The UK: Will it rebalance in time?

The UK is on an earnest path to rebalance its economy away from government spending and domestic consumption towards business investment and exports. The recovery so far appears to suggest that it is well on its path to do so. Most of the growth since the recession induced by the financial crisis has come from private investment and exports. Consumers have been playing safe: the declining trend in consumer loan, which started in 2003 but accelerated after the financial crisis, is yet to reverse. The housing market is still caught in the doldrums. Meanwhile, cuts in government spending are expected to bite from the latter half of 2011. The Comprehensive Spending Review stipulates that the budget will record a surplus of 0.4% in 2014-15 and public debt will peak at 70.9% of GDP in 2013-14.

The targets do appear ambitious. Consumer spending has been the primary driver of economic growth in the UK, contributing 69% of the annual growth in GDP between 1990 and 2008. Recovery from the previous recession in the early 1990s was closely linked to the sharp rise in household consumption. With household disposable income expected to decline for the first time in three decades due to rising taxes and decline in real wages, consumer confidence will likely remain weak through 2011. At best, we can hope that private consumption will not subtract from economic growth.

In the face of weak growth in consumption and substantial spare capacity, it is a debatable whether positive investment intentions, as expressed in surveys conducted by the British Chambers of Commerce, will translate into actual investment. There are two factors that may support a fairly strong recovery in business investment despite weak domestic demand: refurbishing and exports. Both these factors are, however, uncertain. Refurbishing cannot continue forever. At some point, it has to translate into rising employment, wages and consumer spending for investment to continue to grow. Exports, going by past trends, are highly volatile. The advantage of a weaker currency can dissipate quickly. Further, the current economic uncertainty in UK's primary exports markets--especially, the issue of a potential sovereign debt crisis--also gives cause for concern. Estimates also suggest that manufacturing faces severe supply side constraints and may not be able to sustain its good performance for long.

There are some who are still upbeat about the UK economy. Goldman Sachs and UBS have projected 2% growth in 2011. This sounds a bit too optimistic. It is likely that the UK will continue its recovery through 2011, but may grow only around 1.5%. There are also several downside risks and so another recession is not completely out of the cards. If the economy stabilizes in 2011, it may grow 2% or slightly higher in 2012.

The Bank of England will likely not begin to raise interest rates before September 2011. The uncertain economic recovery is one issue. The other is to keep the government's debt burden under check. With continued easy monetary policy and rising crude and food prices, CPI inflation will likely be 4% this year. RPI inflation may be higher than CPI inflation. The risk is that inflationary pressures may grow if high RPI inflation starts getting reflected in rising wages.

Overall, how the UK performs over the next couple of years and beyond will likely depend on how quickly the economy begins to rebalance. It is not easy to manage a shift in the economic structure in a short period. It is likely that the economic trajectory in the medium term will remain volatile, unless the UK is helped by some extraneous factors, such as an extremely benign global economic environment.