July 2010

Improved growth shows investment works – the 2nd quarter UK GDP figuresBy Michael Burke

The British economy expanded at its fastest rate since the recession ended, up 1.1% in Q2 according to preliminary data. These data are often subject to substantial revisions, but the hope must be that, having been held over and scrutinised for 2 weeks, they are an accurate reflection of the pick-up in activity.

The latest growth rate represents a significant acceleration over the prior two quarters when the cumulative expansion was just 0.7%. But the pace of the recovery is almost exactly in line with the recoveries from both the 1980 and 1992 recessions, which were much milder and shorter than the recent slump. In both the 1980s and 1990s recessions the previous peak in activity was recovered after 3 years. At this similar pace it will take close to 5 years to recover the previous peak in activity.

There are two key factors which supported the modest rebound in activity- the depreciation of the pound and the 2009 Budget.

The fall in the pound has been precipitate. As the chart below shows, prior to the recession Sterling was valued at over 2 US Dollars, and fell by over 26% in 2008 and to a low of US/£$1.37 early in 2009. This depreciation and the recovery in global trade prompted a very modest pick-up in exports. In the Q1 GDP data (the preliminary Q2 do not provide a breakdown of the national accounts) exports are 2.9% above their recession low in Q2 2008.

At the same time government spending has been the main support for the recovery. Current government spending and government’s share of investment (gross fixed capital formation) have risen by a combined 12.6% since the recession began. In the course of the recession, government spending rose by £18bn compared to an aggregate contraction of £88bn. In the two quarters of recovery to Q1, the further direct effect of these two factors, export growth (£7.3bn) and increased government spending (£13.6bn) has more than accounted for the entire growth of the economy (£9.7bn). If, as reported, other sectors of the economy made a greater contribution to growth in Q2 – with construction said to add 0.4% to GDP in the quarter, it will be because of the direct and indirect support received from government spending.

Economic Outlook

These positive effects of increased government spending and a weaker currency are already beginning to wear off and the impulse being reversed. As the chart above shows, the currency has already appreciated by over 10% from its January 2009 low against the US Dollar, and Sterling has also been appreciating against the Euro, the currency of Britain’s main export markets.

It is also widely known that this expansionary fiscal policy is shifting into reverse, with significant cuts enacted and vastly more in the pipeline.

The forward-looking indicators of the economy are already warning of a slowdown, before those cuts bite. Recent surveys of both manufacturing and construction growth have both shown a levelling off in activity. But surveys of the service sector, which accounts for three-quarters of the economy, have seen a marked deceleration with the June reading the lowest for 10 months . As the Bloomberg news service puts it, ‘U.K. services growth slowed more than economists forecast in June after the government’s austerity measures to cut the budget deficit sapped confidence’. Both house prices and consumer confidence recently recorded their first falls in over a year.

Previous optimism that a pronounced slump would lead to a sharp recovery has given way to a more sober assessment. These are strong grounds for the view that the growth rate is already peaking and a slowdown likely later in the year. With the extraordinarily deep cuts planned by the ConDem coalition, a double-dip recession or a severe slowdown in recovery is a real threat.

The Deficit & Growth

It is evidently the case that a further increase in government spending would benefit the economy. It might even lead to a renewed decline in the currency, as the combination of relatively loose monetary policy and fiscal policy is held to be a prescription for currency depreciation.

But the argument of the government and its supporters is that there is simply no room to increase government spending. Drawing comfort from Liam Byrne’s crassly ignorant phrase, they argue that ‘there’s no money left’.

On that logic, of course, however desirable increased government investment might be to support the economy, it is not sustainable. Government finances would go to hell, with huge deficits, loss of credit rating, IMF missions, and so on.

All of which seems very compelling – except that it is factually incorrect. As SEB has previously noted, the 2009 Budget was moderately stimulative and that worked. Growth was higher than anticipated and the deficit narrowed as a result.

The latest trends in public finances confirm that point and amplify it, as well as providing a warning about the impact of cuts. In the December Pre-Budget Report Alistair Darling forecast a public sector borrowing requirement (PSBR) of £178bn in the current financial year. In his March Budget this year, that projection had fallen to £167bn. The Office for Budget Responsibility lowered it to £156bn and Osborne’s June Budget shaved it to £155bn. Yet they are all still playing catch-up to the trend improvement in government finances.

