United Kingdom: Recent Economic Developments

International Monetary Fund

doi:10.5089/9781451814057.002.A001

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United Kingdom

Recent Economic Developments

Author: International Monetary Fund

Publication Date:: 02 Jan 1996

eISBN:: 9781451814057

Language:: English

Keywords:: ISCR; CR; inflation rate; gross domestic product; retail price index; consumer spending; export market growth; Export performance; Imports; Inflation; Real exchange rates; departure from the ERM

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This paper reviews economic developments in the United Kingdom during 1991–95. Following a brisk expansion in 1994, when the economy achieved a rare combination of above-trend output growth and historically low inflation, the pace of economic activity in the United Kingdom has moderated in the course of 1995. Real GDP growth picked up to an annual rate of 4 percent in the first half of 1994, moderating to 3½ percent in the second half. Real GDP growth slowed further to just more than 2 percent in the first half of 1995.

Abstract

I. Developments in the Real Economy and the Balance of Payments ^1/

1. Demand and output

Following a brisk expansion in 1994, when the economy achieved a rare combination of above-trend output growth and historically low inflation, the pace of economic activity in the U.K. has moderated in the course of 1995. Real GDP growth picked up to an annual rate of 4 percent in the first half of 1994, moderating to 3 1/2 percent in the second half. Reflecting both policy tightening and an easing in overseas growth, real GDP growth slowed further to just over 2 percent in the first half of 1995.

Between 1993 and 1994, the underlying source of growth shifted from private consumption to exports. Mainly reflecting a tightening of fiscal policy, a sustained real depreciation and buoyant world export markets, a recovery primarily powered by consumption gave way to an expansion in which export and investment demand became increasingly important in late 1994 and early 1995. With the moderation in economic expansion, growth has recently been close to its trend rate, ^2/ and there remains an output gap of about 2 percent (Chart 1.1).

While increasing signs of duality have emerged on the output side--a buoyant manufacturing sector (at least through 1994) benefitting from improved competitiveness and international trade, and a weak nontraded sector held back by recent sluggishness of consumer demand--overall, the current economic recovery in the U.K. has been well balanced from the demand side. Both domestic and external demand growth contributed significantly to GDP growth in 1994 although there was a shift in the composition of demand from domestic to foreign during the year as export market growth strengthened. By the second quarter of 1995 this trend was partly reversed as demand softened in some key foreign markets such as the United States.

a. Domestic demand

Private consumption dominated the initial stages of recovery from early 1992 to late 1993, supported by an easing of monetary policy and a decline in household financial saving from its cyclical peak in 1992. But, as 1994 progressed, growing signs of moderation emerged; growth in retail sales, new car registrations and housing starts slowed markedly in response to higher interest rates and higher taxes associated with the fiscal consolidation measures of the past two years. Although supported by a decline in the saving ratio (Chart 1.2), the pace of private consumption growth declined to 3 percent in 1994 and an estimated 2 percent in 1995, compared with 3 1/4 percent during 1993. Hence, after contributing around three-quarters of the total growth in GDP in 1993, the growth in consumer spending accounted for less than fifty percent of total growth in 1994 and 1995.

Higher interest rates, a subdued housing market, and a squeeze on disposable income served to dampen consumption expenditures from the second half of 1994. The freezing of tax allowances, the restriction of the married couples’ allowance and mortgage interest relief, and increases in indirect taxation, limited growth in real personal disposable income to 1.2 percent in 1994. However, with a saving ratio still relatively high and a comparatively low level of housing investment, the personal sector remained in a large financial surplus estimated at about 4 percent of disposable income in 1994 (compared with the long-run average of about 3 percent).

Recent data for 1995 suggests that growth of consumption--still digesting the steady diet of interest rate and tax increases of the past two years--is once more decelerating. In the eight months to August, the volume of retail sales (which accounts for around 50 percent of consumer spending) remained virtually unchanged. But the greatest drag on consumer spending is mainly coming from the housing market which has been in a moribund state in recent months as both turnover and house prices remain subdued ^1/ and home owners cautious in the presence of “negative housing equity”. ^2/.

