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02/10/2012

UK: 2012 Outlook - Deleveraging and Stagnation

Michael Saunders, Citigroup, London.

This article appeared in the January 2012 issue of Current Economics with permission of the author.

Key Concepts: Stagnation | GDP Growth |

Key Economies: United Kingdom |

 

The UK economy faces another difficult year in 2012, with continued emphasis on balance sheet repair after the surge in private and public debt of recent years. The drag from simultaneous aggressive deleveraging by both public and private sectors is without precedent in recent decades, and is far from over. Exports are benefiting from the low pound, but this boost will be limited by the probable European Monetary Union (EMU) recession.

We are again cutting our growth forecasts, and now expect GDP growth of just 0.2% in 2012 and 1.0% in 2013, versus prior forecasts of 0.5% and 1.2% respectively.1 We estimate that GDP was roughly flat in Q4-2011, will fall slightly in Q1 and Q2 2012 (both down 0.1% q-o-q), rising slightly in Q3 and Q4. But quarterly GDP data may be distorted by the extra Bank Holiday for the Royal Diamond Jubilee on June 5 and the Summer Olympics (starting in July). The big picture is that the economy should be roughly flat during 2012 with only a slow recovery thereafter. We expect that real GDP will not regain its pre-recession peak until 2015. Domestic demand is likely to fall again in 2012 and 2013, and probably will not regain its pre-recession peak until 2016. In terms of real GDP, the UK’s performance during 2008-2016 should match or under-perform Japan’s “lost decade” experience since the early 1990s. We expect the jobless total will rise to about 3 million people (9.5% rate) by end-2012.

But this bleak picture is by no means a worst case, given the scale of the UK’s debt burdens. The key policy priorities for 2012 are to ensure that (1) the pace of private deleveraging is not so rapid as to precipitate a deep new recession; (2) the UK’s commitment to low inflation is not sacrificed in a desire to inflate away debt; (3) the UK returns to a sustainable fiscal path; (4) if the EMU crisis weakens markedly, to provide the backstop of greater stimulus. Provided these are achieved — and we believe they will be — then the UK’s “lost decade” experience of 2008-2016 will give way to better growth thereafter. The next few pages discuss six themes which underpin our view: (1) private sector deleveraging will continue; (2) fiscal policy will stay tight; (3) exports will give a modest boost to growth but investment is likely to be weak; (4) inflation will finally plunge back to target in 2012; (5) the Olympics will not be a launch pad for recovery; and (6) the Monetary Policy Committee (MPC) will expand Quantitative Easing (QE) on a huge scale, far above market expectations.

Private Sector Deleveraging Will Continue

We regard the UK as a classic and super-sized case of a “Reinhart and Rogoff” boom-bust credit cycle2, with the extraordinarily large credit boom now followed by a prolonged period of high private savings, falling private debt/GDP ratios and sluggish spending. The UK’s recent credit boom was huge: the private debt/GDP ratio rose by 105% from Q1-1997 to Q4-2008, the biggest rise over recent decades, and well above the average for major boom-bust credit cycles around the world (which on average have seen the private debt/GDP ratio rise by 40-45% over seven years). The UK’s private debt/GDP ratio hit 231% in Q4-2008, even exceeding the early 1990s Japan peak (222%). With a severe recession and sluggish recovery, real GDP in 2011 was about 15% below its rising pre-recession trend, a rather deeper shortfall than the 10% norm in countries with boom-bust credit cycles. Private savings rates are now unusually high, with the corporate sector running a surplus of 4-5% of GDP on average in recent quarters and the private sector as a whole running a financial surplus of 6-7% of GDP. But, this is consistent with the fact that the UK’s credit boom-bust cycle was unusually big (and fiscal policy also is tight).