In the chart below we show the 12-month rolling total for the PSBR, which has consistently undershot official forecasts and has been falling outright since February this year, when it peaked at £144.4bn. In June it had declined to £143.1bn.

The reason for the undershoot in the deficit is that tax receipts are much higher than anticipated, up £8.3bn in the latest 3 months alone. In the latest 12 months, that is in the period after the 2009 Budget, total government spending is £36.8bn higher than in the prior 12 months. Of that, £3.4bn is increased interest payments, and therefore £32.4bn is the actual increase in government outlays on goods, services and investment. This boosted economic activity, and the taxes that derive from it. Taxes on production are £18bn higher in the latest 12 months than in the prior period. In addition, the rise in unemployment has only been a proportion of what was expected. This feeds into lower-than-anticipated welfare payments.

Yet according to official wisdom, this cannot be. Increased government spending ought to be leading to an increase in the deficit, not its narrowing. The reason that the forecasts on the deficit are so faulty is that they overlook or completely ignore the stimulative effects of government spending and its positive effects on government finances, both revenues and outlays.

That ignorance stretches into the labour movement. Ex-Chancellor Alistair Darling quite rightly ascribes the improvement in the economy to Labour government’s actions. But these were from the investment and increased spending of the 2009 Budget not his 2010 cuts Budget where he threatened to be ‘worse than Thatcher’. Further, the connection between this rebound in GDP and the improvement in government finances seems to have escaped him entirely.

By contrast, Brendan Barber says, ‘The impressive GDP figures are the result of fiscal stimulus and active policymaking. But continued growth cannot be taken for granted, and there is now a huge risk that cuts in spending will bring the recovery to a shuddering halt. Deficit fetishism still risks a return to a flat line economy’.

The TUC general secretary is quite right. Not only is the policy of cuts to public spending sure to weaken growth, but it threatens, as a result, to lead to renewed widening of the deficit.

Green Campaign Builds for RBS’s Capital To Be Used ProductivelyBy Michael Burke

Campaigners have called for the Royal Bank of Scotland to be transformed into a Green Investment Bank to kick start a wave of investment in green technologies The supporting document suggests that it would create 50,000 new green jobs a year, boost the UK economy, reduce the UK’s carbon emissions and improve international competitiveness – whilst not increasing the budget deficit. The report was commissioned by pressure group PLATFORM and the anti-poverty campaigners, World Development Movement, who reject the premise that investment in a green economy should be scrapped due to public sector cuts.

By contrast, it has recently been reported that the coalition government may scrap plans to invest public money in a Green Investment Bank. Instead the government may rely on private capital to fund green projects such as wind farms, high-speed rail and electric cars.

Deborah Doane, director of the World Development Movement, said, ‘It would be completely irresponsible and short-sighted to scrap public investment in a low carbon economy. RBS is sitting on billions of pounds from the taxpayer which is going to finance dirty projects often linked to human rights abuses, instead of more productive ends. The money we’ve invested in RBS should be directed towards green investment. It’s a no-brainer: not only wouldn’t it cost the taxpayer directly, it would boost the economy and create new jobs in the UK at a much-needed time.’

The idea has received backing within parliament; one hundred and seven MPs signed an Early Day Motion which calls on the Government to use its majority share in RBS to prioritise climate change as a principal concern in RBS’s lending decisions.

Room To Invest

SEB has previously argued that RBS, 84% owned by taxpayers, has scope to increase its lending very substantially without endangering its solvency. Indeed, attempts to bolster RBS’s capital beyond those of its High St. rivals simply increase that spare lending capacity

The recent European-wide stress-testing of banks’ balance sheets was widely criticized as insufficiently robust. British banks had previously been put to a more severe test by the Financial Services Authority (FSA), which also published the results.

The key features of those are set out in the table below – it is calculated from the FSA data.

Table 1. FSA ‘Stress Test’ Results for British Banks

The FSA focuses on ‘Tier 1’ capital, mainly shareholders’ funds, as the main buffer against further crises. It projects what the ratio will be in 2011 assuming economic recovery, rising profits and weak lending growth. It also provided a stress test which included double-dip recession, a rise to 12.5% unemployment, a 60% fall in house prices and default by one or more European government. The FSA’s estimate of the impact of all those events combined for each bank is shown in the final column.

