UK recovery reliant on a roaring trade with the tiger economies - Ernst & Young - United Kingdom

London 18 January 2010: The UK economy has moved out of a decade of debt and into a decade of painful readjustment, according to the latest Ernst & Young ITEM Club quarterly forecast, released today. After years of relying on domestic spending and borrowing the economy now needs to rebalance towards saving and exporting, or risk stagnating.

Professor Peter Spencer, chief economic advisor to the Ernst & Young ITEM Club, explains, “The UK is facing another challenging year. We are no longer in a position to borrow – the massive debts that we racked up in the last decade now need to be repaid. The consumer is completely cashed out – with consumer spending likely to increase by just 0.4% this year.

“The economy must now stand on its own two feet. Growth is almost totally dependent on a sustained upturn in the world economy and upon the energy and enterprise of UK exporters of our prized goods and services, from whisky to water pumps, and education to entertainment, to cash in on a rebound in world trade. But let’s not be under any illusion – this high-wire rebalancing act is going to be very challenging.”

Business optimism has started to improve and ITEM expects positive Q4 2009 GDP figures later this month, which should confirm that the UK is out of recession. But this modest recovery has been driven by restocking; the car scrappage scheme and the anticipated VAT increase. Once the effects of these temporary stimuli have worn off, it is difficult to see where the growth is going to come from in the short-term. ITEM forecasts that GDP will struggle to reach 1% this year, with interest rates likely to remain flat well into 2010.

Driving Miss Prudence into Miss Disaster Scenario
Today’s outlook stands in stark contrast to the optimism that characterised the approach of the millennium – an overvalued pound, little spare capacity, a lax fiscal policy and financial deregulation, which allowed for excessive borrowing and left the economy hugely exposed to the financial risks that led to its near collapse in 2008.

Spencer comments, “In the last decade Miss Prudence morphed into Miss Rosy Scenario and ultimately Miss Disaster Scenario. Mr Brown was guilty of running a large current account deficit even as the economy peaked, leaving little leeway for fiscal policy to be relaxed to deal with the credit crunch, and helping to explain why the UK remains in recession as other countries pull out.”

Export or stagnate
To avoid repeating the mistakes of the past and to ensure that the UK is on track to grow above 1% later this year and beyond, Spencer says, “it is vital the UK rejuvenates its overseas investment model and starts selling into countries such as China, where we have an exceptionally low market share compared to our leading competitors. The UK’s recovery is reliant on a roaring trade with the tiger economies.”

Exports and investment now appear to be stabilising after the sharp falls of early 2009, and the only real bright spot in ITEM’s latest forecast is that it sees exports rebuilding rapidly. With world trade forecast to grow by 8% in 2010, ITEM sees UK exports hitting 9% growth in 2011 and 10% in 2012.

“After a decade of relying on the domestic consumer, companies have to start chasing overseas customers,” says Spencer, “This will require a major investment in people, products and processes. With the Anglo-Saxons stony broke, earning money from world trade has to provide the main stimulus to keep output growing, especially if the global imbalances are to be reduced.”

He adds, “Because we are not locked into the Euro, as are countries such as Ireland and Greece, the fall in the exchange rate will provide support. However, UK exports are not very price-sensitive and we think that the push towards overseas markets will mainly be driven by a lack of demand at home.”

Treasury and Bank of England forecasts suggest that spare capacity in the economy will ensure that output will bounce back strongly as it did that after the last recession. However, the difference is that this time producers will have to muscle their way into new overseas markets – a much greater challenge than just relying on UK consumers to start spending.

Reasons to be cheerful
Despite the gloomy economic situation of the last year, there are some reasons to be cheerful. The UK’s supply side performance over the last decade has put us in pole position to take advantage of the recovery. Low rates of inflation have allowed the MPC to cut interest rates right back to support the economy, and the cooperativeness of the UK workforce has been particularly impressive.

Spencer says, “The performance of the UK labour market since the beginning of the recession is remarkable when compared with the sharp fall in output. Companies and employees have agreed to pay freezes and reduced working hours in preference to redundancies, and this has had the double benefit of restraining unemployment while keeping our skills base and productive capacity intact for the upturn.

“Employment levels have fallen by just 2.5% in contrast with the US, Ireland and Spain where unemployment rates have almost doubled. Longer term, with inflation remaining relatively low, these supply side improvements hold out the promise that we could potentially return to a stable economic environment, provided that the imbalances in the UK and global economies are addressed seriously.”

A nation of savers?
UK households and companies have seemingly caught the savings bug. In the last 12 months there has been a huge increase in the savings ratio. It is estimated that households saved £74 billion in 2009, up from just £14 billion in 2008, while companies have been cutting back on investment and inventories. The private sector ran a financial surplus of around £150 billion in 2009, compared to just £50 billion in 2008.

But appearances can be deceiving – these savings were only made possible because interest rates were cut back to the bone, giving households extra disposable incomes, while UK banks benefited from government bail-outs. In reality the nation’s financial surplus has been minuscule, with savings cancelled out by a huge public sector deficit.

ITEM remains concerned about the Treasury’s projections for next year, which are based upon very optimistic assumptions for both the pace of the economic recovery and for the value of tax revenues raised. Spencer says, “the fiscal position remains a major uncertainty and the Pre-Budget Report was a big disappointment, with the Chancellor failing to come up with any credible medium-term plan for restoring the public finances to health.”

Bumping along the bottom
He concludes, “The recovery this year will be weak at best. Unless the wider recovery turns out to be significantly stronger than we anticipate some further increases in unemployment are still likely in the coming months – prolonging consumer caution. With banks and consumers deleveraging, no scope for further relaxation of monetary policy and the government in retrenchment mode, the UK’s only hope of significant growth is a rebound in overseas exports and income – as well as inward investment.”