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Monday July 28, 2008 - 11:44:59 GMT
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Economics Weekly -How bad can the UK's fiscal position get? Weekly economic data preview - Focus on UK housing market, Eurozone CPI inflation and US Q2 GDP growth & NFP jobs report

Economics Weekly

How bad can the UK's fiscal position get?

Calls for a looser UK fiscal stance are rising...
With UK economic growth slowing and the housing market weakening, the call for government
action is rising. In the
US, they have cut taxation by nearly 2% and slashed interest rates by 3.25
percentage points to 2%. But the
UK economy is in a different position, for one thing its budget deficit as a share of gdp is slightly larger and for another it is not clear whether a relaxation of fiscal policy would be met by a response from the Monetary Policy Committee (MPC) in the form of higher interest rates. Further, the weakening of annual UK economic growth from an above trend pace last year of 3% to a below trend pace this year of about 1.8% has resulted in a widening of the fiscal deficit, to its worst position since the 1990s. But how bad can it get and why does it matter?

...but there is no scope to cut taxes or increase public spending in the UK...
Chart a shows that the UK’s budget deficit is turning out to be bigger than expected and more than last year, as growth in the economy weakens to a sub 2% annual rate. Indeed, it is on course to be about £50bn in 2008/9, well above the official projection of £43bn. Why is this happening so quickly? The answer is shown in chart b: slowing economic growth hits tax revenues at a time that expenditure is pushed up by falling unemployment and more claims on government spending, as it acts as an ‘automatic stabiliser’. In the case of revenue, we are already seeing lower stamp duty from falling house sales and a weaker equity market, but there will also be an impact in due course from lower corporate tax receipts and lower income tax as unemployment rises, albeit modestly. the budget deficit is already high...
What chart b highlights is that, since 2001, UK government tax revenue growth has been buoyant but spending growth has been even faster. Although the chart implies that the difference between the two growth rates is small, that gap represents the difference between two very large numbers. General government expenditure in 2007/8 was £618bn and revenue was £575bn. Hence, a small percentage change, with receipts falling and expenditure rising, will lead to a big shift in the gap between the two, which is the net borrowing requirement. This is happening now and has occurred in past cycles, as shown in chart c, where it is clear that government borrowing as a share of the economy can be even more volatile than the economic cycle. As an example of this, at 2008 prices, tax receipts in the 1990s recession fell by £30bn a year and, in 2001/2 to 2002/3 when the UK economy narrowly managed to avoid recession, tax revenues still fell by £10bn. Analysis by the Institute of Fiscal Studies suggests that the biggest errors in computing the UK’s budget deficit have been in predicting tax revenues and government spending for a given level of national income.

...potentially putting pressure on interest rates and the economy
With this in mind, one major issue has to be how bad can it get? The answer is that it could get very
bad or it could turn out to be surprisingly good. Using the Treasury’s past errors in projecting public sector net borrowing shows that it can on average be 1% above or below the central projection in the year ahead and by 1.5% two years ahead. Moreover, it is as likely to be worse as it is to be better. Under current circumstances, of course, one could argue that it will be worse but we show both outcomes in chart d. It highlights that in just two years, at the extreme end of the range of possible outcomes, government net borrowing could be as high as £94bn, some 6% of gdp, or as low as a repayment of £20bn, or 1.3% of gdp.

Why does this matter? The answer is that it could mean higher long term interest rates and so weaker economic growth than otherwise and a weaker exchange rate, implying higher than otherwise inflation and higher short term interest rates. Part of the reason for the latter could also be that inflation expectations are higher when government debt is high because of a fear that price inflation will be the consequence of loose fiscal policy.

The fiscal deficit has been worsening for some time, and now requires action to prevent it becoming an even more serious issue in the future
But this potential deterioration in the UK’s fiscal position did not happen overnight. Using the OECD’s estimate of structural budget deficits, which attempts to strip out the effects of the economic cycle on the peaks and troughs in government revenue and expenditure and only leave the underlying position of the deficit, shows that it has been deteriorating for some time, see chart e. Further, the UK’s structural budget deficit is amongst the worst of any major economy, after being one of the best between 1997 and 2002, and is now even higher than the euro area average. This is not good news for the future ability of the UK government to borrow, but the saving grace is shown in chart f, which is that the UK’s outstanding debt to gdp ratio is still lower than the industrial country average. This means that it has time to adjust its budget deficit without facing a serious funding problem that would mean even higher future long and short term interest rates. However, the rate at which the outstanding debt position deteriorates will depend on just how bad the budget deficit is from year to year. The challenge will be to prevent it from deteriorating too rapidly and potentially destabilise the UK economy.
Trevor Williams
Chief Economist, Corporate Markets


