and voluntary redundancy schemes, which I think will become an increasingly common feature of the ÖйúAƬ landscape."

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His comments followed the publication of a report by Hefce that identified pay costs as a risky area, and added a wider warning about "volatile" economic conditions.

"If (universities) have enjoyed some immunity in the past, today their financial health is much more tied to the health of the economy and the wellbeing of local businesses," he said. "So it's right to be concerned about the effect that rising pay and pension costs will have on the ability of institutions to respond to this downturn."

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john.gill@tsleducation.com

HEFCE GRANT SETTLEMENT

All figures are ? million in cash terms

Financial year 2008-09 / 2009-10 / Change

Total grant 7,123 / 7,809 / 9.6%

Recurrent grant for teaching 4,920 / 5,076 / 3.2%

Recurrent resources for research 1,444 / 1,509 / 4.5%.