Country Report United Kingdom
UK’s economy has been stagnating since mid-2010. Strong currency depreciation and a very accommodative monetary policy have failed to boost output while the public sector is pursuing a harsh fiscal adjustment program. Either the government will resort to a more back-loaded austerity plan to give recovery a chance, or it will risk carrying out even more consolidation measures to meet ambitious fiscal targets. So far, the administration has shown no appetite for slowing down the pace of austerity. What the authorities fail to realise is that growth shortfalls are equally credit-negative. The poor macroeconomic performance and the resulting downside risks to banks’ asset quality also remains a concern.
The UK economic recovery, which commenced during the second half of 2009, has been extremely sluggish. Output has essentially stagnated since mid-2010 and by the end of last year GDP was still 3.3%-points below its peak in 08Q1. This came as a surprise to the government officials since they believed their fiscal consolidation plan would not weigh too much on activity given that currency flexibility and activist monetary policy would support economic rebalancing and growth. As regards the former, the sterling’s strong depreciation on a trade-weighted basis  has failed to materially boost export growth, which is why the current account balance is still deep in the red (-3.5% of GDP). Naturally, the UK’s main export markets were very weak during the post-crisis period. The major trading partner of Britain, the eurozone, is still mired in a recession and a debt crisis. Hence, we are not entirely convinced that the external sector will give the economy the support it needs to withstand the sharp fiscal squeeze that lies ahead. The currency depreciation did, however, manage to push up import prices which squeezed real incomes.
Meanwhile, the BoE’s ultra-accommodative monetary stance in the form of near-zero policy rate and quantitative easing (QE) measures (GBP 375bn assets purchased) have not been successful in spurring growth. Thus, the Bank has initiated a new scheme known as “Funding for Lending” that is supposed to stimulate credit creation. There are signs that bank lending conditions are loosening as a result, but it is too soon to judge its success because the private sector may opt to repair its balance sheet by paying down debt instead of borrowing more.
The simultaneous private and public sector deleveraging will continue to pose substantial downside risks to the growth outlook. Undeterred by these headwinds, the Chancellor of the Exchequer, George Osborne, decided to present a fiscally neutral budget in March 2013 . Sticking to the consolidation plan without taking its adverse impact on growth into account is unwise, as the recent rating downgrade of Moody’s testifies . The risk is that public sector retrenchment leads to a weaker recovery and this, in turn, forces the government’s hands to carry out even further austerity to reach its fiscal target. As we have said on numerous occasions in the past, it would be justifiable for the government to slow down the pace of fiscal adjustment so that the recovery gets a chance to pick up some steam. This is particularly relevant when (i) the external environment remains weak, (ii) the private sector is deleveraging and (iii) the central bank’s ammo fails to boost the recovery. The alternative can be either missing budget targets and thereby losing credibility or accepting the harsh consequences of even more restrictive fiscal policy on growth, which will further endanger the country’s credit rating.
 ^ UK’s nominal effective exchange rate dropped by 25% between February 2007 and February 2013.
 ^ The main fiscal giveaways – the 1% cut in corporation tax in 2015 (to 20%) and the allowance to reduce firms’ National Insurance contributions – were paid for by higher taxes in other areas and lower spending.
 ^ In February, Moody’s downgraded the UK’s government bond rating from Aaa to Aa1 with a stable outlook.
There has been a gradual improvement in the health of UK banks in recent years as capital buffers have increased. That said, there are still a number of weaknesses in the system worth mentioning. On the domestic front, the elevated uncertainty about the UK economy and the resulting downside risks to asset quality remains a concern. We expect the challenging macroeconomic environment, combined with a high level of private sector indebtedness, to weigh on banks’ asset quality. We should note that renewed price falls in the property market could trigger further losses in the banking sector. On the external front, the major source of concern stems from the UK banks' relatively large exposure to Greece, Ireland, Italy, Portugal and Spain (amounting to USD 267bn or 11% of GDP in 12Q3). The good news is that the direct exposure of banks to the sovereigns of the crisis-hit countries is limited (USD 13.3bn in 12Q3). However, UK banks have significant exposures to the private sectors of Ireland, Italy and Spain. Therefore, any escalation of the eurozone crisis can have a strong negative impact on banks’ balance sheets. Risks of further losses do persist through indirect exposures due to the high interconnectedness of European financial centers. For example, the freezing of the interbank market and corresponding re-pricing of credit risk following renewed stress in the eurozone can have disruptive effects for the UK banking system.