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UK Economic OutlookMarch 2010

Special features:• Outlook for the public finances• Bank lending and the recovery• The savings enigma: is the UK consumer on the mend?

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PricewaterhouseCoopers UK Economic Outlook March 2010 1

UK Economic Outlook – March 2010

Highlights

• The UK economy is estimated in our main scenario to show modest average GDP growth of around 1% in 2010, picking up gradually to around 2.5% in 2011.

• Consumer spending fell by less than GDP in 2009 due to support from low interest rates, the temporary VAT cut, a recovery in house prices and a lower than expected rise in unemployment. Looking forward, however, we expect consumer spending to lag behind GDP growth in the recovery phase of the cycle as monetary and fiscal policy tighten and earnings growth remains subdued.

• Our analysis indicates that the sharp rise in the headline household savings ratio during 2009 was largely driven by special factors, rather than indicating that necessary adjustments in household balance sheets were already well advanced.

• Given these considerations, we expect relatively modest real consumer spending growth of only around 0.75% in 2010 and 2% in 2011 in our main scenario.

• The main drivers of growth in 2010 are expected to be exports and restocking. We should also see a gradual upturn in business investment growth in 2011.

• Bank lending constraints could act as a drag on business investment and employment growth in the medium term. Our analysis suggests that this effect applies particularly to small and medium-sized enterprises that lack other ready sources of funding.

• Public spending growth will remain modestly positive in 2010, but will need to be cut back sharply in the medium term to bring under control an unsustainably large budget deficit. We estimate that additional tax rises or real spending cuts of around £20 billion, over and above current plans, will be needed to eliminate the structural current budget deficit by the end of the next Parliament.

• This fiscal squeeze will act as a drag on medium-term growth but should help to keep interest rates relatively low. Although inflation has spiked up in the short term, we expect it to fall back towards target over the next year given continued subdued earnings growth.

• This should allow the Bank of England to keep base rates low during 2010, although they are projected to rise to around 2.5% by the end of 2011 in our main scenario.

• Risks around growth in our main scenario are more balanced than a year ago, but are still somewhat weighted to the downside. We therefore recommend that businesses should stress test their plans and valuations against an alternative ‘double dip’ scenario. But an upside scenario where growth rebounds rapidly to above trend rates can also not be ruled out.

2 PricewaterhouseCoopers UK Economic Outlook March 2010

Section Author Page

1. Summary 3

2. UK economic prospects Sajeel Shah/John Hawksworth 6

2.1 Recent developments and the current situation 6

2.2 Economic growth prospects 11

2.3 Prospects for inflation and interest rates 13

2.4 Sectoral and regional prospects 14

2.5 Longer term prospects 15

2.6 Summary and conclusions 15

Box 2.1 Outlook for the public finances John Hawksworth 16

3. Bank lending and the recovery Nick Forrest 18

3.1 Bank lending during the recession 18

3.2 Bank lending and the recovery 20

3.3 Impact of bank regulation on the economy 21

3.4 Conclusions 22

4. The savings enigma: is the UK consumer already on the mend? John Hawksworth 23

4.1 What has driven the recent rise in the household savings ratio? 23

4.2 Will the household savings ratio rise further? Lessons from past recessions 25

4.3 Key factors underlying prospects for the savings ratio and consumer spending 25

4.4 Conclusions: implications for consumer spending growth 26

Appendices

A Global economic outlook Sajeel Shah 27

B UK economic trends: 1979-2009 32

Contacts and Services 33

Contents


1 – Summary

Recent developments

The UK economy edged out of recession during the fourth quarter of 2009 according to the latest official estimates (see Figure 1.1), but the level of GDP was still around 6% lower than its pre-recession peak.

Most recent business surveys point to a revival in activity during the latter part of 2009, led by the services sector but with manufacturing activity also showing stronger growth in early 2010 on the back of an upturn in world trade volumes.

Consumer and business confidence has gradually become less negative over the past year and the housing market has shown signs of recovery. Most other major economies have also shown clear signs of recovery, with China and India registering particularly strong growth over the past year.

However, the extent of the good news should not be exaggerated and to a significant extent may just reflect the normal operation of the stock cycle: the period of very sharp destocking has run its course, which will lead to an automatic recovery in orders and output levels in the short term, but the question is whether this upturn can be sustained. Retail sales, unemployment and house price data point to a possible dampening of growth in early 2010, but this may just be a blip.

Governments around the world have introduced fiscal stimulus packages to support monetary policy easing, which was an appropriate policy in the short term although it has pushed budget deficits up to worryingly high levels from a longer term perspective, not least in the UK. The global financial system appears to have stabilised, but it will take some years for US and European banks to repair fully the damage to their balance sheets due to the crisis. Credit conditions in the UK and elsewhere may therefore remain relatively constrained for some time to come.

Future prospects

Our main scenario sees UK GDP rising by a relatively modest 1% in 2010, picking up to

a near trend rate of around 2.5% in 2011. But there could be pitfalls along this road to recovery as the effects of past monetary and fiscal stimulus fade.

As shown in Table 1.1, our main scenario is broadly similar to the latest average independent forecast, but less optimistic than the Treasury’s Budget forecast for 2011 (although similar for 2010). However, both our main scenario and the projections of other forecasters are subject to significant margins of uncertainty, as indicated by the alternative GDP growth scenarios shown in Figure 1.2.

Risks to our main scenario for growth are more balanced than a year ago, but may still be weighted somewhat to the downside. We would therefore recommend that businesses should stress test their plans against the ‘double dip’ scenario shown in Figure 1.2, which envisages a further fall

in GDP in 2010-11. This is not the most likely scenario, but it certainly cannot be entirely ruled out. At the same time, the possibility of a stronger recovery can also not now be ignored given recent relatively more positive survey data.

Consumer spending is projected to grow by only around 0.75% in 2010 and 2% in 2011 in our main scenario, lagging behind overall GDP growth. This reflects the squeeze on household spending power from continued credit constraints and, in 2011, from expected fiscal tightening and interest rate increases. This is backed up by our analysis of recent trends in the household savings ratio as discussed further below and in Section 4.

Business investment is also likely to remain relatively weak in 2010. This reflects both subdued final demand growth and the continued influence of relatively tight credit

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Figure 1.1 – Quarterly GDP growth

Source: ONS

% change on the previous quarter

Table 1.1 – Summary of UK economic prospects

Indicator(% change onprevious year)

HM Treasuryforecasts

(December 2009)

2010 2011 2010 2011 2010 2011

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1.5 to 2

1.75

3.25 to 3.75

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1.5

1.4

0.4

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1.7

2.1

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2.4

2.6

1.7

1

0.75

-2.5

1.25

2

2.5

2

3

2.5

2

Independentforecasts

(February 2010)

PwCMain scenario(March 2010)

Source: HM Treasury Budget 2009 and Survey of Independent Forecasts (average values), PwC main scenario projections rounded to the nearest quarter of a percent. Investment refers to total fixed investment.

GDP

Consumerspending

Investment

Manufacturingoutput

CPI (Q4)


conditions, but investment should start to pick up more strongly in 2011 in our main scenario.

Net exports are estimated to have made a negative contribution to GDP growth in the second half of 2009, but this should turn around gradually in 2010 and particularly 2011 as UK exports are helped by stronger global growth and the relatively competitive value of the pound (compared to average levels between 1997 and 2007).

Our main scenario for UK GDP growth would be consistent with inflation (CPI), which has spiked up sharply in recent months due to the VAT rise and earlier energy price rises, falling back towards target over the next year.

In our main scenario, it should be possible for official short-term interest rates to be held at current low levels during 2010 with only a gradual rise thereafter. In the medium term, there is a risk that inflation could pick up again as and when the economy recovers, which could eventually cause interest rates to rise quite sharply to pre-empt this risk. This is not likely to be an issue in the short term, but could occur later in 2011 or 2012.

Looking further ahead, we would expect the pace of recovery in the UK economy in 2011 and beyond to be held back by the need to get the public finances back under control in the medium term. Public spending will need to be tightly constrained in 2011 and beyond as part of a programme of fiscal austerity, probably also including significant tax rises. As discussed further in Box 2.1, we estimate that a combined additional fiscal tightening of around 1.4% of GDP (around £20 billion per annum at today’s values) could be needed by 2013/14 through some combination of additional tax rises and greater real public spending cuts than included in current Treasury plans.

Bank lending and the recovery

The credit crunch that began in mid-2007 and intensified into a major global financial crisis in September 2008 clearly played a key role in triggering the recession in the UK

and other major economies. But how far did constraints on the supply of bank lending further deepen the recession in 2009?

Certainly bank lending was weak during 2009, as shown in Figure 1.3, but the analysis set out in Section 3 below suggests that this was probably driven as much by weak demand for loans as by lending supply constraints. These supply and demand effects are, however, not easy to untangle and there remains the possibility that the impact of supply constraints could become more binding as the economy starts to recover and companies need more funding for working capital and, a bit later in the process, new capital investment. This applies particularly to small and medium-sized enterprises (SMEs) with less access than larger companies to alternative funding sources for investment like corporate bond

and equity markets. These SMEs (defined here as those with less than 250 employees) account for around 60% of UK private sector employment, so their significance should not be underestimated.

Therefore, there remains a risk that bank lending constraints could limit the growth of SME investment and employment in the medium term, which is one reason why we project a relatively modest growth rate in 2011 in our main scenario (rather than the above trend growth rate projected by the Treasury in 2011). Lending demand may not, however, be strong enough in 2010 for credit supply constraints to be a major factor this year.

Internationally co-ordinated bank regulatory reforms are needed in order to mitigate the risks of future financial crises. But such

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Figure 1.2 – Alternative GDP growth scenarios

Source: ONS, PricewaterhouseCoopers

Year-on-year % growth

Annual % changeFigure 1.3 – Annual growth in lending to UK private non-financial corporations

Source: Bank of England

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reforms could also impose significant additional costs on banks that might worsen the constraints on bank lending during the recovery, particularly as and when interest rates start to rise from current low levels. These factors need to be carefully balanced in designing and implementing efficient and effective reforms at international and UK level.

Why has the household savings ratio risen so far during the recession?

The most striking feature of the UK national accounts data for Q3 2009 was the sharp rise in the household savings ratio to 8.6%, somewhat above its long-term average of around 7.6% (see Figure 1.4). What has driven this rapid recovery in the savings ratio and does it suggest that households are relatively far advanced in adjusting their balance sheets?

Our conclusion, based on the detailed analysis in Section 4 below, is that this rise in the household savings ratio is in large part driven by temporary factors that boosted real disposable income growth to unusually high levels in the year to Q3 2009, but which are unlikely to persist.

In particular, as Table 1.2 shows, pre-tax earnings growth was weak (-3.1%), but this was offset by a marked cyclical fall in tax and national insurance contributions and a rise in social security benefit payments. So post-tax earnings and benefits actually rose by 2% and this was further enhanced by strong growth in dividend payments and a fall in net interest payments. As a result, household disposable incomes rose by an exceptionally strong 6.5% in the year to Q3 2009 and it was this that drove the rise in the household savings ratio over this period.

But this strength in household disposable incomes is expected to go into reverse in 2010-11 as fiscal and monetary policy tightens while average earnings growth remains subdued. This underpins our view

that there is still some considerable way to go for households to adjust their balance sheets and that consumer spending growth is therefore likely to lag behind the recovery in GDP over the next couple of years.

Table 1.2 – Drivers of savings ratio rise between Q3 2008 and Q3 2009

Wages and salaries

Household share of gross operating profits

Pre-tax earnings

Income tax paid

National insurance contributions paid (by workers)

Post-tax earnings

Social security benefits

Post-tax earnings and benefits

Net property income received (interest, dividends, rent etc)

Net current transfers (other than social security benefits)

Household disposable income

Change in net equity of households in pension funds

Available household resources

Household expenditure

Memo: GDP at current market prices

Household income or spending category

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% nominal growthin year to Q3 2009

Source: ONS quarterly national accounts (22 December 2009)

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1963 ’65 ’67 ’69 ’71 ’73 ’75 ’77 ’79 ’81 ’83 ’85 ’87 ’89 ’91 ’93 ’95 ’97 ’99 ’01 ’03 ’05 ’07 ’09Q3

Figure 1.4 – Household savings ratio% of household resources


2 – UK Economic prospects

Introduction

In this section we describe recent developments in the UK economy and review future prospects. The analysis is divided into the following sub-sections:

2.1 Recent developments and the current situation

2.2 Economic growth prospects

2.3 Prospects for inflation and interest rates

2.4 Sectoral and regional prospects

2.5 Longer term prospects

2.6 Summary and conclusions

Additional analysis on the outlook for the public finances is contained in Box 2.1 at the end of this section, while trends in bank lending and the household savings ratio are discussed in more detail in Sections 3 and 4 respectively.

