|Outlook for U.K. Growth Amid Budget Cutting|
|Long Term Forecasts | Written by Wells Fargo Securities | Oct 26 10 18:02 GMT|
Outlook for U.K. Growth Amid Budget Cutting
U.K. Chancellor of the Exchequer Osborne recently released details of the budget cuts he plans to make over the next five years. As he outlined a few months ago, spending reductions will make up the bulk of the budget cuts over the planning horizon. Although the plan is necessary to return Britain's fiscal accounts to a firmer footing, the cuts will likely exert headwinds on U.K. economic growth over the foreseeable future.
Unfortunately, the United Kingdom probably won't be able to rely on strong export growth to offset the contractionary effects of the budget cuts. Three-quarters of Britain's exports go to other European countries and the United States, countries that will likely have their own growth challenges over the next few years. Although we do not project a return to recession in the United Kingdom next year, we forecast that British real GDP will grow only 2 percent or less per annum over the next two years. Further quantitative easing (QE) is probably not imminent. However, as growth remains sluggish and inflationary pressures recede, we look for the Bank of England to eventually authorize further QE that we expect will contribute to downward pressure on sterling in the months ahead.
Chancellor Osborne Releases Details of Budget
Recent data, which show that real GDP in the United Kingdom rose at an annualized rate of 3.2 percent in the third quarter of 2010 relative to the previous quarter, indicate that the British economy continues to expand (Figure 1). However, the level of real GDP remains about 4 percent below its peak in the first quarter of 2010, and the sequential pace of growth has slowed, at least relative to the 4.7 percent annualized rate that was registered in the second quarter. Moreover, the significant fiscal retrenchment that is planned in the United Kingdom, which is discussed in greater detail below, makes the British economic outlook rather uncertain for the foreseeable future.
On October 20, Chancellor of the Exchequer George Osborne released his "Spending Review," which detailed the budget cuts that were originally outlined in his June budget blueprint. In that blueprint, Osborne laid out a plan that is intended to reduce the government's fiscal deficit by 8 percent of GDP by 2015 by concentrating on spending reductions.1 In general, the recent "Spending Review" made few changes to the blueprint that was presented in June. The only alterations concerned the level of public investment spending where the Chancellor added back £2 billion or so per annum over the next few years from the cuts that were originally announced. Between tax hikes and spending cuts, the government intends to slice £39 billion (about 2.8 percent of GDP) from the deficit in fiscal year 2012, which will begin in April 2011. Because the value-added tax will be increased from its current rate of 17.5 percent to 20 percent at the beginning of 2011, revenue increases will account for nearly one-half of the deficit reduction measures next year. However, spending reductions become more important over the next few years so that by 2015 they account for three-quarters of the planned consolidation (Figure 2).
The fiscal retrenchment that the United Kingdom plans over the next few years will exert significant restraint on economic growth, at least according to textbook Keynesian economic theory. However, some economists have argued recently that fiscal consolidation need not cause recessions because credible deficit reduction measures may help to boost consumer and business confidence and lead to stronger private demand.2 These economists argue that fiscal consolidations based on spending reductions, like the blueprint that the United Kingdom intends to follow, are less likely to be contractionary than retrenchments based on tax hikes. Because governments generally need to spend more political capital cutting spending than in raising taxes, consolidations based on spending reductions are seen to be more credible by the private sector.
The case of the Canadian economy, which grew nearly 3 percent per annum in the mid-1990s as it underwent a fiscal consolidation worth about 7 percent of GDP, shows that significant budget cutting does not need to lead to economic stagnation. However, strong economic growth in the United States in the mid-1990s helped to offset the effects of fiscal consolidation in Canada via robust export growth north of the border.3 Indeed, the International Monetary Fund (IMF) worries that simultaneous fiscal consolidation by a number of large economies will have a depressing effect on global economic activity via weak growth in global export volumes.
What Spending Category Will Drive U.K. Economic Growth?
Our purpose in this report is not to adjudicate the recent dispute about the effects of fiscal consolidation. However, the IMF's argument that export growth may not be able to offset the contractionary effects of fiscal consolidation seems to be relevant for the United Kingdom. About 60 percent of Britain's exports go to other European countries, which we expect will have their own growth challenges next year due, at least in part, to fiscal consolidation efforts in those countries (Figure 3). Another 15 percent is destined for the United States, where we also project continued sluggish economic growth as consumers continue to deleverage.5 Only 10 percent of British exports go to developing Asia and Latin America, regions in which economic growth will likely be solid for the foreseeable future. Because the lion's share of British exports are destined for countries that will probably continue to experience lackluster economic growth, robust export growth in the United Kingdom does not seem likely anytime soon.
