jka on economics UK

Governor warns the Treasury on debt and deficits .. some options

This week giving evidence to the Treasury select committee the Governor offered three warnings to the Chancellor and the Government on the scale of Public sector borrowing and debt.

1 The deficit is extraordinary.
"We are confronted with a situation where the scale of deficits is truly extraordinary. 12.5% of GDP is not something which would have ben expected a year ago. This reflects the scale of the global downturn, but it also reflects the fact that we came into this crisis with fiscal policy on a path that wasn't sustainable and a correction was needed."

2 Plans for deficit reduction must be more ambitious
There needs to be a plan for the lifetime of the next parliament, contingent upon the state of the economy, which demonstrates how the deficit will be brought down. Brought down to levels below those shown in the budget figures. "If the economy were to recover along the path assumed in the budget projections of GDP then I think the time over which deficits need to be reduced is likely to have to be faster than was implied by that projection.”

3 Financing the deficits could be problematic
Without a credible action plan to bring the public finances back in line, the government could struggle to find buyers for its debts in the years ahead. "Although we are finding it easy now to finance those deficits by issuing gilts, there could be problems down the road. We need a credible statement of what will guide the deficit reduction."

Under Darling's forecasts, set out in the budget, it will take until 2013-14 to bring the government's current deficit down to 5.5% of national income. But King thinks the budget should be returned to balance faster.

So what should the Treasury and Chancellor Darling do?
1 History tells us the impact of a financial crisis leads to a dramatic increase in government borrowing as the recession impacts. The deficit is not so extraordinary in an historical context.
2 Undertake or commission a formal review and update of the quantum of the “fiscal stabilisers”, the impact on spending could be as much as £100 billion in the current year. The reversal of the stabilisers as the economy recovers could yield a dramatic reduction in the scale of borrowing and more quickly than envisaged.
3 Undertake a review of the trend rate of growth and the output gap assessments. The observed rate of GDP growth over 40 years is just over 2.4%, the Bank estimates a trend rate around 2.5% but the Treasury adheres to an unrealistic trend rate of 2.75%.
The combination of the reviews would produce a clearer understanding of the output gap and the “cyclically adjusted deficits”.
4 Commission a review of the potential programme of banking sector assets disposals, which could yield significant gains and assist the debt reduction process as the economy recovers and the upsides in the plan are achieved. Assuming for example that Stephen Hester achieves the £9 million bonus package what would be the potential returns to HMG.
5 Accept the twin deficits of the current account and the Public Sector debt are evidence of a structural problem within the UK economy, to which the Governor alludes in his comments. Some reduction in spending and an increase in consumption taxes are high on the agenda as the economy recovers to address the imbalance. Remedial action is required but "contingent upon the state of the economy".

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World trade winners and losers - why we all need the US Dollar.

World trade fell by almost 20% in the first four months of the year according to revised data from the Netherlands Bureau of Economic Analysis and is expected to fall by 16% in the year according to the OECD June forecast.

The prospects for a recovery in merchandise trade are limited. World GDP growth is expected to fall by 3% according to the IMF and OECD growth is expected to fall by 4.1% according to the OECD June report.

World trade is modelled as a function of GDP growth with adjustments for price, stock changes and a trade finance constraint in the current year. But prospects for world recovery are limited without a revival in the fortunes of the USA.

Largest world exporters nations are Germany, China, USA, and Japan, China is in second place. The major import nations are USA, Germany, China and Japan. China is in third place but the USA is the dominant importer accounting for over 15% of all merchandise imports. (WTO).

Analysing the balance on merchandise trade amongst the major economies, Germany, China and Japan are the largest surplus economies. India, Spain, the UK and the USA are the largest deficit nations. The USA alone has a trade deficit (merchandise) basis of over $857 billion compared to a surplus amongst the big three surplus nations of $620 billion.

Global imbalances in the world trade system can be ameliorated by a U.S. recession, together with a falling dollar and falling oil price but the rest of the world pays the price as world trade collapses. The USA remains the engine or locomotive of world trade, the UK and Spain as the “little shunters”.

