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Economics Weekly - Prospects for the UK hang in the (im)balance; Weekly economic data preview - Markets to focus on ECB policy meeting and US non-farm payrolls...

Economics Weekly - 31 August 2009


Prospects for the UK hang in the (im)balance

One of the positive by-products of the UK economic downturn over the past two years - and there have not been many - has been the improvement in the UK’s economic imbalances. It is hoped that these improvements, if sustained, will eventually leave the UK economy better placed to benefit from the next cyclical upturn. So what is meant by the UK’s imbalances; why have they improved; and what are the implications for the UK economy over the coming years?


Opposite sides of the same coin

There are two key imbalances that economists typically refer to when discussing the structure of a economy: the internal and external imbalance. By construction, they are the opposite sides of the same coin. The internal imbalance represents the difference between domestic savings and domestic investment. By implication, the gap shows the extent to which domestic saving is available to finance domestic investment. The history of these imbalances in the UK are shown in chart a. As can be seen from the chart, the UK has traditionally had a domestic savings shortfall. As a consequence, the UK has tended to rely on borrowing from abroad to plug the deficit. The amount of money borrowed from abroad, known as net foreign investment, represents the UK’s external imbalance. By implication, it is equal, but opposite in sign, to the UK’s balance of payments. In other words, a positive inflow of foreign investment is represented by a current account deficit.


In the UK, the economy’s dependence on debt-financed consumer spending for much of the 1990s and 2000s was reflected in a marked deterioration in the household saving ratio – see chart b. The decline in the saving ratio over much of this period occurred at a time when house prices were rising sharply. It appears that households viewed the increase in the market value of their housing wealth as a reason to reduce their savings. At the same time, the strength of consumer spending was fuelling a rise in imports, leading to a widening the UK’s current account deficit, or its external imbalance. Since reaching a flat payments position in 1997, the UK’s current account deficit rose steadily, hitting a recent high of 3.4% of gdp in 2007. The deterioration in the UK’s economic imbalances since the mid-1990s is widely viewed as having left the UK more exposed to economic shocks and sharp movements in its domestic currency. Indeed, this appears to be borne out by recent evidence, with sterling and the US dollar having experienced greater volatility since the credit crisis began than the swiss franc or euro - currencies whose economies have domestic saving surpluses – chart c. Moreover, the UK and US have experienced sharper downturns in their housing markets and, judging by the latest data, have remained in recession longer, with Germany and Japan both posting positive growth in Q2.


The tide appears to have turned

Nonetheless, there are now clear signs that the UK’s imbalances are improving, as evidenced by the recent fall in the current account deficit and the closing in the domestic saving and investment gap. As the recession has taken root, and credit availability has tightened, the private sector has started to deleverage. For households, the desire to reduce debt and rebuild savings has no doubt been motivated by the 20% fall in house prices since mid 2007 and by fears of unemployment. Similarly, firms have sought to retain internal surpluses rather than undertake new investment, mindful of the need to remain liquid in the current environment.


That the process of deleveraging has started in the private sector can be seen in chart d. Since the beginning of 2007, the financial deficit run by the household sector has fallen from 4% to 2% of gdp, consistent with the improvement in the saving ratio over this period. Notably, the corporate sector started its process of balance sheet repair earlier this decade, aided by strong profitability. Although corporate profits have turned lower over the past two years, the corporate sector has continued to run a financial surplus by reducing investment spending. In the second quarter alone, business investment dropped by 10.4%, a fall of 18.4% on the year. Similarly, since the credit crisis erupted, the financial sector has undergone substantial balance sheet repair.


The one notable exception to this process of deleveraging, of course, has been the public sector. It’s financial balance has widened from a surplus of 2% of gdp in 2000 to a deficit of over 6% of gdp currently, and rising. For now, the increase in public borrowing is being relatively easily absorbed by the rise in private sector savings – hence gilt yields remain historically low. Unless the scale of public borrowing is addressed over the coming years, however, it risks crowding our private sector investment, leading to higher borrowing costs and a potentially disorderly decline in sterling’s exchange rate. Faced with this risk, it appears almost certain that, whichever government is in power after next year’s general election, fiscal policy will be tightened.


