HMG ACKNOWLEDGES UK ECONOMY ENTERING RECESSION

UNCLAS SECTION 01 OF 02 LONDON 002683

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TAGS: ECON EFIN ETRD EINV UK
SUBJECT: HMG ACKNOWLEDGES UK ECONOMY ENTERING RECESSION

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1. (SBU) Summary: This week, officials publicly acknowledged that
the UK is likely to be entering a recession. For months, prominent
public figures refused to mention the 'R' word, in favor of talking
up the underlying strength of the UK's economic position. However,
Mervyn King, Governor of the Bank of England, broke the silence and
explicitly acknowledged that the UK is likely to enter a recession.
His comment was soon echoed by PM Brown and supported by independent
forecasts. Such a bleak horizon has pushed sterling to a five-year
low against the dollar while equity prices continue to fall.
Despite a record public deficit, HMG has announced that it will
borrow more to invest in projects that will help stimulate the
economy. The opposition has accused PM Brown of presiding over a
decade of heavy borrowing and lax regulation which has aggravated
the impact of the credit crunch. End Summary.

Governor King Uses The 'R' Word As GDP Growth Turns Negative
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2. (SBU) The UK economy is likely to be entering a recession,
according to Mervyn King, Governor of the Bank of England, in his
gloomiest assessment of the UK outlook since becoming Governor in

2003. His comments were supported by confirmation that GDP growth
was negative 0.5 percent in the third quarter. King told business
executives that the credit crunch, combined with a fall in real
disposable incomes, poses the risk of a prolonged slowdown in
domestic demand. Additionally, the trauma of the banking crisis is
likely to damage business and consumer confidence. His comments
were echoed by the Prime Minister who said Britain's economic
downturn is likely to cause a recession. Lord Mandelson, the new
Business Secretary, acknowledged that it is now 'unavoidable' that
the UK economy will contract and added that many small and
medium-sized businesses might go bankrupt.


3. (SBU) Ernst & Young's ITEM Club agrees with recession
predictions. In its quarterly macroeconomic forecast, the Club says
it expects UK GDP to shrink by 1 percent next year, followed by a
modest recovery in 2010 with GDP growth of 1 percent. If the Club
is correct, 2009 will be the first full year of shrinking output
since the last recession in 1991, when output fell by 1.4 percent
over the year prior. The report also says that the credit crunch
will hit the economy hard even if wholesale markets reopen and
equity markets stabilize. It suggests that the downward momentum in
the housing market will be difficult to arrest and that it is
spreading to other sectors. While the recent government rescue
package may have pulled the economy back from a depression, the
report says the financial system remains in an enfeebled state.
(Note: The financial sector accounts for approximately 10 percent of
UK GDP and nearly 20 percent of tax receipts. End note.)


4. (SBU) NIESR, an influential UK think tank, agrees that the
country is on the brink of recession. It forecasts that the British
economy will suffer more than any other G7 country in 2009, with the
economy shrinking by 0.9 percent, consumer spending falling by 3.4
percent, business investment down 3.8 percent and private housing
investment 17.1 percent lower. Its forecast assumes that the Bank
of England will cut the Bank Rate to 4 percent in early 2009. NIESR
thinks that if the government's banking bail-out does not succeed,
the recession will be deeper and longer than currently anticipated.
The NIESR report also predicts that trend growth is now only 2.2-2.3
percent and said that this will have serious implications for HM
Treasury revenue forecasts in the Pre-Budget Report that is expected
in November.

Sterling At Five-Year Low On Recession Warnings
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5. (SBU) Following Mervyn King's statement, the pound fell to a
five-year low against the U.S. dollar. On October 22 sterling fell
five cents or 3 percent against the dollar and also declined versus
the euro, the lowest level since 2003. This was the steepest one
day decline in 16 years. Simon Derrick, Chief Currency Strategist
in London at Bank of New York Mellon Corp said "These are...moves
that come along once in a decade...King certainly acted as a
catalyst, but in fairness, risk aversion had been kicking around
long before that."

Public Finances To Support Economy
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6. (SBU) PM Brown told the House of Commons on October 20 that HMG
will increase borrowing to support the economy. Despite public
finances reaching a record deficit in the first six months of the
financial year (which begins in April),Brown said increased
borrowing is a viable option because of the strength of the UK's
economic indicators. HMG will support mortgage holders, small firms
and employees through "carefully targeted, rigorously worked through
investments." HMG will also bring forward construction projects on
schools and hospitals, the Chancellor told the Sunday Telegraph.

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7. (SBU) Spending plans will be formally announced in the
Chancellor's Pre-Budget Report. Speculation is rife that the
Chancellor will have to announce an amendment to HMG's sustainable
investment rule, implemented while Gordon Brown was Chancellor,
which limits national debt to 40 percent of GDP. The Chancellor
will also have to concede that the Treasury's economic forecast in
the March Budget was too optimistic.


8. (SBU) In public comments, Opposition leader David Cameron
accused the PM of aggravating the credit crunch by overseeing a
decade of heavy borrowing and lax regulation. He said the
government has presided over ten years of irresponsible capitalism
and that the 'complete and utter failure' of their economic record
is now clear. The Conservatives favor measures giving small
businesses the chance to defer value-added tax (VAT) bills for up to
six months to offset cash flow problems posed by tight credit
conditions. They also advocate cutting the payroll taxes for firms
with fewer than five employees by 1 percent.


9. (SBU) Comment: The UK's slide into recession was not unexpected.
The OECD predicted almost two months ago that the UK was the most
likely among G7 countries to experience such an economic downturn.
Sterling's plummeting value vis-`-vis major economies will
exacerbate pressures on exporters, who already have seen their
access to credit dry up. While accelerated spending plans will give
a shot-in-arm to the economy, no one expects any type of recovery
until the latter half of 2010.


LEBARON