The analysis is supported as usual by a review of global trends and prospects (Appendix A). Historic trends in selected UK economic indicators are included for reference in Appendix B.

2.1 – Recent developments and the current situation

Growth of GDP and major industry sectors

UK GDP grew by 0.3% in Q4 2009 according to latest revised estimates by the Office for National Statistics (ONS), with the year-on-year rate of contraction easing to 3.3% (see Figure 2.1). For 2009 as a whole, the UK economy is estimated to have shrunk by 5%, which if confirmed would represent the largest calendar year decline in GDP since the post-First World War depression of 1919-21.

The revised Q4 data suggest that the UK has started to edge out of recession,

but still by a little less than had earlier been expected by analysts based on the business survey data discussed further below. During the six quarters of contraction (which extended from the second quarter of 2008 to the third quarter of 2009 based on current estimates), the economy shrank by around 6.2%, which was marginally greater than in the early 1980s recession (5.9%), and more than twice as great a fall in GDP as in the early 1990s recession (2.5%).

At this early stage it would be premature to declare definitively that the recession is over, however, given the possibility of a future ‘double dip’ of the kind seen in some previous recessions (notably in mid-1975 and to a much lesser degree in Q2 1992).

The most we can say is that it appears that the economy bottomed out during the second half of 2009 after earlier very sharp declines in output, with a modest recovery in Q4.

Industrial production expanded by an estimated 0.4% in Q4 2009 relative to the previous quarter, while services output was up by 0.5% over the same period. In the year to Q4 2009, the production industries (accounting for around 18% of GDP1) contracted by 5.9%, while output of the service industries (accounting for around 75% of GDP ) fell by 2.5%.

A more detailed analysis of fourth quarter growth estimates for the services sub-sectors (see Figure 2.2) shows that:

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% real output growth

Construction ManufacturingBusiness andfinancial services

GDP Transport &communication

Governmentservices

Distribution, hotels& catering

Figure 2.2 – Sectoral output growth trends

Source: ONS estimates (no bar = zero growth in Q4)Quarter to Q4 2009Year to Q4 2009

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1 Construction accounts for a further 6% of GDP and agriculture for around 1%.


• The business and financial services sector grew by 0.3% in Q4 2009 according to preliminary official estimates, but with output down by 4.5% on a year earlier due to sharp contractions in previous quarters. The latest PwC/CBI financial services survey indicates that, although financial services sentiment improved in the fourth quarter, short-term prospects are weaker than had been expected in the previous survey, suggesting that the recovery in activity may be slow. Subsequent equity price falls in January have reinforced this more cautious outlook for the financial sector though share prices rose again in February.

• The distribution, hotels and catering sector expanded by 1.6% in Q4 2009, compared with an increase of 0.7% in the previous quarter. Motor trades and retail made positive contributions to growth in this sector, but the contraction in the hotels and restaurants sub-sector continued in Q4.

• Transport and communications sector output rose by 0.5% in Q4 2009, with a strong positive contribution from the post and telecommunications sub-sector.

• The government and other services sector was flat in Q4 2009, but output in the sector was down by 1.2% on a year earlier.

The sectoral breakdown of industrial production reveals that:

• The manufacturing sector expanded by an estimated 0.8% in Q4 2009, but output in the sector was still 4.8% lower in Q4 than a year earlier. In 2009 as a whole, manufacturing output contracted by 10.5% compared to 2008.

• Output from the mining, oil and gas sector increased by 0.2% in Q4 2009, compared with a third quarter decline of 6%. Output in this sector was 10.7% lower in Q4 2009 than a year earlier, reflecting in particular continued reductions in North Sea oil and gas production over this period.

• Output in the utilities sector fell by 2.7% in Q4 2009 following an expansion of 0.1% in the previous quarter. In 2009 as a whole, output in the utilities sector contracted by 7.8%, the sharpest drop in 25 years. This is likely to have been caused by significant falls in demand for energy from commercial customers, particularly electricity demand by the relatively cyclical manufacturing and construction sectors.

The CIPS/Markit Manufacturing purchasing managers’ index (PMI) has been on an upward trend since Spring 2009. The index reached a 15 year high of 56.6 in January and February 2010, a sharp rise from the 51.8 recorded in November (see Figure 2.3). The services PMI also increased in December, but then

fell back somewhat to 54.5 in January although remaining well above the ‘no change level’ of 50. These purchasing managers’ indices have been signalling a stronger pace of recovery since mid-2009 than the official GDP data, although the latest ONS data revisions have reduced this apparent discrepancy in Q4. At least for the last couple of years, the PMI services index in particular seems to have been a leading indicator of official services output data, so it may be that this is just a timing issue.

Construction sector output fell by 1% in Q4 2009 relative to Q3 2009 and was down by around 4% on a year earlier. The CIPS/Markit construction sector PMI reached 48.6 in January 2010; whilst this represents an improvement from the historic low of 23.9 in December 2008, the figure remains below the ‘no change level’ of 50 and thus signals a continued slight decline in UK construction sector activity. The commercial and civil engineering sub-sectors reported further declines during January, although house-building continues to pick up somewhat on the back of earlier rises in residential property prices.

Index

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Figure 2.3 – Purchasing manager’s index of activity

Source: CIPS/MarkitManufacturingServices

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Drivers of GDP growth

Turning to the demand side of the economy, domestic demand contracted by an estimated 2.7% in the year to Q4 2009 (see Figure 2.4). Consumer spending held up relatively well but investment fell very sharply and there was continued destocking (although at a slower rate than in Q3).

Domestic demand

Consumer spending expanded by an estimated 0.4% in real terms in Q4 2009, the second successive quarter of positive growth, suggesting that the recovery in consumer spending might be gathering pace. Although credit conditions seem to have eased in recent months (driven by an improved economic outlook and housing prospects, according to the latest Bank of England’s credit conditions survey for the fourth quarter) real household spending fell by an estimated 1.9% in the year to Q4 2009 (see Figure 2.5).

Retail sales volume growth showed signs of improvement in the fourth quarter, with growth of 2.7% recorded in the year to Q4 2009 (see Figure 2.6). Retail sales for January were less positive, however, and it could be that the generally relatively strong retail sales data from December may have been boosted by consumers choosing to bring forward their expenditures ahead of the VAT increase in January. The snow may also have dampened retail sales in January, but this should only be a temporary effect of little macroeconomic significance. The CBI survey showed some upturn in retail sales in February.

Consumer confidence, as measured by a PwC/ICM survey looking at households’ expectations of their disposable income growth over the next year, has recovered gradually over the past year, climbing to -21% in January 2010 (see Figure 2.7). However, this negative balance still indicates a relatively cautious outlook by consumers. This is justified in our view as discussed further in Section 4 below, which looks in detail at recent trends in the household savings ratio and what this might imply for future consumer spending prospects.

House price indices rose during 2009. The Nationwide house price index rose by 8.6% in the year to January 2010, while the

Halifax index increased by 3.6% over the same period (see Figure 2.8). However, house price prospects should be viewed

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GDPDomestic demandNet exports Source: ONS

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Figure 2.5 – Domestic demand growth

Source: ONSInvestment GDPConsumer spending

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Figure 2.6 – Retail sales volume growth

Source: ONS

Three month moving average - % change on a year earlier


with some caution as the apparent recovery since mid-2009 may reflect a lack of houses being offered for sale, rather than an improvement in market fundamentals. Furthermore, mortgage credit conditions still remain significantly tighter than before the downturn and the boost from current historically low mortgage interest rates is likely to be gradually withdrawn over the next few years. The Nationwide reported a 1% fall in house prices in February, but it is too soon to judge if this is the start of a more persistent downward trend.

Total investment in fixed capital is estimated to have fallen by 3.1% in Q4 2009 relative to the previous quarter. This reversed the modest increase in investment in Q3 2009 activity following a period of rapid decline from the latter half of 2008 to the second quarter of 2009. Business investment has remained weak due to subdued demand conditions and high levels of uncertainty. Credit constraints may also have played some part in restraining business investment, particularly for small and medium sized companies (as discussed further in Section 3).

Public sector investment has been relatively strong in 2009/10 given government plans to bring forward some capital spending from later financial years as part of the fiscal stimulus package announced in the 2008 Pre-Budget Report (PBR) and the 2009 Budget. However, this is a temporary effect that will begin to be reversed from 2010/11 onwards.

Real growth in general government consumption expenditure was 1.2% in the fourth quarter of 2009 and positive growth seems set to continue in the short term. However, public spending is likely to be severely constrained from 2011 onwards as discussed further in Box 2.1.

Inventories fell by an estimated 0.9% of GDP in Q4 2009. Preliminary stockbuilding

estimates are often subject to significant later revision, so too much should not be read into these figures at this stage. If the figures do prove to be broadly accurate, however, then the end of this period of destocking should lead to an automatic rebound in quarterly GDP growth during 2010. This factor is taken into account in the GDP growth projections discussed in Section 2.2.

The trade deficit and current account balance

The current account deficit rose slightly to

£4.7bn in Q3 2009 from £4.4 billion in the previous quarter. The deficit was equivalent to 1.3% of GDP in Q3 2009, but was nonetheless lower than the 1.5% deficit of GDP average deficit in 2008.

The trade deficit in goods and services has been relatively stable over the past year, although the Q4 2009 showed some widening of the deficit relative to the previous quarter. Both exports and imports are starting to show signs of recovery after earlier sharp falls, with car imports up particularly sharply in December due the effects of the car scrappage scheme in boosting demand for new cars from overseas.

% net balance expecting increased income

Apr-08 Jun-08 Aug-08 Oct-08 Dec-08 Feb-09 May-09 Oct-09 Jan-10

Figure 2.7 – Household expectations for their disposable income growth over next 12 months

Source: PwC/ICM consumer survey

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Figure 2.8 – House price inflation

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Inflation and the labour market

Inflation, as measured by the Consumer Price Index (CPI), reached 3.5% in January following a surge in December when it increased to 2.9% from 1.9% in the previous month (see Figure 2.9). This large increase occurred due to a number of unusual events which depressed prices in December 2008. The combination of low energy prices, the reduction of VAT to 15% and heavy retail discounting in that month caused a significant base effect on inflation.

Annual headline RPI inflation climbed even more sharply to 3.7% in January from 0.3% in November (see Figure 2.9). While the key factors in the rising CPI inflation rate also contributed to higher RPI inflation rate over recent months, there was also a significant upward contribution from earlier falls in mortgage interest payments dropping out of the 12 month inflation comparison. CPI and RPI have been converging in recent months, with RPI likely to rise above CPI during 2010 due to rising house prices and a gradual increase in mortgage interest rates that is likely to pre-date any increase in the Bank of England base rate.

Producer input price inflation rose to 8.4% in the year to January 2010, which is a significant change from the low of -12.2% recorded for the year to July 2009 (see Figure 2.10). The reflects the continued rollercoaster ride of oil and other commodity prices in recent years, with recent rapid growth in China and other large emerging economies driving the rally in these commodity prices over the past year.

Annual producer output price inflation reached 3.8% in January 2010, up sharply from the low of -1.3% rate recorded in July 2009 as the effect of higher commodity prices has worked its way through the supply chain.

