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Economics Weekly - UK corporate sector financial surplus bigger than expected; Weekly economic data preview - Bank of England faces tough decision

Economics Weekly  6 October 2008

UK corporate sector financial surplus bigger than expected


Last week saw the release of the annual ‘Blue Book’, which looks at the UK’s national accounts data.

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.


…and confirm that the household sector has been racking up debt…

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?


…but what is new is the size of the surplus of the non-financial company sector…

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 households’ 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 employment

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 £0.3bn to other sectors to £20.6bn. From a previous balance of close to zero in Q1 of this year, there has been a revision to £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 news...

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.


…as this does not mean all companies are better off…

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.


…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 debt-led growth

Notwithstanding the 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.

Trevor Williams, Chief Economist, Corporate Markets



Weekly economic data preview W/c 6 October 2008

Bank of England faces tough decision

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.


• 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.


• 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.


• 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 technical recession.

Jeavon Lolay, Senior Economist



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


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