Weekly economic data preview W/c 28 July 2008

Focus on UK housing market, Eurozone CPI inflation and US Q2 GDP growth & NFP jobs report

Bank of England mortgage approval and lending data (June) and Nationwide house prices (July) will show further retrenchment in the UK housing market, while survey data are likely to confirm a sharp slowdown in economic growth. In the eurozone, flash CPI inflation for July may rise to a record high of 4.2%, up from 4% in June, and over double the ECB's 2% target rate, reinforcing the difficult challenge facing the ECB as the region's economic growth is under pressure, limiting the scope for another rate hike. Advance US Q2 GDP and core PCE inflation will provide invaluable information about US economic performance. While financial market tensions will, as usual, remain high in the run up to the monthly US non-farm payroll jobs figure on Friday - NFP jobs have contracted each month since January.

• Housing market-related data and consumer/ business surveys feature in the UK. The monthly BoE mortgage approval figure may have fallen further below May's all-time low of 42,000 to 38,000 in June, well below the level of 114,000 a year ago. This indicates that housing market activity will be weak for around 6-9 months ahead, that is, at least until next Spring. Another key indicator of the health of the housing market, net mortgage lending may have fallen from £4.1bn in May to $3.8bn in June (£9.5bn in June 2007). Also, consumer credit figures for May will provide useful insight into monetary growth; we expect an outcome of £1.1bn (the May outcome of £1.4bn was distorted by a +£0.5bn technical adjustment). In addition, Nationwide house price data may show a ninth consecutive monthly contraction, exacerbating market weakness. In terms of surveys, GfK consumer confidence index could fall further from -34in June to -38 in July. Also, the CBI distributive trades' survey will provide a useful alternative to the official data, which have been particularly volatile in the last few months, providing insight into retailers' own perceptions of their business - we expect little change on the month. The manufacturing PMI index for July may confirm that industrial prospects have worsened this year, which seems strange given the fall in the value of the pound.

• In the eurozone, flash July CPI inflation may break another high of 4.2% (4% in June). This poses significant near-term challenges to the ECB given that there are also growing signs that the region's economic growth outlook is weakening rapidly, limiting the prospect for the ECB to raise interest rates further. However, an even higher CPI outcome would strengthen the case for another 0.25% hike to 4.5%, possibly in September or October, but an outcome close to/ or below the market consensus will make the ECB hold off from raising rates until the region's economic prospects brighten. EU-15 consumer and industrial confidence surveys for July may offer little hope that economic growth fears are overdone. EU-15 manufacturing PMI should be confirmed at a level of 47.5 in July down from 49.2 in June, the second month below the key expansion level of 50 and supporting the results of the German IFO index which showed the largest drop in business confidence in almost seven years. It appears that there has been a marked slowdown in German industrial production, suggesting that exporters are finally feeling the adverse effect of the loss of the euro's competitiveness in foreign markets.

• In the US, the first estimate of Q2 GDP and the key monthly NFP labour market report feature. Rising from 0.6% in Q4 2007, final Q1 GDP annualised was revised up to 1% from the Q1 advance growth rate of 0.6%. The consensus view for Q2 economic growth is for a further strengthening to 2%, although this figure is often subject to revision. Any variation on the consensus view will trigger a market reaction, either alleviating or worsening perceptions of the likelihood of technical recession. Published simultaneously, the quarterly core PCE deflator could rise to 2.5% from 2.3% in Q1, highlighting near term inflation pressures that are coming from higher energy prices. The key monthly NFP jobs report could show a 70,000 fall in jobs in July, but monthly wage growth is expected to remain at around of 0.3%. Other US data releases include S & P/ CaseShiller house prices, consumer confidence, the July ISM manufacturing index and June construction spending.
Nichola James, Senior Economist

Economic Research,
Lloyds TSB Corporate
10 Gresham Street,
London EC2V 7AE
0207 626 - 1500

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