The UK has finally exited recession in the 4th quarter of 2009 according to preliminary estimates released by the Office of National Statistics (ONS) Jan. 26, ending six consecutive quarters of contraction. The showing was generally underwhelming as UK gross domestic product (GDP) in the 4th quarter of 2009 grew at an annualized rate of just 0.1 percent over the previous three-month period. This tepid performance speaks to the depth of the recession in the UK and the long hard road ahead for growth, employment and debt reduction.
The United Kingdom has a long history of and reputation for being an international financial center. "The City," as London is called, has attracted international capital that has fostered growth, created jobs and generated revenue. As an island nation, the UK’s geography required a strong and sophisticated banking culture to finance trade. As a result, the UK has historically been at the forefront of financial innovation. However, the financial crisis has wrecked havoc on the UK’s banking sector and is now being propped up by government support. The question now is to what extent the current political dynamic will negatively impact London’s future as a financial hub and how it will affect its economic recovery.
How We Got Here
For much of the last decade the UK economy—as well as many western and European economies— had expanded greatly due to a ‘virtuous circle’ of increasing financial leverage and rising asset prices. This positive feedback between the financial sector and the wider econom generated much growth and tax revenue— financial services alone accounts for around 12 percent of all tax revenues and 17 percent of all corporate tax revenues. However, the global financial crisis dramatically and definitively laid bare the inherent instability of this relationship, which centered on ever-increasing debt and excessive leverage.
“Leveraging” is a self-reinforcing financial process that works like this: when the value of an asset on its books increases, a bank is able to extend more credit against it. This credit fuels demand, forcing asset prices higher, which in turn enables the bank to extend even more credit. This process works especially well when the asset to be purchased is used as collateral for a loan to finance that purchase— as is often the case in the housing market— since the credit, demand and price appreciation are all directly linked. It’s easy to see how this could get out of hand, especially as lending conditions are relaxed and ‘ever-rising prices’ lull market participants into complacency, as they did in the UK, United States, Spain, and Ireland, amongst other countries. Unwinding this process is very tricky and can lead to falling asset values that can take years to rectify. For example, a leverage-related property boom in Japan burst in 1991, but didn’t hit bottom until 2007.
Severity of the recession in the UK can be traced to the fact that (i) the economy was faced with an overheating housing market well before the financial crisis began in earnest, and (ii) given its enormity relative to the rest of the economy, the UK's financial sector was extremely vulnerable to the credit crisis. In the years leading up to the crisis, the leveraging process was hard at work, inflating the size of and the risks associated with the both the banking industry and the housing market.
On the consumer side, the combination of de-regulating lending standards and bankers' unrelenting quest for yield contributed to innovative— and eventually alchemical— financial products, particularly consumer products, such as mortgages. The popularity of these products combined with an increasing willingness assume risk resulted in a massive consumer debt explosion not just in the UK, but Europe in general. UK households dramatically increased their total debt relative to their income from 100 percent in 1997 to about 170 percent a decade later. Over this same period, house prices in the UK essentially trebled.
On the banking side, since asset prices were rising, UK banks also dramatically increased their borrowing, particularly of short-term debt. Since short-term debt is usually cheaper than long-term debt, banks assumed more of it, despite the fact that it needed to be refinanced more frequently [check if there was an inverted yield curve]. Since 1990 total UK financial sector debts tripled to nearly 200 percent of GDP, increasing its share of total UK debt from 27 to slightly more than 41 percent. Though banks increased their overall debt levels the most, the rest of the UK economy increased their debt level as well—and as a recent report by McKinsey showed, from 1990 to 2Q2009, the total combined debts of UK government, businesses, and households had swelled from about 200 to 466 percent of GDP, a debt level on par with the overly-indebted Japan[Chart].
