The Chancellor downgrades his forecast for the UK
economy, as the credit crunch impacts on the economy
It was crunch time for Alistair Darling as he stepped up to the
dispatch box. Not only was he faced with the challenge of
delivering his first Pre-Budget Report but also at a time when the
UK economy is faltering for the first time in well over a decade.
The Chancellor responded with eye-catching inheritance and
corporation tax cuts. But the significantly reduced growth
forecasts for the UK economy as a result of the credit crunch took
the shine off his performance.
The UK economy begins to stumble
The latest indications suggest that UK plc is heading for a
marked slowdown. HM Treasury now expects growth of only 2-2.5% in
2008, compared to 2.5-3% forecast in the last PBR. HMT is not alone
in their change of heart - almost all commentators have been
quietly downgrading their forecasts as the summer turmoil in global
credit markets take hold.
This is all very different to the position faced by his
predecessor, who presided over robust growth, low inflation and a
low interest rate economic fairytale. The economy expanded by a
healthy 2.8% in 2006 and a further 2.8% is estimated for 2007,
driven by a strong London based financial services sector.
As the economy slows in 2008, the new Chancellor will not be quite
so lucky. The Government pointed to the highest per capita growth
in GDP of any of the G7 nations, but downside risks are becoming
increasingly evident.
The credit squeeze bites
Concerns that UK banks have been caught up in the US sub-prime
credit crisis has led to a reassessment of risk across the board
leading to increasing credit spreads and sharp falls in equity
markets. Northern Rock in particular has been caught out by its
risky business model. This has shaken trust in the banking sector
which is now in danger of feeding through to consumer confidence
and the wider economy, as banks tighten their lending criteria and
mortgage terms become more expensive for riskier
groups.
Savings as a percentage of disposable income has increased markedly
in the second quarter of 2007, suggesting that consumers are
tightening their belts. And across the pond, US consumer spending
is in a sharp slowdown on the back of falling house prices, which
could have serious knock-on effects for the whole global
economy.
One would expect UK interest rates to be cut dramatically in such
circumstances. But inflationary concerns still dominate the Bank of
England's thinking - the Banks' priority is to maintain the
government's explicit inflation target of 2%. Inflation has fallen
sharply from its peak of 3.1% in March (which prompted an open
explanatory letter from the Bank to the Chancellor) to 1.8% in
August. But upside pressures remain. The continued expansion of
credit, food price inflation, the still resilient house market and
rising oil prices all feature on the list of worries.
The US federal reserve has already cut interest rates in an attempt
to stave off a full blown recession. But this has not yet been
followed in the UK. The coming months will show whether the Banks
decision to hold steady and not give a boost to the economy was the
correct one.
Borrowing levels increase significantly
The government has structured its fiscal policy around two
cherished rules. Both appear to be met. The first, the 'sustainable
investment' rule states that public sector net debt should be
maintained below 40% of GDP. In the last PBR the forecast for
2007/08 was 38.2%, rising to 38.5% by 2011/12. The forecast for
2011/12 in this PBR is slightly higher at 38.8% of GDP but
still below the cap. However, each year the figure seems to rise
ever so slightly, getting worryingly closer and closer to the
Government's maximum.
On the second rule, the 'golden' rule, the Government forecast an
aggregate surplus of £8 billion over the economic cycle at the time
of the last PBR. This year, that surplus has increased to £18
billion as the economic downturn is expected to be
short-lived.
Of most concern is the dramatic increase in borrowing at a time
when the economy appears to be slowing. Compared to the Budget in
March 2007, net borrowing figures are expected to be higher by £4
billion, £6.5 billion and £1.5 billion for 2007-8, 2008-9 and
2009-10 respectively. Turmoil in the financial markets, lower oil
revenues and one-off changes to corporation taxes being the key
reasons cited. The tax-GDP ratio is still forecast to rise from its
current level of 39.2% in 2007-08 to 40.0% by 2011-12, but this is
slightly better than the previous PBR 2006 forecast of 40.4% for
2011-12.
Challenges going forward
Going forward, the government's commitment to above inflation
increases in public spending gives Darling little room for
manoeuvre. The anticipated economic slowdown will feed into lower
tax receipts causing further pressure on the fiscal rules. It is
unlikely that the Chancellor will look to fund public spending
through general tax increases especially since a general election
looks to be on the horizon. So, he will have to hope that his
forecasts are correct.
The relatively benign economic environment enjoyed by the last
Chancellor, has been consigned to the history books. Independent
growth forecasts have been revised downwards, in part due to the
short term credit crisis, but also due to increasing inflationary
expectations. Given the Governments' spending pledges at the last
budget and a tax burden already close to 40%, the Chancellor will
find it possible to balance the books only if the current turmoil
is short-lived.