Perspectives



Economic Review & Outlook: Implications for the UK

In the last edition of EFR (Volume 5, Issue 1, June 2011), I reported on the flat growth of the UK economy at the start of 2011 and looked at a number of the issues facing the UK as it sought to achieve its forecast growth rates. These included some consideration of what could undermine its economic performance. That article was written in April 2011 and the growth forecasts by the government’s Office for Budget Responsibility (OBR) were 1.7 percent in 2011, 2.5 percent by 2012 and just short of three percent by 2015. 

Current Status 

Eight months later and the Bank of England is forecasting growth of only one percent in GDP for both 2011 and 2012. Only three months ago, the Bank of England’s forecast was similar to the OBR’s—namely 1.7 percent for this year. And a little more than a few weeks after the Bank of England’s new forecasts, the OBR has downgraded its prediction with figures of 0.9 percent for this year and 0.7 percent for 2012-13 (see Box 1 on the following page). On top of this the Organisation for Economic Cooperation and Development (OECD) has forecast that the UK economy will shrink in the final quarter of this year and the first of 2012—the double dip recession that has been feared.

The somewhat limited good news is that the government’s strategy for reducing government debt continues to be supported by the markets as well as organisations like the OECD and International Monetary Fund (IMF), although they warn that if the global economy stalls even further, the strategy may need reviewing. As a result, the UK still retains its AAA rating and is paying one of the lowest levels of interest on debt in the world. For the current financial year, borrowing to date is £68.3 billion, helped by a better than expected October, down by £7.7 billion compared with a year earlier. And the rate of inflation, which peaked at 5.2 percent in September 2011 is now at five percent and is expected to fall swiftly towards the two percent target in 2012. 

But everything else has changed and not for the better. Growth has stalled, although earlier in the year there was a short period where the private sector was creating jobs at a faster rate than the public sector was shedding them. Unemployment has now reached 2.63 million or approximately 8.3 percent of the working population— the highest since 1996. Youth unemployment (16 to 24 year-olds) has now reached over one million, triggering concerns of a “lost” generation. This suggests that the workforce supply is ready and available but the demand is not. However, in relative terms, the UK is performing better in terms of youth unemployment than other European countries with the exception of Germany. And, as previously predicted, there is a continuing squeeze on employee’s pay (in real terms) and benefits, particularly pension entitlements. As the private sector has been forced to reconsider pension arrangements over the last decade and more, much of the change being promoted today concerns public sector pensions, prompting industrial unrest with many unions participating, for example, in a national one day strike on November 30th.

The consequence of this is that the debt mountain continues to grow, unemployment will continue to grow, and those that have jobs will have to work longer before being able to draw on their pension, whilst seeing their pay reduce in real terms, at least in the short term. 

 

Drivers of Change

So what has happened for such sharp revisions to forecasts since the last edition of EFR was published? In short, the global economy has stalled prompted by an apparent inability for politicians to work together across and within borders to put in place the appropriate economic solutions. This is exemplified by the continuing crisis within the eurozone which is still, at the time of writing (November 2011), showing signs of political disagreement and compromise. Although the UK is not in the eurozone, its main trading partners are the eurozone countries. Consequently, as European growth struggles, so too does the UK.

The situation has not been helped by the impact of unexpected events, such as the announcement by the then Greek Prime Minister, George Papandreou to hold a referendum following the successful bail-out talks in October 2011 followed by the run on Italian bonds which sent bond yields to an unsustainable seven percent in a matter of hours. Both these unexpected events resulted in the loss of their respective prime ministers within days with governments of national unity being formed in their place.  

Future Predictions

In the 2011 Government Autumn Statement, Chancellor George Osborne announced that borrowing will increase over previous estimates by £5 billion this year, £19 billion next year, and £30 billion in 2013-14. However, as shown in Box 2, the ratio of debt to GDP will peak in 2014-15 at 78 percent (previously 70.9 percent in 2013-14). Although growth will be less than one percent for both this year and next, growth of 2.1 percent, 2.7 percent, and three percent is forecast for the following three years. Meanwhile, the Bank of England does not expect to see a rise in its interest rate of 0.5 percent until 2013 and has injected a further £75 billion into the economy as part of its quantitative easing programme (which now stands at £275 billion).