Figure 1: UK - Private SectorDebt/GDP Ratios,
1987-2011
Private sector debt/GDP ratios
Figure 2: UK and Global - Shortfall in Real GDP from Pre-Recession Trend in Countries with Banking Crisis
shortfall in real GDP

We expect this emphasis on debt repayment will continue for several more years, consistent with the typical “Reinhart and Rogoff” pattern. Both supply and demand for credit are likely to remain weak, with households and businesses seeking to cut debt levels while banks face regulatory and market pressure to raise capital ratios and shrink balance sheets. To be sure, the private debt/GDP ratio (combining households and non-financial companies) is down from 231% in Q4-2008 to 207% in Q3-2011, the biggest drop in recent decades. But this ratio remains very high versus historic norms and other countries. The private debt ratio was 127% just 15 years ago (Q1-1997). The UK private debt/GDP ratio is the highest among G7 countries and among the highest in Europe, exceeded only by Ireland and Portugal. The UK’s current private debt/GDP ratio is similar to mid-1998 Japan, and Japan’s private sector kept deleveraging (ie falling debt/GDP ratio) until 2005-2006. Moreover, the UK’s private debt ratio is even higher (extra 14% of GDP) if the large pension shortfall of defined benefit pension schemes is added. Consumer spending in Q3-2011 was still 5.5% below the pre-recession peak, the weakest recession/recovery path in the G7. But household savings are likely to rise a bit further, and high private savings rates are likely to be the norm for several years.

Fiscal Policy Will Stay Tight, Deficit Likely to Keep Falling

The combination of the coalition’s commitment to fiscal consolidation, the Office for Budget Responsibility’s (OBR’s) role as fiscal watchdog, and the UK government’s strong executive powers is proving highly effective in locking the UK into a tough multi-year fiscal retrenchment. With tax hikes and the start of the public spending squeeze, the fiscal stance (cyclically adjusted primary balance) tightened by about 2½% of GDP in 2010/2011 and by a further 1% of GDP in the current fiscal year (2011/2012). If anything, the 2011/2012 deficit may fall a little faster than the OBR expects given recent trends in revenues and spending. Even with some slippage in coming months, we expect the 2011/2012 deficit will be about £123bn (8.0% of GDP), a little below the OBR’s £127bn forecast and well down from the £156bn peak (11.1% of GDP) in 2009/2010.

The fiscal stance should tighten by a further 1¼% of GDP in 2012/2013, via more spending cuts (but no extra significant tax hikes), and by a further 1%-1¼% of GDP in each of the subsequent four years (2013/2014 to 2016/2017). Hence, despite the weak economy, we expect the deficit will edge down to about £119bn (7.6% of GDP) in 2012/2013, £108bn (6.6% of GDP) in 2013/2014 and £95bn (5.6% of GDP) in 2014/2015. The government debt/GDP ratio (Maastricht basis) is up from 43% at end-2006 to about 82% at end-2011, but will probably level off at about 95% in 2015 and then edge down. We regard the UK as a relatively weak AAA but, provided the coalition does not splinter and the economy is not soft enough to cause a sustained deficit uptrend, the UK probably will stay in the shrinking pool of AAA-rated sovereigns.

A key risk to the UK’s fiscal outlook is that the coalition could split, either forcing a new election or leaving a minority Conservative government that cannot implement spending cuts. We believe this is unlikely in 2012 and 2013, because both coalition parties have strong reasons to make the coalition work. Indeed, with recent changes in the electoral law, the Conservatives by themselves cannot call an early election. The Liberal Democrats could, with Labour support, defeat the Government on a vote of confidence, which, if no government is formed in 14 days, would then force a new election. But, with the Liberal Democrats’ low poll ratings, an early election would probably cost the Liberal Democrats most of their parliamentary seats. Their only real chance of retaining a sizeable presence in parliament, in our view, is to show that — contrary to the UK’s 20th century experience — coalition governments can work: and that leaves them locked into the coalition.