Latest figures suggest that the labour market has broadly stabilised in recent months. The claimant count measure of unemployment increased by 23,500 to reach around 1.64 million in January. The ILO measure of unemployment, which is defined more widely than the claimant count, remained at 7.8% of the labour force in the three months to

December 2009 and recorded a 3,000 fall on the previous three months to 2.46 million. However, total employment fell by 12,000

over the same period compared to the previous three months due to increased economic inactivity levels. Despite the recent

Consumer price index (% change over previous year)Figure 2.9 – Inflation (CPI and RPI)

Source: ONSRPICPI

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Source: ONS

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Apr'05

Oct'05

Apr'06

Oct'06

Apr'07

Oct'07

Apr'08

Oct'08

Apr'09

Oct'09


1997 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10

Figure 2.10 – Producer price inflation

Source: ONSOutput pricesInput prices

-20

-10

0

10

20

30

40


apparent peak in unemployment, the labour market is expected to remain relatively weak for some time, with average hours worked still tending to fall as part-time employment has risen at the expense of full-time employment.

Employment rates remain diverse across regional labour markets. In the three months to November 2009, total employment rates were highest in the South East (76.8%), the East (76.2%) and the South West (75.2%), and lowest in Northern Ireland (67.2%), London (68.8%) and the North East (69%). The prospects for regional economies are discussed in Section 2.4.

The pace of average earnings growth, which is closely watched by the Bank of England’s Monetary Policy Committee (MPC) due to its potential impact on price inflation, reached 1.6% in the year to November 2009 (see Figure 2.11). Average earnings excluding bonuses also grew by 1.5% in the year to December, which was a very subdued rate of increase by historic standards. The ONS’s preferred new average weakly earnings growth measure was even weaker at around 1%.

Monetary and fiscal policy developments

The MPC has kept its official base rate on hold at a historic low of 0.5% since March 2009 (see Figure 2.12). The combination of low interest rates and the earlier quantitative easing (QE) programme should provide a supporting role to the economy during 2010, although it will fade away over time now that QE appears to have been put on hold. The MPC seems likely to move into ‘wait and see’ mode for some months unless there are major growth or inflation surprises.

The last couple of months have seen slightly better news on the public finances, suggesting that public sector net borrowing (PSNB) in 2009/10 may come out somewhat below the Chancellor’s £178 billion forecast in the December 2009 Pre-Budget Report (PBR). Nonetheless, significant fiscal

tightening through tax rises and real spending cuts is expected to be required from 2011 onwards, as discussed further in Box 2.1.

2.2 – Economic growth prospects

Independent forecasts

The February 2010 survey of independent economic forecasts by HM Treasury showed an average projection for real GDP growth of 1.4% in 2010 and 2.3% in 2011 (see Table 2.1).

The Treasury’s 2009 PBR projection for GDP growth of 1% to 1.5% in 2010 appears reasonable, but its forecast that growth will then pick up to around 3.5% in 2011 looks optimistic relative to the consensus view. The Bank of England was also relatively optimistic about growth in its February 2010 Inflation Report projections (although their median growth projections were revised down slightly from those in the November 2009 report).

Future growth prospects remain subject to many uncertainties, as reflected in the alternative scenarios that we present and discuss.

% yieldFigure 2.12 – Short and long term interest rates

Source: Bank of England10 year governent bondOfficial rate

0

1

2

3

4

5

6

7

8

9

10

Jan'96

Jan'95

Jan'94

Jan'97

Jan'98

Jan'99

Jan'00

Jan'01

Jan'02

Jan'03

Jan'04

Jan'05

Jan'06

Jan'07

Jan'08

Jan'09

Table 2.1 – HM Treasury and independent forecasts for the UK economy

GDP

Manufacturing output

Consumer spending

Fixed investment

Government consumption

Change in stock building(contribution to % GDP growth)

Domestic demand

Exports

Imports

Current account (£ billion)

Unemployment (m)claimant count – Q4

Indicators(% real growth)

2011

2.1

2.6

1.5

2.4

-0.6

1.7

1.7

5.5

3.9

-21.4

1.73

Averageindependent forecast

(February 2010)

HM Treasuryforecast

(December 2009)

Actua or latest

estimates

Source: ONS for 2009, HM Treasury Pre-Budget 2009 and Treasury survey of independent forecasts (February 2010)

2010

1.4

1.7

0.4

-0.9

1.3

-3.1

1.3

4.1

3.6

-23.1

1.75

2011

3.25 to 3.75

3.5 to 4

2.75 to 3.25

4.25 to 4.75

-1.5

0.5

2.75 to 3.25

4.5 to 5

1.75 to 2.25

-32

n/a

2010

1 to 1.5

1.5 to 2

0 to 0.5

-2 to -1.5

1.25

0.75

0.75 to 1.25

2 to 2.5

0.5 to 1

-31

n/a

2009

-4.8

-10.5

-3

-13.8

2

-1.4

-5.3

-11.4

-13

-21.7

1.62


Alternative UK growth scenarios

Our main scenario for the UK economy, as summarised in Table 2.2, has the following key features:

• Real GDP expands by around 1% in 2010 before picking up gradually to a rate of around 2.5% in 2011 (see main scenario in Figure 2.13). GDP would not, however, return to pre-crisis levels until the first half of 2012 in this scenario.

• Real consumer spending is expected to grow only very modestly by around 0.75% in 2010 before picking up somewhat to 2% in 2011. Relatively tight (if gradually easing) credit conditions, subdued post-tax earnings growth and a continued weak labour market by the standards of recent years will all weigh down on household spending (as discussed further in Section 4).

• Companies will continue to be cautious over their investment plans in this scenario given uncertainty about the strength of demand. Total investment is therefore expected to fall by around 2.5% in 2010, but should strengthen in 2011, growing by around 3% in our main scenario.

• Stockbuilding is expected to be a significant positive driver of GDP growth in our main scenario in 2010-11, reverse the large negative impact of de-stocking on growth in 2009.

• The contribution of net trade to overall GDP growth is projected to be slightly negative in 2010 due to earlier base effects, but should be slightly positive in 2011 as exports recover with world trade and the support from a continued relatively weak pound (compared to 1997-2007 levels).

• Unemployment on the Labour Force Survey measure has been fairly stable at around 2.5 million recently, but could pick up a little during 2010 before edging back down in 2011 in this scenario. The fact that unemployment has risen less far in the current recession than in the previous two UK recessions does, however, mean that any such projection

is subject to considerable uncertainty atpresent as standard econometric modelsbased on historic data are of limited valuein such circumstances.

Our main scenario for GDP growth is broadly similar to the latest average independent forecast (as can be seen by comparing Tables 2.1 and 2.2), but somewhat less optimistic than the Treasury’s PBR forecast for 2011 (or indeed the median projection in the latest Bank of England inflation report, although the latter estimate is subject to risks that are biased somewhat to the downside according to the full probability distribution of possible future outcomes presented in that report).

We also present two alternative growth scenarios, which reflect the uncertainties surrounding our main scenario for the UK economy (see Figure 2.13).

• Our ‘strong recovery’ scenario assumes that financial markets stabilise more quickly and credit constraints on businesses and households ease significantly in the first half of 2010. Together with the effects of rapid restocking and fiscal and monetary loosening, this leads to a progressive revival in the UK and global economies. UK GDP would turn around quite rapidly following the large contraction of 2009. Growth in this optimistic scenario would rebound from -5% in 2009 to around 2% in 2010 and 4.5% in 2011.

• By contrast, our ‘double dip’ scenario involves further adverse financial shocks affecting the global banking system and capital markets, leading to even more severe constraints on credit and other sources of funding for both businesses and households. This could prompt large cuts in consumer spending and business

-8

-6

-4

-2

0

2

4

6

’10Q4

’10Q3

’10Q2

’10Q1

’10Q4

’10Q3

’10Q2

’10Q1

’09Q4

’09Q3

’09Q2

’09Q1

’08Q4

’08Q3

’08Q2

’08Q1

’07Q4

’07Q3

’07Q2

’07Q1

Figure 2.13 – Alternative GDP growth scenarios

Source: ONS, PwC

Year-on-year % growth

Table 2.2 – Main scenario for the UK economy and independent forecasts for the UK economy

GDP growth

Consumer spending

Government consumption

Fixed investment

Change in stock-building (% GDP)

Domestic demand

Net exports (% of GDP)

CPI (%: Q4)

% change unless stated 2011

2.5

2

-0.5

3

0.75

2.25

0.25

2

Source: ONS for historic data to 2009, PwC main scenario for 2010 and 2011 (rounded to the nearest quarter of a percentage point to avoid spurious accuracy).

2010

1

0.75

1.75

-2.5

1

1.25

-0.25

2

2009

-5

-3.1

2.0

-14.6

-1.2

-5.2

0.7

2.1

2008

0.5

0.9

2.6

-3.5

-0.4

0.1

0.5

3.9

2007

2.6

2.5

1.2

7.8

0.1

3

-0.6

2.1

2006

2.9

1.5

1.6

6.5

0

2.4

0.4

2.7


investment and a renewed increase in company failures and unemployment. A ‘double dip’ recession in the US and Euroland in 2010 would also lead to a further fall in UK export demand in this scenario. The UK economy could shrink by around 0.5% in 2010 in this scenario with a further 1% decline in 2011. A sharply rising budget deficit would also constrain the scope for significant support from fiscal policy in this scenario.

As noted above, both scenarios merit serious consideration in current circumstances, although stress testing against the downside ‘double dip’ scenario remains particularly important on grounds of prudence.

2.3 – Prospects for inflation and interest rates

As presented in Table 2.3, the average independent forecast is for inflation (on the CPI measure) to return to around its 2% target rate at the end of 2010, although it will rise further in the short term. This is also broadly in line with the latest Treasury and Bank of England inflation projections.

Our main scenario is similar to this consensus view in that we expect headline inflation, as measured by the CPI, to fall back from recent high levels to around its 2% target at the end of the year given continuing excess capacity in the economy, which will tend to depress domestic inflationary pressures for some time to come.

Figure 2.14 shows this main scenario for CPI inflation alongside two alternative scenarios that are consistent with those for growth discussed in Section II.2 above. The prospect of a deflationary period appears to have eased in recent months, but our downside scenario is still characterised by very low inflation in 2011. Our strong recovery scenario, however, could see inflation remaining much more persistently above target in 2010. Inflation will clearly also depend heavily on trends in world commodity prices and the exchange rate, both of which are very hard to predict.

Figure 2.15 shows illustrative profiles for the official UK short-term interest rate in each of our three scenarios. In our main scenario, base rates would remain at their historic low of 0.5% until August before rising gradually later in 2010 and through 2011 as the economic recovery becomes more

firmly based and the MPC turns its attention to controlling inflation in the medium term. Quantitative easing (QE) would not be expanded further in this main scenario, but nor would it be unwound to any significant degree over the next year or so.

0

1

2

3

4

5

6

’11’10’09’08’07’06’05’04’03’02’01’00’991998

Figure 2.14 – Alternative inflation scenarios

Source: ONS, PwC

*High inflation scenario is consistent with strong recovery scenario for growth,while the low inflation scenario is consistent with double dip scenario

% CPI inflation

Mainscenario

Highinflation

Low inflation

Scenarios*

MPC target (2%)

0

1

2

3

4

5

6

7

8

’11’10’09’08’07’06’05’04’03’02’01’00’991998

Figure 2.15 – Alternative interest rate scenarios

Source: Bank of England, PwC scenarios

% Bank rate

Double dip

Mainscenario

Strongrecovery

Scenarios

Table 2.3 – Inflation, earnings growth and interest rate projections

CPI (%: Q4)

Earnings growth (% annual average)

BoE official rate (%: Q4)

Indicator Consensus forecasts(February ’10)

HM Treasury(December ’09)

Source: HM Treasury Pre-Budget 2009 and Treasury survey of independent forecasts (February 2010).

Range

2010

1.4 to 3.8

0.4 to 4.3

0.5 to 2

Average

2011

1.7

2.8

2.2

2011

0 to 3.1

0 to 4.1

0 to 3.5

2010

2.1

2.4

1.1

2011

1.5

n/a

n/a

2010

1.75

n/a

n/a


In our strong recovery scenario, base rates would be increased much more rapidly as soon as the pace of recovery was clear, and QE would be unwound more rapidly through sale of the gilts currently held by the Bank of England. However, this would probably be too late to prevent a revival of inflationary pressures in this scenario, given the normal time lag of around two years between monetary policy changes and their full impact on inflation being felt.

In our double dip scenario, by contrast, the Bank of England would need to implement even greater quantitative easing that is sustained on a longer term basis. Base rates would remain at current low levels through 2010 and 2011 in this downside scenario.

