Economics Weekly - UK corporate sector financial surplus bigger than expected; Weekly economic data preview - Bank of England faces tough decision
Economics Weekly6 October 2008
UK corporate sector
financial surplus bigger than expected
Last week saw the
release of the annual â€˜Blue Bookâ€™, which looks at the UKâ€™s national accounts
The latest release
makes fascinating reading, though the publication will not be available until
November. There were
surprising changes in the report that have some important implications for
the future, not least
for the way the UK economy develops in
the years ahead and copes with the economic slowdown it is now experiencing. Particularly
interesting were the changes to the sectoral financial balances. The UK economy can be broken
into four main sectors, household, government, company (and then financial and
nonfinancial) and overseas. Savings and investment must balance, so that if one
or more sector is in financial deficit (net borrowing), i.e. investing more than
it is saving, it must be balanced by a surplus (net lending) in other sectors.
We look in more detail below at this aspect of the report.
â€¦and confirm that the
household sector has been racking up debtâ€¦
The latest data show,
as we knew, that households in the UK have been running down
their savings and borrowing to fund their
spending, and so has the government sector. In contrast, the company sector has been running a surplus
(lending), in particular non-financial companies. And so has the overseas sector (the flip side
of the current account deficit). In other words, for the UK as a whole,
consumption has been driven by
higher levels of debt, and by households and government within the UK. But what was so interesting
in the latest data release, which gave figures for 2007, was the upward
revision to the surplus being generated by the non-financial company sector.
What does this mean for the economy in the current slowdown and prospects for
the corporate sector in the years ahead?
â€¦but what is new is the
size of the surplus of the non-financial company sectorâ€¦
The first thing to note
is that the trend of the surplus for the non-financial company sector is not a
recent event, nor is the deficit of the household sector, see chart a. This is
one way of understanding the dependence the UK economy has had on
consumption in the last decade or so. Since a peak in 1992 of almost 4% of gdp,
the UK householdsâ€™ financial
surplus has been declining, and has been in consistent and ever larger deficits
since around Q2 of 2001. This deficit is now well over 4% of gdp. This explains
why consumer spending growth has been so strong in this period. There may be sound
reasons for this, such as increased wealth, lower interest rates, higher
etc, but the fact is
that this helps to explain how the economy managed to grow so strongly in the
period, an average of nearly 3% a year.
But this is not the
surprise, nor is the fact that the public sector has been running a financial
deficit as well since 2001, about the same time as the household sector. The
surprise is that the financial surplus of the non-financial company sector has
been revised up, quite substantially. For 2007, for example, there was a
revision from net lending of Â£0.3bn to other sectors to Â£20.6bn. From a
previous balance of close to zero in Q1 of this year, there has been a revision
to Â£11bn or approximately 1% of gdp. Borrowing from overseas has been revised
lower and so has the interest payments linked to it. This means that the
corporate sector is in better financial shape than thought hitherto, as
investment is more than covered by its ability to generate funds. Of course,
with investment spending now being cut, the surplus is bigger.
But it is not all good
Deep recessions in the UK have not been
associated with a positive financial balance like this for the company sector,
see chart b. In Q2 this year, perhaps to be on the safe side, companies have
been cutting investment spending as demand uncertainty has risen and profits
have been squeezed. The reason is that, non-financial companies are still
facing big problems in this economic downturn. Rising raw materials costs and
slowing demand, as customers' real (inflation-adjusted) spending falls owing to
higher price inflation, has hit profit growth. This is shown in chart c, where
the downward trend is similar even if oil and gas firms are included. Moreover,
although the non-financial company sector has improved its asset growth
relative to its liabilities growth, see chart d, there is still a significant
net debt position. In fact, the improvement has only taken it back to where it
was in 1987 after a period of sharply higher net indebtedness in the decade up
to 1997. The other issue worth bearing in mind is that the better financial
position of the corporate sector is not uniform across all industry sectors or
firms. Table 1 highlights the fact that if bank deposits are measured against
loans, there is a wide variation in the positions of different industries.
â€¦as this does not mean
all companies are better offâ€¦
Of course, some sectors
always seem to have a high level of implied gearing and some a surplus, like
real estate for high gearing and computer firms for a positive balance. And
this pattern has not changed much in the last five years. But the economic
slowdown underway however, has hit some sectors more than others, so for
instance construction has seen a big negative shift in its ratio between 2002
and Q2 2008. But in the last five years, the computer services sector has
exhibited a large positive shift and business services a big downward shift
though both remain well in a surplus of deposits relative to borrowing. Of
course, companies can also borrow from other sources and this picture is just
one measure of their debt position.
