eInsight, Economics Update Bulletin, October 09' __________________________
In This Issue »
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Welcome __________________ |
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Over the course of the recession the UK has seen its balance of trade deficit fall - that is, the gap between what the UK imports and what it exports has been declining. This is directly linked to the recession through a number of mechanisms.
Firstly, the fall in the value of sterling has made foreign goods sold in the UK more expensive from the perspective of UK consumers. As such individuals have shifted their consumption towards UK-produced goods and services.
Secondly, the fall in GDP in the UK has been greater than the average fall in GDP in the UK's trading partners. As such, UK demand for foreign goods has declined quicker than foreign demand for UK goods - meaning that the gap between what the UK imports and exports has been shrinking.
The growing imbalance in the UK in terms of production and consumption, summarised by the trade deficit, has been an ongoing economic concern for the last 10 years. Indeed, on a global stage trade imbalances were a root cause of the credit crunch and recession. This is because the build-up of savings in the trade surplus countries (e.g China, Japan, Germany and the Middle East) provided the money which was to become the cheap credit that drove the asset price and lending bubble in the deficit countries (e.g. US and UK).
It is interesting that one of the effects of the recession has been to reduce this imbalance and therefore improve the UK's current account. More than this though, the correction of trade imbalances on a global scale is required to address the underlying root causes of the global crisis.
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At the peak of the financial crisis, the divergence of LIBOR and Base Rate was cited as a major symptom of the freezing up of credit.
In November 2008 the gap between LIBOR and Base Rate peaked at 2.5 per cent. Since then it has been declining and now stands at 0.08 per cent - some way below the historic average. So, if the gap between LIBOR and Base Rate is an indicator of the health of the financial system, why do credit conditions remain so tight?
Firstly, the gap between the two rates is an incomplete measure. The ratio between the two measures is also very important. For example, at present interest rates are so low that the gap is bound to be below historic levels. The ratio of the two rates, at 1.16, remains above the historic average however.
Secondly, the importance of LIBOR as a financial indicator has faded, and issues of capital availability, liquidity and funding sources now dominate lending decisions. Although lenders want to lend - demonstrated by the low LIBOR - there is a scarcity of available funds. This is because the securitization and covered-bond markets remain closed - banks are unable to raise capital by selling-on loans.
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Whilst the Base Rate remains at an all-time low of 0.5 per cent, average mortgage interest rates continue to be stubbornly high. The gap that has opened up between average tracker and SVR rates over Base Rate - at around 3.4 per cent - is an historic high. Fixed rates have also spiked in recent months, with an average fixed rate now at 5.7 per cent. This is a truly exceptional margin over Base Rate.
The previous section discussed one of the reasons that rates are so high - there is simply not the available capital in the system with which to lend. Banks are under-capitalised and face a major task in rebuilding their balance sheets.
A second reason for the recent spike in rates is that banks are already anticipating future rises in Base Rate. Although there is little sign of interest rate rises for the rest of the year, once the recovery gains momentum rates must come up. Lenders do not want to be caught out by offering low fixed rates now that in two years time will be significantly less than Base Rate.
Interest rates on loans to corporates also remain elevated, although significantly below mortgage lending rates to individuals.
It remains to be seen whether banks will seek to maintain these huge margins over Base Rate going forwards. If they do, it could undermine the recovery as soon as it begins.
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The Government's Sustainable Investment Rule aimed to hold public sector debt (the total amount owed by the government to the private sector) at around 40 per cent, over the course of the economic cycle. The latest data shows debt to actually be 57 per cent of GDP and growing. Forecasts from the 2009 Budget show the debt level increasing to 80 per cent by 2014.
The UK debt level has grown due to the nationalisations of several major banks, in the process staving off the worst of the financial crisis. More recently, the Bank of England's programme of quantitative easing has been buying up vast quantities of government debt. This is effectively monetising public sector debt, converting it directly into new money that is immediately available for spending - not too far off from printing money to fund spending.
