Country report United Kingdom
The UK economy has seen a solid recovery which has pushed real GDP above the pre-crisis level. Wage growth has returned, debt levels are gradually falling and the housing market has cooled down. The external balance remains weak and is under pressure from the low Euro while the risk of a Brexit remains.
Strengths (+) and weaknesses (-)
(+) Well diversified and competitive economy
The UK is one of the largest economies in the world. Its competitiveness, especially in (financial) services, is underpinned by a well-educated and flexible labour force.
(+) Strong public institutions
Governance, rule of law and transparency indicators confirm strong institutional quality. The UK 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.
(+/-) Large international banking sector
The UK is the second largest banking centre of the world with bank assets totalling 450% of GDP in 2014. Although banks strengthened their capital position after the crisis, a number of banks are too big to fail and foreign exposure makes the country and government vulnerable to external shocks.
(-) Negative Relatively high amount of both public and private debt
Gross public debt increased from 43.7%-GDP in 2007 to 90%-GDP in 2014 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.
1. More broad based recovery but bleak outlook for external balance
The UK has weathered the crisis relatively well in terms of growth but there has been concern about the sustainability of this (unbalanced) growth. These concerns have been mitigated somewhat. In the second half of 2014, for the first time since crisis, real wage growth returned to positive rates. Coupled with employment growth this makes the case for more sustainable, less credit-based, consumption growth in the near future. After peaking at 205% of GDP, private debt to GDP has declined to 163% in 2014Q2 (figure 2). This deleveraging is primarily concentrated in the corporate sector where outstanding credit contracted in nominal terms (10% since 2008). Household debt has grown by 6% over the same period but declined as percentage of GDP. Compared to disposable income household deleveraging has been even stronger.
The mirror image of the unbalanced recovery, the negative external balance inspired by loose monetary policy and credit growth, remains in place and will deteriorate somewhat. Imports are stimulated by the projected strong consumption growth while exports are weighed down by the low Euro, as a result of quantitative easing (QE) in the Eurozone. The CBI and ECFIN surveys show that producers are quite pessimistic about their export order books. Together these suggest that external conditions will remain a drag on growth throughout 2015 and 2016 and keep the current account firmly negative.
2. Housing market cooled down after policy interventions
Last year’s country risk report identified the state of the UK housing market as one of the key risks of the UK economy. House prices had been growing strongly as a result of government and monetary policy. This increase house prices has declined substantially to 5% year on year in February 2015 , down from 12% at the start of 2014. The Bank of England (BoE) and the Financial Policy Committee (FPC) had signaled that house prices were excessive and introduced a cap on loan to income (LTI) ratio’s in June 2014. A bill that would grant regulatory powers to the BoE/FPC on LTVs and DTIs, will be put before Parliament in the first half of 2015, signaling the UK is government has recognized the risk. Meanwhile, UK households remain vulnerable to a mortgage rate increase as a majority of mortgages have variable rates or short interest rate fixations. Since we do not expect a BoE rate hike before 2016Q1, the risk for households may only materialise in the medium term and gradually. Moreover, sustained real wage growth would mitigate this risk.
3. Referendum on ‘Brexit’ likely after Conservative victory
May 2015 has seen a Conservative victory in the UK national elections, with the incumbent Conservative party securing 331 of 650 seats in the House of Commons. The result also shows increasing political fragmentation as the Scottish Nationalist Party (SNP) has almost completely driven Labour out of Scotland. While the Scottish independence referendum was rejected with a 55% majority, negotiations over devolvement will continue. A draft accord between the Scottish parties will be input to a bill put before the Westminster Parliament. The draft includes considerable tax and spending devolvement and could open the door to an unbalanced Scottish budget, depending on the fiscal framework that will be agreed upon. Another potential referendum also proves eventful as Conservative party leader David Cameron has vowed to hold a referendum on a potential ‘Brexit’ of the UK out of the EU. With a Conservative majority in Westminster the likelihood of this scenario has increased markedly. The outcome partially depends on the extent to which Cameron succeeds in renegotiating the Anglo-EU relationship. The referendum is expected to take place in 2017 and could take the UK out of the EU which would have significant economic consequences. Moreover this would significantly reduce the UK’s role as strategic partner for the US.
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 (financial) services, it now constitutes about 40% of total exports, which is a relatively high percentage in international comparison. The current account balance has been persistently negative since 1984 (average -1.8%-GDP over 1984-2013),. This did, however, not lead to a significant deterioration of the net international investment position (NIIP), which was around -2% of GDP in 2013. 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 an international financial centre.
The financial sector makes a major contribution to the economy but also constitutes a risk as assets totalled 450%-GDP in 2014. With higher capital buffers in response to the crisis and subsequent regulatory changes, the risk is lower than before. British banks also have limited exposure to sovereign debt of South European countries, but their exposure to China is significant.
The government has a strong track record in pursuing sustainable fiscal policies. During the crisis, public debt increased strongly. A risk mitigating factor is that 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 a significant share of the gilds as part of the quantitative easing programme, that started in 2009 in order to stimulate the economy.