The OBR presented its latest report to the UK government in late November 2011 and many of its findings form the basis for the Autumn Statement. In brief, the OBR concludes that the economy has got less room for growth over the next few years, even though growth in the past year has been much slower than forecast. The growth that has been lost will not be recovered quickly. The causes are primarily due to the continuing eurozone crisis, the  increase in global commodity prices, and the fact that the UK’s boom years created a larger crash than previously recognised.

The OBR also forecasts that this low growth means that the reduction in structural deficit will not be closed in 2014-15 as originally planned but a year later in 2015-16. Borrowing is reducing with forecasts of £120 billion in 2012-13 (cf £127 billion this year), £100 billion in 2013-14, and £79 billion in 2014-15. The cost of borrowing has also dropped for the UK, saving £22 billion. 

There is concern that there may be worse to come if the eurozone suffers further, and the government is engaged in contingency planning to meet its budget rules whilst weathering the economic storm. The OBR has not, unlike the OECD, forecast a second recessionary dip, although the government has not ruled that out if the rest of Europe falls into recession.

The implications of this are that unemployment will remain higher for longer and the probability of an extended period of financial restraint for most of the UK’s population.

Prospects for UK Infrastructure

So what does all this mean for infrastructure projects in the UK? The UK government has recognized that investment in infrastructure is one of the best means of generating economic growth. Ironically, because of the economic shock waves emitted from Europe, the infrastructure sector may benefit more than it would otherwise have done as the government looks for means to increase investment in infrastructure to compensate for slow global growth. 

The New PFI and Infrastructure Fund Proposals

However, the government does not wish to be a direct investor in new major infrastructure projects if they can be better developed in the private sector. It is looking at two complimentary approaches to raise new finance for infrastructure.

The first is a more transparent form of the private finance initiative (PFI) to facilitate and deliver new infrastructure investment. Its objective is to create a new model for delivering public assets and services that takes advantage of private sector expertise, but at a lower cost to the taxpayer. 

The government has therefore established a review of a new PFI model to achieve a better balance of risk between the private and the public sectors.

The second, and more substantive announcement made in the Autumn Statement, commits an additional £5 billion of government funding to infrastructure between now and 2015, and a further £5 billion thereafter, coupled with the signing of memoranda of understanding with two groups of pension funds to facilitate £20 billion of investment in new infrastructure projects, along with the establishment of a new infrastructure investment forum for the Association of British Insurers. Pension funds are looking for inflation-linked, long-term investments and infrastructure provides a suitable return profile, but investment models had so far made it difficult for schemes to invest efficiently. To date only two percent of the UK pension funds’ £1 trillion assets are invested in infrastructure. The government’s proposals are designed to overcome this. 

National Infrastructure Plan 2011 

A new National Infrastructure Plan was also published alongside the Autumn Statement and identifies 500 projects valued at £250 billion that the government wished to see being built to 2015 and beyond. 

A summary of the types of public sector promoted projects and their spending profile to 2015 are shown in Box 3. In addition, there is also significant proposed capital investment in the electricity and water sectors being undertaken by the private sector.

Proceed with Caution

The prognosis for infrastructure is perhaps better than it was six months ago, whereas the general economy has moved in the opposite direction. However, caution is the word of the day. As Mervyn King, Governor of the Bank of England, stated earlier this month in response to a question regarding inflation “….we do believe that inflation is likely to come down sharply at the beginning of next year. But in the last three years we have seen extraordinary events. Who knows what’s going to happen tomorrow, let alone in the next 12 months? So big changes in the next 12 months could unsettle that.” 

In other words, do not under-estimate the impact of unexpected events in these unprecedented times

 

Image Header Source: Source: Rob Hawkes (Creative Commons)