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As the global economic meltdown continues to spread, it touches nearly every corner of the globe including the U.K. In fact, the U.K. economy is deteriorating faster than their Treasury forecast, sparking fears that things will slide even deeper into the red in the coming year. The outlook is so troublesome, the Treasury has joined ranks with the Bank of England to discuss how to manage both monetary and fiscal policy in the event that the Bank’s benchmark rate falls to zero.
As early as May 2008, economists were sounding the alarm that the U.K. economy could slow sharply throughout the year based on first quarter figures that showed growth had fallen to its slowest pace since 2005. First quarter gains of 0.5% were primarily due to robust consumer spending, but it was widely believed that weaker spending would follow as consumers got hit with falling house prices, high inflation and a slowing of public spending.
Predictions were accurate and in early December, the UK’s National Institute for Economic and Social Research reported that in the last quarter of 2008, the U.K. economy was headed for the fastest-paced contraction in 18 years. When word spread that the government was facing a huge budget deficit, currency traders started dumping British currency. The value of the pound plunged to an all-time low of 88 pence against the euro. It was also the weakest level on record versus the currencies of its main trading partners.
Consumer Debt
The troubling credit markets seems to have hit the UK harder than other European countries, mainly because the financial sector accounts for a bigger part of the UK economy.
Consumers had been on such an extended spending spree with credit cards in hand, for two years running the U.K personal debt was at a higher level than GDP, meaning the country would have to dip into the proceeds from next year's GDP in order to pay off all its outstanding personal debt still owed in January 2009.
The total outstanding U.K. consumer debt accumulated through mortgages, loans and credit cards increased by 7.3% to £1,444 billion over the past year, up from £1,346 billion in June 2007. Furthermore, personal debt, which increased by 5.1% in nominal terms over the past year, currently stands at £1,410 billion.
Lending Still Frozen
In an effort to spur lending, the Bank of England cut key rates by 1.5% in November, and in December, a further cut saw rates down to two per cent, the deepest cut since 1939 when Britain and Europe were heading off to World War II. But when rate cuts—which generally encourage investors to switch to other currencies that have a higher rate of return—failed to halt a slide into a recession, Prime Minister Gordon Brown pledged a bank-rescue package that both granted government credit lines and set aside £50 billion ($74 billion) to boost capital reserves at eight financial institutions. In tandem, the Bank of England extended a £200 billion Special Liquidity Scheme until next year.
Back in October, the Treasury had agreed to a £250 billion ($300 billion) credit line to be offered to banks in addition to the central bank’s support. Pumping billions of pounds into their economy was intended to not just stabilize the British banking system—which was in dire straits because of its exposure to U.S. sub-prime mortgages and the U.K.’s own bursting housing bubble—but to also unfreeze the lending market.
Under the bank rescue program, banks can sell government bonds paying the Treasury interest of a half percentage point a year plus a fee based on the average cost of five-year credit-default swaps and an additional charge for sales in currencies other than British pounds. The Plan Stalls
But now the rescue plan is running into problems because, as with the U.S. banking industry, U.K. banks are resisting pressure to lend more and are hunkered down to survive what is expected to be a long and damaging recession. Instead of lending, they are focusing on rebuilding their own balance sheets that were hit by the global financial crisis, as well as by their own mortgage crisis in which housing sales are down to 1978 levels.
The plan was supposed to give banks enough capital to stay liquid while they wrote down their toxic assets—the defaulted mortgage loans. But it was also contingent upon the banks setting aside more capital as a cushion against future losses. It wasn’t enough cash to motivate them to lend, and according to Britain’s bank executives who are defending the positions during the lending freeze, they are making fewer home loans partly because of a decline in property prices.
Some analysts believe the plan was flawed from the outset. When you break down the plan’s objectives, they appear to be conflicting. On one hand, it tried to force banks to reduce risks and return to profitability so they could repay the government loans, but on the other, it put pressure on banks to lend more and take on more risk. In other words, it was a tug of war, with each side canceling the other out.
The second flaw was that nobody was able to set a value on the toxic assets or assess the associated risks.
Now Brown is working on a second stage of the banking rescue plan Brown also promised a £20 billion stimulus package, the biggest in two decades, and reduced sales tax to encourage consumer spending.
GDP Down/ Loan Guarantees Up
Gross domestic product fell 1 percent from September through November and could worsen by year-end. It’s nearly as bad as the third quarter of 1990, when the GDP contracted 1.2 percent. The figures reflect a deteriorating rate of output, which has caused October unemployment claims to rise at the fastest pace since 1992.
The Office for National Statistics will not report the final quarter's GDP until January. If reports show a decline for the three months through December, then the UK will officially be declared in recession under the generally accepted definition.
Meanwhile, Alistair Darling, the Chancellor of the Exchequer, is considering an unprecedented move--offering credit guarantees to households and companies as a way to stimulate bank lending. Under this plan, the government would directly underwrite commercial, as well household loans. The intention is to reduce bank concerns over lending losses, but it would also increase the risks for taxpayers. As of December, £37 billion had already been allocated to buy stakes in HBOS Plc, Royal Bank of Scotland Group Plc and Lloyds TSB Group Plc.
Another plan on the table is for the government to pool all the bank’s toxic assets and off-load them onto a separate entity, a so-called “bad bank.” That would potentially free up bank’s balance sheets with the hope of recouping some of the investments later. Good for the banks, not so good for the taxpayers who would once again end up holding the bag of bad debts.
Thinking Positively
Some experts believe the interventions by the Government and the Bank, as well as the actions of certain British companies will eventually work to get the economy turned around.
While it’s difficult to be overly optimistic, there are a number of interventionist policy actions in the works. Interest rate cuts and fiscal and banking actions could eventually work their way into the economy and gradually lead to a recovery, or at least stabilize the financial crisis.
However, no one will dispute the fact that things will get worse before they get better. But most, like Bank of England Monetary Policy Committee member Kate Barker, feel that signs of recovery will likely emerge near the end of 2009. |