Emergence of a huge U.S. current account deficit in the first half of the 1980s was primarily driven by the United States’ role as a “locomotive” in pulling the world economy out of the recession of the early 1980s.

At present, the US locomotive is derailed and prospects for recovery are stalled until the engine is back on track.

Some argue, there can be no return to business as usual. It is neither desirable nor sustainable for global macroeconomic balance to be achieved by recycling huge savings surpluses into the excess consumption of the world’s richest consumers. The answer is a decoupling from the American engine. Decoupling involves a reversal in global current account trends manifest since the Asian crises.

China alone is in a position to effect a change. Two of the largest surplus economies, Japan and Germany have been badly hit in this cycle. This is because domestic demand has been constrained, creating an over reliance on the export surplus. In China, the impact of the slow down in world trade has been less dramatic. GDP growth is expected to be over 7% in the current year. China’s role as an assembler, in the Asian triangular trade, has meant imports can be reduced as export demand falls reducing the impact on current account. Domestic demand is rising and the prospects for further investment and infrastructure investment remain immense.

For the decoupling model to work, domestic demand has to be increased in the surplus economies and demand restrained within the USA, UK and elsewhere. Relative price adjustments in currency terms are of little significance.

Is decoupling the solution? Not really, the US will remain the engine of world growth. At present US consumption is falling and savings ratios increasing, the trade deficit is falling as a cyclical adjustment is fulfilled. But the economy will return to growth by the end of the year. The “decoupling” solution is a misnomer and not an option. The world is hooked on the American dollar and requires a recovery. Nevertheless, it is time for the Chinese rail network to couple up.

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World trade down by 15% in 2009 Q1 : four reasons why it is worse than the Great Depression

In the first quarter of 2009, world trade volumes fell by 15% according to the Netherlands Bureau for Economic Policy Analysis and down by a staggering 30% in value according to the World Trade Organisation.

The fall in world trade activity is unprecedented in post war history and is worse than the collapse in world trade during the Great Depression, according to Eichengreen and O’Rorke. ( 2009)

Why is the collapse in world trade so dramatic? It is possible to outline four key reasons.

First, world domestic demand is falling and GDP growth contracts. Output, exports and world trade fall, compounding the impact on Total Final Expenditure defined as Domestic Demand plus exports.

Second, the reduction in demand is compounded by stock reduction, the so-called “Honda effect”. Stock levels are reduced to match the lower demand levels, output is cut, capacity is reduced and or capital plants are mothballed until stock levels are brought under control. The impact on output and trade is dramatic at this stage in the cycle.

Third, the banking crisis and liquidity challenges are inhibiting the availability of trade finance. The global market for trade finance (credit and insurance) represented approximately 80% of trade flows, valued at $15 trillion in 2008. The World Bank estimates the fall in the supply of trade finance has contributed some 10% to 15% of the decrease in world trade since the second half of 2008.

Finally, the globalisation or “triangular trade” phenomenon. Within the Asia block, there exists a “triangular trade” in which the advanced economies of Asia, Japan, South Korea, and Taiwan, export key components to developing countries, such as China, Thailand and Vietnam.  Manufactured goods are then assembled and exported to the US and Europe to complete the triangle. (Fukua and Yuan 2009)

The Asian developing countries specialise in relatively low value-added assembly and manufacturing, while the advanced countries concentrate on high-value added processes, such as the production of key components. The “triangular process” creates a measure of multiple counting of manufactured components, semi- assembled and manufactured goods as the supply chain is linked.

Trade multiplication is not a “new phenomenon”. Since 1970, world GDP growth has averaged 3% and the output of manufactured goods has increased pro rata at 3%. However, the rate of growth in manufactured exports has averaged 6% over the period, twice the rate of output growth. More recently,  the process has accelerated, as the Asian triangular trade and the China “Open Door” policy developed from 1993 onwards.

Demand from the major “trade deficit economies” USA, UK, Spain, India, and France is falling and hitting trade volumes. The Major surplus traders in manufactured goods China, Germany and Japan are badly hit as a result. In China, the impact is mitigated by domestic demand and the “assembly effect”. As exports fall, so too does the level of imports of semi- manufactures and components.

