UK STILL IN RECESSION AND FACING SLOW, VOLATILE RECOVERY

UNCLAS SECTION 01 OF 03 LONDON 002427

SENSITIVE
SIPDIS

E.O. 12958: N/A
TAGS: ECON EFIN ETRD EINV UK
SUBJECT: UK STILL IN RECESSION AND FACING SLOW, VOLATILE RECOVERY

REF: London 2307 and London 2357

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1. (SBU) Summary: The UK economy is still in recession and faces a
slow, patchy recovery. According to official data released October
23, output in the third quarter was significantly weaker than
expected. Economists at Oxford Economics and Morgan Stanley expect
the UK to emerge from recession in the fourth quarter, in line with
Chancellor Darling's forecast that growth will return by the end of
the year, but have not ruled-out a "double-dip" recession. Weak
sterling may improve the prospects of an export-driven recovery.
Poor credit availability and mounting public debt pose significant
risks to recovery. While the Bank of England's quantitative easing
program could affect credit conditions, the Bank faces difficult
decisions about when to start unwinding its position. Unemployment
is set to stabilize next year, at a peak of approximately 9 percent.
Inflation is likely to remain below the Bank of England's two
percent target in the medium term. End summary.

UK Faces Bumpy Recovery
--------------


2. (SBU) The UK economy is still in recession, with a 0.4 percent
contraction of GDP in the third quarter, according to data released
by the Office for National Statistics on October 23. Output was
significantly weaker than expected, with many analysts previously
forecasting mild growth (of approximately 0.2 percent) which would
have kick-started the recovery. The UK has now had six consecutive
quarters of contracting output, the longest period of contraction
since quarterly records began in 1955. It has been one of the
global economic stragglers, with an emergence from the recession
only expected in the fourth quarter, according to Andrew Goodwin, a
consultant for Oxford Economics, a forecasting firm. During a
macroeconomic briefing, Goodwin said the UK remains a long way
behind most G7 countries, only performing better than Canada in the
second quarter. He blamed this on sluggish domestic demand as
consumers and businesses deleverage. Andrea Boltho, an Oxford
University professor, said "spring is in the air," but the UK will
not see a return to business as usual for a long time. He said it
would take approximately 12 quarters for UK GDP growth to return to
peak levels.


3. (SBU) Oxford Economics expects growth in the fourth quarter of
0.5 percent, slightly more pessimistic than Morgan Stanley's
forecast. Melanie Baker, Morgan Stanley's chief UK economist, told
us she expects 0.8 percent growth in the final quarter of 2009. She
forecasts strong end of year growth driven by money from HMG's car
scrappage scheme and increased consumer spending resulting from the
imminent reversal of the value-added tax (VAT) cut (in January 2010
VAT will return to 17.5 percent after a year at 15 percent). She
believes, however, 2010 will be a subpar year. Household savings
rates are likely to increase, with consumer spending slowing as
consumers deleverage. Business investment, likely to be low because
of spare capacity, will not be a driver of recovery.


4. (SBU) The exact shape of the recovery is unknown. Baker said
there is great uncertainty around all forecasts because of continued
uncertainty around the fiscal outlook. While most analysts expect
significant fiscal tightening following the election, the speed of
this tightening will depend largely on the governing political
party. She said people will remain concerned about the potential
for a "double-dip" or "W-shaped" recession through next year.
Echoing concern about a W-shaped recession, Goodwin said that while
growth could be boosted by inventory rebuilding through the
remainder of 2009, final demand may remain weak as banks and
households deleverage. This would result in sluggish growth through
2010 and 2011, despite an initial bounce-back in the second half of

2009.

Possible Export-Driven Recovery
--------------


5. (SBU) The UK's economic recovery is expected to be slow and
patchy, largely because it is difficult to detect a sustainable
driver of growth. Both Goodwin and Baker expect fiscal policy will
be limited in its ability to support economic recovery. There is no
money left, they say, for further fiscal stimulus, despite media
speculation that Chancellor Darling could announce further stimulus
in his pre-Budget report. Baker told us consumer spending also will
remain subdued, domestic business investment will likely be weak in
the near term, and the bulk of government spending has already
played through. While loose monetary policy may drive growth in the
near term, she said it is not a viable foundation for sustained
economic recovery. One possible driver, however, is exports. Baker
said exports are likely to be buoyed by sterling's weakness. The
weak pound will place the UK in good stead to benefit from eventual
growth in the eurozone. Her comments were echoed by Andy Scott,
Director of International and UK Operations for the Confederation of
British Industry (CBI). During an evidence session with the House

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of Commons Business, Innovation and Skills Committee, Scott said the
UK recovery will be supported by a strong export market. As the
UK's domestic market "evaporates," companies are increasingly
looking at overseas opportunities. Sterling's weakness, he said,
will improve their competitiveness.


6. (SBU) However, there is reason to remain skeptical about the
possibility of an export-driven recovery. Adam Marshall, Director
of Policy at the British Chambers of Commerce, told the Committee
that many companies have been driven to export markets looking for a
quick fix. He said that while established companies will benefit
from a weak sterling, companies new to exporting will find it more
difficult. Costs of establishing in a foreign market, particularly
the cost of foreign trade shows, will be heightened by the weak
sterling. Oxford University's Boltho was also skeptical about
relying on exports for recovery. He said Ireland, the UK's fourth
largest export market, is still suffering from problems in its
housing market, and is unlikely to be a large importer of UK goods
and services.

