Scottish Economic Report

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Scottish Economic Report: June 2002

1.3 The UK Economy

1.3.1 Overview

The Chancellor of the Exchequer published his Financial Statement and Budget Report on 17 April 2002, setting out the current economic position and the forecasts for future years. The forecasts for the UK economy were favourable, with total output expected to increase by 2 to 2.5 per cent in 2002, rising to between 3 and 3.5 per cent in 2003. However, the Chancellor cautioned that growth of the UK economy in 2002 would be affected by the pace and timing of the global recovery.

Official data released since the time of the Budget have shown that activity in the first quarter of 2002 was weaker than expected by most commentators, including the Treasury: GDP was unchanged; manufacturing output recorded a further sizeable contraction; and exports fell further. Nevertheless, most commentators agree that the performance of the UK economy will improve in the second half of the year.

The UK government's latest forecasts, as outlined in the Budget 2002, and other recent economic indicators show that:

  • GDP growth is forecast to be between 2 and 2.5 per cent in 2002, rising to between 3 and 3.5 per cent in 2003;

  • RPIX inflation is forecast to remain around the UK government's target rate of 2.5 per cent for the coming years;

  • Public sector net debt is projected to fall to around 30.2 per cent of GDP by the end of 2002-03;

  • The UK Government remains on track to meet its fiscal rules in the years ahead, with the current budget surplus projected to be 3 billion in 2002-03 (0.3 per cent of GDP);

  • The Monetary Policy Committee held UK interest rates at 4.0 per cent at their June 2002 meeting, the lowest rate in 37 years.

1.3.2 Recent Developments and Risks

Despite the difficult global economic environment, the UK economy performed strongly in 2001, underpinned by the resilience of domestic household consumption and the output of the service sector. Service sector output grew 0.5 per cent in the fourth quarter of 2001, up 3.1 per cent on the same quarter of the previous year. The strength of this growth can be explained partly by the modest contribution of exports to UK services demand. Total UK output expanded by 2.2 per cent in 2001.

One of the main reasons behind the UK's strong growth in 2001 was the resilience of household consumption which continued to grow strongly despite the large uncertainties which surrounded the UK economy at that time. Strong household consumption helped to maintain employment at its highest levels since records began, with unemployment also remaining at record low levels. This came at the time when all major economies throughout the world were suffering increases in unemployment.

The UK economy could not, of course, escape the global slowdown completely unaffected. The synchronised world slowdown and the collapse in demand for ICT-related goods led to a marked contraction in UK manufacturing output and exports, and depressed business confidence and investment.

Output in the final quarter of 2001 and the first quarter of 2002 was flat. This was the first time the UK economy has failed to grow over two successive quarters since 1991. This development suggests that there should be increased caution over the timing of the recovery of the UK economy. The UK's growth performance in the first quarter trailed behind that of many of the G7 countries: Germany and France grew by 0.2 per cent and 0.4 per cent respectively, based on quarter-on-quarter growth; the US economy also grew strongly, with annualised growth of 5.6 per cent for 2002 Q1.

The manufacturing sector continued to struggle in 2002, with output falling 1.4 per cent in the three months to February 2002, down 6.2 per cent on a year earlier. However, there are signs that this decline in manufacturing output is set to stabilise and forecasters are predicting a recovery in the second half of 2002 as demand for manufactured goods increases.

The OECD suggest that the biggest risk to the UK economy in the coming years is the imbalance between internal and external demand which has emerged over the past few years. Furthermore, they suggest that some deep-seated structural problems remain. In particular, OECD emphasises the importance of structural policy aimed at enhancing human capital and work incentives, raising competitive pressures and improving public infrastructure. Overall, the OECD's assessment is that UK growth will return to a solid pace soon, boosted by the expected turnaround in international trade and the substantial increases in public investment already announced.

Although the increasing uncertainty in the Middle East, and its associated implications for the world's oil supply, is a particular threat to the global economy recovering in 2002, this will have a relatively smaller effect on the UK. In general, the shock to the UK economy of a rise in oil prices will be smaller than on the US or the Euro area, owing to the UK's status as an oil producing country. This has led to forecasters predicting that the recent rise in oil prices will pose relatively little threat to the inflation outlook, even if it were to be permanent. 9

1.3.3 Current UK Monetary and Fiscal Indicators

Monetary Indicators

RPIX inflation was 2.1 per cent in 2001, and - apart from an erratic January figure (2.6 per cent) - has remained just below the UK government's target rate in the early months of 2002. The main driver for inflation in recent months has been the increase in seasonal food prices caused by the unusually bad weather conditions throughout Europe over the Winter. However, housing costs, which continue to increase as the housing sector remains buoyant, along with the rising price of oil, are likely to be the main drivers behind any price rises in the immediate future.