Fixed investment has so far picked up only moderately in the current cycle with firms using profits instead to correct the debt buildup associated with overinvestment during the late 1980s boom (Chart 1.3). ^3/ The share of total investment in GDP in this recovery has also fallen short of that of the 1981-83 recovery (Chart 1.4). Compared with the 1981-83 recovery during which total fixed investment grew by 16 1/2 percent, fixed investment grew by only 4 1/2 percent from the 1992 trough to the end of 1994, a period of comparable output growth. Fixed investment in the whole economy rose by over 3 percent in 1994, below the rate of output growth. The pattern of investment growth across the various industrial sectors and the housing sector, however was quite disparate with private residential investment having grown by over 6 percent and non-residential investment by slightly less than 2 1/2 percent. Manufacturing investment also rose by less than 1 percent in 1994 and declined in the first quarter of 1995.

The fall in manufacturing investment in the first quarter of 1995 was quite puzzling, as business surveys data pointed to above-average capacity utilization and high business confidence. The CBI surveys show that levels of capacity utilization are above both their historic average and the levels seen in the mid-1980s. Business confidence, although weakening slightly in late 1994, remains relatively buoyant reflecting expectations of steady export-led output growth. The CBI and BCC surveys have shown substantial rises in manufacturing investment intentions as well over the past year in line with the steady rises in capacity utilization in manufacturing. This pick-up in investment intentions partly reflects the fact that the climate for investment continues to be favorable, with the economy continuing to grow and profitability remaining high.

During 1994, there were a number of signs that the process of corporate balance sheet adjustment had been completed. Industrial and commercial companies (ICC) transformed financial deficits of 4 percent of GDP in 1989 and 1990 into a surplus of over 2 percent of GDP in 1994 as a result reductions in interest and tax payments, lower capital expenditure and employment, rising output, and higher margins (particularly for exporters). Dividend payout ratios rose and for the first time since 1991, net bank borrowing began to increase significantly in late 1994. ICCs’ gross trading profits increased by 16 1/2 percent in 1994 following a 14 percent increase in 1993. Stockbuilding, which contributed about 0.4 percent to GDP growth in 1994 and has continued in 1995, but may be partly involuntary in the face of slackening domestic demand.

b. External demand

Foreign demand made a significant contribution to growth in 1994. Both exports and imports of goods and services picked up markedly in 1994, with the net effect being a positive contribution to GDP growth of about 1/2 percentage point. The pick-up in world trade in 1994 was partly responsible for the strength in exports, but export market share also improved. For 1995, second quarter data indicate that net external demand--which explained nearly all of GDP growth in the first quarter--appears to be slowing down. Export growth levelled off in response to slower demand growth in some key markets such as the United States, and import growth picked up.

Export volumes of goods and services increased by 9 percent in 1994, reflecting strong recovery in European export markets and continuing gains in export market share. The improvement in cost competitiveness following ERH exit, which has been largely sustained, has played a large part in recent export performance. In the first quarter of 1995, the growth of export volumes slowed to just 1 percent over the previous quarter. However, import volumes fell by 3 percent, and net trade made a large positive contribution of about 1 1/2 percentage points to quarterly GDP growth. Second quarter data indicate a further slowdown in export growth. Although the slowdown in export growth appears to be mirroring the slowing of some foreign markets, it does not match well with the strong survey evidence indicating that export orders are at their highest level.

Import volumes grew faster in 1994 reflecting higher final expenditure growth. But in the first quarter of 1995 imports of non-oil goods fell by 3 1/2 percent, partly reflecting the fairly subdued growth of domestic demand and gains in import price competitiveness brought about by sterling’s depreciation; it also reflected a reversal of the surge in imports at the end of 1994. Import volumes have rebounded in recent months on account of higher than expected domestic demand. As in most countries, U.K. import volume growth has tended to exceed demand growth by several percentage points a year, reflecting the excess of world trade growth over world GDP growth. Therefore, import penetration has continued to rise in the past few years (Chart 1.5).

c. Output

Output in the whole economy grew by 3.9 percent in 1994, a rate partly attributable to a 27 percent increase in the output of oil and gas industries. Non-oil GDP rose by 3.4 percent in the year as a whole, with the manufacturing sector enjoying 4.1 percent growth and the service sector seeing a 3.3 percent gain. Although the construction sector rose by 3.3 percent compared with 1993, the latter quarters of the year saw little progress by the building industry, as a combination of cuts in public sector spending and sluggish private sector activity led to a fall-off in orders after a bright start in the year.

In the first half of 1995, output appeared to be slowing. The index of industrial production declined by 0.1 percent in May following a drop of 0.7 percent in April. Manufacturing output was also stagnant, with a 0.1 percent decline in the first quarter of 1995 on the previous quarter. While growth of manufacturing output appears to have paused, at least temporarily, services output has continued to rise quite strongly. Service sector output in total grew by 3/4 percent in the first quarter, with transport and communications especially strong.

