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Viewing cable 08LONDON1921, SQUEEZED IN THE JAWS OF THE CREDIT CRUNCH -- UK ECONOMY

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Reference ID Created Released Classification Origin
08LONDON1921 2008-07-23 13:00 2011-08-25 00:00 UNCLASSIFIED//FOR OFFICIAL USE ONLY Embassy London
VZCZCXRO4157
PP RUEHAG RUEHDF RUEHIK RUEHLZ RUEHROV
DE RUEHLO #1921/01 2051300
ZNR UUUUU ZZH
P 231300Z JUL 08
FM AMEMBASSY LONDON
TO RUEHC/SECSTATE WASHDC PRIORITY 9267
INFO RUCNMEM/EU MEMBER STATES COLLECTIVE PRIORITY
RUCPDOC/DEPT OF COMMERCE WASHDC PRIORITY
RUEATRS/DEPT OF TREASURY WASHDC PRIORITY
RUEHBL/AMCONSUL BELFAST PRIORITY 1089
RUEHED/AMCONSUL EDINBURGH PRIORITY 0954
UNCLAS SECTION 01 OF 03 LONDON 001921 
 
SENSITIVE 
SIPDIS 
 
E.O. 12958: N/A 
TAGS: ECON EFIN ETRD UK EINV
SUBJECT: SQUEEZED IN THE JAWS OF THE CREDIT CRUNCH -- UK ECONOMY 
QUARTERLY UPDATE 
 
LONDON 00001921  001.2 OF 003 
 
 
1. (SBU) Summary: The British economy will slow dramatically in 2008 
and 2009 after leading the G7 with GDP growth of three percent in 
2007. Ernst and Young predict GDP growth to fall to only 1.5 percent 
in 2008, the OECD forecasts 1.8 percent, and Oxford Economics says 
1.6 percent. Inflation is running above the Bank of England's target 
of two percent at 3.8 percent, and demands from unions for higher 
wages could push it even higher. The employment rate remains fairly 
stable although there are signs that it may weaken. Ernst and Young 
predicts the Bank of England will cut interest rates again in 
November, but any future cuts will depend on inflation. Public 
finances are in their worst state since 1993. The weakening economy 
is weighing heavily on PM Brown's reputation as an astute manager of 
the economy. HMG may be forced to modify fiscal rules he established 
as Chancellor of the Exchequer and the new Chancellor, Alistair 
Darling, may be made a scapegoat for economic woes in a fall cabinet 
re-shuffle. This is the first of quarterly reports on the British 
macroeconomic situation. End summary. 
 
Gross Domestic Product 
---------------------- 
 
2. (U) In its quarterly economic forecast, the Ernst and Young ITEM 
Club forecasts UK GDP growth to fall to one percent in 2009 as the 
economy 'flirts with recession'.  The forecast says the UK economy 
is in danger of 'being crushed between the jaws of world credit and 
commodity markets, with little prospect of early relief'.  Oxford 
Economics, a consultancy firm, is more optimistic.  It forecasts UK 
growth at 1.6 percent in 2008 and 1.6 percent in 2009.  It has 
revised down its previous estimates of 1.8 percent and 1.7 percent 
respectively. 
 
3. (SBU) HM Treasury (HMT) expected the financial markets to recover 
more quickly when they announced their annual economic growth 
forecasts in their March 2008 budget report, according to Chris 
Kelly, Senior Economic Advisor at HMT. At that time, Darling 
predicted the UK's economy would grow between 1.75 and 2.25 percent 
in 2008 and recover in 2009. Since then, Darling as admitted that 
his forecast will be revised downward. 
 
4.(U) GDP rose by 0.3 percent in the first quarter of 2008, and is 
2.3 percent higher than Q107.  Output of the production industries 
fell by 0.2 percent, compared with a rise of 0.2 percent in the 
previous quarter.  While manufacturing output saw growth of 0.4 
percent, it was more than offset by falls in energy extraction and 
supply.  Growth in the services sector was 0.3 percent, down from 
0.6 percent growth in the previous quarter.  Household expenditure 
rose 1.1 percent, up from 0.4 percent in Q407.  Government final 
consumption expenditure rose by 0.9 percent. 
 
Figures show real quarterly growth and are seasonally adjusted 
 
------------------------------------- 
 Q107 Q207 Q307 Q407 Q108 
 
GDP 0.8 0.9 0.6 0.6 0.3 
------------------------------------- 
 
Inflation Above Targets 
----------------------- 
 
5. (U) ITEM expects CPI to remain above the Bank of England's target 
range of 1-3 percent for the next 12 months.  It predicts that 
inflation will average 3.5 percent in 2008, coming down to 3 percent 
in 2009 and 2 percent by 2010.  It notes that this forecast assumes 
that wage and domestic cost inflation remain subdued.  In the UK 
there is currently a significant push for higher wages to offset 
price increases.  This pressure is particularly acute in the public 
sector where pay increases have been held below those in the private 
sector and below the cost of living for two years.  Chancellor 
Darling has called for pay constraint but unions are threatening a 
season of industrial action if pay deals are not reopened.  ITEM 
urged the government not to accept any excessive public sector pay 
demands which could put severe pressure on any attempts to dampen 
inflation and potentially destroy any hopes of a medium term 
recovery. 
 
6. (U) During the first quarter of 2008, the largest upward pressure 
on inflation came from food, mainly meat, vegetables, and 
non-alcoholic beverages, and fuel, particularly heating oil. 
Despite growth in the CPI, however, the UK inflation rate is below 
the provisional figure of 4 percent for the European Union as a 
whole.  The main factors affecting the CPI also affected the RPI. 
However, the Retail Price Index experienced a downward contribution 
from housing.  This came mainly from mortgage interest payments as 
lenders passed on April's quarter point decrease in the bank rate to 
customers, in addition to house price depreciation. 
 
