21 May 2009
Vanessa Rossi
(Former Chatham House Expert)


Why the UK Needs to Pay More Attention to how its Economy is Viewed at Home and Abroad

For the last year, pundits everywhere have enjoyed putting the UK economy and pound at the bottom of the economic heap - indeed the UK itself, far from fighting this, seems to have quite happily taken on the role of punch bag. Whatever international organisation you looked at, forecasters were keen to point to the UK being the bottom of the class and the worst impacted by the crisis. Few people seemed to object to this - in spite of the fact that it was highly unlikely to be true. No doubt the UK taking this role suited those countries which did not want to accept that their economies had even more severe problems, although statistics suggested otherwise before as well as after the outbreak of financial mayhem last September. Epitomising the saga of "UK bashing" has been the position of the pound: as it slid to near parity with the euro at the start of 2009, headlines enthusiastically quoted "experts" who were suggesting that it would fall even further - and they notably fell silent when the pound actually picked up again.

By now, with dire results coming not only from Japan but also Germany and other parts of Europe, forecasts have had to change and the UK is no longer at the bottom of the league tables. But this is only being whispered, with talk of the UK perhaps being "first out" of recession masking forecasters errors. And far from the revision leading to a relatively positive view of the UK, the doom-mongers are instead turning their attention to the rise in the UK's budget deficit and debt - and hence the risk to the UK's AAA status in financial markets. True the "small print" suggest looming questions over other countries as well - the UK may not "win" the race to reach a debt/GDP ratio of 100% - but it is nevertheless the UK that has been first in the spotlight. Why?

The UK's complacency about persistently incorrect forecast assessments and rankings was foolish - such perceptions have consequences. The threat to the AAA credit rating means the UK has been served a rude awakening over the risks posed by wallowing in its economic problems and not fighting back regarding its relative strengths. While other countries have carefully have protected their image - often with little justification in the economic data or even in terms of financial sector behaviour - UK PLC has seemed bent on shooting itself down. But the costs of this, if they do get built into a loss in credit ratings, will be significant.

It is true - and honest - that we can be under no illusions about the depth of this recession and the serious issues facing the financial sector and public sector finances as well. The UK economy has been hit hard and will remain under significant pressure. But it is far from alone - and probably far from the worst - in this regard. Relatively, the economic losses may turn out middle-of-the-road. And the debt position may be similar.

The UK went into this disastrous recession, with lower levels of government debt (about 50% of GDP) than most other major economies - less than the US and key EU partners such as Germany and France (in the 60-70% of GDP range) and of course much less than Japan (which has a debt to GDP ratio of around 170% gross and 100% net). Arguably, the UK government could have reduced its annual deficit in the years just before the crisis, rather than going into recession with an already fairly high deficit, but total government debt was well under control. This year the UK, like the US, may well have a public sector deficit of 10-15% of GDP, sharply bumping up debt. But other countries are also experiencing larger deficits, with the EU average possibly around 5%, which means the UK's debt/GDP ratio would still be lower than its peers. Previous experience of recessions such as the early 1990s, also points to the probability that the UK has particularly strong cyclical impacts on tax revenues and thus its budget deficit may also see larger short-term swings (possibly from large deficit in recession to surplus in recovery) than other countries. While it would be foolish to argue that the UK economy and finances are in a strong position today in absolute terms, given the global nature of this unprecedented recession and prospective slow recovery, it is more reasonable to judge the UK in relative terms - and on this basis the UK's outlook both for GDP growth and public finances is almost certainly not as bad as many seem to think and better than many competitors.

As we began by remarking, this matters. Although credit rating agencies have seen their reputations tarnished by the rating follies of recent years, justifying scepticism about their analysis and ratings, the AAA status still makes a difference to the financial sector and to the rest of the broad economy. It can impact on the cost of capital for companies, on pubic sector debt costs and even on household mortgages, as well as affecting the potential to transact profitable financial business and grow the financial sector. Financiers fight over every basis point of interest rates for good reason.

So the AAA rating must be worth fighting for. We should start by getting more sense into the estimates for the UK economy's position relative to the rest of the world. Others will be only too happy to gain an advantage if this situation is not addressed.

Further Reading

The AAA Threat to the UK's Credit Rating
Vanessa Rossi
Briefing Note, May 2009