Figure 3: UK - Central Government Revenues and Spending YoY, Fiscal Year 2011/12
UK government revenues and spending
Figure 4: UK - Fiscal Deficit and Government Debt/GDP Ratio, Pct of GDP, 1990/91 to 2016/17F
Fiscal deficit and government debt/GDP ratio


Will Exports and Business Investment Come to the Rescue?

With tight fiscal policy and high household debts, the OBR looks to business investment and exports as the key drivers for recovery. The OBR projects that business investment will rise by 87% from Q1-2011 to Q1-2017 (average growth of 11% y-o-y), with net trade also adding significantly to growth in each year 2012-2016.

We believe such an investment boom is no longer likely. To be sure, investment fell sharply in the recession and corporate finances have improved sharply. But, this is consistent with the classic pattern that real investment per head typically falls by about 30% below its pre-recession trend after a major banking crisis, and does not regain the lost ground. The cost of capital has soared in the last year, demand is sluggish, capacity use is falling, the corporate sector’s aggregate pension deficit is at a record high, and economic uncertainty has soared. Under these conditions, firms probably will continue to hoard cash and defer investment, and indeed this is what recent business surveys indicate. We expect business investment will fall again in 2012 and 2013, remaining about 20% below the pre-recession peak (Q4- 2007) even at the end of 2016.

We are more optimistic about prospects for export-led growth, but would not get too carried away. The volume of exports of goods has risen 17% in the nine quarters since the recession ended, well ahead of the recoveries after the 1980s and 1990s recessions. However, the UK has a structurally poor export mix: 47% of UK exports of goods go to the euro area and exports to emerging markets (which generally are high-growth regions) account for only 3.4% of UK GDP, the lowest among EU15 countries. By contrast, in 1980, exports of goods to emerging markets accounted for 5.2% of UK GDP, the highest among the big EU countries. In addition, with banks cutting back on trade finance, the share of firms reporting that exports are hindered by a lack of credit or finance is the highest since 1973 (in the Confederation of British Industry (CBI) survey). The UK needs a long period with a weak pound to revive export profitability and build market share in emerging markets. We do expect that net trade will add significantly to growth in 2012 and beyond, with the current account moving into surplus in coming years. But, this mainly reflects our forecast that domestic demand, and hence imports, will stay weak rather than a German-style export miracle.

Figure 5: UK - Cumulative Change in Real Economic Activity in First Nine Quarters After Recessions, 1974-2011
cumulative change in real economic activity
Figure 6: EU15 Countries, US, Japan - Exports of Goods to Emerging Markets as Pct of GDP, 2011
Exports of goods to emerging markets

Finally, Inflation Will Fall Back to Target

In recent years, we have generally warned that, despite the severe 2008/2009 recession, UK inflation risks were to the upside because of the weak pound and supply-side deterioration. And, in turn, CPI inflation has repeatedly overshot MPC and consensus forecasts — and the 2% target — in recent years. But, for 2012, we expect that inflation data will be benign, with CPI inflation collapsing from 4.8% (y-o-y) in Nov-2011 to about 2.0% in Q4-2012, finally returning to target on a sustained basis. We do not believe that deflation is a major risk. But, risks that the prolonged inflation overshoot will destabilise inflation expectations have receded and — barring new external shocks — the UK is now set for a prolonged period with inflation close to the 2% target.

The direct inflation boost from the weak pound is now mostly complete. Sterling’s trade weighted index fell about 25% from Q1-07 to Q1-09 and previous experience suggests that it usually takes four or five years for the full effects of currency moves on consumer goods prices to feed through. We remain worried about the deterioration in the UK supply side over recent years but from here this, and remaining inflationary effects from the weak pound, would be overwhelmed by the renewed weakness in the economy. The jobless rate is rising, surveys suggest that capacity use in firms is now falling again, and output prices are clearly slowing. The CBI survey of manufacturing prices, which is very sensitive to external costs and hence is a useful lead guide to core CPI inflation, recently has turned down sharply.