In 2009, the World Bank expects GDP to fall by 3% and world trade by 10% as demand elasticities are compounded by the finance and stock effect. World trade volumes are a key barometer of the economic health. Until trade recovers, it is premature to call the end of the recession.

Netherlands Bureau for Economic Policy Analysis - World Trade Monitor
World Trade Organisation
A Tale of Two Depressions. Eichengreen and O’Rorke (2009) Voxeu.
Why is Japan so heavily affected    by the Global Economic Crisis? (Fukua and Yuan 2009) Voxeu.

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World GDP to contract by almost 3% in 2009 : World Bank

According to latest World Bank estimates, the global economy will decline this year by 2.9 percent, a significant revision from a previous estimate of 1.7 percent. Most developing country economies will contract this year and face increasingly bleak prospects unless the slump in their exports, remittances, and foreign direct investment is reversed by the end of 2010.
 
“Although growth is expected to revive during the course of 2010, the pace of the recovery is uncertain and the poor in many developing countries will continue to be buffeted by the aftershocks,” World Bank Group President Robert B. Zoellick said.

Global GDP, after falling by a record 2.9% in 2009 is expected to recover by 2% in 2010 and by 3.2% in 2011 as banking sector consolidation, negative wealth effects, high unemployment rates, and risk aversion restrict demand growth throughout the forecast period.

The World Bank said the US economy would shrink by 3 per cent this year while developing countries will grow by only 1.2 per cent. Latest forecasts within the BRIC countries are for an expected growth rate of 7.2% in China and 5% in India. Brazil’s GDP declined 1.8 percent annually in the first quarter of 2009, reducing forecasts for the year as a whole to -1.5% and the economy of the Russian Federation is expected to contract by between 4% and 5%.

World trade collapsed by a staggering 15% in volume terms in the first quarter of the year and by some 30% in value terms according to the WTO. In the current year world trade is expected to contract by 10%.

World Bank             World Trade Organisation

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Governor King outlines three reasons for recovery - it's time to worry.

This week the Governor of the Bank of England was cautious about the prospects for the UK economy and outlined "three solid reasons" for thinking a recovery was likely to occur at some point this year.
 
The first, the  so-called “Honda” or “stock adjustment” effect. Many firms, such as Honda, have cut back production, mothballed plant, and met demand from stock, planning to resume production once inventories had been reduced.  
 
The second factor is the level of Sterling, some 20% lower than in the summer of 2007.  This, says the Governor, will encourage a switch in spending, at home and abroad, towards goods and services produced in the UK.  

Finally, and perhaps most important, is the enormous policy stimulus that has been injected into the economy.  Bank Rate has been cut by four percentage points in four months and the Monetary Policy Committee embarked on a programme of asset purchases designed to increase the money supply and liquidity in the financial system.

The Governor cautioned, as have many of the MPC members, the setback to recovery could yet be found within the banking system, as lending within the economy remains constrained. There has been a withdrawal of overseas banking capacity, UK banks are faced with balance sheet and liquidity ratio restraints, there is a degree of caution on risk exposure and asset value deterioration. This may well restrict the availability of credit within the economy.

The Bank of England, Trends in Lending for June confirmed the problem. Data suggest the value of gross new corporate loan facilities granted fell in May. Most gross lending reflects the refinancing of past loans,  new facilities are offset by the removal of existing facilities. There is no flow through into net new lending. Banks are restricting facilities, increasing spreads and fees to re-build margins and profits.

As for the three reasons for recovery, the current monetary policy is the most positive. Never has policy been so accommodating. The caution is the underlying rate of CPI inflation in the service sector averaging 3.5%. The CPI target rate may not easily be brought to target in the near term. Base rates may have to rise earlier than expected.

The Sterling argument is of limited value as we have frequently argued. There can be no recovery in export volumes as long as world trade remains so weak. The CBI report this week confirms the problem. A balance of -52% members reported export order books below trend, the lowest since October 1998. Furthermore, there is little scope for import substitution and a growth in export capacity as policy makers hope.

