SQUEEZED IN THE JAWS OF THE CREDIT CRUNCH -- UK ECONOMY

UNCLAS SECTION 01 OF 03 LONDON 001921

SENSITIVE
SIPDIS

E.O. 12958: N/A
TAGS: ECON EFIN ETRD UK EINV
SUBJECT: SQUEEZED IN THE JAWS OF THE CREDIT CRUNCH -- UK ECONOMY
QUARTERLY UPDATE

LONDON 00001921 001.2 OF 003



1. (SBU) Summary: The British economy will slow dramatically in 2008
and 2009 after leading the G7 with GDP growth of three percent in

2007. Ernst and Young predict GDP growth to fall to only 1.5 percent
in 2008, the OECD forecasts 1.8 percent, and Oxford Economics says
1.6 percent. Inflation is running above the Bank of England's target
of two percent at 3.8 percent, and demands from unions for higher
wages could push it even higher. The employment rate remains fairly
stable although there are signs that it may weaken. Ernst and Young
predicts the Bank of England will cut interest rates again in
November, but any future cuts will depend on inflation. Public
finances are in their worst state since 1993. The weakening economy
is weighing heavily on PM Brown's reputation as an astute manager of
the economy. HMG may be forced to modify fiscal rules he established
as Chancellor of the Exchequer and the new Chancellor, Alistair
Darling, may be made a scapegoat for economic woes in a fall cabinet
re-shuffle. This is the first of quarterly reports on the British
macroeconomic situation. End summary.

Gross Domestic Product
--------------


2. (U) In its quarterly economic forecast, the Ernst and Young ITEM
Club forecasts UK GDP growth to fall to one percent in 2009 as the
economy 'flirts with recession'. The forecast says the UK economy
is in danger of 'being crushed between the jaws of world credit and
commodity markets, with little prospect of early relief'. Oxford
Economics, a consultancy firm, is more optimistic. It forecasts UK
growth at 1.6 percent in 2008 and 1.6 percent in 2009. It has
revised down its previous estimates of 1.8 percent and 1.7 percent
respectively.


3. (SBU) HM Treasury (HMT) expected the financial markets to recover
more quickly when they announced their annual economic growth
forecasts in their March 2008 budget report, according to Chris
Kelly, Senior Economic Advisor at HMT. At that time, Darling
predicted the UK's economy would grow between 1.75 and 2.25 percent
in 2008 and recover in 2009. Since then, Darling as admitted that
his forecast will be revised downward.

4.(U) GDP rose by 0.3 percent in the first quarter of 2008, and is
2.3 percent higher than Q107. Output of the production industries
fell by 0.2 percent, compared with a rise of 0.2 percent in the
previous quarter. While manufacturing output saw growth of 0.4
percent, it was more than offset by falls in energy extraction and
supply. Growth in the services sector was 0.3 percent, down from
0.6 percent growth in the previous quarter. Household expenditure
rose 1.1 percent, up from 0.4 percent in Q407. Government final
consumption expenditure rose by 0.9 percent.

Figures show real quarterly growth and are seasonally adjusted

--------------
Q107 Q207 Q307 Q407 Q108

GDP 0.8 0.9 0.6 0.6 0.3
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Inflation Above Targets
--------------


5. (U) ITEM expects CPI to remain above the Bank of England's target
range of 1-3 percent for the next 12 months. It predicts that
inflation will average 3.5 percent in 2008, coming down to 3 percent
in 2009 and 2 percent by 2010. It notes that this forecast assumes
that wage and domestic cost inflation remain subdued. In the UK
there is currently a significant push for higher wages to offset
price increases. This pressure is particularly acute in the public
sector where pay increases have been held below those in the private
sector and below the cost of living for two years. Chancellor
Darling has called for pay constraint but unions are threatening a
season of industrial action if pay deals are not reopened. ITEM
urged the government not to accept any excessive public sector pay
demands which could put severe pressure on any attempts to dampen
inflation and potentially destroy any hopes of a medium term
recovery.


6. (U) During the first quarter of 2008, the largest upward pressure
on inflation came from food, mainly meat, vegetables, and
non-alcoholic beverages, and fuel, particularly heating oil.
Despite growth in the CPI, however, the UK inflation rate is below
the provisional figure of 4 percent for the European Union as a
whole. The main factors affecting the CPI also affected the RPI.
However, the Retail Price Index experienced a downward contribution
from housing. This came mainly from mortgage interest payments as
lenders passed on April's quarter point decrease in the bank rate to
customers, in addition to house price depreciation.