2.4 – Sectoral and regional prospects

Figure 2.16 illustrates our main scenario for sectoral output growth in 2009 and 2010. The relatively more cyclical sectors such as manufacturing and construction have been worst hit by the recession, but should tend to stabilise in 2010, while other services sectors should return to modestly positive growth next year, but still well below pre-crisis growth rates.

Illustrative estimates of regional output growth for 2009 and 2010 in our UK main scenario are shown in Figure 2.17. The projected growth differentials between regions are driven in part by variations in industry structures, although our model also takes account of relative regional growth rates for particular sectors, based on a combination of judgement and extrapolation from historic trends.

All regions are projected to see a moderate rise in output in 2010. The South East and London may tend to lead the recovery to some degree, but in general regional variations are not projected to be large relative to the margins of error on any such projections.

Real growth %

ConstructionUtilities ManufacturingBusinessservices and

financial

GDP Transport &communication

Governmentservices

Distribution

Figure 2.16 – Sector growth profile in PwC main scenario

Source: ONS, PwC20102009

-15

-13

-11

-9

-7

-5

-3

-1

1

3

5

Table 2.4 – Long-term independent forecasts for UK economy

GDP

Domestic demand

Consumer prices (CPI)*

Retail prices (RPI)

Short term interest rate (%)*

% growth unless stated 2014

2.5

2.4

2.2

2.9

4.0

2013

2.7

2.3

2.1

3.2

3.5

2012

2.4

2.1

1.9

2.8

2.8

2011

2.1

1.7

1.6

2.6

1.6

2010

1.1

0.1

2.4

3.2

0.6

2009

-5.0

-5.2

2.0

-0.7

0.6

Real annual growth %

N Ireland SouthWest

London SouthEast

Yorks& Humbs

Scotland Wales EastMidlands

EastAnglia

WestMidlands

NorthWest

North

Figure 2.17 – Regional growth profile in PwC main scenario

Source: PricewaterhouseCoopers estimates and projections20102009

-6

-5

-4

-3

-2

-1

0

1

2


2.5 – Longer term prospects

Table 2.4 summarises the latest long-term average independent forecasts, based on the HM Treasury survey in February for the period to 2014. These longer term projections are subject to particularly large uncertainties at present, so little attention should be paid to the precise year-by-year figures, but we can note a number of general points from this table.

First, average annual UK GDP growth in 2012-14 is still only projected to be around its long-term trend rate of 2.5%, rather than seeing a bounce-back in growth to above trend as has been more common in previous recoveries from recession and as is assumed by the Treasury in its PBR projections for growth and the public finances.

Second, the consensus forecasts suggest domestic demand will grow at a slightly slower rate than GDP in 2011-14, which is also our view. We would expect consumer spending growth in the medium term to be constrained by both tax rises and continued relatively modest earnings growth, while public spending will be severely limited by the need to cut the large budget deficit as discussed in Box 2.1 below. Assuming that sterling remains relatively competitive over the next few years, an export-led recovery seems more plausible.

Third, consumer price inflation (CPI) is expected to settle back to around the government’s 2% target rate in the medium term, with base rates rising back gradually to 4% by 2013, although there is a risk that

rates could need to go higher to keep inflation under control.

Due to the high level of uncertainty inherent in macroeconomic forecasting over this longer time horizon, we would recommend considering alternative scenarios in which average GDP growth was, say, 0.5 percentage points higher or lower than the central scenario, and in which inflation and interest rates were, say, around 1 percentage point higher or lower on average.

2.6 – Summary and conclusions

The UK economy appears to have bottomed out during the second half of 2009, but output fell by over 6% during the recession and it will be a long time before GDP returns to pre-crisis levels. Even when it does, there is a likely to be a significant permanent loss of output due to the recession relative to the pre-crisis growth trend.

In our main scenario, UK GDP is projected to grow by around 1% in 2010 followed by a return to trend growth of around 2.5% in 2011, led by exports and a reversal of recent destocking.

Consumer spending is expected to remain relatively subdued growing by only around 0.75% in 2010 and 2% in 2011. This reflects expectations that households will remain cautious given subdued post-tax earnings growth and high legacy debt levels that will exert more of a drag on spending power as and when interest rates return to more normal levels in the medium term.

Business investment is expected to pick up in 2011, but there are uncertainties as to how far this might be constrained by credit supply. As discussed further in Section 3 below, this is particularly true for medium-sized businesses with a relatively heavy dependence on bank funding.

CPI inflation has risen sharply recently, but is expected to fall back towards its 2% target rate later this year, allowing the MPC to keep rates at 0.5% until at least August 2010 in our main scenario. We would not expect a rapid reversal of monetary loosening after that date given our relatively subdued main scenario for growth.

Risks to UK economic growth are more balanced than they were in 2009, but downside risks nonetheless remain significant. We recommend that businesses should stress test their plans against a ‘double dip’ scenario in which there is a further fall in GDP of 0.5% in 2010 and 1% in 2011. This is not the most likely scenario, but it cannot be ruled out at this stage. At the same time, there are also clear upside risks now, which could see a more rapid recovery of the economy to a growth rate well above trend by 2011, although this would be likely to provoke earlier and much larger rises in interest rates in response.

In summary, there are grounds for cautious optimism about the outlook for the UK economy, but also many pitfalls still to negotiate along what is likely to be a long and bumpy road to recovery.


As indicated in Table 2.1.1, our main scenario projections suggest that public borrowing could be close to the Treasury forecast in 2009/10 and 2010/11. Beyond that, however, the Treasury projections are based on sustaining average GDP growth of 3.25% from 2011/12 through to 2014/15, which is well above the consensus forecasts shown in Table 2.4 above, which project average GDP growth over this period of only around 2.5% per annum.

Our own main scenario projections are also based on a more cautious view of medium-term growth potential than assumed by the Treasury. We assume the same 5% of GDP permanent loss of output due to the recession as the Treasury, but assume that the underlying trend growth rate from 2008/9 onwards is 2.25%, rather than the Treasury’s 2.75% central estimate and what they describe as a ‘cautious’ assumption of 2.5% used in their own public finance projections.

As a result in large part of this more cautious view on trend growth, we see public sector net borrowing remaining at around 5% of GDP in 2014/15, as compared to the latest Treasury forecast of a 4.4% of GDP budget deficit in that year. Of course, the Treasury forecast is still within the plausible range given the considerable uncertainties surrounding any such projections, but it does appear to be towards the more optimistic end of that range1.

Public borrowing in the medium term could therefore exceed the levels projected by the Treasury and there must be a risk that, with public debt heading to just above 80% of GDP in 2014/15 on our estimates, there could eventually be an adverse bond market reaction that would push up significantly the cost of servicing this rising public debt.

Box 2.1 – Outlook for the public finances

Table 2.1.1 – Comparison of Treasury fiscal projections with PwC main scenario

HMT – public sector net borrowing (£ billion)

PwC – public sector net borrowing (£ billion)

HMT – public sector net borrowing (% of GDP)

PwC – public sector net borrowing (% of GDP)

HMT – current budget deficit (% of GDP)

PwC – current budget deficit (% of GDP)

HMT – structural current deficit (% of GDP)

PwC – structural current deficit (% of GDP)

HMT – public sector net debt (% of GDP)

PwC – public sector net debt (% of GDP)

2015/16

n/a

79

n/a

4.1

n/a

2.8

1.2*

2.3

n/a

80

*The Treasury did not publish precise projections for 2015/16 in the PBR,but this is an approximate figure based on Chart 2.4 in the PBR and the accompanying textual commentary.

Source: HM Treasury (Pre-Budget Report 2009), PricewaterhouseCoopers main scenario

2014/15

82

94

4.4

5.1

3.2

3.9

1.9

2.8

78

80

2013/14

96

110

5.5

6.4

4.3

5.1

2.3

3.3

77

79

2012/13

117

134

7.1

8.3

5.6

6.7

3.0

4.2

75

77

2011/12

140

153

9.1

10.0

7.2

8.1

3.9

5.0

72

73

2010/11

176

174

12.0

11.9

9.3

9.2

5.4

5.7

65

66

2009/10

178

175

12.6

12.5

9.1

9.0

5.5

5.5

56

56

Table 2.1.2 – Alternative tax and public spending scenarios

Source: HM Treasury Pre-Budget Report 2009 for first three rows in the first column; PwC estimates for other rows and columns (but assuming that net public investment is always as in the Treasury plans). The first column excluding the tax increases

effectively shows our estimates of what the Treasury’s PBR plans imply for departmental expenditure limits (DEL), although debt interest would be slightly higher if taxes were not raised. But the latter effect would be too small

to alter materially the DEL estimates over this period.

*Health, schools, Sure Start and international aid. We assume here that spending on health,schools and Sure Start is frozen in real terms in 2013/14.

Note: Numbers in square brackets show cumulative real spending cuts in 3 years to 2013/14,whereas other numbers in the table show average annual real spending growth rates.

Option 3:Mix of additional

tax rises and furtherspending cuts

Option 2:No further tax rises

with severespending cuts

Option 1:Tax rises with

spending in linewith PBR plans

% real growth perannnum in 3 years to 2013/14

Current spending

Net investment

Total managedexpenditure (TME)

– Debt interest

– Social security benefits/tax credits

– Other AME

Departmental expenditure limits (DEL)

– DEL excludingprotecting areas*

Additional tax risesby 2013/14

0.8

-19.2

0.0

11.1

1.4

3.1

-3 [-9]

-6 [-17]

1.4% of GDP (£20bn at 2009/10 GDP values)

-0.8

-19.2

-1.4

10.1

1.4

3.1

-5 [-14]

-10 [-27]

None

0.0

-19.2

-0.7

10.6

1.4

3.1

-4 [-12]

-8 [-22]

0.7% of GDP (£10bn at 2009/10 GDP values)

1 We note here that Barclays Capital, in their contribution to the 2010 IFS Green Budget, suggest a central case based on a 7.5% of GDP permanent output loss and a 1.75% underlying trend growth rate. This seems rather too pessimistic to us, but what Barclays describes as their ‘optimistic case’ is broadly in line with our main scenario trend growth assumptions and produces similar public finance projections.


To mitigate this risk and provide a buffer against future recessionary shocks and the longer term fiscal costs of ageing, we have argued in several previous reports2 that the government should aim to eliminate its cyclically-adjusted current budget deficit by 2015/16, rather than by 2017/18 as planned by the Treasury. This is also the recommendation of the CBI and is consistent with advice given in past reports by the OECD and the IMF.

Based on our own trend growth assumptions, we would project (as shown in Table 2.1.1) a cyclically-adjusted current budget deficit of around 2.3% of GDP in 2015/16. If we assume that this deficit is eliminated at an even rate between 2011/12 and 2015/16, this would imply a fiscal tightening, over and above PBR plans, of around 1.4% of GDP by 2013/14, or around £20 billion at 2009/10 GDP values.

This ‘fiscal gap’ could be closed through many possible combinations of additional tax rises and spending cuts. Table 2.1.2 illustrates three possible options and sets out the implications both for total departmental spending and for those areas not identified as being protected from real cuts in the PBR (i.e. the NHS, schools, Sure Start and international aid).

We can see from this table that, depending on the mix of tax rises and spending cuts adopted, the scale of the cumulative real departmental spending cuts required in the three years to 2013/14 would be around 9-14%, while the real cuts in unprotected areas could vary from 17% to 27%. The bottom end of this range (i.e. the first column in Table 2.1.2 but excluding any tax rises) corresponds to the government’s current spending plans.

In practice, a spending squeeze towards the middle of the range might appear most plausible, supplemented by perhaps around £10 billion or so of additional tax increases.

The details of this package will be a matter for the next government to decide, but the bond markets and the credit rating agencies will be looking for some such credible fiscal consolidation plan to be announced in an emergency Budget soon after the next general election. Whatever the precise package adopted, however, public spending is likely to be squeezed hard over the next five years or so after a decade of relatively strong growth. Capital-intensive departments such as transport, housing and defence seem likely to be particularly hard hit in the next spending review.

2 See, for example, ‘Dealing with (even more) debt’, PwC Public Sector Research Centre, October 2009, which is available to download from www.psrc-pwc.com.

1 Real interest rates are also low now, but nominal rates are more important for corporate cash flows and therefore short-term decisions on debt repayments.