 
LONDON 00001921  002.2 OF 003 
 
 
(Annual inflation rates - 12 month percentage change) 
 
----------------------------------------- 
 Jan08 Feb08 Mar08 Apr08 May08 Jun08 
 
CPI 2.2 2.5 2.5 3.0 3.3 3.8 
 
RPI 4.1 4.1 3.8 4.0 4.3 4.6 
 
----------------------------------------- 
 
Employment Stable 
----------------- 
 
7. (U) Overall employment and unemployment figures have remained 
fairly stable, despite volatility in the economy.  The total number 
of people in work rose in the three months to May to an all time 
high of 29.59 million.  However, the number of people in the UK 
claiming unemployment benefit saw the biggest jump in 16 years.  The 
claimant count has risen by 45,000 since the end of January 2007, to 
2.6 percent of the working age population.  Job losses are most 
prominent in the building and financial sectors. 
 
8. (U) Professor David Blanchflower, a member of the Bank of 
England's Monetary Policy Committee who has voted for interest rate 
cuts for the last nine months, has predicted that the UK is heading 
for a recession which could cost hundreds of thousands of jobs.  He 
expects unemployment to rise from 5.2 percent to more than 7 
percent.  While ITEM is forecasting a rise in the overall numbers of 
unemployed, it remains hopeful that it will only be a modest jump, 
particularly in comparison with previous downturns.  A major 
contributory factor to the limited nature of this increase is that 
poorer UK employment and economic prospects, combined with a weaker 
exchange rate, is causing a reversal in migration flows.  However, 
it still anticipates that unemployment will rise from 1.6 million at 
the end of 2007 to the 2 million mark by 2010. 
 
 
Seasonally Adjusted (Percentage) 
 
--------------------------------------------- -- 
   Q107 Q207 Q307 Q407 Q108 
 
Employment  74.3 74.4 74.4 74.7 74.9 
 
Unemployment 5.5 5.4 5.4 5.2 5.2 
--------------------------------------------- -- 
 
Interest Rate, Pulled Both Ways, Doesn't Move 
--------------------------------------------- 
 
9. (U) The Bank of England's Monetary Policy Committee (MPC) has 
resisted calls to cut the interest rate as the economy continues to 
falter.  With inflationary expectations rising in line with headline 
inflation figures, the MPC has felt unable to offer relief from a 
lower base rate.  However, ITEM expects a slowdown in consumer 
spending to pave the way for a rate cut this winter, perhaps as 
early as November.  Beyond that, interest rate decisions will likely 
be determined by the behavior of commodity prices.  If crude oil 
prices follow the expectations of the futures market and peak at 
$150 a barrel this fall, before easing back, ITEM expects interest 
rates to fall back to 4 percent by the end of 2009.  This will help 
to put a cushion under the level of demand in the economy and set 
the scene for recovery in 2010. 
 
--------------------------------------------- -- 
  Jan08 Feb08 Mar08 Apr08 May08 Jun08 
 
Bank Rate 5.50 5.25 5.25 5.00 5.00 5.00 
--------------------------------------------- -- 
 
Public Finances Breaking the Rules 
---------------------------------- 
 
10. (U) HMG's current budget deficit in May, at GBP 9.1 billion, was 
the worst May figure since monthly records began in 1993, and the 
second worst figure on record.  Tax receipts in the first two months 
of the fiscal year (which begins in April) were up only 3.6 percent 
year on year, worse than the 4.8 percent forecast by the Chancellor 
in his March Budget.  The Chancellor has predicted public sector net 
borrowing to reach GBP 43 billion at the end of the financial year, 
but analysts believe he will exceed this target by a substantial 
margin. 
 
11. (U) There has been media speculation, widely regarded as 
accurate, that Treasury officials have begun working privately on 
plans to rework the fiscal rule, established by Gordon Brown as 
 
LONDON 00001921  003.2 OF 003 
 
 
Chancellor, that limits public sector debt to 40 percent of national 
income.  Following the rule changes, it is likely that public sector 
debt could rise to 42-45 percent of GDP.  At a Downing Street press 
briefing, the Prime Minister's spokesman noted that according to the 
IMF's latest estimates for 2008, the UK is in a stronger position 
than most countries.  Net debt in the Euro area as a percentage of 
GDP is currently 55.9 percent and in the U.S. is 47.9 percent. 
 
------------------------ ---------------------------------- 
 Apr08 May08 Jun08 
 
Current Budget (Billions) 0.6 (9.1) (7.6) 
(Deficit in brackets) 
 
Public Sector Net Lending 0.5 (11.0)  (9.2) 
(Billions-Borrowing in brackets) 
 
Public Sector Net Debt   36.5     37.2  38.3 
(Percentage of GDP) 
----------------------- ----------------------------------- 
 
 
Chancellor to Pay the Price? 
---------------------------- 
 
12. (SBU) Darling threatened to resign twice prior to publishing the 
2008 HMT budget report, according to recent reports in the media. 
One influential MP told us that a shake-up of Brown's cabinet is 
very likely in the fall, confirming press reports. Darling could 
likely lose the Chancellorship in any government re-shuffle, given 
Brown's need to demonstrate a response to the growing public 
perception of economic malaise in the UK. Darling has also been the 
point person in multiple unpopular tax proposals that were later 
revised or scrapped, including the non-dom tax changes, car taxes, 
and most recently a tax on passive income for multinational firms. 
The constant reversals have battered Darling's and the government's 
reputations as responsible guardians of the British economy.