Finally, caution is required on the stock adjustment effect, once stock levels have been normalised, output will resume but capacity will be constrained to meet current levels of output. The SMMT production figures for May are a case in point. Car production in May was down by 43% and commercial vehicle production was down by 74%. Stock adjustment is not a kicker to growth.

The real "kicker to growth" will only occur as the US economy is set for recovery and world trade returns to some semblance of normality. For the UK, we say watch the USA and add six months. Not much of a policy to offer the electorate.The recession isn’t over yet. For now, there are those who echo the words of Herbert Hoover “I am convinced we are past the worst” Originally stated in May 1930. It's time to worry a little.

Bank of England - Mansion House Speech

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Government borrowing May - on track to beat the £175 billion target.

Government borrowing in May was £19.9 billion compared to £12 billion in May 2008. In the first two months of the year, public sector net borrowing was £30.5 billion.  This was £16.4 billion higher than in the same period of 2008/09 and almost as much as the whole of the financial year 2007/8.

The Chancellor is well on track to beat the £175 billion borrowing target set for the PSNBR this year. At the end of May net debt was £774.8 billion, equivalent to 54.7 per cent of gross domestic product.

No wonder the Governor of the Bank of England is warning of  the need to produce a clear plan to show how prospective deficits will be reduced to get us out of the borrowing whole.

The fiscal stabilisers are vicious in this cycle. VAT receipts in the month were down by £1.8 billion of which £ 1 billion is a result of the rate reduction, the balance the result of lost sales in the cycle. Income tax, NI and capital gains taxes were down by £1.5 billion. Social security/benefits expenditure increased by almost £1 billion and other current expenditure was up by £2.4 billion including a £400 million increase in the interest charge.

The “fiscal stabilisers” account for almost £5 billion in the May alone. The upside is the reversal in public sector fortunes will be as equally dramatic as the economy recovers from 2010 onwards and the stabilisers unwind. Borrowing will fall but debt reduction will present a serious fiscal challenge to appease the Governor.

ONS Public Sector Finances May 2009            Governor : Mansion House Speech June 2009

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Retail sales down in May - still tough on the high street

Retail sales volumes fell by  1.6% in May compared to prior year, by value sales fell by 1.1% according to latest data from the ONS. It’s still tough on the high street and the retail parks especially for the big ticket items.

By sector food sales were down by 1.3% in volume and non food sales were down by 3%. Household goods stores were again badly hit down by 6.5% and textiles followed the down trend down by just over 2%.

Non store retail predominantly internet and catalogue based retailing was up by 9.8% and non specialist department stores were up by 3%.

The ONS pattern reflects a similar picture presented by the British Retail Consortium and the John Lewis Partnership. Trends in the high street suggest the worst is not over yet for the retail sector and the UK economy in general.

Reacting to the retail figures, Stephen Robertson, British Retail Consortium Director General, said: "These figures confirm our findings that May's sales growth was well down on April's Easter-driven surge. Until we see a turnaround in the sales of big-ticket items it's seems premature to talk of ‘green shoots'.

ONS Retail Sales May                         British Retail Consortium

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UK unemployment in May - much less than expected ...

Unemployment claimant count basis increased by 39,300 in May to 1.545 million. The increase in April has been modified to just under fifty thousand. The rate of job losses in the first quarter was 280,000. In the second quarter job losses will be around 125,000 if current trends are maintained, compared to initial estimates of some 250,000.

Unemployment in the first quarter is consistent with a GDP decline year on year of over 4%. A similar GDP decline is anticipated in the second quarter but the unemployment figures do not correlate with this extensive decline. Either labour is being hoarded at this stage in the cycle, there is a data error, or the GDP outlook is too pessimistic.

The broader Labour Force survey measure increased to 2.261 million in the three months February to April, an unemployment rate of 7.2%. The number of vacancies was 444,000.  Average earnings excluding bonuses were 2.7% down from 3.0%.