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(Annual inflation rates - 12 month percentage change)

--------------
Jan08 Feb08 Mar08 Apr08 May08 Jun08

CPI 2.2 2.5 2.5 3.0 3.3 3.8

RPI 4.1 4.1 3.8 4.0 4.3 4.6

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Employment Stable
--------------


7. (U) Overall employment and unemployment figures have remained
fairly stable, despite volatility in the economy. The total number
of people in work rose in the three months to May to an all time
high of 29.59 million. However, the number of people in the UK
claiming unemployment benefit saw the biggest jump in 16 years. The
claimant count has risen by 45,000 since the end of January 2007, to
2.6 percent of the working age population. Job losses are most
prominent in the building and financial sectors.


8. (U) Professor David Blanchflower, a member of the Bank of
England's Monetary Policy Committee who has voted for interest rate
cuts for the last nine months, has predicted that the UK is heading
for a recession which could cost hundreds of thousands of jobs. He
expects unemployment to rise from 5.2 percent to more than 7
percent. While ITEM is forecasting a rise in the overall numbers of
unemployed, it remains hopeful that it will only be a modest jump,
particularly in comparison with previous downturns. A major
contributory factor to the limited nature of this increase is that
poorer UK employment and economic prospects, combined with a weaker
exchange rate, is causing a reversal in migration flows. However,
it still anticipates that unemployment will rise from 1.6 million at
the end of 2007 to the 2 million mark by 2010.


Seasonally Adjusted (Percentage)

-------------- --
Q107 Q207 Q307 Q407 Q108

Employment 74.3 74.4 74.4 74.7 74.9

Unemployment 5.5 5.4 5.4 5.2 5.2
-------------- --

Interest Rate, Pulled Both Ways, Doesn't Move
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9. (U) The Bank of England's Monetary Policy Committee (MPC) has
resisted calls to cut the interest rate as the economy continues to
falter. With inflationary expectations rising in line with headline
inflation figures, the MPC has felt unable to offer relief from a
lower base rate. However, ITEM expects a slowdown in consumer
spending to pave the way for a rate cut this winter, perhaps as
early as November. Beyond that, interest rate decisions will likely
be determined by the behavior of commodity prices. If crude oil
prices follow the expectations of the futures market and peak at
$150 a barrel this fall, before easing back, ITEM expects interest
rates to fall back to 4 percent by the end of 2009. This will help
to put a cushion under the level of demand in the economy and set
the scene for recovery in 2010.

-------------- --
Jan08 Feb08 Mar08 Apr08 May08 Jun08

Bank Rate 5.50 5.25 5.25 5.00 5.00 5.00
-------------- --

Public Finances Breaking the Rules
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10. (U) HMG's current budget deficit in May, at GBP 9.1 billion, was
the worst May figure since monthly records began in 1993, and the
second worst figure on record. Tax receipts in the first two months
of the fiscal year (which begins in April) were up only 3.6 percent
year on year, worse than the 4.8 percent forecast by the Chancellor
in his March Budget. The Chancellor has predicted public sector net
borrowing to reach GBP 43 billion at the end of the financial year,
but analysts believe he will exceed this target by a substantial
margin.


11. (U) There has been media speculation, widely regarded as
accurate, that Treasury officials have begun working privately on
plans to rework the fiscal rule, established by Gordon Brown as

LONDON 00001921 003.2 OF 003


Chancellor, that limits public sector debt to 40 percent of national
income. Following the rule changes, it is likely that public sector
debt could rise to 42-45 percent of GDP. At a Downing Street press
briefing, the Prime Minister's spokesman noted that according to the
IMF's latest estimates for 2008, the UK is in a stronger position
than most countries. Net debt in the Euro area as a percentage of
GDP is currently 55.9 percent and in the U.S. is 47.9 percent.

-------------- --------------
Apr08 May08 Jun08

Current Budget (Billions) 0.6 (9.1) (7.6)
(Deficit in brackets)

Public Sector Net Lending 0.5 (11.0) (9.2)
(Billions-Borrowing in brackets)

Public Sector Net Debt 36.5 37.2 38.3
(Percentage of GDP)
-------------- --------------


Chancellor to Pay the Price?
--------------


12. (SBU) Darling threatened to resign twice prior to publishing the
2008 HMT budget report, according to recent reports in the media.
One influential MP told us that a shake-up of Brown's cabinet is
very likely in the fall, confirming press reports. Darling could
likely lose the Chancellorship in any government re-shuffle, given
Brown's need to demonstrate a response to the growing public
perception of economic malaise in the UK. Darling has also been the
point person in multiple unpopular tax proposals that were later
revised or scrapped, including the non-dom tax changes, car taxes,
and most recently a tax on passive income for multinational firms.
The constant reversals have battered Darling's and the government's
reputations as responsible guardians of the British economy.