3 – Bank lending and the recovery

Introduction

The role of banks as suppliers of credit to the economy has been highly scrutinised during the recession.

A key question has been whether constrained bank lending has contributed to the weakness in the economy, or whether the weakness in aggregate demand has contributed to the reduction in bank lending, or whether the former (during the initial stages of the credit crunch starting in mid-2007) turned into the latter (during the later full-blown UK recession). While anecdotal evidence has regularly pointed to difficulties in accessing credit, particularly for small and medium-sized enterprises (SMEs), banks have defended their behaviour, declaring themselves to be ‘open for business’.

In this article we revisit the role which credit provision has played during the recession (Section 3.1) and then move on to the more critical question of whether weak credit supply could hold back the recovery (Section 3.2). We then discuss the potential impact of regulatory reform in the banking industry on the wider economy (Section 3.3). Section 3.4 summarises the key conclusions from the analysis.

3.1 – Bank lending during the recession

The challenge of understanding the role of credit in the economy, and more specifically bank lending, is that we cannot separately observe supply and demand for credit. We observe the interaction of supply and demand and resultant lending, but it is difficult to tell whether supply factors or demand factors are dominant in driving trends.

Figure 3.1 shows how bank lending to non-financial companies continued to rise (but at a slowing rate) during the initial phase of the credit crunch from mid-2007 through to September 2008. But as the UK moved from a mild to a deep recession in the fourth quarter of 2008, bank lending

started to slow and, from May 2009, net lending to private non-financial corporations actually started to fall. This downward trend had stabilised at the end of 2009, with a small positive monthly growth rate in December, but was still negative when measured on a quarterly or annual basis. Part of the explanation of why lending growth did not actually turn negative until some way into the recession could be due to the inherent inertia in bank lending – the time to process applications and draw down funds means that a slowdown in lending decisions (for either demand or supply reasons) can take some months to flow into the aggregate net lending figures.

It is possible to compare bank lending during this recession with the experience in previous recessions which were not associated with a banking crisis and hence may have been less constrained by the supply of credit. Table 3.1 below presents the peak to trough drop in real GDP, real bank lending, average interest rates and

inflation during the last three recessions. This shows that the overall drop in lending this time around is not too dissimilar to the drop in the 1990s recession, being larger for consumer lending but less sharp for business lending. This could suggest that demand has been the bigger driver of weak lending in the latest recession. However, the inflation and interest rate environment was considerably different in previous recessions – high nominal1 interest rates in the early 1980s and 1990s recessions meant that companies had to use spare cash to meet interest payments, while current very low interest rates help companies and households to reduce debts by repaying principal rather than just debt interest. This difference makes it difficult to draw reliable conclusions from such historic comparisons of lending trends in recessions.

There is a range of other evidence that could be used to support either the supply side or demand side explanations for weak lending during the current recession.

Annual % changeFigure 3.1 – Annual growth in lending to UK private non-financial corporations

Source: Bank of England

-5

0

5

10

15

20

25

Jul’09

Jan’09

Jul’08

Jan’08

Jul’07

Jan’07

Jul’06

Jan’06

Jul’05

Jan’05

Jul’04

Jan’04

Table 3.1– Comparison of last three UK recessions

1979 - 1981

1990 - 1992

2008 - 2009

Recession

17%

8.0%

1.5%

Averageinflation rate

17.8%

13.0%

2.6%

Averageinterest rate

-0.3%

-5.5%

-4.2%

Real banklending change

(business)

n/a

-6.1%

-12.9%

Real banklending change

(consumer)

-4.7%

-2.5%

-6.2%

Real GDPchange

2 For example, in its November 2009 survey of UK businesses, the British Chambers of Commerce found that 33% of companies reported that accessing finance had been more difficult over the last three months (as compared to 20% in their June survey). 3 This point is supported by analysis in the Bank of England’s February 2010 Inflation Report, which shows that employment and investment fell by significantly more in SMEs during the year to Q3 2009 than in the corporate sector as a whole (although output trends were less differentiated by company size).


Evidence supporting weak demand for bank lending being critical includes the following:

• Businesses and households have not been using all available credit facilities. RBS, for example, have publicly stated that British companies have unused overdrafts with it worth a total of £27bn and this figure has remained steady through the recession.

• In an environment of low confidence and high uncertainty, low interest rates mean that companies and consumers are more easily able to repay debt, thereby reducing net outstanding lending. Lending panel data shows that while gross business lending to SMEs fell by 22% in the 11 months to November 2009 compared to the previous year, repayments rose by 13% for the year to November compared to the previous year. This is in contrast to earlier recessions where high interest rates meant that more cash was used to pay debt interest charges, rather than debt repayment.

• Company insolvencies have not risen nearly as sharply as in the early 1990s recession (see Figure 3.2). Company liquidations rose by 154% from their mid-cycle trough to their 1992 peak, as compared to a 54% rise from their mid-cycle trough to the end of 2009. Although it is too early to be confident that insolvencies have peaked in the current cycle, the evidence to date suggests that many struggling companies have been able to access credit in 2008-9 due to banks taking a more supportive attitude than in the last recession.

• Larger companies have been able to access corporate bond markets and equity markets as an alternative to bank funding, thereby reducing demand for bank lending.

Evidence supporting weak supply of credit as the key factor includes the following:

• Surveys during the recession have typically found that businesses’ views of credit availability have been weak2.

• Investment was very weak during the recession as discussed in Section 2.1 above. Part of this was due to weak demand conditions for these companies and high levels of uncertainty, but part could be due to difficulty in accessing finance, particularly for SMEs3.

• Certain sectors, such as private equity and commercial real estate, whose business

models are heavily dependent upon bank finance, have been significantly impacted by constraints on this funding over the past two years.

• Problems at certain banks clearly restricted credit supply during the recession. For example, HBOS’s market share of mortgages and charges registered with Companies House dropped from above 15% in 2007 to below 5% during the course of 2009, while some foreign lenders have exited the UK market altogether.

Figure 3.2 – UK company insolvencies

Source: Company liquidations in England and Wales, Insolvency Service.

0

5,000

10,000

15,000

20,000

25,000

30,000

1985 1988 1991 1994 1997 2000 2003 2006 2009

Figure 3.3 – Perceptions of access to finance – 2009 compared to 2007

Source: Continental Research (February 2010)Note: Not all companies responded to all questions

Q: Compared to this time in 2007, would you say it is now easier or harder for your business to obtain the following forms of finance?(Base = 219/308/161/131/95)

Invoice discounting

Equity finance

Unsecured loans

Overdrafts

Secured loans/mortgages

Very much harder 24 Very much easier3

22%

18%

31%

11%

15%

23%

26%

12%

19%

7%

45% 4% 4%

50% 4%2%

50% 2% 6%

57% 10% 4%

67% 5% 6%


On balance, we find the demand-side arguments more persuasive in explaining reduced bank lending in 2009, although it seems likely that supply constraint also played a supplementary role, particularly for SMEs. However, even for SMEs, it is important to recognise that many business surveys tend to pick up sentiment and perceptions rather than reality, a point well demonstrated by a recent BIS survey on access to finance. This found that, while 31% of mid-sized companies perceived that it was now very much harder to access unsecured loans than in 2007 (see Figure 3.3), only around 15% had not been able to access the fiance they needed from any source (see Figure 3.4).

The undoubted supply shocks around the collapse of Lehmans and difficulties at HBOS clearly had serious short-term impacts, but the more recent stabilisation at HBOS and the bottoming out of the recession during the second half of 2009 has begun to restore the lending appetite of banks, albeit at a lower level than the over-exuberant levels prior to the crisis. This has been picked up in the Banks of England’s Q4 2009 Credit Conditions Survey.

3.2 – Bank lending and the recovery

So if weak demand has probably been the most significant driver of weak bank lending during the recession, what happens when demand returns during the recovery? At some point credit constraints may become a problem as demand for lending picks up, even if credit supply has not been a serious constraint on growth during the recession itself.

The latest PricewaterhouseCoopers Global CEO survey, published in January 2010, throws some light on this issue. While some other concerns ranked even higher, 13% of CEOs were still extremely concerned about a potential inability to finance growth and 35% were somewhat concerned (see Figure 3.5).

This concern is supported by evidence from insolvency statistics (as shown in Figure 3.2) that companies often find it harder to grow

out of recession than to survive the recession itself. This is because working capital needs shrink (so releasing funds)

during the recession, but expand as companies recover. So demand for working capital finance typically follows the stock

Figure 3.4 – Company experience of actual loan approvals or refusals

Source: BIS survey (February 2010)

Loan Overdraft

8% couldn’t obtained

Overall 15% couldn’t obtain finance from any source

25% couldn’t obtained

First Source• 38% had problems• 75% ultimately obtained

Second Source• 18% obtained

First Source• 75% ultimately obtained

Second Source• None tried

% weighted totalFigure 3.5 – Key risks perceived by global CEOs

Source: PwC survey (January 2010)

0 5 10 15 20 25 30 35 40 45 50 55 60 65 70

Exchange rate volatility

Over regulation

Macroeconomic imbalances(e.g. trade or fiscal)

Protracted global recession

Lack of stability in capital markets

Energy costs

Inability to finance costs

Availability of key skills

Financially stressed suppliers

Extremely concernedSomewhat concerned

-8

-6

-4

-2

0

2

4

2006 Q1 2007 Q1 2008 Q1 2009 Q1 2010 Q1 2011 Q1

Figure 3.6 – Stockbuilding and investment recovery profiles in PwC main scenarioQuarter-on-quarter % change

Source: ONS, PwC main scenarioChanges in inventories (% of GDP)Changes in investment


cycle and should increase markedly as stock levels bounce back from current low levels. We expect this process to be an important factor during the course of the current recovery. Demand for investment capital normally takes longer to recover, as surplus capacity reduces the need to invest, but could become a significant factor in 2011 in particular (see Figure 3.6).

The historical evidence suggests that as economies grow out of recession, bank lending takes some time to respond. For example, it was not until late 1994 when lending to firms and households picked up after the previous UK recession, as shown in Figure 3.7.

The requirement for bank funding will also depend on the nature of the recovery:

• An export-led recovery may not require additional credit if it involves switching domestic supply to international markets, but if the exporting manufacturing sectors are to expand (as our main scenario in Section 2 above assumes), then additional credit will be required.

• A services-led recovery would tend to involve lower lending requirements than a manufacturing-led recovery because a services-led upturn would depend less on re-stocking and capital investment. In practice, however, we assume both sectors will pick up gradually in 2010-11.

• A consumer-led recovery would require restored credit supply, as weak wage growth and continued relatively high levels of unemployment (compared to pre-recession levels) will tend to dampen down consumer expenditure growth. Given the stretched nature of household finances, we do not anticipate a substantial consumer-led recovery, as discussed further in Section 4 below. But demand for mortgage credit may pick up further and this could be somewhat constrained by supply for the next few years.

• A public spending-led recovery would not require private credit growth, but the size of the fiscal deficit rules this out as a credible option.

Overall, therefore, there may be some impact of credit constraints on the recovery as regards the working capital required to rebuild stock levels in 2010 and support export growth. In 2011, funding for capital investment could also face some credit constraints, although these should be easing somewhat by that time as the banking sector gradually returns to health. Generally, any such constraints will have their greatest impact on SMEs given their greater reliance on bank lending.

3.3 – Impact of bank regulation on the economy

A potentially distinctive feature of this recovery is the possibility of increased banking sector regulation, in contrast in particular to the financial deregulation of the 1980s recovery phase (the 1990s were more neutral in this respect). International banking regulators are currently busy proposing and evaluating a range of possible regulatory reforms. For example, the Basel committee has proposed a set of reforms to capital and liquidity requirements; the FSA is proposing ‘living wills’ to improve the robustness of banks’ subsidiaries and the orderliness in the case of wind down; the Bank of England is proposing a range of new macro-prudential tools; the Obama administration has proposed a levy on bank liabilities; and the G20 is proposing a global resolution fund – to name just a selection. It is beyond the scope of this article to describe or evaluate these possible banking

reforms in detail, but we can try to sketch out the possible economic impacts at a high level.