Here it is important to note that the banks actually have a huge and growing excess of capital over any prudent requirements, with RBS one of the most awash with the capital that is being hoarded. Previously, the FSA had required Tier 1 capital to amount to 4% of total assets. During the financial crisis in 2008 it altered the requirement so that total capital, Tiers 1 and2, must be 8% of assets . There has been some discussion that new international rules (‘Basle III’) will change the requirement so that Tier 1 capital must be 6% of assets.

Yet all the banks have spare capital way in excess of the expected 6% total. RBS currently has 14.4%. And even in a disastrous set of circumstances it would have nearly double the required international level. Paradoxically, it is the banks’ refusal to lend which is one of the key factors, along with government economic policy, increasing the risk of a double-dip recession and all its negative consequences. Furthermore, the ratios are based on ‘risk-weighted’ assets where values are already deflated by that adjustment for risk. RBS’s actual assets amounted £1,523bn at the end of 2009 .

Given the vast sums in the banks’ balance sheets, even fractional changes in the capital ratios through increased lending would release very large funds for investment. Currently, £100bn in new investment would only entail RBS’s Tier 1 capital ratio dropping to 13.5% from 14.4%. This could provide an enormous economic boost, kick-starting a Green transformation of the economy, creating new jobs, meeting the needs for housing, transport and infrastructure – and not a penny of new government borrowing.

The Budget’s attack on women, disabled and black peopleBy Anne Kane

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Should RBS be used for the interests of the British economy or for private profit

By Michael Burke

RBS has announced it is selling off its insurance arm and getting rid of 2,600 jobs. This is not simply a personal disaster for those workers and the communities in which they live, but it also concerns all taxpayers. That state owns 84% of the bank.

The RBS share price was 44.5p at the end of last week, having been as high as 590p in March 2007. The low was 10.5p in January 2009.While no-one can predict where the share price will go it is clear that all financial assets remain close to fire-sale prices.

But the government is allowing an asset sale when assets can be bought extremely cheaply. There is no doubt too that RBS and other banks are viewed as risky propositions, but the sell-offs, which include branches in Britain and in the high-growth Indian market as well as the insurance businesses are the least risky part of the entire group.

These are effectively public assets which are being sold off cheaply to the private sector in order to boost its profitability. They will also have the simultaneous effect of increasing the public sector’s underlying deficit by reducing its cashflows. SEB has previously pointed out that the management of publicly-owned RBS was also attempting to replace low-interest debt government with higher interest private sector debt, in order to curry favour with financial markets. This is because they intend to be back in the private sector as soon as they can, again at a knock-down price against the interest of taxpayers. So far, they have been frustrated in their fund-raising aims but they are persisting. But the urgency is growing because RBS has moved back into profit. Operating profits were £713mn in Q1, compared to losses of £1.353bn in Q4, partly as bad debts declined .

The stated aim of the RBS bond issuance is to bolster its capital strength. But RBS’s capital strength, measured by its ratio of ‘core assets’ to total loans is currently 10.6%, much higher than both Lloyds and Barclays, which are below 9%. It is difficult to believe that RBS’s loan book is much worse than its rivals and it will face higher levels of default, given the disastrous merger of Lloyds with HBoS.

But so be it. Let RBS borrow more, even at higher interest rates than available from the government. But taxpayers should insist that its capital ratio does not need to be astronomically high, just a circumspect 9%, a little above Lloyds and Barclays. With current capital levels, that would mean RBS could fund a huge increase in productive investment.

RBS’s balance sheet is shrinking because it is refusing to lend and because of losses incurred in speculative investments. But it remains a colossal £1,583bn. Bringing down the capital ratio to 9.0% from 10.6% would release £280bn for productive investment. And with a 9.0% capital ratio, every further £10bn to bolster core capital would release another £100bn for investment. These sums would more than compensate for the entire fall in output during the recession.

RBS can be used for asset-stripping by the private sector and robbing taxpayers, who have poured £122bn into the banks to keep them afloat. Alternatively the public sector, which owns RBS, can use it to benefit the whole of society. The government could end the private investment strike in the British economy simply by instructing RBS to lend to infrastructure projects, transport, Green technologies and housing.