Practical Advice

On the Road to Recovery, UK Economic Outlook

About the Author

Ben Jones

Senior Economist, CBI

The UK’s economic fortunes have undergone a remarkable transformation. Only a year ago the economy was widely feared to be on the brink of a triple dip recession. But not only did the downturn not materialize, by the end of 2013 the UK had one of the fastest growing economies in the developed world. Concerns over the absence of growth have been replaced by worries that the UK is experiencing the wrong sort of growth, being too reliant on consumer spending. While the risks of an unbalanced recovery are clear, the CBI sees signs that growth is broadening out, with rising business investment expected both this year and next.

THE RECOVERY FINDS ITS FEET

With real GDP growth of 1.7 percent in 2013, the UK economy experienced its fastest expansion since 2007, beating expectations by a significant margin. This raises the question of why, after several false dawns, did growth suddenly take off? One obvious reason was the absence of any significant shocks in the world economy last year—especially the receding threat of a break-up of the Eurozone. A reduction in financial market tensions within the euro area helped to ease the pressures on UK banks. Back in the UK, concerted attempts by policymakers to encourage bank lending (such as through the Funding for Lending scheme) led to a significant improvement in credit availability for many companies and households. Taken together, improving confidence and the easing of credit conditions helped to unlock a lot of pent-up consumer demand.

The importance of the household sector in driving the recovery is clear from a breakdown of real GDP growth last year: private consumption accounted for almost 90 percent of growth (Chart 1). Retail sales volumes increased at the fastest pace since 2007, while purchases of new automobiles rose more rapidly than any time since the early 1990s, as households took advantage of cheap financing deals to trade up to the latest models.

Charts 1 and 2

The thawing of credit conditions has released a lot of pent-up demand for housing too. In the UK, as in the U.S., the 2008-9 crisis triggered a collapse in home sales, falling house prices and a drop in construction activity. However, as mortgage rates began to fall progressively from mid-2012, to reach historic lows at the start of this year, interest among buyers and sellers revived. By early 2014 the value of new housing loans was around 40 percent higher than a year earlier. House prices are increasing at double-digit rates in parts of the country, prompting fears of another housing bubble (and crash), particularly in and around London, which is attracting significant inflows into property from overseas investors. These developments are now being closely watched by the Bank of England, which recently noted the UK housing market’s “microwave-type quality”—its tendency to move from lukewarm to scalding hot in a very short space of time.

A key catalyst for the turnaround in the UK housing market was the government’s “Help to Buy” (HtB) scheme which, through a combination of shared equity in newly built properties or state guarantees on mortgage loans, has helped increase the availability of mortgages for buyers with small deposits. The scheme has contributed directly to raising the supply of new homes, with around one third of all new builds currently funded by HtB. But its main impact has probably been an indirect one, helping to lift sentiment more broadly. It is not the first time that UK policymakers have used the housing market to kick-start a broader economic recovery and this tactic is not short of critics. Some argue it risks encouraging households to take on debt they may not be able to afford—a UK version of Fannie Mae and Freddie Mac.

So the big question now is whether the UK’s economic recovery is sustainable. The fear is that the upswing is too reliant on consumer spending and a debt-fueled housing boom, with too little investment and trade. Indeed, real household disposable income actually fell in 2013, meaning that rising consumer spending was accompanied by a falling savings ratio. The more fundamental drivers of consumer spending growth are not yet in place: inflation has generally run ahead of average earnings growth since 2008 (although the gap between the two is narrowing), unemployment remains high (close to 7 percent) and households have not paid down their debts as rapidly as they have in the U.S.

However, the CBI believes that there are grounds for some optimism. Our surveys and discussions with members suggest that rising confidence and supportive monetary conditions will serve to broaden the recovery, feeding through to business investment and the labor market in particular, with productivity and earnings expected to recover.

MORE BALANCED GROWTH AHEAD

The near term outlook certainly appears favorable. Earlier this year the CBI began publishing a growth indicator, which brings together the CBI’s surveys of economic activity in various sectors of the economy into an aggregate index (Chart 2). This suggests that strong momentum seen last year was sustained into 2014 and the outlook remains bright: we predict real GDP growth of 2.6 percent in 2014 and 2.5 percent in 2015, with the drivers of growth becoming more balanced (Table 1).

Table 1

For example, we do not think the recent strength of consumer spending will be sustained through 2014, as a falling savings rate is unlikely to support growth to the same extent. However, we do expect a recovery in productivity and earnings to provide firmer foundations to household spending (see box). The speed with which unemployment fell during the second half of 2013 took many economists by surprise. Although recent data suggests that employment growth and the rate of decline in unemployment has slowed, the flip-side of this is that wage growth has started to pick up. With inflation remaining low, real wage increases may now be in sight after the longest squeeze on living standards for 50 years.

Business investment has been the weakest component of growth since the financial crisis, and although it increased in every quarter last year, business investment remained 20 percent below its pre-crisis peak by the end of 2013. However, the CBI’s surveys point to strengthening investment intentions across the board, as uncertainty about demand has diminished, optimism has improved, and external and internal finance has become more readily available. (Chart 3) The drivers of investment appear to be shifting from replacement to the expansion of capacity, suggesting some response to an upturn in growth. Our survey data also suggests that ‘intangible’ investment has already gathered pace in the manufacturing sector, with plans for spending on product innovation, marketing, and staff training all strengthening.