On the positive side, such reforms should produce a more resilient banking sector, which should have economic benefits in terms of a more stable growth path and a reduced risk of the large permanent output losses associated with severe financial crises such as the recent one, which have been variously estimated at around 4-10% of GDP in recent studies by the OECD, the National Institute for Economic and Social Research (NIESR), HM Treasury and the IMF. At the same time, history shows that such financial crises will always happen from time to time however much effort goes into addressing the regulatory shortcomings that led to the most recent crisis. Furthermore, badly designed regulatory reforms could even sow the seeds of the next crisis as some financiers seek to circumvent the new regulations with adverse unintended consequences in the longer term.

In designing and implementing these reforms, a balance will therefore need to be struck between a desire to increase financial resilience and stability and the need to leave banks healthy enough to support future economic growth. We do not know yet where this balance will be struck, but it seems likely that banks will need to hold more capital and liquid assets and that bank profitability and equity returns will probably reduce as a result relative to pre-crisis levels. Because these reform

-10

-5

0

5

10

15

20

25

1990Q1

91Q1

92Q1

93Q1

94Q1

95Q1

96Q1

97Q1

98Q1

99Q1

00Q1

01Q1

02Q1

03Q1

04Q1

05Q1

06Q1

07Q1

08Q1

09Q1

Figure 3.7 – Bank lending to businesses and households and GDP, 1990-2008% change on a year earlier

Source: ONS, Bank of EnglandGDP y/yM4 lending to firms and households

4 See, for example, the speech by MPC member David Miles on ‘The Future Financial Landscape’, 16 December 2009.


changes will be carried out at an industry-wide level, economic theory would suggest that they will raise the whole industry cost curve and that all or most of the cost of additional regulation is therefore ultimately likely to feed through into higher prices for businesses and consumers. For example, JP Morgan recently published a research note suggesting that current regulatory reform proposals could add a margin to loan pricing of around 1.2% across a selection of global banks.

Determining the exact mix of responses that banks will make is impossible at this stage and will no doubt vary across banks and over time, but Table 3.2 summarises some of the possible responses that banks might make. It is also worth noting that, if bank loan rate spreads are raised, one mitigating factor could be a reduction in the Bank of England base rate needed to achieve a given inflation target4. Nonetheless, there are clearly some potential adverse economic impacts from tougher bank regulation that need to be taken into account when designing and implementing this new regime.

3.4 – Conclusions

We would draw three main conclusions from the analysis:

• Weak bank lending during 2009 was probably driven more by weak demand for lending than by lending supply shortages (although the latter may have played some role for SMEs in particular).

• There remains a risk that credit shortages could restrict the pace of recovery in the medium term, which is one reason why we project a relatively modest rate of growth in 2011 in our main scenario.

• Bank regulatory reform could impose significant costs on loan rates. In a low interest rate environment pricing impacts will be concentrated in the medium term. These costs need to be balanced against the need to mitigate the risk of large permanent output losses from future financial crises.

Source: ONS, Bank of England

Table 3.2 – Possible bank responses to increased regulatory costs

Potential economic impact DescriptionPossible response

Increase loan pricing

Increases could be concentrated in areas where borrowers have fewer substitutes and areas where regulatory capital requirements are high (such as high LTV property loans and SME lending).

In an environment of low interest rates and where banks are seeking to increase deposit funding in place of wholesale sources, reducing deposit rates may not be an attractive option at present. But it could be more of an option in a few years time when base rates have returned to more normal levels.

Increased loan pricing will tend to dampen lending demand and reduce corporate investment. It could also reduce mortgage demand and so dampen house prices. Large companies may shift to corporate bond and equity markets, but smaller companies could be squeezed by higher bank lending costs due to the lack of alternatives.

Reduce deposit pricing

Reduced deposit pricing has an uncertain impact on the economy, because saving through banks may be discouraged, but this could shift savings into other asset classes, such as equities. Certain demographic groups would be more affected – e.g. pensioners, who tend to have a lot of their financial assets in bank and building society accounts.

Reduced employment and other operating costs impacts the banking sector directly (e.g. employee wages) and the supply chains to the banking sector. Customers may have to adapt to a different way of consuming banking services (i.e. more use of online banking and less access to bank staff).

Reduce operating costs

Any job losses in banking as a result would have some impact on the economy although this should not be over-exaggerated in macroeconomic terms. The banking sector is the biggest customer of the IT services sector and the communications sector, which could be boosted to the extent that computerised systems are replacements for bank staff.

Sectors that are particularly at risk might include high-LTV property loans and SME lending, particularly if pricing cannot provide an adequate return.

Change business mix – moving out of low return or high capital requirement activities

Reduced supply of lending to high -LTV mortgages could impact housing markets (as high-LTV mortgage first time buyers tend to enable a housing chain of 2-3 further transactions).

If capital raising on the scale required is difficult, then lending could be constrained, or banks will seek other ways to reduce their balance sheets (e.g. sale of loan portfolios).

Reduce balance sheet and lending

Reduced lending would have a direct impact on business activity levels and consumer spending. Of the potential banking sector responses, this would be most damaging to the economy.

A key function of banks is maturity transformation – taking short term deposits and lending over longer terms. This naturally introduces risks, which are reflected in the regulatory regime. Shortening lending terms would reduce bank risk and regulatory capital requirements.

Reduce maturity of loans

A reduction in longer maturity lending could impact certain sectors (e.g. infrastructure) which rely on longer term finance. This could be of concern at a time when public funding for major infrastructure projects looks set to be constrained for many years to come given the need to reduce the budget deficit.


The most striking bit of news in the National Accounts for Q3 2009 was the fact that the household savings ratio rose to 8.6% in Q3 2009. This was up from its record low of -0.7% in Q1 2008 just prior to the start of the recession and actually now above its long-term historic average of 7.6% since comparable data began in 1963 (see Figure 4.1).

Is this dramatic rise in the household savings ratio an anomaly or a sign that the adjustment of household balance sheets is further advanced than realised, thus pointing to a rather healthier outlook for consumer spending going forward? To answer this question we need to:

• look in more detail at what has driven the rise in the savings ratio over the past year (Section 4.1);

• consider what lessons we can draw from trends in the savings ratio during the recovery phases of previous recessions during the last four decades, bearing in mind the similarities and differences between those past recessions and the current downturn in terms of trends in factors like earnings growth, employment and unemployment, house prices and financial wealth levels (Sections 4.2 and 4.3); and

• draw conclusions as to the likely strength of consumer spending growth over the next couple of years (Section 4.4).

4.1 – What has driven the recent rise in the household savings ratio?

The savings ratio is calculated by the ONS as the difference between available household ‘resources’ (post-tax disposable income plus an adjustment for the change in the net equity of households held in pension funds) and consumer spending, expressed as a proportion of available resources.

Table 4.1 shows how the key drivers of the ratio have moved over the year to Q3 2009, during which it increased from 0.9% to 8.6% (the change in the savings ratio being much more modest during the first six months of the recession). All year-on-year growth rates are measured in nominal terms, without adjusting for inflation (which averaged around 1.3% over this period based on the consumer expenditure deflator).

We can see that the rise in the savings ratio was driven primarily by a rise of 6.5% in household disposable income, rather than by a comparatively modest 2.7% fall in household expenditure over the year to Q3 2009 (less than the 3.5% fall in nominal GDP over the same period, which was driven to a significant degree by destocking and sharp cuts in capital spending). Even after adjusting for inflation, real household

4 – The savings enigma: is the UK consumer already on the mend?

0

2

4

6

8

10

12

14

Figure 4.1 – Household savings ratio

Source: ONS, (annual averages except for 2009 data for Q3)

% of household resources

Table 4.1 – Drivers of savings ratio rise between Q3 2008 and Q3 2009

Wages and salaries

Household share of gross operating profits

Pre-tax earnings

Income tax paid

National insurance contributions paid (by workers)

Post-tax earnings

Social security benefits

Post-tax earnings and benefits

Net property income received (interest, dividends, rent etc)

Net current transfers (other than social security benefits)

Household disposable income

Change in net equity of households in pension funds

Available household resources

Household expenditure

Memo: GDP at current market prices

Household income or spending category

-1.3

-10.3

-3.1

-8.4

-3.6

-1.1

+8.5

+2.0

+41.3

+7.1

+6.5

-16.7

+5.9

-2.7

-3.5

% nominal growthin year to Q3 2009

Source: ONS quarterly national accounts (22 December 2009)

1 The full quarterly national accounts for Q3 2009 were published on 22 December 2009 and include the latest available savings ratio estimates prior to finalisation of this report at the end of February 2010. Estimates for the savings ratio in Q4 will be published on 30 March 2010.


disposable income growth was 5.2% over the year to Q3 2009, which is around twice what might usually be expected based on trend GDP growth.

Why have household disposable incomes been so exceptionally strong during such a deep recession? It is not because pre-tax earnings have been strong because, as we can see from Table 4.1, these actually fell by 3.1% in the year to Q3 2009. Wages and salaries fell by 1.3% while the profits earned by the self-employed and small business owners fell by over 10%.

This fall in pre-tax earnings was offset in part by a marked fall in national insurance contributions (NICs) and, in particular, income tax payments (down 8.4%). This reflects the progressive, counter-cyclical nature of the tax system. But this is a temporary effect and will go into reverse gradually as the economy recovers and as higher rate income tax and NIC rates are raised from April 2011 to help bring the budget deficit back under control in the medium term (as has already been announced in the Budget and PBR).

Even after allowing for the cushioning effect of the tax system, however, there was still a 1.1% fall in post-tax earnings in the year

to Q3 2009. Had household disposable incomes fallen in line with post-tax earnings with the same consumer spending profile, the household savings ratio would only have edged up marginally from 0.9% in Q3 2008 to around 2% in Q3 2009. If this had been the case, then it would have still left a long way for the savings ratio to rise to return to long-term average levels of around 7-8%.

As Table 4.1 shows, however, household disposable income growth has been much stronger than post-tax earnings growth over the past year for two main reasons:

• as would be expected during a recession, social security benefits paid to households rose strongly by 8.5%, adding to the ‘automatic stabiliser’ effect of the tax system; but these cyclical benefit rises (bolstered by some often time-limited favourable decisions on indexation of benefits such as the basic state pension) will be temporary in nature and future governments may indeed need to take action to rein in benefits spending after the next election as part of the wider deficit reduction strategy; and

• net property income2 rose very strongly by over 40% in the year to Q3 2009 due

both to the relative strength of dividend receipts and the low level of interest paid, although there are also some statistical oddities here in the precise way that interest payments and receipts are scored in the national accounts that may exaggerate this effect; the exceptionally rapid growth in net property income, as recorded in the national accounts, seems unlikely to persist for long, so this seems likely to dampen household disposable income growth somewhat over the next couple of years.

In summary, underlying trends in pre-tax earnings would not have suggested a significant rise in the household savings ratio, but this has been exaggerated by a number of special factors that seem likely to be largely temporary. Of course, as the recovery proceeds, one would also expect pre-tax earnings growth to resume, although probably not at a dramatic rate over the next year or two given that companies seem likely to remain cautious about hiring new workers and the public sector is likely to start cutting back on staff numbers as part of the deficit reduction strategy. Average earnings growth also seems likely to remain relatively subdued so long as there is a reasonable amount of slack in the labour market.

2 Net property income is a technical national accounting term referring to net income from all kinds of assets not just physical property. It therefore includes items like dividend receipts on equities.


4.2 – Will the household savings ratio rise further? Lessons from past recessions

If this analysis is correct and household disposable income growth is going to slow markedly going forward, then any further rise in the savings ratio would need to come from consumer spending rising less strongly than even this much weaker growth in disposable income. But should we actually expect any such trend?

There is no easy answer to this question but the experience of previous economic cycles can offer some guidance. Table 4.2 summarises some key points of comparison in relation to the timing and magnitude of savings ratio movements during the last three recessions.

If Q3 2009 turns out to be the trough in the level of GDP in the current recession3, this historical evidence might suggest that the savings ratio should already have reached its peak by now. This would leave the peak level of the savings ratio some way below previous peaks, although this might be defended on the basis that the pre-recession trough was much lower in the current cycle than in previous cycles. The absolute increase in the savings ratio (9.3 percentage points since Q1 2008) is actually already larger than the increase in previous recessions, so it might be argued that enough has already been done.