The probable return of inflation to around the target must count as a policy triumph of sorts for the MPC, given the huge economic turbulence in recent years. But it must be stressed that the UK’s growth-inflation trade-off has worsened markedly in recent years. Real GDP growth exceeded CPI inflation in every year from 1994 to 2007, helped by sharp drops in prices of imported consumer goods and supply-side gains. But, CPI inflation exceeded real GDP growth in 2008, 2009, 2010 and 2011 — and probably will do so again in 2012, 2013 and 2014. With externally-induced disinflation over, the prolonged economic weakness since 2008 probably will simply leave inflation roughly on target. Moreover, we do not expect that lower inflation will give much boost to consumers: with employment falling, real household disposable incomes will probably fall again in 2012 and 2013.

Figure 7: UK - Inflation Data
and Forecast,
1997-2015
UK inflation
Figure 8: UK - Manufacturers' Price Expectations and CPI Inflation, 1993-2011
manufacturers' price expectations

Will the Olympics Boost Growth?

The Games of the XXX Olympiad will take place in London from July 27 to August 12, the first Olympics held in the UK since 1948. There are some fairly clear positive economic effects (construction of Olympic facilities, inflow of tourists to watch the Olympics)3. But there also are various possible adverse effects: some firms may work less intensively than usual during the Olympic period, travel will be disrupted, tourists who would come otherwise to the UK in 2012 may stay away (i.e. discouraged tourists), and some people who come to watch the Olympics in 2012 might then not return to the UK in later years (i.e. tourist inflows may be front-loaded but not permanently raised). For example, the numbers of short-term tourist visitors to Australia rose by 16% (y-o-y) in Sep-2000, when the Games were held in Sydney, but fell y-o-y in 2001, 2002 and 2003. Australia’s real GDP itself was roughly flat in Q3-2000 and fell in Q4. These adverse factors might be more powerful in the UK given that the Games are being held in the country’s major business and tourist location (unlike, say, the 1992 Barcelona Olympics). Of course, these economic effects are less important for a country as big as the US.

In our view, the Olympics are likely to be very entertaining. But the Games are not an economic policy. The Games may distort the q-o-q path of GDP, but the growth impetus probably is now at its peak — or, since the UK’s construction programme is well advanced, already over. We have calculated y-o-y real GDP growth in 10 Olympics host countries since 1964, excluding Mexico in 1968 and Russia in 1980 because of data issues. These economies were mostly growing strongly at the time. On average, real GDP growth increased in the run-up to the Olympics, from 5.9% (y-o-y) six quarters before the Games to 7.1% (y-o-y) two quarters before the Games, probably reflecting construction activity. But, real GDP growth on average slowed during the Games, and then fell sharply, to an average of 3.4% (y-o-y) two quarters after the Games. The pattern of post-Games slowdown is sharper excluding those in the US, and is very persistent: in 9 of the last 10 Olympics, real y-o-y GDP growth was slower two quarters after the Games than two quarters before the Games. There is no systematic pattern for inflation in host countries.


Figure 9: Selected Countries - Average for YoY Real GDP Growth in Olympic Host Countries Around The Olympic Games, 1964-2008
Average growth for Olympic host countries
Figure 10: Selected Countries - Real YoY GDP Growth in Olympic Host Countries Around The Olympic Games,
1964-2008
Real y-o-y growth for Olympic host countries