â€¦however it increases
the chances that the UK economy will better navigate through the current
economic slowdown and in future help to rebalance the economy away from
caveats, the fact is that the UK economy will need to tilt away from
consumer-led growth in the years ahead and the company sector may help to take
up some of the slack, though not all. A better financial position will help it
to do so, however, as will the weak level of the pound. Low capital costs are
also needed, and that will partly depend on the end of the credit crisis and
inflation. Manufacturing output ought to be benefiting from a weaker currency
by late 2009 or 2010, and the worst of the credit crisis should be past. The UK economy needs net
trade to contribute more to growth; otherwise, it will be condemned not to
growth of 2.3 to 2.5% a year but less even than this.
The Bank of England Monetary Policy
Committee (MPC) arguably faces its toughest test this week, facing rising
pressure to lower interest rates at a time when inflation, its official remit,
is at decade highs and still to peak. We expect a close decision but for the MPC
to ultimately decide to maintain Bank rate at 5% on Thursday (in truth it could
go either way). The extreme strains in money markets need to be calmed by
targeted liquidity measures and it is unlikely that lowering official interest
rates will provide much relief, especially to the problems in term lending. In
addition, although recent data, such as the September PMI surveys, suggest the UK economy may have contracted in Q3, the
risk was highlighted in the August BoE Inflation Report and so should not change
the MPC's medium-term outlook for inflation. Waiting for the Inflation Report
in November would make sense. The amended
TARP package was finally approved by the House of Representatives last Friday,
providing relief to global financial markets. However, recent weak economic
data have raised pressure on the Fed to also consider lowering interest rates.
The minutes of the September FOMC meeting published on Tuesday will be
interesting in this regard. It is a relatively quiet week for data in the euro
zone and so developments in funding markets may dominate. We look for the RBA
to cut interest rates by 0.5% to 6.5% on Tuesday, responding to signs of
slowing economic growth.
â€¢ The focus in the UK this week will be on the Bank of
England interest rate decision on Thursday. The decision is finely balanced,
with strong arguments for both maintaining Bank rate at 5% and cutting,
possibly by 0.5% in our view. The minutes of the September MPC meeting showed
an 8-1 vote for no change, with Tim Besley no longer favouring a 0.25% hike and
David Blanchflower looking for a larger 0.5% reduction. For the majority of the
MPC, maintaining Bank rate at 5% was appropriate to balance the upside and
downside risks to inflation but the committee was keen to stress that it would
continue to make its judgement each month on the basis of changing evidence. So
what has changed since the last meeting? Developments in global banking markets
have certainly added further uncertainty about UK economic prospects. Money market funding
has seized up, with term lending affected most. Three-month sterling Libor was
at 6.27% on Friday, over 0.5% above the rate at the last rate decision. The
latest BoE Credit Conditions Survey showed UK financial institutions expected to
further scale back credit to households and companies in Q4, after reducing its
availability by more than anticipated in the third quarter. The news on
economic activity has been mixed, with official retail sales proving
surprisingly strong but survey data in general proving weaker. On balance, a
modest contraction in economic activity in Q3, the first since Q2 1992, is now
likely. However, acting as a crucial counterweight to these developments was a
further rise in CPI inflation to 4.7% in August, signs of rising consumer
inflation expectations and surging import prices. The inflationary threat has
not diminished. Therefore the dilemma facing the MPC is effectively the same as
last month, as the medium term outlook for inflation remains very uncertain.
The best course of action may be to wait for the detailed forecasts provided by
the Inflation Report in November. At that meeting with inflation having peaked
(in our opinion), the MPC could contemplate a larger cut of 1/2%. We look for
no change on Thursday but will not be surprised if rates are cut.
â€¢ Recent data suggest US economic
growth has slowed significantly, primarily reflecting weakening consumer
spending. Data on Friday showed non-farm payrolls declined by 159,000 in
September, the ninth consecutive monthly fall, while the unemployment rate
stayed at 6.1%. However, the robust performance of external trade, which
provided the biggest contribution to gdp in Q2 since 1980, has been the key
reason the economy has avoided outright contraction in 2008. We expect US trade data, on Friday, to show a
sharp narrowing in the deficit in August after a surprise rise in July.
Developments in funding and banking markets may continue to provide the main highlights.
â€¢ The ECB held interest rates at 4.25%
last week, however comments at the press conference suggested the balance had
shifted slightly towards a more balanced stance. Nevertheless, the onus
remained on minimising second round inflation effects to ensure medium-term price
stability, suggesting no imminent cut in interest rates. The final estimate of
euro zone Q2 gdp, on Wednesday, should confirm the economy contracted by 0.2%.
Recent data have raised the possibility of a further fall in Q3, confirming a
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