On the other hand, previous recessions saw GDP oscillate around its trough level for some time before moving decisively into its recovery phase and it could be that this will happen again (i.e. a U-shaped or W-shaped recession rather than a V-shaped one). In this case, the savings ratio could well still have further to rise before it peaks, or at least might remain at or around current levels for an extended period of time before falling back again.

Another important point to note here is that the rise in the savings ratio since early 2008 has been driven by reduced borrowing (particularly via mortgage equity withdrawal, which fell to record negative levels from mid-2008 as shown in Figure 4.2) rather than by increased financial asset accumulation.

The savings ratio is only likely to start to trend down again, excluding short-term volatility due to temporary factors, once borrowing picks up again, particularly for mortgages. This depends both on more confident consumers and more willing lenders. Higher house prices have helped

to generate a modest revival in mortgage borrowing recently, but the sustainability of this housing market revival remains to be proven.

4.3 – Key factors underlying prospects for the savings ratio and consumer spending

Another way to look at this is to consider prospects for the key factors such as earnings growth, employment and asset prices relative to past recessions. Broadly speaking, the current downturn has been characterised by:

-4

-2

0

2

4

6

8

10

Figure 4.2 – Housing equity withdrawal as % disposable income

3 GDP troughs for the previous three recessions are estimated to occur in Q3 1975, Q2 1981 and Q2 1992 based on latest ONS estimates for real GDP.

Table 4.2 – Comparison of behaviour of UK household savings ratio in past recessions

Peak household savings ratio

Timing of peak relative to GDP trough (quarters before/after)

Change in ratio in 2 years after GDP trough

Timing of return to ratio below historic average level (quarters)

Key indicators

12.2%

-1

-2.5%

+24

Early 1990srecession

13.9%*

-2

-4.0%

+19

Early 1980srecession

10.6%

-2

-2.4%

+6

Mid 1970srecession

*Excluding an apparently anomalous spike in the ratio to 14.1% in 1979 Q4Source: PwC analysis of ONS data

• more subdued average earnings growth than in previous cycles, which is expected to continue according to consensus forecasts of average earnings growth of only 2.2% in 2010 and 2.8% in 2011; furthermore, higher taxes and national insurance contributions will mean that post-tax earnings growth is likely to be considerably slower than this, particularly from April 2011 when many of the pre-announced tax rises come into effect and bearing in mind the probable need for further tax increases over and above those already announced (as discussed in Box 2.1);

• a less marked fall in employment and a smaller rise in unemployment than in past recessions, perhaps reflecting the greater flexibility of the labour market; this has been a positive so far for consumer spending, although it remains possible that this will mean that employment has less far to bounce back when the economy recovers than was the case in past cycles, which will dampen disposable income growth and so consumer spending;

• house prices have bounced back earlier than in the early 1990s recession, which may have supported consumer confidence and spending to some degree over the past year; there are doubts as to how far this house price recovery will be sustained as the supply of houses for sale picks up to meet increased buyer demand and, looking to 2011 and beyond, as base rates and mortgage interest rates move back up again to normal levels; if house prices stall or start falling again, people may no longer see house price appreciation as ‘doing their saving for them’, so resulting in a rise in the savings ratio; and

• stock market prices have also recovered strongly during the last nine months of

2009, although this also tended to be the pattern in past recessions and may not have that large an impact on household spending and saving given that much of this equity price effect will be reflected via pension fund values that most households may have little awareness of in practice. Share prices also fell back in early 2010, although it is too early at the time of writing to assess whether this will be a blip or a more sustained correction.

4.4 – Conclusions: implications for consumer spending growth

Our key conclusion is that the rise in the savings ratio has been driven to a significant degree by temporary factors boosting measured household disposable income growth well above post-tax earnings growth over the past year. Over the next year, our main scenario is that real disposable income growth will be negative as these temporary factors are reversed, with only a very modest recovery in 2011 (see Figure 4.3). This is likely to imply a fall in the headline household savings ratio in 2010 and

possibly also 2011, even if the underlying ratio is stable or rising.

There have been some more positive influences on consumer spending in relation to recent trends in asset prices and employment, which have been generally more favourable than in previous recessions. However, it is not guaranteed that these positive trends will continue and there are likely to be significant adverse headwinds from subdued earnings growth and the expected fiscal squeeze following the general election.

In summary, while the worst of the fever may be over for UK consumers, it will be some time before they are fully back on their feet. The recovery process is likely to be slow and uneven, with our main scenario being for consumer spending to lag behind GDP growth in 2010-11 (as shown in Figure 4.3). In these circumstances, policymakers will have to be careful not to take the patient off medication too quickly and risk a major economic relapse. Given the clear need to tighten fiscal policy in the medium term, this suggests that monetary policy may need to remain relatively loose throughout the next few years.

-6

-5

-4

-3

-2

-1

0

1

2

3

4

5

Consumer spending Household disposable incomeGDP

2008 2009 2010 2011

Figure 4.3 – Relative real growth in GDP, consumer spending and household disposable income% real growth



1 Average growth would be significantly higher using GDP at purchasing power parity (PPP) exchange rates, which give much greater weight to the relatively rapidly growing emerging markets such as China and India. On this alternative basis, the IMF estimates world GDP growth to have been 5.2% in 2007, 3% in 2008 and -0.8% in 2009 and forecasts growth of around 3.9% in 2010 in PPP terms (as compared to 3% at market exchange rates). However, from the perspective of assessing the current size and short-term growth potential of global markets for Western companies operating in hard currencies, GDP growth using market exchange rate weights is more immediately relevant. PPP rates are more relevant as a guide to longer term trends.

This appendix reviews recent developments and assesses short-term prospects for the major global economies other than the UK. We consider first the overall global scene, and then look in turn at North America, Europe, the Asia Pacific region and Latin America (see Table A.1 for a summary of recent and projected growth and inflation for the countries covered). To give an overview of the importance of each economy in the global market, its estimated share of total world GDP in 2008 (at average market exchange rates) is also shown in the table.

Global Overview

Global economic growth in 2004-7 was generally above its long-term trend of around 3.2% per annum (using market exchange rate weights) , but then fell sharply in 2008 and early 2009 (see Figure A.1) as a result of the global financial crisis and an associated very sharp drop in world trade.

The global economy has emerged from recession since mid-2009, however, with emerging economies tending to outpace the main advanced economies by a significant margin. China and India in particular continued to grow at a robust pace in 2009 and should accelerate further in 2010. Indeed, China is expected to account for a larger share of the increase in global GDP this year than the US despite the fact that China’s economy is still much smaller when measured at current market exchange rates.

The recovery of the developed economies is progressing slowly and this has required interest rates there to be kept very low. Additional steps, such as quantitative easing, have also been taken to increase liquidity. Some of these large sums of money pumped into the global economy by central banks have found their way to emerging markets in search of higher returns. Emerging market assets, such as

Appendix A – Global Economic Outlook

Table A.1 – Global economic prospects

Source: National statistical offices or IMF for 2008 data; PricewaterhouseCoopers main scenario for 2009-10; IMF for GDP shares (at market exchange rates) in 2008.

Country Share ofWorld GDP

(%:2008)

23.1

2.5

6.2

4.5

4.8

3.9

2.7

1.5

7.8

6.8

2.0

1.7

1.5

2.9

1.3

0.9

0.4

0.3

2.7

1.8

0.5

2008

0.4

0.6

1.3

0.5

0.4

-1.0

0.9

2.0

-0.7

9.0

7.5

2.3

2.2

5.6

0.9

5.0

2.5

0.6

5.1

1.4

6.8

GDP growth (%)

-2.5

-2.5

-5.0

-5.0

-2.2

-4.9

-3.6

-4.1

-5.4

8.5

7.0

0.9

0.2

-7.9

-6.0

1.4

-4.2

-6.6

-0.2

-6.5

-2.6

2010

2.6

2.6

1.6

1.0

1.3

0.8

-0.5

1.3

1.2

9.6

7.7

2.8

4.8

4.1

3.7

2.3

1.5

-0.4

5.4

3.2

3.3

2008

3.8

2.4

2.8

3.6

3.2

3.5

4.1

2.2

1.4

5.9

9.1

4.4

4.7

14.1

10.4

4.2

6.3

6.0

6.1

5.1

8.6

Consumer price inflation (%)

-0.3

0.3

0.2

2.2

0.1

0.8

-0.3

1.0

-1.3

-0.7

0.8

1.8

2.8

11.8

6.3

4.0

0.6

4.0

4.5

5.3

6.3

USA

Canada

Germany

UK

France

Italy

Spain

Netherlands

Japan

China

India

Australia

South Korea

Russia

Turkey

Poland

Czech Republic

Hungary

Brazil

Mexico

Argentina

201020092009

2.0

1.9

1.1

2.6

1.3

1.6

1.4

0.9

-0.9

2.6

3.9

2.4

2.7

7.3

7.8

2.6

1.7

3.6

4.5

4.8

8.7

-3

-2

-1

0

1

2

3

4

5

6

7

’10’08’06’04’02’00’98’96’94’92’90’88’86’84’82’80’78’76’74’721970*

Figure A.1 – World GDP growth

Source: World Bank up to 1997, IMF for 1998-2008 and PwC main scenario for 2009-10 (using market exchange rates to aggregate world GDP)

Long-run average = 3.2%

Forecast

Real growth (%)

stocks, therefore rose strongly in 2009, while the inflow of capital has pushed up the currencies of recipient countries.

The main exception is China, where capital controls have enabled the government to keep the exchange rate relatively stable at the cost of accumulating very large foreign exchange reserves that have added to domestic inflationary pressures and potential asset price bubbles within China.

Fiscal policy was loosened significantly throughout the world in 2009, with many major economies (although not the UK) continuing this fiscal stimulus into 2010. This has left large structural budget deficits in many countries, however, which will require a lengthy period of fiscal consolidation through tax rises and/or public spending cuts in the medium term. This will tend to retard the pace of recovery in economies such as the US and the UK in 2011 and beyond.

There were renewed increases in commodity prices (such as the price of oil, as shown in Figure A.2) as the world economy picked up during the course of 2009, which helped boost commodity exporters such as the Middle East, Brazil and Russia. This has pushed up headline inflation in commodity-importing economies such as the UK and Euroland, however, which could tend to dampen the pace of recovery in those countries.

Due to the combination of the US economy’s recent return to growth and the resilience of the Chinese economy, our main scenario projects that global GDP will expand by around 2.75% this year (at market exchange rates). This scenario assumes that credit constraints will gradually ease and that destocking will continue to reverse, while monetary and fiscal policy will remain generally supportive of growth in most major economies in 2010. Prospects are less clear for 2011 and beyond at this stage, depending on whether private sector recoveries can maintain their momentum in the face of expected fiscal and monetary tightening.

Growth prospects for the main world regions in our main scenario are summarised in Figure A.3, confirming that the Asia-Pacific region, led by China and India, is expected to lead the global recovery this year. We discuss these projections in more detail below, first considering North America and then looking in turn at Europe, Asia Pacific and Latin America.

North America

The US economy grew at its fastest rate in over six years during the fourth quarter of 2009. GDP increased by an annualised rate of 5.9% compared to 2.2% in the previous quarter (see Figure A.4). An increase in consumer spending and business investment activity were the main drivers of growth,

which has raised hopes that a sustainable recovery is in progress. There was also a strong recovery in exports in the fourth quarter, outstripping growth of imports.

Recent unemployment data suggests a somewhat mixed picture regarding the health of the US labour market. On the one hand, the unemployment rate declined unexpectedly to 9.7% in January, after being around 10% since October 2009. But non-farm employment (which is estimated based on a business rather than a household survey) fell by 20,000 in January. Overall, it is too early to conclude that unemployment has peaked, with job insecurity remaining a good reason for people to save more and spend less for some time to come.

0

20

40

60

80

100

120

140

160

’09’07’05’03’01’99’97’95’93’91’89’87’85’83’811979*

Figure A.2 – Nominal oil price trends

Source: St. Louis Fed (monthly data)

West Texas Intermediate ($ per barrel)

-7

-5

-3

-1

1

3

5

7

Western EuropeNorth AmericaLatin AmericaEastern EuropeAsia Pacific

201020092008

Figure A.3 – Growth prospects for the main world regions

Source: PwC estimates and main scenario for 2009-10

Annual % growth


PricewaterhouseCoopers UK Economic Outlook March 2010 2930 PricewaterhouseCoopers UK Economic Outlook March 2010

Meanwhile US labour mobility is at an all time low, probably reflecting the fact that this recession has been on a national scale rather than being regionally concentrated. Furthermore a significant number of homeowners are estimated to be in negative equity, which makes it more difficult for them to move.