Could private domestic demand (consumer spending and business fixed-investment spending) take up the slack? British consumers face a number of challenges. For starters, growth in real disposable income, which is highly correlated with growth in real personal consumption expenditures, is weak at present (Figure 4). Moreover, the scheduled increase in the VAT in January, which was discussed above, and sluggish employment growth, will likely keep real income growth constrained for some time. In addition, leverage among consumers remains high, although the debt-to-income ratio today is not quite as elevated as it was at the peak of the housing boom a few years ago (Figure 5). High leverage and a desire to repair battered balance sheets could cause households to save more.6 That said, the sharp decline in mortgage interest payments, which has occurred over the past few years as short-term interest rates have fallen to unprecedented lows, gives consumers some extra spending power.
Business fixed investment (BFI) spending is slowly starting to recover (Figure 6). The level of BFI at present is 20 percent below its Q4-2007 peak, so a case could be made that pent-up demand could spur strong BFI spending in the coming quarters. In addition, British corporations are cash "rich" at present as cash presently accounts for 35 percent of total financial assets held by private non-financial corporations, which is one of the highest ratios over the past two decades. In addition, there are indications that business confidence has recovered, which could lead corporations to put some of their cash to work in stronger capital spending.8 Although we are cautiously optimistic about the outlook for capex, business investment in machinery and equipment and non-residential construction account for only 10 percent of British GDP. Therefore, BFI spending would need to be white hot, which we do not believe is very likely, to completely offset lackluster growth in personal consumption expenditures.
Is QE2 Imminent?
In response to the deepest British recession in decades, the Bank of England (BoE) slashed its main policy rate to only 0.50 percent in March 2009 from 5.75 percent in December 2007 (Figure 7). In addition, the BoE kicked off its QE program in March 2009 when it announced that it would buy £75 billion worth of long-term securities. The size of the QE program was eventually increased to £200 billion by November 2009. However, the BoE has maintained its policy rate at 0.50 percent since March 2009 and the size of its QE program at £200 billion since last November. In the view of some members of the Monetary Policy Committee (MPC), the ongoing economic recovery has called into question the need for further stimulus. In addition, the overall CPI inflation rate has been 3 percent or higher, which is more than a full percentage point above the BoE's target inflation rate of 2 percent, for nine consecutive months (Figure 8). This above-target rate of inflation has also made it difficult to justify further QE.
However, forecasts contained in the BoE's quarterly Inflation Report project that CPI inflation will recede below the 2 percent target by the end of 2011. Moreover, MPC member Adam Posen voted at the October 7 policy meeting to increase the size of the QE program to £250 billion, and Bank of England Governor Mervyn King seems to be sympathetic to further QE, although he has not yet officially proposed an increase in the size of the program. Because the third quarter GDP growth data that were released on October 26 were stronger than the BoE had anticipated, Governor King likely won't propose a second round of QE in the near term. However, as growth slows further in the months ahead and as underlying inflationary pressures ease, we expect that a majority of MPC members will eventually sanction an increase in the size of the BoE's asset purchase program. Further monetary easing should add to downward pressure on the British pound in the months ahead.
A modest recovery has taken hold in the British economy. However, the significant fiscal retrenchment that the government plans over the next few years should exert headwinds on U.K. economic growth. Unfortunately, the United Kingdom probably won't be able to rely on strong export growth, like Canada did in the mid-1990s, to offset the contractionary effects of budget cuts. Roughly three-quarters of British exports are destined for other European countries and the United States, countries that will likely have their own growth challenges over the next few years. Capital spending could turn out to be stronger than expected, but this relatively small spending category very likely would not be able to fully offset lackluster growth in consumer spending. Although we do not project a return to recession in the United Kingdom next year, we forecast that British real GDP will grow 2 percent or less per annum over the next two years, much slower than the 2.8 percent average annual growth rate that was achieved during the long expansion of 1992-2007.
The stronger-than-expected Q3 GDP data that was released on October 26 in conjunction with the above-target rate of CPI inflation at present make it difficult of the MPC to sanction a second round of QE at this time. In our view, however, the fiscal tightening that is planned in the United Kingdom over the next few years will exert headwinds on British economic growth. As real GDP growth remains sluggish and inflationary pressures recede, we look for the Bank of England to eventually authorize further QE that we expect will contribute to downward pressure on the sterling in the months ahead.
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