2. Prices, Wages, and Employment

The underlying inflation rate in the United Kingdom bottomed out in late 1994 and has since increased somewhat, although remaining at moderate levels when compared with historical standards. The behavior of retail prices has been notably subdued given developments in producer and other prices.

Headline inflation, measured by the Retail Price Index (RPI), registered a sudden jump in late 1994 following the increase in interest rates that fed through payments of mortgage interest (Chart 1.6). Underlying inflation (measured by retail prices excluding mortgage interest, RPIX) reached its trough in late 1994 at 2 percent on a twelve-month-basis, and since then has exhibited a steady upward trend, reflecting external cost increases. During all of 1995, it has still been within the official 1-4 percent inflation target range set in October 1992, but in the upper half (the authorities’ objective is to be in the lower half of the range by the end of Parliament, i.e., by spring 1997). In September 1995, year-on-year RPIX inflation was 3.1 percent. The retail price index that excludes also the effect of indirect taxes (RPIY) has followed a similar pattern. The 12-month inflation rate according to this index stood at 2.5 percent in August 1995.

Output prices have been rising faster than retail prices, squeezing retail margins in the process. The inflationary pressures in prices of materials and other inputs originated mostly from external factors, and reflected the boom in commodity prices that took place in 1994 and the effective depreciation of sterling during the first half of 1995. In fact, price increases of both non-oil imports of goods and of manufacturing inputs peaked above 10 percent during the first quarter of 1995 (with respect to the same period of 1994) before subsiding in the second quarter of 1995 (Chart 1.7). Output prices in manufacturing absorbed some of this input price increase and also exhibited an upward, if more moderate, trend in 1995 (4.4 percent in the year to August 1995).

Labor costs, which account for the largest share of production costs, have remained surprisingly subdued. Despite robust economic activity and a strong demand for labor, the growth in underlying earnings has hovered in a plateau below 4 percent for the whole 1994-95 period, which is remarkably moderate when compared to the behavior of previous recoveries at the same stage of the cycle. As of July 1995, underlying earnings registered a modest 3 1/4 percent rate of expansion, driven mostly by restrained wage growth in the services sector. Wage settlements accelerated modestly in 1994 and averaged about 3 percent during the first half of 1995. The natural cyclical slowdown of productivity growth during 1995 has implied a moderate rise in labor costs. Unit wage costs grew 0.7 percent in the year to the second quarter of 1995 for the whole economy, and 2.5 percent for manufacturing.

Statistical discrepancies between the Labor Force Survey (based on households) and the workforce in employment survey (based on employers) have clouded somewhat the interpretation of events in the labor market Against the background of a stagnant labor force, both indicators show a recovery of employment in 1994, a recovery that is more pronounced in the LFS figures (Chart 1.8). The two surveys diverge more significantly in 1995, when the workforce in employment registered a fall in the first quarter of 1995 while the LFS continued with an upward trend for all the employed, although admittedly at a lower pace than in 1994.

The slowdown in economic activity during 1995--together with some changes in benefit eligibility criteria and other structural changes--is also evident in the unemployment figures. The unemployment rate declined almost continuously from a peak of 10.5 percent in late 1992 to 8.3 percent by mid-1995. As of August 1995, it stood at 8.2 percent of the labor force. The behavior of unemployment is more consistent with the employment increase registered by the LFS than with the employment decline of the workforce in employment.

3. Balance of payments and exchange rate development

Developments in the balance of payments during 1994 were encouraging as the external current account moved close to balance, but recent evidence for 1995 shoved a widening current account deficit. The effective depreciation of sterling during the first half of 1995 was the most important development in the foreign exchange market.

a. The balance of payments in 1994

The ongoing recovery of economic activity in the United Kingdom, in contrast with previous experience, has been characterized by a positive contribution of net external demand. Exports benefitted in 1993-94 from the sustained real depreciation of sterling and from the larger-than-expected expansion in North America and Europe. Merchandise exports from the U.K., as well as non-oil exports, grew about 11 percent in 1994, of which 10 percent corresponded to an increase in the export volume (9.4 percent growth of non-oil export volumes) (Chart 1.9). This vigorous export growth permitted an increase in the United Kingdom’s export market share for the second consecutive year, reversing a long-term declining trend. Simultaneously, fueled by the strong domestic recovery, total imports of goods expanded 7.6 percent in 1994 (8.7 percent for non-oil imports) with roughly 5.2 percent coming from an increase in the volume of imports (6.3 percent increase in the volume of non-oil imports). During 1994 import prices increased at a slightly faster pace than export prices, producing a deterioration in the terms of trade of 1.2 percent. ^1/ These developments in merchandise trade helped to reduce the deficit in the visible balance from £13.4 billion in 1993 to £10.6 billion in 1994.