The latest Purchasing Managers’ Index (PMI) of 58.4 in January for the manufacturing sector suggests that output growth accelerated in early 2010. Increases were recorded in all of the key components of the index, including production, employment and new orders. Meanwhile the services PMI picked up more modestly to 50.5 in January, indicating a return to slightly positive growth in the non-manufacturing sector after two months of contraction.

In the light of the resurgence of the global economy, continuing monetary and fiscal stimulus and the positive data emerging from most forward-looking indicators, we project the US economy to grow by around 2.5% this year, but sustaining this growth in the longer term will be more difficult once interest rates start to rise again and fiscal policy has to be tightened to begin to address the large structural budget deficit.

The Canadian economy emerged out of recession during the third quarter of 2009, recording annualised growth of 0.4%. The relatively strong Canadian dollar has hampered exports together with the earlier weakness of US domestic demand, but the latter is now starting to turn around as noted above. Canadian domestic demand has been more resilient with retail sales generally following an upward trend during the second half of 2009 despite a small dip in November. Employment has been steadily rising with 43,000 more jobs being added in January. The increase in commodity prices and the resurgence of the US economy augers well for Canada and our main scenario is for reasonably strong growth of around 2.5% in 2010, similar to the US.

Europe

The recovery in Euroland2 weakened somewhat during the final three months of 2009 with the economy expanding by 0.1% quarter-on-quarter in Q4 after emerging from recession during the third quarter of 2009, when GDP grew by 0.4%. Sentiment has weakened further more recently as problems related to Greece’s soaring budget deficit have led to concerns about public finances in other Euroland economies such as Spain, Portugal, Ireland and potentially also Italy.

The speed of recovery in Euroland seems likely to be dampened by a combination of uncertainty related to these fiscal problems, a still relatively weak banking sector, rising unemployment and the end of government schemes such as those which aided car sales in 2009. In view of these factors, our main scenario is for Euroland GDP to grow by only a modest 1% in 2010 (see Table A.2), significantly less than the US. Relative inflexibility in Euroland labour markets may also constrain the pace of recovery in the longer term as will the need to tackle rising budget deficits in many European countries.

-8

-6

-4

-2

0

2

4

6

8

10

’09’08’07’06’05’04’03’02’01’00’991998*

Figure A.4 – US GDP growth

Source: BEA

% change from preceding period (annualised)

Table A.2 – Outlook for European GDP growth (%)

Source: Eurostat for 2008 data, PricewaterhouseCoopers main

scenario for 2009 and 2010.

Country/region 2008 PwC main scenario

2009 2010

1.3

0.4

-1.0

0.9

2.0

0.7

0.5

-0.2

1.8

0.6

5.0

2.5

0.6

-5.0

-2.2

-4.9

-3.6

-4.1

-4.0

-5.0

-4.5

-1.6

-4.0

0.4

-4.2

-6.6

1.6

1.3

0.8

-0.5

1.3

1.0

1.0

2.1

1.1

1.1

2.3

1.5

-0.4

Germany

France

Italy

Spain

Netherlands

Euroland

UK

Sweden

Switzerland

Western Europe

Poland

Czech Republic

Hungary

2 ‘Euroland’ consists of the 16 countries that are now using the euro: Belgium, Germany, Finland, Ireland, Greece, Spain, France, Italy, Luxembourg, the Netherlands, Austria, Portugal, Slovenia, Slovakia, Cyprus and Malta.

The average inflation rate in Euroland rose slightly to 1% in January compared to 0.9% in December, but this was largely due to commodity price effects. Underlying inflationary pressures remain subdued, which should allow the ECB to maintain a loose monetary policy for the majority of 2010. This should provide some support for growth, particularly if it is associated with a declining trend in the euro, which appeared relatively overvalued in 2008-9.

The German economy recorded zero growth in Q4 2009 after having expanded in the previous quarter, suggesting that the recovery in Europe’s largest economy might be stalling. The German national statistics office estimated that the economy contracted by 5% in 2009 as a whole, a post-1945 record decline. The end of Germany’s car scrappage and short-time working schemes seem to have dampened the pace of growth recently and consumer confidence has dipped in recent months. Unemployment in Germany is expected to increase in future periods as further labour market adjustments are more likely to come from redundancies than reductions in working hours. Overall, our main scenario is for German GDP to expand by around 1.5% in 2010, but this headline figure is boosted by base effects relating to the sharp turnaround in GDP between the first and third quarters of 2009. Certainly risks appear to be weighted to the downside, with the latest data raising concerns about a possible double dip recession in Germany.

The French economy grew by 0.6% quarter-on-quarter in Q4 2009 following growth of 0.2% in the previous quarter. Despite the combination of rising unemployment and apparently subdued consumer confidence according to survey results, French consumer spending grew by 0.9% in Q4 2009, the seventh consecutive quarterly expansion. Going forward, however, consumer spending may weaken if conditions in the labour market deteriorate. Our main scenario is therefore for the French economy to grow by around 1.3% in 2010.

Preliminary estimates for Q4 2009 suggest that the Italian economy contracted by 0.2% quarter-on-quarter, after coming out of recession in the third quarter when

GDP grew by 0.6%. Continued high public debt levels and relatively high inflation (by Euroland standards) are negative factors for Italy and our main scenario is therefore for only modest growth of around 1% in 2010.

Spain is the only large Euroland economy to have remained in recession throughout 2009, although the pace of contraction eased with GDP contracting by 0.1% in Q4 relative to Q3, when it fell by 0.3%. Consumer spending and exports were the main contributors to growth in the fourth quarter, but this was more than offset by the increase in imports and declining investment activity. Contractions in the tourism and construction sectors have helped to push Spanish unemployment towards 20%, the highest rate in Euroland, and there are also now concerns about its fiscal position as a knock-on effect from the Greek crisis. All of these factors suggest that the Spanish economic recovery will continue to lag behind those in Germany and France, with our main scenario being for a further decline in Spanish GDP of around 0.5% in 2010.

The economies of Central Europe have been severely hit by the effects of the global financial crisis and the subsequent ‘flight to safety’ of international capital. Indeed the region is estimated to have contracted by around 6% on average in 2009. But within Central Europe, the picture has been very varied, with Poland being the only EU country to register positive economic growth in 2009 whilst the three

Baltic States have all suffered severe double digit contractions.

The recovery in Central Europe is expected to continue during 2010 albeit at a gradual pace with the region lagging other emerging areas such as Asia Pacific. Boosted by the global economic recovery and improving commodity prices, the Russian economy is expected to grow by around 4% this year, however, while Poland should also see reasonable growth of around 2-2.5%.

Asia Pacific

The recovery in the Japanese economy continued in Q4 2009 at a more rapid rate than in the third quarter (see Figure A.5). Economic growth has been reliant on overseas demand, which has been particularly strong in East Asia, and on state subsidy schemes to support consumer spending. However, concerns remain over whether the recovery is sustainable, particularly as Japanese domestic demand remains weak.

Core inflation, which excludes more volatile components such as energy and food, fell by 1.2% in the year to December, indicating continued weak demand and deflationary risks. Our main scenario is therefore for the Japanese economy to grow only modestly by just over 1% this year.

China’s economy finished 2009 strongly, with GDP growth accelerating to 10.7% in the year to the fourth quarter. Fixed

-14

-12

-10-8

-6

-4

-2

0

2

4

6

8

2009Q1

2008Q1

2007Q1

2006Q1

2005Q1

2004Q1

2003Q1

2002Q1

2001Q1

Figure A.5 – Japanese GDP growth

Source: Japanese Cabinet Office

% change from preceding period (annualised)



investment growth was very strong at around 30% in 2009, driven in large part by the massive government stimulus package directed towards the domestic economy.

By contrast, the external sector acted as a drag on the Chinese economy in 2009, with exports falling by more than imports and the trade surplus shrinking. However, exports appear to have bottomed out towards the end of 2009, which will further support growth going into 2010, which we project to be close to 10% in our main scenario.

In 2009 as a whole, the Chinese consumer price index fell by 0.7%, but inflationary fears have started to grow more recently due to the strength of the recovery. This has already led to some moves by the Chinese authorities to tighten bank credit growth and further such monetary and fiscal tightening is likely in 2010 as the focus of policy switches from promoting growth to preventing overheating.

The Indian economy grew solidly through 2009, with GDP up by an estimated 7% in the year as a whole and gathering pace later in the year. Both manufacturing and services sector output were up by around 9% in the year to Q3 2009, although agricultural output has been much weaker as a result of the 2009 drought, which is expected to affect winter crops. Our main scenario is for growth of 7.7% in 2010.

Inflation risks are looming, however, due to higher energy prices and stronger domestic demand. The wholesale price index (WPI), widely used to track inflation in India because it includes a broader basket of commodities than the consumer price index, has started to accelerate again to 7.3% in the year to December 2009, up from 4.3% in November. At its meeting on 29 January 2010, the Indian central bank responded by hiking the cash reserve ratio by 75 basis points to 5.75% to ‘help anchor inflationary

expectations’ while continuing to support the recovery process.

Despite these inflationary concerns, China and India are expected to continue to lead the global recovery in 2010-11, reinforcing the longer term shift in the global economic centre of gravity towards these two emerging giants.

Australian economic growth continued for the third consecutive quarter in Q3 2009 and Australian unemployment falling to 5.3% in January underlined the fact that the Australian economy is recovering relatively well, helped by robust commodity demand from China and other Asian economies. The Reserve Bank of Australia (RBA) kept its official cash rate (OCR) at 3.75% when it held its latest monetary policy meeting in early February 2010 after raising the OCR by 25 basis points in each of the last three months of 2009. The RBA halted its monetary tightening because it believes that inflation may now be on course to meet the official target of 2-3%. In our main scenario we project the Australian economy to expand by around 2.8% in 2010 with inflation remaining under control at an average of 2.4%.

Latin America

Although the Latin American economies experienced negative growth in 2009 as a whole, the region has come out of the current crisis better than in previous downturns. In general, those economies with a greater focus on exporting to relatively buoyant Asian markets have experienced an earlier recovery than those such as Mexico with closer ties to the US.

The Brazilian economy held up relatively well following the financial crisis, experiencing only a relatively brief recession. GDP growth

returned to positive territory in Q2 and Q3 2009, with investment activity being the main driver behind economic growth, followed by private consumption. Commodity exports to China and other Asian markets have also recovered strongly since Q2 2009. After being relatively flat in 2009 as a whole, we expect Brazilian GDP growth to resume in 2010 at a relatively strong rate.

Argentina has suffered more than Brazil, but the pace of contraction slowed significantly in the third quarter of 2009. The Argentine agriculture sector is expected to recover this year after having suffered prolonged strikes and drought like conditions in 2009 and an improving outlook for exports to countries such as Brazil and China should provide a boost to Argentina’s industrial sector looking ahead. Nonetheless, we would expect a more modest recovery in 2010 in Argentina than in Brazil.

The Mexican economy suffered a much deeper recession, with a contraction by around 6.5% in 2009. Indeed the depth of the decline in GDP last year was even more severe than the one which Mexico experienced in 1994, following a domestic financial crisis. Exports of goods to the US were hit by the recession there, while the combination of swine flu and much published drug violence hit the Mexican tourism industry particularly hard in addition to the general impact of the global recession. Remittances from Mexicans working in the US were also down, as was revenue from oil relative to 2008. Nevertheless the pace of economic contraction eased during the second half of 2009 and, with the US expected to record reasonably strong growth this year, the projections for Mexico have also improved significantly with the economy expected to grow by around 3% in 2010, albeit from a very low base in 2009.


Appendix B – UK economic trends: 1979 - 2009

UK Economic Outlook is produced three times a year by macroeconomists at PricewaterhouseCoopers (PwC). For more information about the technical contentof this report please contact: John Hawksworth ([email protected]).

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