A painful period of adjustment ahead

The prospect of continued balance sheet repair and a tightening in fiscal policy should lead to a further improvement in the UK’s imbalances over the coming years. When the dust eventually settles, the UK could emerge less reliant on debt-financed consumption, be less exposed to the vagaries of foreign investor sentiment, and have more internally-generated funds to help finance productive business investment. All of these outcomes represent virtuous goals that could be forced upon the UK by the scale of deleveraging that needs to take place. Unfortunately, however, in the absence of monetary reflation, the process of adjustment is likely to be long and painful. In an environment where households and businesses are seeking to rebuild savings, and the government is not in a position to act as a buffer, domestic demand is likely to remain constrained for some time. As such, prospects for UK growth may well hinge crucially on the external sector. As the UK’s internal imbalance has improved, so has its external imbalance. Since 2007, the current account deficit has trended lower. The main reason for this has been falling imports, as domestic demand has weakened. A further import led improvement in the current account deficit is likely over the coming years.


Yet, falling imports do not generate long-term economic growth. What is needed is an improvement in UK exports. Unfortunately, there is little sign of this, with export volumes having fallen around 15% since 2007. Still, it is to be hoped that global demand will recover sufficiently over the coming years to help lift the UK’s export performance, and that sterling’s exchange rate adjusts to boost the UK’s competitiveness. If this occurs, the UK could eventually end up with a current account surplus. However, if this does not happen, the implications for the UK economy would be all the more severe.

Adam Chester, Senior UK Economist, Corporate Markets



Weekly economic data preview - 31 August 2009


Markets to focus on ECB policy meeting and US non-farm payrolls...

The ECB is poised to leave its key refinancing rate on hold at 1.0% at Thursday’s Governing Council meeting. But perhaps of greater interest to markets will be the latest set of ECB staff projections, where an upgrade to the 2010 GDP forecast range is widely anticipated. Importantly, this week also sees August’s US non-farm payrolls data, where the market anticipates a further slowdown in the pace of job losses. The minutes of the 11-12 August FOMC meeting are also due this week, providing details of the reasoning behind the Federal Reserve’s decision to slow the pace of its asset purchases under the credit easing programme. Meanwhile, the upcoming week is a busy one for survey data, with the US ISM manufacturing and non-manufacturing reports released along with the equivalent European PMI surveys. Finally, in Japan, financial markets will be reacting to Sunday’s general election results.


􀂄 Following the recent Inflation Report and minutes of August’s Monetary Policy Committee (MPC) meeting, this week is fairly quiet in terms of UK economic data releases. Bank of England mortgage approvals data are expected to improve to around 50k in July, continuing the upward trend seen since the end of last year. This is consistent with data showing increases in gross mortgage lending for house purchase and also the firmer tone of housing market surveys (e.g. from the RICS). In addition, this week sees the release of August’s purchasing manager’s surveys. In the manufacturing sector, we look for the PMI to register 51.0, the best reading since last March. Meanwhile, within services, we expect a fourth consecutive reading above the 50 level denoting stable activity. Our forecast stands at 52.7, partly reflecting a further wave of optimism in financial markets (especially stock markets).


􀂄 In the euro area, the ECB is likely to keep its main refinancing rate on hold at 1.0%, where it has stood since early May. Furthermore, Jean-Claude Trichet will present the latest ECB staff economic projections, where a modestly brighter outlook for GDP next year is widely expected. Nonetheless, as in August, he is likely to underline the threat posed by a faster pace of increase in unemployment. And following weak lending data for July, there is work to be done in restoring the euro-zone banking system to some kind of normality. Indeed, Mr. Trichet may even repeat August’s message that ‘banks should take appropriate measures to strengthen further their capital bases and, where necessary, take full advantage of government measures to support the financial sector’. In terms of regular economic data, final August euro-zone PMI surveys for the manufacturing and services sectors are published this week. On Tuesday, German unemployment figures are released, and we envisage a monthly increase of 20k. To date, job losses in Germany appear to have been limited by government labour market subsidies. Just how long this dampening effect can be sustained is an open question (German federal elections are held on 27 September).


􀂄 In the US, key features include the minutes of August’s FOMC meeting and latest non-farm payrolls data. In terms of the latest Federal Reserve policy thinking, August’s minutes have probably been superseded by Chairman Bernanke’s remarks at the recent Jackson Hole conference. But importantly, the minutes will provide additional details of the rationale for the Federal Reserve’s decision to slow the pace of asset purchases under its credit easing programme. Meanwhile, with so much attention centred on a nascent global economic recovery, Friday’s US employment data may take on even greater significance. We look for a 260k decline in August non-farm payrolls. Beyond this, the ISM manufacturing and non-manufacturing indices are published this week along with the ADP employment survey, jobless claims and unit wage cost data.

Mark Miller, Global Macroeconomist


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


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