United Kingdom: Brexit poses the main risk to the economy
An exit out the European Union poses the main risk to the UK economy. In case of a Brexit, a prolonged period of heightened uncertainty is likely, hurting the British financial sector and business investments. Other risks stem from the high private debt and the banking sector.
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 positions after the crisis, a number of banks are too big to fail and foreign exposure makes country and government vulnerable to external shocks.
(-) Relatively high amount of both public and private debt
Gross public debt increased from 43.5%-GDP in 2007 to 91%-GDP in 2015 and is not expected to stabilize before 2017, despite the large amount of fiscal consolidation. Private debt remains elevated (166%-GDP) among slow deleveraging.
1. Referendum on ‘Brexit’ risks heightened and prolonged uncertainty
´No Brexit´ is our baseline scenario, although polls and bookmakers suggest the outcome of the EU-referendum on 23 June will be a close call. As a result of increasing pro-Brexit sentiment, the pound has weakened and may slide slightly further heading towards the referendum date. As a Brexit is only partly priced in, sterling volatility is expected, regardless of the referendum result. To keep markets running smoothly in the weeks around the referendum, the Bank of England (BoE) will offer three additional indexed long-term repo (ILTR) operations, providing six-month finance. The operations could provide banks with unlimited liquidity if markets become stressed ahead of, and directly after, the referendum. In case of a Brexit, a prolonged period of heightened uncertainty is likely given the time needed to negotiate trade relations with the EU and third parties. This will probably hurt business investments, and possibly result in financial institutions leaving London. A weaker pound could alleviate some of the negative economic impact by boosting UK exports.
2. Economic growth is slowing down and remains unbalanced
Economic growth slowed down in 2015, posting only 2.2% compared to 2.9% in 2014. Real wage and robust employment growth have boosted household demand, the main driver of economic growth in 2015. Consumer spending was further supported by an improving housing market. Projected growth of disposable household income and business investments in the second half of 2016 are expected to stimulate imports. Weak external demand and a stronger pound in the second half of 2016 (amid fading Brexit risks and continued expansionary ECB monetary policy) will suppress export growth. Together this suggest that net trade will remain a drag on growth throughout 2016 and keep the current account firmly negative. Economic growth remains, therefore, unbalanced and highly dependent on consumer spending. To reverse this trend, the UK should increase productivity growth and enhance firms’ global competitiveness. British productivity has grown at a slower pace compared to other leading western economies (Office for National Statistics). In addition, the Office for Budget Responsibility revised down its British potential productivity growth outlook to somewhat below the pre-crisis level. As a result it decreased its GDP growth forecast for the coming decade by 0.3% to an average 2.1% a year. Short term risks to economic growth include a negative impact of the EU referendum on business and consumer sentiment and financial markets. Other risks stem from increased volatility of commodity prices, weaker external demand and a (vote in favour of) Brexit.
3. Budget deficit continues to fall, but not enough to secure the fiscal mandate
We expect a steady narrowing of the budget deficit over the coming years, as the government will continue to pursue austerity while it is facilitated by lower interest costs. However, the fiscal mandate, which requires a budget surplus by end of FY2019-20, will prove difficult to achieve due to several reasons. First, the budget for FY2015-2016 will probably be larger than projected. As a result, public debt probably further increased to 91% and is now projected to decrease only from FY2016-17 onwards. Second, the OBR decreased the potential and medium term growth outlook and therefore projects lower growth in tax receipts than previously forecast. Third, divisions within the ruling Conservative Party over austerity will likely impede additional austerity measures going forward. Positive for sovereign risk in the long term is that the government has adopted a new fiscal rule requiring a budget surplus starting in FY2019-20 as long as rolling 4Q on 4Q GDP growth exceeds 1%. However, the rule is not strictly binding, therefore providing flexibility.
4. Banking sector remains vulnerable to house price increases
The large size of the banking sector and elevated levels of mortgage-related household debt make households and banks vulnerable to sharp house price increases. Risks have declined, however, as the household debt-to-income (DTI) ratio declined to 139% in 2014, from a 149% peak level in 2006. This remains a high level compared to other Western countries, though. Furthermore, house prices have grown at a slower pace compared to 2013 and 2014. A side note is necessary though, as prices have been picking up during 2015 and into 2016, and so did credit growth. On the positive side, house building picked up recently as well, diminishing price pressures, although it’s still not nearly enough to meet demand. The government plans to further stimulate house building by the Housing and Planning Bill, which is expected to pass parliament this year. In addition, macro prudential policy measures, like increased regulatory power for the Financial Policy Committee over loan-to-value and DTI ratios mitigate the risks for the banking sector. Given that a majority of mortgages have variable rates or short interest rate fixations, UK households remain vulnerable to a mortgage rate increase. As we do not expect a policy rate hike before 2017Q1, but do expect real wages to grow, this risk may only materialise gradually in the medium term.
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 has shifted towards (financial) services over time, now constituting about 40% of total exports, which is a relatively high percentage in international comparison. The current account balance has been persistently negative since 1984 (-1.8%-GDP on average during 1984-2013). This has not lead to a significant deterioration of the net international investment position (NIIP) though, which was around -22.5% of GDP in 2014. Foreign assets (531%-GDP in 2014) and foreign liabilities (554%-GDP in 2014) are large, but can be mainly attributed to the position of London as an international financial centre. The banking 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, this risk has been mitigated to some extent. British banks also have limited exposure to sovereign debt of Southern 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 GBP 375bn of the gilts as part of the quantitative easing programme that started in 2009. There have been no further purchases since 2012, but maturing bonds are being replaced, keeping the total stock at GBR 375bn.