The performance of invisibles in 1994 was characterized by a strong £10.5 billion surplus in investment income that was the highest figure on record, and compares to an average of around £3 billion on average for the last two years (Chart 1.10). The substantial surplus in investment income was fed by an impressive 34 percent growth of U.K. earnings on overseas direct investment (mostly in North America). The investment income surplus was also fueled to a lesser extent by net interest and dividends reported by U.K. banks reflecting, among other things, a fall in profits of U.K. subsidiaries of foreign banks. The surplus on traded non-factor services fell by almost £1.9 billion in 1994 to £3.8 billion mostly due to the strong growth in the spending of U.K. residents travelling abroad. Net investment income and balances in non-factor services, together with transfers that were more in line with their previous experience, contributed to an unprecedented £8.9 billion surplus in the invisible balance.

Helped by the smaller deficit in visibles and the huge surplus in invisibles, the external current account moved closer to balance in 1994 (a £1.7 billion deficit amounting to 1/4 of one percent of GDP). In fact, after having experienced a deficit in the trough of the recession, the (seasonally adjusted) current account registered a surplus in the third quarter of 1994. The counterpart of the 1994 movements in the current account was a substantial fall in the capital flowing into the United Kingdom. In operations that seem to be partly related to the February 1994 correction in bond markets, outward portfolio investment was drastically reduced, while lending overseas by U.K. banks increased significantly; in addition, the non-banking private sector became a net exporter of capital in 1994.

The identified net foreign asset position of the United Kingdom in 1994 is estimated (with the usual degree of uncertainty) to have increased slightly to £17.7 billion (about 2.6 percent of GDP) (Chart 1.11). The increase in net external assets was achieved despite a deficit in the current account and basically implies a revaluation of U.K. net assets. From the point of view of the aggregate resource balance, the improvement in the current account of the United Kingdom in 1994 is associated with a recovery in the financial balances of both the public and the private sectors. In particular, private saving continued to increase as a proportion of GDP (from 18.3 percent of GDP in 1993, to 19.5 percent of GDP in 1994) while private investment has remained somewhat sluggish during the current economic recovery (hovering just above 12 percent of GDP during 1992-94). The correction of almost one percentage point of GDP in the public sector’s financial balance was the outcome of the fiscal adjustment initiated with the 1993 Budget.

b. The balance of payments in 1995

Preliminary data for 1995 indicate that the deficit in the current account of the balance of payments has widened. Although some deterioration was registered in the visible balance, the bulk of the increased current account deficit originated on a substantially smaller surplus in invisibles.

With respect to trade developments in 1995, on the one hand, the growth of exports experienced a slowdown as a consequence of the pause in the world economic expansion, especially during the second quarter. Despite an increase of 14 percent in total exports of goods in the first semester of 1995 with respect to the same period in 1994, only 6.8 percent corresponded to a growth in export volume. In fact, non-oil export prices grew 6.6 percent in the year to the first semester of 1995. This increase in export prices corroborates the documented evidence that, upon departure from the ERM, export prices increased their partial passthrough from exchange rate movements, thus building exporters’ profit margins more than boosting export market share. ^1/ On the other hand, after having been rather depressed during the first quarter of 1995, imports were stimulated by the recovery of domestic demand in the second quarter. Total imports of goods expanded about 14.2 percent in the year to the second quarter of 1995, while import volumes grew 3.6 percent in the same period. The depreciation of sterling during the first semester of 1995 was also reflected in import price developments: the implicit deflator of non-oil imports rose 8.5 percent in the first half of 1995 in relation to the same period of 1994. These price movements implied a deterioration of the terms of trade, which was the main factor contributing to a widening deficit in visibles from £2.0 billion in the first quarter of 1995 to £3.2 billion in the second quarter.