Chart 3

Finally, another aspect of a sustainable recovery would be a much stronger contribution to growth from the external sector. Export volumes have remained fairly flat since the beginning of 2011. In the years ahead, exports should benefit from a somewhat more favorable environment in the Eurozone and the U.S., the UK’s main trading partners, which should help offset the modest appreciation of sterling since early 2013. But although we expect the UK’s export performance to strengthen as global growth picks up, the slow recovery expected in the euro area will act as a restraint, and with stronger domestic demand growth boosting imports, the contribution of net trade to the British economy is likely to remain muted.

RISKS REMAIN

Global developments continue to pose the greatest threat to the UK’s growth outlook, not least the risk of renewed problems in the Eurozone. There are also risks for global financial market stability as the exceptionally loose monetary policies put in place in the aftermath of the crisis are unwound. And at home, there remains the possibility that the crisis has had a more damaging effect on the UK economy than currently estimated, which could lead to a weaker-than- expected recovery in productivity and real wages. For now, however, the CBI is confident that the UK is well down the road towards a lasting recovery.

Bank of England, London

Bank of England, London

BUDGET 2014: CREATING A SUSTAINABLE RECOVERY

Against this backdrop, the CBI welcomed the government’s annual budget statement (presented in March 2014) for its focus on creating a sustainable economic and fiscal recovery. The budget contained numerous policy measures that seem well-timed to translate rising confidence amongst businesses into robust investment growth. And with public borrowing still in excess of $165 billion per year, the Chancellor also appeared to strike an appropriate balance between supporting the recovery and ensuring a fiscally neutral budget. The CBI particularly welcomed the following reforms:

  • An energy package, including a freeze from 2015 of the Carbon Price Support (the premium that UK industrial companies and utilities pay for emitting carbon above the price paid by their EU neighbors) and measures to reduce energy costs for energy intensive industries. The package seemed to strike the right balance between supporting investment by energy users, while underpinning investment in the UK’s energy infrastructure.
  • The doubling of the 100 percent tax relief (Annual Investment Allowance) on investment in plant and machinery to around $800,000 and its extension by one year to the end of 2015. This will provide a shot in the arm for investment by small and medium-sized firms in particular.
  • Making the Seed Enterprise Investment Scheme (SEIS) permanent, which will further support start-ups and growing firms. This important incentive has had a demonstrable impact in boosting investment by “business angels”.
  • The simplification of Air Passenger Duty (APD) through the abolition of the two highest tax bands, which is a first step to removing tax and air capacity barriers to UK businesses seeking to establish relationships with potential overseas customers and suppliers.

STILL PUZZLED

In terms of labor market performance, the UK’s experience has been very different from the U.S. Since the crisis, British workers have shown an atypical determination to remain within the labor force, with the result that for the first time since 1978 the labor force participation rate has climbed above that in the U.S. (where it has fallen steadily in recent years). UK workers seem to have been much more willing than previously to accept pay restraint or turn to part-time work or self-employment. As a result, employment in the UK is now higher than it was before the crisis, while in the U.S. it has yet to fully recover lost ground.

Of course, the counterpart to rising participation and employment in the UK (in an environment of subdued economic growth) has been low productivity growth and stagnant wages, both of which have held help much better in the U.S. Output per hour worked in the UK remains more than 4 percent below its peak in 2008, despite a modest rise at the end of 2013, whereas in the U.S. productivity is up by almost 11 percent over the same period. British economists have been obsessing over this “productivity puzzle” for some years now, but there is still little consensus over how fast productivity (and earnings) might recover as demand strengthens, or to what extent the UK has suffered a permanent hit to its productive capacity.

Some economists point to structural shifts to explain the productivity gap, such as a trend decline in output in the offshore oil and gas sector or a less productive financial services industry in the wake of the crisis. The impaired functioning of the financial system may also have reduced the flow of credit to higher productivity business seeking to expand or fund spending on R&D. Others point to cyclical factors, such as the additional effort needed to secure business in an environment of weak demand, a reluctance to shed skilled labor or a fall in the capital-labor ratio, as firms have postponed investment in favor of less costly labor-intensive expansion. Another possibility is that there is less of a puzzle than the data suggests: there is a tendency for official output data to be revised up over time, so in a few years’ time the picture may look very different.

Our discussions with CBI member companies suggest there are many factors at work. We continue to believe that there is scope for productivity to bounce back as demand recovers and that the Bank of England will be able to keep interest rates low for some time yet. However, if supply-side factors turn out to be more dominant than we expect, a recovery in productivity may be slower in coming and the UK economy will have less room to grow before inflationary pressures begin to build.

Further Information

For further information visit www.cbi.org.uk or contact Ben Jones, Senior Economist, CBI at ben.jones@cbi.org.uk

The CBI (The Confederation of British Industry)

The CBI provides a voice for businesspeople and their businesses on a national and international level. We speak for more than 240,000 companies of every size, including many in the FTSE 100 and FTSE 350, midcaps, SMEs, micro businesses, private and family owned businesses, start ups, and trade associations in every sector. Our mission is to promote the conditions in which businesses of all sizes and sectors in the UK can compete and prosper for the benefit of all. To achieve this, we campaign in the UK, the EU and internationally for a competitive policy landscape.

Screen shot 2013-06-26 at 12.37.09

Read More
0