Credit Conditions Pose Risk to Recovery
--------------


7. (SBU) A lack of bank lending poses a serious risk to recovery,
according to Boltho. Prior to the crisis, he said, "banks would
lend any amount to anyone, now they won't lend anything to anyone -
regardless of how meritorious the project." Goodwin agreed credit
is still scarce for consumers and businesses. Lending hasn't
returned following its "spectacular collapse" in the second half of
2008 and first half of 2009 and lending is becoming more expensive
as banks increase their margins. Morgan Stanley's Baker disagreed
with their analysis. She told us that banks are showing signs of
willingness to increase credit availability and are improving credit
terms. She said demand for credit has not returned, particularly in
the large corporate sector, where companies have just started
raising funds in the capital markets. She acknowledged, though,
there is unmet demand for credit among small companies. She said
this problem requires a government solution and cannot be solved
through further loosening of monetary policy. (Note: HMG has put
significant pressure on British banks to lend. It set 2009 lending
targets for two partly nationalized banks, the Royal Bank of
Scotland (GBP 25 billion) and Lloyds Banking Group (GBP 14 billion)
in return for their participation in the asset protection scheme.
Chancellor Darling and Business Secretary Lord Mandelson have also
made public comments that banks should increase lending or HMG will
be forced to take further action.)


8. (SBU) All three analysts believed the Bank of England's
quantitative easing (QE) program is beginning to work and could
eventually improve credit conditions. Goodwin said interbank
spreads are back to normal levels and gilt yields are low, despite
spiraling government borrowing. Money growth (M4),which was
negative from October 2008 to May 2009, moved out of negative
territory in July, although it is too early to tell whether this
growth is durable. Goodwin thought there was a 50 percent chance
the Bank of England would extend its QE program in November,
alongside the publication of its inflation report. If it does
extend the program, however, Goodwin thinks it will only be by GBP
25 - GBP 50 billion.


9. (SBU) Unwinding the Bank's position will be difficult and timing
will be crucial. Goodwin said the Bank, HM Treasury and the Debt
Management Office (which auctions UK government bonds) must work
together to maintain stability in the gilt market once the Bank
begins to dispose of its assets. He warned that the Bank will start
selling its gilts at the same time HM Treasury increases its gilt
auctions to finance borrowing. Therefore, he argued, gilt yields
are likely to rise in the next six to twelve months. He said the
Bank needs to be careful about the timing of the gilt sales,
particularly needing to avoid choking off recovery by tightening
monetary policy too soon.

Public Finances: Debt to Reach Almost 100 Percent of GDP
-------------- --------------


10. (SBU) Alongside poor credit conditions, weak public finances
are cited as a risk to UK economic recovery. Public debt rose to 59
percent of GDP in September, as HMG borrowed GBP 77.3 billion in the
first half of the fiscal year - the highest borrowing level for the
period since 1946. Goodwin expected UK debt to reach almost 100
percent of GDP by 2010. He said social security payments are rising
while income tax revenue is falling, so the fiscal deficit will
continue to climb, particularly in the next six to twelve months.
He said the massive fiscal deficit needs to be addressed. He
expected an extended period of austerity - with potentially ten
years of tax increases. His comments reflect wider concern
regarding the UK's public purse. In its 2009 Sustainability Report,
the European Commission said the UK is at high risk of running an

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unsustainable deficit. It said the UK will suffer a "sustainability
gap" of 12.4 percent - meaning tax increases or spending cuts of
approximately GBP 200 billion a year will be necessary. The
National Institute for Economic and Social Research warned about the
sustainability of UK debt, saying fiscal consolidation will be
expensive, but the faster it happens, the lower the rise in debt.


Unemployment Up, Inflation Down
--------------


11. (SBU) Public finances will be significantly impacted by further
rises in unemployment until next year. Baker told us unemployment
will stabilize next year, with a peak of around 9 percent (from a
current rate of 7.9 percent). It will then begin to decline, but it
is unlikely that there will be any rapid improvement. Goodwin also
expects unemployment to peak towards the end of 2010. Opinion is
divided on what will happen to CPI inflation in the short term, but
there is consensus that it will remain below the Bank of England's
two percent target in the medium term. Goodwin expected a prolonged
period of below target inflation through 2012. Baker thought
inflation would bounce back at the beginning of next year, above
target, and then fall below target in 2011. She expected domestic
inflationary pressure to remain subdued.


12. (SBU) Comment: Despite encouraging signs the UK is emerging
from recession, there are still questions about the strength and
sustainability of any recovery. Mounting public debt will remain an
enormous drag on the economy and could undermine any recovery in the
fourth quarter. Both the Labour and Conservative Parties will need
to form credible, comprehensive plans to address mounting public
debt in the run up to the next general election (see reftels).
However, these plans will be contingent on the UK emerging from the
downturn and embarking on a path of steady, sustainable growth.
Implementing any fiscal tightening before the recovery is assured
could risk choking off growth and pushing the economy back into
recession.


SUSMAN