Initial estimates for 1995 indicate a current account deficit in the first half of 1995 that, although substantially higher than the deficit observed in the second semester of 1994--£3.7 billion compared to £0.1 billion--remained modest in terms of GDP (1.1 percent of GDP). A slightly higher deficit in the balance of visibles in the first semester of 1995 (£5.3 billion) was compounded by a smaller surplus in invisibles (£1.6 billion). The balance in investment income, in particular, moved to more “normal” levels--a £2.4 billion surplus in the first half of 1995 compared with surpluses exceeding £5 billion in each of the two semesters of 1994--as net direct investment income registered a lower surplus and net interest payments by U.K. banks moved to a deficit position. The surplus on services rose slightly from £2 billion in the second half of 1994 to £2.2 billion in the first half of 1995, assisted by a significant improvement in the travel deficit.

c. Exchange rate developments

Sterling sustained an effective devaluation of 12 percent after leaving abruptly the Exchange Rate Mechanism (ERM) of the European Monetary System in September 1992. During most of 1993-94, sterling’s nominal effective rate index (1990-100) remained relatively stable hovering in the 88-90 range despite larger variations in bilateral rates (Chart 1.12). ^1/ However, sterling came under pressure during the first half of 1995. Several factors affected sterling: internal dissensions in the ruling Conservative party culminated in the Prime Minister calling a leadership election; turmoil in foreign exchange markets, especially the weakness of the U.S. dollar in the aftermath of the Mexican crisis; and the disagreement between the Chancellor and the Governor on the stance of monetary policy after their monthly meeting in May, in which it was widely rumored--and later confirmed by the published minutes--that the Chancellor had overruled the Governor’s advice to increase interest rates. During the first half of 1995 the nominal effective exchange rate index fell about 6 percent, and has stabilized around the 83-85 range after recovering from a low of 82.7 in May just after the monthly meeting between the Chancellor and the Governor.

On a bilateral basis, sterling has exhibited more gyrations. The effective fall of sterling in the first half of 1995 had its counterpart in a depreciation of around 8 percent vis-à-vis the deutsche mark (averaging DM 2.23 to the pound during March-July) and an appreciation of around 2 percent with respect to the U.S. dollar (stable around US$ 1.60 per pound sterling during most of the March-July period). During August and September, coinciding with the strengthening of the U.S. dollar in world currency markets, sterling reversed in part some of the earlier bilateral movements, firming (to DM 2.26 per pound by end-September) with respect to the DM and weakening slightly (to US$ 1.58 per pound by end-September) in relation to the U.S. dollar. These bilateral movements in August-September implied a 1.5 percent appreciation of sterling on a trade-weighted basis, moving the nominal effective exchange rate index to the top of the recent 83-85 trading range.

The movements in the nominal effective exchange rate have been closely mirrored by real exchange rate indicators. During 1994 the real exchange rate sustained the effective depreciation that took place upon sterling’s departure from the ERM--11.3 percent based on normalized unit labor costs, and 12.2 percent based on relative consumer prices when compared to the 1990-91 period (Chart 1.13). Sterling’s weakness during 1995 has not been offset by price and wage increases, and thus the real exchange rate has depreciated accordingly (about 4.8 percent based on normalized unit labor costs in the first seven months of 1995). Seen from a longer-term perspective, the real exchange rate is at a competitive level, not seen since late 1986 and early 1993 periods in the aftermath of two different depreciations of sterling.

According to recent financial developments, no major real exchange rate movements are expected. By end-September 1995, interest differentials in 10-year government bonds widened marginally to about 160 basis points with respect to Germany and 170 basis points with respect to the United States (Chart 1.14). Assuming a 4.3 percent expected medium-term inflation rate in the United Kingdom (derived from the difference between indexed and nonindexed gilts), a 2 percent inflation in Germany, and 3 percent inflation for the United States, the implied movements in the real exchange rate are a 0.7 percent real appreciation of sterling with respect to the DM and a 0.4 percent real depreciation vis-à-vis the U.S. dollar.

Prepared by Ousmane Doré (Section 1) and Julio Santaella (Sections 2 and 3).

Staff estimates of potential GDP growth currently at 2-2 1/4 percent are obtained by estimating a production function for non-oil output. The official estimates of potential output growth are 2-2 1/2 percent.

House prices fell by 1.9 percent in the year to June on the Halifax index.

Negative equity in housing was estimated by the Bank of England to amount to about £6 billion in the fourth quarter of 1994.

The determinants of investment demand during the current recovery are examined in Chapter IV.

The collection methodology of trade data was changed in January 1993 with the introduction of the Intrastat system in the EU. The new breakdown of trade figures into prices and volumes is not strictly comparable to the previous methodology.

See WP/94/132.

This index has been recalculated with new weights since February 1995 in order to reflect more recent trade patterns. In particular, the weight of Germany increased from 20.0 percent to 22.5 percent, while the U.S. fell from 20.4 percent to 16.5 percent.

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