For the year as a whole, expectations have been modified slightly. We expect unemployment to increase by a further 500,000 in 2009 and by a further 200,000 in 2010. Claimant count unemployment will rise to 2.1 million by the end of the year. The headline rate will be around 2.8 million rising to 3.0 million in 2010. The rate of unemployment is likely to rise to 9% this year and over 10.0% in 2010.

The GDP forecast is based on a slow down in GDP of -3.8% in 2009 and modest growth of 0.7% in 2010. This compares with a Treasury forecast of -3.5% in 2009 and a more pessimistic IMF forecast of -4.1% in 2009.

ONS - Labour Market Statistics

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May CPI Inflation 2.2% - service sector inflation 3.5%

CPI inflation slowed to 2.2% in April from 2.3% but service sector inflation at 3.5% remains well above target.  RPIX inflation slowed to 1.6 per cent from 1.7 per cent. and the RPI  rate moderated slighty to -1.1%. The largest downward contribution to the change in the RPI annual rate came from housing costs down by 12%.

Are we heading for a prolonged period of deflation? Clearly not. As we said last month, the key number to watch is service sector inflation - CPI basis. Service sector inflation slowed from 3.6% to 3.5% well above target rate. The CPI goods inflation fell to 1.1% from 1.2%.

Since 1995, service sector inflation has averaged 3.7% and goods inflation has averaged just 0.6%. CPI has averaged 1.9% in line with target. The headline rate has been flattered by low and volatile goods inflation. Services inflation accounting for almost half the weighting, has remained consistently well above the target rate.

CPI based, clothing and footwear prices fell once again by 8% producing the largest move to the downside in the CPI level. Food prices remained high at 8%. Housing utilities, water, gas, and other fuels, were up by 6%. Education costs were up once again by almost 9%. Furniture and household goods were higher by 3.2% and restaurants and hotels were higher by 2.5%.

Barring a total collapse in earnings, service sector inflation will prevent a fall in the CPI rate much below the target rate.

According to the Bank of England Inflation report, CPI inflation is expected to fall towards, then below the target this year but deflation in the CPI index is not projected. By the final quarter the target rate may be as low as 0.5% according to the Bank but the rate will increase towards 1.5% by the end of 2010. CPI service sector inflation is the key index to watch and may present a challenge to the Bank scenario.

ONS : Consumer Price Indices May

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CBI June forecasts - no real recovery until 2010

The CBI economic forecasts June, restore a little sanity to the debate on prospects for the UK economy - forecasting no real recovery until 2010.

Following the release of the NIESR GDP data last week, The Telegraph claimed “The British recession is almost certainly over”, The Times declared the recession is over according to the NIESR think tank. Green shoots were blooming into a tropical forest.

In the UK, recession is defined as two or more quarters of negative GDP growth year on year basis. Recovery is defined as one or more quarters of positive GDP growth year on year basis. [Real GDP seasonally adjusted]. On this definition, the recession of 1980 lasted six quarters and the recession of 1990 lasted seven quarters. The current recession is expected to last between six and seven quarters having begun in Q4 2008.

According to the latest CBI data, the economy will return to growth in the second quarter of 2010 albeit by a modest 0.3% year on year. This will mark the end of the recession according to Richard Lambert Director General of the CBI. UK GDP is expected to have fallen by 4.4% in the first quarter and by 4.7% in the second quarter of the year.

For the year as a whole, GDP is expected to fall by 3.9% and rise by 0.7% in 2010. 2009 will be a “bleak year” and “2010 won’t be much better”.

The CBI survey is slightly more optimistic on unemployment in the cycle compared to the April forecast. A peak of 3 million is now expected compared to 3.2 million in the April forecast.

The forecast is once again a pretty good scenario for the UK economy with a much better “headline” this time around. The uncertainties relate to oil and commodity prices. The collapse in world trade is concerning but given the lower propensity to export and lower demand elasticities, the UK is not as vulnerable as the big exporters including Germany, Japan and China.

New CBI forecast – still no real recovery until 2010
Telegraph, the British recession is almost certainly over.
Times : Think tank says the recession is over.
NIESR May - no recovery, no green shoots

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