Monetary Policy: Colossal QE, Plus Low Rates for Many Years

We believe that colossal amounts of QE are likely in 2012 given (1) the sluggish economy; (2) the lack of offsetting fiscal stimulus; and (3) the MPC’s view that a huge amount of QE is needed to have much effect on the economy. With the further slight downgrade to our GDP forecast, we are raising our forecast for the total QE programme from £500bn to £600bn (i.e. the £200bn done in 2009/2010, plus the current £75bn programme, plus a further £325bn). The scale of QE may be even greater if sterling rises significantly. We regard this as a fairly cautious forecast. For example, in Aug-2011, the MPC forecast that inflation will undershoot the 2% target slightly over time even if growth picks up to 2-3% y-o-y in 2012-2014. Our forecasts imply that real GDP growth in 2012-2014 will undershoot those MPC forecasts by about 6% in total. If the MPC share our growth forecast then, unless they believe the supply side has worsened markedly, they will aim to reverse that prospective growth undershoot. The Bank of England’s (BoE’s) own ready-reckoner4 implies that this would require £600-£800bn extra QE (i.e. on top of the £200bn QE done in 09-10).

In theory the MPC could cut rates a bit, but they seem to have decided that 0.5% is the floor for the base rate and so any extra stimulus will come via QE. The MPC appears to prefer a policy of QE gradualism, accompanying the current £75bn QE programme with a forecast that inflation will undershoot the 2% target sharply 2-3 years ahead, implying that more QE is likely. This gradualism aims to allow markets to absorb BoE buying. In addition, the MPC want to see data to confirm that their forecast of lower inflation is valid — to reassure themselves and investors that they are not making another major inflation forecast error. The next expansion (of £100bn, we expect) will probably come at the February meeting, but there is a chance the MPC will pre-announce their intentions at the January meeting. The gilt market currently is £1154bn at nominal value, split between £896bn conventional gilts and £258bn of index-linked. Net issuance will be about £130bn in the current year. So our forecast implies that the BoE will own about 45% of the gilt market by end-2012, and a far higher share of the liquid conventional issues. That would still leave enough gilts for UK banks (who hold £146bn of gilts) to meet liquid asset targets, but the BoE may have to include index-linked gilts in the QE programme.

Figure 11: UK - Holding of Gilts By Sector, £bn,
1999-2013Q1F
UK holdings of gilts by sector
Figure 12: Selected Countries - Cumulative Change in Central Bank Policy Rate Before and After Major Banking Crisis, 1970-2011
Central bank policy reponse to crises

 

The MPC are likely to maintain QE and ultra-low interest rates for several years, and we have not pencilled in the first rate hike until 2015. This is consistent with the standard pattern of a long period of low interest rates seen in other countries with major credit cycles and banking crises. There clearly are dangers that such a long period of loose monetary policy will be viewed as a return to the “financial repression” policies pursued in the 1950s, 1960s and 1970s, whereby low interest rates and constraints on investors were used as tools to cap government financing costs amidst rising inflation. But, provided the MPC can produce tolerably accurate inflation forecasts and stand ready to withdraw stimulus once prospective inflation worsens — and the OBR keeps the government committed to fiscal stability — there should be scope to use QE as an unconventional, but not dangerous, monetary policy tool to help the economy through this period of great difficulty.

Of course, there are many risks in the outlook, and key downside risks are (1) faster private deleveraging; (2) even worse EMU recession or EMU exit and associated higher financial strains; and (3) sharp appreciation of sterling. We regard it as highly unlikely that the UK government will respond with fiscal loosening if worries about EMU sovereign debt intensify. Rather, if these extreme downside risks become the base case, we believe the main policy response will be even larger QE, with perhaps renewed liquidity support for UK banks from the BoE, and measures from the government to force UK banks to lend more to small UK firms at low interest rates (this may happen anyway).

 


Notes:

1 See “Prospects for 2012 and Beyond”, Willem Buiter et al, November 2011, Citi.
2 See “This Time is Different”, Reinhart and Rogoff, 2009 and “IMF World Economic Outlook”, September 2009.
3 See, “A London Olympic Bid for 2012”, Report by the House of Commons Committee for Culture, Media and Sport, 2003, and “Economic Impact of the London 2012 Olympics”, Adam Blake, 2005.
4 See Bank of England Quarterly Bulletin, September 2011.


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