Beginning to Unravel
When the credit crisis hit and a few large financial institutions in both the US and the UK went under, the leveraging process went into reverse, giving way to the process of 'deleveraging': since asset prices were falling, the banks' ability to lend against those assets also fell. As the supply of credit contracted, so did demand for many assets, which only further depressed asset prices—thereby completing a ‘vicious circle.’ Due to the very high levels of leverage and the enormous size of the banking institutions involved, a disorderly de-leveraging of UK banks’ massive balance sheets threatened a total financial meltdown, not to mention collateral damage to its trade partners and other economies. Northern Rock Bank was the first to go, and then after the US’s Lehman brothers and Bear Stearns went to bankruptcy court, the Royal Bank of Scotland and Lloyd's— whose combined balance sheets amounted to a colossal 200 percent of UK’s GDP— sought the support of the 'lender of last resort,' the UK government.
The UK government therefore sought to halt the implosion of the financial sector by slashing interest rates, recapitalizing banks, guaranteeing debts, and purchasing assets through a scheme funded by 'quantitative easing' (QE)— essentially the creation of new money. QE is more of an art than a science; it is normally considered dangerous and wildly inflationary, but can help to governments plug budgetary holes and conduct monetary policy under certain conditions. The UK government's support for the financial sector has been unprecedented in modern times— a report by the UK’s National Audit Office published Dec. 6, 2009 showed that the Treasury’s anti-crisis measures amounted to about £846 billion, or 64 percent of GDP, the largest of any major western economy. [Chart].
What Now
An utter collapsed has been prevented for the immediate future and the recession is finally over. However, the UK’s ability to maintain its status as afinancial powerhouse is questionable and the outlook for the wider economy remains highly uncertain due to three forces that each aggravates the others.
First, given the scale of government support in response to the crisis, public finances are a mess. In its Dec. 2009 Pre-Budget Report, the Treasury forecasts that— despite the government’s plan to reduce the budget deficit (currently 12 percent of GDP)— UK gross public debt is expected to vault from 55 to 91.1 percent of GDP by 2014-15, a level approaching that of eurozone's fiscally troubled Greece[CHART]. This debt will eventually need to be consolidated and reduced at some point, but until then it will act as an increasing tax on the economy, hampering recovery.
Second, the world’s policymakers are now discussing ways to crackdown on excessive risk taking. One of the proposals is a global leverage ceiling, which would disproportionately affect the UK since its banks are among the world’s most highly leveraged. To bring there leverage down to the ceiling, UK banks would either need to raise substantial capital or call in existing loans and liquidate other positions. This would limit credit to businesses and consumers, which the UK’s Monetary Policy Committee has identified as critical to maintaining the recovery's momentum. Additionally, since banks’ profits were largely driven by leverage in recent years, the ceiling could complicate future efforts to resolve the UK’s debt because it would weigh on government tax receipts.
Third, since the UK in the midst of a heated election campaign, the UK government’s now-substantial equity ownership of UK banks makes the financial community a convenient (and not altogether unjustified) populist target, for both parties. In Dec. 2009,current Prime Minister Gordon Brown’s Labor government announced a 50 percent tax to be levied on all bonuses over £25,000 and made it partially retroactive. Though a few banks have so far opted to just pay the tax, there have been reports that a number of prominent investment banks are considering packing their bags and relocating elsewhere, including Goldman Sachs, HSBC, JP Morgan, BNP Paribas, and Societe Generale. Any exodus of key financial institutions in the UK to more tax-friendly and less political locales would likely complicate (if not hamstring) the UK’s ability to spur growth and reconcile its finances without incurring additional political and economic pain. Such as exodus would be an apocalyptic scenario, since growth and tax receipts would both fall precipitously.
This combination of weak economic growth, tighter regulation and political populism is exerting tremendous pressure on UK banks, which are the heart of the UK's economy. Even if the political uncertainty surrounding the outcome of coming elections is resolved by June, these lingering problems threaten to paralyze the UK economy an unseat the UK as the world’s leading financial hub.