Business World

Sunday 18 March 2018

Britain is on the up - but could sterling now be facing into a crisis?

THE GANG'S ALL HERE: UK Prime Minister David Cameron with newly-elected Tory MPs. Photo: Stefan Roussea/Reuters
THE GANG'S ALL HERE: UK Prime Minister David Cameron with newly-elected Tory MPs. Photo: Stefan Roussea/Reuters
Dan O'Brien

Dan O'Brien

Britain is getting back to normal - normal single-party rule, that is. All the pre-election hype about a protracted period of political instability ended up coming to nothing.

While political issues - Scotland and the EU - are very likely to dominate David Cameron's agenda in his second (and final) prime ministerial term, his government will have no shortage of economic challenges. Whether the British economy's strengths prevail over its weaknesses will be of no little consequence for Ireland.

The good news is that Britain has performed relatively well over the past three years, even if per capita GDP is only just returning to the pre-crisis levels of seven years ago (a performance which, among the big three European economies, is similar to that of much maligned France, but not as good as Germany's).

However, the latest GDP figures, released just before the election, were disappointing, representing the slowest quarterly growth in over two years.

The sluggishness of growth was attributable to the construction and production sectors, as well as the usually strong services sector. The services sector had previously made a big contribution to GDP growth in the post-crisis period, reflecting the overall transition of developed economies away from making things (manufacturing) and towards doing things (providing services).

While household debt has declined from its peak in 2009, when it almost matched the value of GDP, it remains high. With interest rates as low as they are at present, people have little difficulty servicing their debts. But high levels of indebtedness are a real vulnerability if and when interest rates increase.

Moreover, the Office for Budgetary Responsibility (a body similar to the Irish Fiscal Advisory Council) expects household indebtedness to start increasing again, and to continue rising for the rest of the decade.

Better news comes from the labour market. During the convulsions of the late 2000s, employment held up reasonably well. Compared with the effect previous recessions had on employment in the UK, this time around fewer people lost their jobs relative to the drop in output.

The proportion of 16- to 64-year-olds at work is back to where it was in 2008, the unemployment rate has fallen to a seven-year low and it is expected to continue edging down towards 5pc.

Comparatively, as the first chart shows, Britain's employment performance among the four large European economies has been closer to best-performer Germany since 2008, with all of the net increase in employment coming in the past three years.

But while employment levels have bounced back, average earnings have not. This partly reflects the growth in the proportion of low-wage and part-time jobs - but it is also a function of an economy recovering from a sudden downturn.

With a larger number of people looking for work, employers can fill vacancies without competing to offer the most attractive salary.

For the moment, flat wages are mitigated by the fact that the things people purchase are not increasing in price. The decreasing cost of energy helped to bring inflation to zero in the last quarter of 2014.

Wages can be expected to remain stagnant unless Britain becomes more productive (by generating greater output per worker). Greater productivity would solve several problems at once - workers could be paid more and enjoy a better quality of life, output would increase and the government would have more revenue to ease its debt burden.

However, since 2007, British productivity has suffered to a greater extent than in the rest of the G7 (the group of the world's richest nations), and no one seems clear on the cause.

And then there is the austerity issue. UK public debt stood at 89pc of GDP in 2014, considerably lower than Ireland's 110pc. But the gap between spending and revenue is larger, with Britain's budget deficit expected to stand at just over 5pc of GDP this year, according to the European Commission, considerably bigger than Ireland's 2.9pc.

If all this means that there is plenty more belt-tightening to come in the years ahead, Britain has plenty more leeway than Ireland. And not only because its debt is lower. Having its own currency means that, in extremis, it can print money to pay its creditors, thereby avoiding the shock of default.

But if having your own currency can lessen fiscal risks, it raises risks related to the balance of payments. And this is one of Britain's biggest weaknesses. The gap between what it earns from the rest of the world and what it pays out is the biggest in five decades - almost as big as Ireland's at the height of our bubble and by far the biggest of any major industrialised economy.

Such deficits are usually a sign of a lack of competitiveness, and a deficit the size of Britain's is always unsustainable over the longer term.

One of the components of the balance of payments is exports and imports. A persistent deficit in the balance of trade means UK residents are continuing to buy more foreign goods and services than they export.

A small share of this is due to trade with Ireland. One third of goods imported here come from the UK, a proportion that has remained steady for over a decade. In the other direction, as we expand into more far-flung destinations, the share of Ireland's exported goods ending up in Britain has declined from almost one- quarter to just over one-seventh over the same period.

In the increasingly important services sector, Ireland sends 18pc of its exports to the UK, down from one- quarter 10 years ago. Much of this sector is accounted for by computer software licences and financial services traded by multinational companies based in Ireland.

If these kinds of services are often lauded as the future of our economy, a more traditional export should not be forgotten. The UK remains an important destination for our food and drink exports. Maintaining and developing this trade could become much more difficult if Ireland and the UK were not governed by the same standards of food production, labelling, safety and consumer protection. This common regulatory platform is currently provided by both countries' membership of the EU.

So while the UK imports more goods and services than it sells to other countries, this is nothing new. What has changed for the worse in recent years, accounting for much of the deficit in the current account balance, is income flows from cross-border investments.

With the value of British assets held by foreigners growing much faster than that of foreign assets held by Britons, the UK's net external asset position has deteriorated markedly in recent years.

While the UK appears to have no problem with all this at present, that could change. If the balance of payments deficit does not narrow, and financial markets decide that it has reached the point of unsustainability, there will be a stampede out of sterling.

The immediate trigger point for a sterling crash appears to have ended with the conclusive election result - but if the external deficit does not narrow, the balance of payments will remain a vulnerability, as it has so often over the past century.

The obvious political trigger point for a sell-off of sterling is the in/out referendum on EU membership that Cameron has committed to holding by the end 2017. If markets perceive the chances of Brexit to be rising, then things could get messy fast.

Sunday Indo Business

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