Country Report United Kingdom
The UK economy finally started to recover, although it still has a long way to go. Productivity is lagging and debt is elevated. The expansionary monetary policy combined with housing subsidies increases the risk of regional housing bubbles.
Strengths (+) and weaknesses (-)
(+) Well diversified and competitive economy
The UK is one of the largest economies in the world. Its competitiveness, especially in the services sector, is underpinned by a well-educated and flexible labour force.
(+) Strong public institutions
Governance, rule of law and transparency indicators confirm the stability of the government. It has a proven track record in implementing fiscal consolidation programs when necessary. The central bank is independent and credible in its inflation mandate and its supervisory role.
(+) The large banking sector became more resilient after the Global Financial Crisis
The UK is the second largest banking centre of the world, with many foreign banks operating in London. Total assets of the banking sector equalled 499%-GDP in 2012. Banks strengthened their balance sheets after the GFC, their Core Tier 1 capital ratio rose from 6.3% to a current 11.7%.
(-) Relatively high amount of both public and private debt
Gross public debt increased from 43.7%-GDP in 2007 to 90%-GDP in 2013 and is not expected to stabilize before 2015/2016, despite the large amount of fiscal consolidation. Private debt remains elevated (166%-GDP) among slow deleveraging and a housing boom that results in higher lending.
1. Economic recovery gains momentum
Economic growth accelerated in 2013 to 1.8% (0.3% in 2012) and we expect growth to gain further speed in 2014 (2½%) and 2015 (2%). These rates are above UK’s potential growth (1.5% for 2014 according to the OECD), which reflects the closing of the still large output gap (-2.5% of potential GDP according to the OECD). Another indication that the recovery still has a long way to go, is that at the end of 2013, the GDP-volume of the UK was still 1.3% below its pre-crisis peak (figure 1). Compared to previous recessions, the recovery so far has been extremely weak.
Up to now, the recovery has been primarily based on domestic demand, with private consumption being the main growth driver. Private consumption mainly increased due to a fall in savings. Household debt is, however, still at a relatively elevated level (figure 2), so the room for more credit driven consumption growth is limited. The improvement on the labour market (unemployment decreased from 7.9% at the end of 2012 to 7.2% at the end of 2013) did, however, not yet lead to an increase in real wages, since labour productivity growth remains slack and many employees work less hours than they would prefer. To give the recovery a broader basis, an increase in business investment is desirable. Luckily, this happened in the final quarter of 2013. For 2014, we expect business investment to increase further, since capacity utilization is back at pre-crisis level, business confidence is high and credit conditions improved. Public sector deleveraging will, however, remain a drag on economic growth. The government’s objective, to return the cyclically adjusted current budget (the amount the government has to borrow for non-investment spending, to balance over a rolling five year period), looks credible and the Office for Budget Responsibility (OBR) expects the government to reach this goal one year in advance. The headline budget deficit is however still negative (an expected -6.6%-GDP) for the fiscal year 2013/2014), but on a downward trend. A risk to a domestic driven recovery is the uncertainty caused by the upcoming referendum on Scottish independence planned on 18 September 2014. It is unclear how big the negative economic effect of a vote for independence would be for both Scotland and the remainder of the UK.
In order to make the recovery more sustainable, it is also necessary that exports start to recover. Export growth remained muted, which is reflected in the negative current account balance (-3.9%-GDP in 2013). The strengthening of the Pound Sterling (the trade weighted exchange rate increased 7.6% in March 2014 compared to the year before) does not help this rebalancing process. On the other hand, the gradual recovery of the main trading partner, the eurozone, and growth gaining speed in the US, a strengthening of exports is expected. If Cameron gets re-elected as Prime Minister in the 2015 elections, the proposed referendum on EU membership in 2017 poses a downside risk to the export outlook. It can cause considerable uncertainty leading up to the vote. An outcome in favour of exiting the EU will probably have serious consequences for UK’s economy.
2. Private sector debt remains elevated
Private sector debt (both households and non-financial corporations) decreased slightly from its historical high (from 186%-GDP in 2009 to 166%-GDP in 2013), but remains elevated. The fall in household debt (mainly mortgages, figure 2) can primarily be attributed to an increase in nominal incomes (due to high inflation). According to the Bank of England (BoE), about 30% of the mortgages are held by households that have high debt-to-income ratios (above a fourfold of income). These households have low amount of income left after mortgage payments. Therefore, in the case of a sharp increase in interest rates, their ability to service the debt will be hurt.
3. House prices increase fast in certain regions
Combination of a loose monetary policy and government support programmes like the ‘Funding for Lending Scheme’ (FLS) (banks could borrow from the BoE for less than market rates) and the ‘Help-to-Buy’ (HTB) programme (a government guarantee of 20% of the mortgage value for a first home buyer) led to a fast increase in house prices in London and its surroundings. The Office for National Statistics (ONS) house price index for London rose 12,3 % y-o-y in 2013, and prices are currently 20% above the level of 2008. In the rest of the country gains in house prices are still relatively modest, 5,5% y-o-y, and the price level is now on about the pre-crisis level. The price-to-income ratio (121.9) and price-to-rent ratio (130.7) have decreased significantly compared to their peak, but are still above their long-term average (100). Therefore, the risk of a price bubble primarily applies to the London and surrounding areas. In response to the rising house prices, FLS for mortgage lending has already been suspended.
The United Kingdom is a wealthy and well-diversified economy. The competitiveness of the British economy is underscored in its high rankings in e.g. the ease of doing business index and the global competitiveness index. The economy is quite open, with imports and exports equalling about 2/3 of GDP. The export package of the UK shifted towards services, it now constitute about 40% of total exports, which is a relatively high percentage. The current account balance has been persistently negative since 1984 (average -1.8%-GDP over 1984-2013), which reflects the consumption- and credit boom in the ‘00s. This did, however, not lead to a significant deterioration of the net international investment position (NIIP), which was -10%-GDP in 2012. Foreign assets (664%-GDP in 2012) and foreign liabilities (654%-GDP in 2012) are large, but can be mainly attributed to the position of London as international financial centre. The large banking sector (total assets equalled 499%-GDP in 2012) increased their capital buffers considerably since the offset of the Global Financial Crisis, partly in response to stricter regulations. Their Core Tier 1 capital ratio rose from 6.3% before the Global Financial Crisis to a current 11.7%. The British banks have Limited exposure to sovereign debt of South European countries, but an escalation in the debt crisis can still lead to disruptions due to central role of London as European banking centre. The government has a strong track record in pursuing sustainable fiscal policies. During the crisis, the public debt increased strongly. A risk mitigating factor is that the government debt is mainly domestically held and has a long average maturity structure (about 15 years), which reduces the interest rate risk for the sovereign. Moreover, the central bank, the Bank of England (BoE), bought many gilds as part of the quantitative easing programme, that started in 2009 in order to stimulate the economy.