Against this benign inflationary backdrop, UK interest rates have remained at 4.0 per cent since November 2001, when the Monetary Policy Committee (MPC) acted to reduce interest rates in the light of the global economic slowdown and the events of 11 September. Rates were unchanged at the most recent MPC meeting on 6 June.

It is useful to remember, however, that the MPC must look ahead to the medium term rather than target current inflationary pressures when setting interest rates. This is because of the lags associated with the operation of monetary policy, typically thought to be around 18 months. The monetary framework set up in 1997 ensures that deviations below the target rate are just as undesirable as deviations above the target rate. Consequently, there is no incentive for the MPC to keep interest rates high when there are low inflationary pressures in the medium term.

The IMF's inflation forecast 10 is very close to the Budget 2002 projections, with inflation forecast to be 2.4 per cent in 2002, rising slightly to 2.5 per cent in 2003.

Fiscal Indicators

The slowdown in the world economy in 2001 has affected the fiscal balances for last year. Weaker external demand, lower equity prices and the deterioration in financial corporations' profits depressed corporation tax receipts in particular. Despite this, the UK government continued to meet its fiscal rules 11 and remains on track to do so over the next five years.

The forecast for government receipts for 2001-02 was revised down significantly in the November 2001 Pre-Budget Report (PBR), and actual receipts outturns since November have been about 1 billion below the PBR forecast. Despite this, the provisional current budget outturn shows a surplus for 2001-02 of 10.6 billion (0.3 billion higher than projected in the PBR), reflecting lower than expected spending outturns. The current budget is expected to remain in surplus over the period to 2006-07 (see Table 1.5), implying that the UK government will meet its golden rule (i.e. borrowing only to invest).

Table 1.5

Public sector net debt was 30.4 per cent of GDP in 2001-02, and is projected to fall slightly to 30.2 per cent in 2002-03. Over the next five years, public sector net debt is forecast to edge up to around 31 per cent of GDP, comfortably meeting the sustainable investment rule.

The overall macroeconomic position of Budget 2002 represents a slight fiscal tightening for this year and next, compared with the November 2001 PBR, as growth gathers pace and the economy returns to trend. The projections indicate that the UK has a broadly sustainable fiscal position in the long-term, with the impact of an ageing population on public finances expected to be both manageable and less marked than in most other EU countries.

1.3.4 Prospects and Forecasts for the UK Economy

The UK government's forecasts for the main economic indicators, including growth and inflation, for the next 3 years were published in the 2002 Budget. The forecast range for output growth for 2002 remained the same as published in the PBR in November, with growth of between 2 to 2.5 per cent forecast. However, the forecasts for 2003 and 2004 were revised up slightly, indicating that the UK economy is expected to strengthen further into 2003 and 2004.

Table 1.6

The latest consensus of independent forecasts 12 for the UK economy shows GDP growth of 1.9 per cent and 2.6 per cent for 2002 and 2003 respectively. This is slightly below the Treasury's forecast range for 2002, and significantly below the Treasury's forecast range for 2003. The IMF forecasts are within the UK government's forecast range, predicting GDP will grow by 2 per cent in 2002, increasing to 2.8 per cent in 2003. The IMF's forecast of UK inflation, at 2.4 per cent in 2002 and 2.5 per cent in 2003 is also close to the UK government's forecast.

Box 1.6: UK Trend Growth

The rate of trend (or potential) growth is the rate at which the output of the economy can grow on a sustainable basis without putting upward or downward pressure on inflation. Factors such as changes in confidence, demand conditions in the UK's trading partners, and the stance of monetary and fiscal policy, will all have temporary effects on economic growth. However it is longer-term factors, such as growth of productivity and the rate of growth and structure of the population, which all have lasting effects which will alter the trend growth rate.

In the April 2002 Budget, the Treasury announced that it was revising upwards the UK trend growth rate from 2.5 per cent to 2.75 per cent. The trend rate of growth calculated by the Treasury is based on four main components: labour productivity; average hours worked; trend employment rate; and population of working age. The Treasury forecasts the following changes to these components over the coming years:

  • Labour productivity: projected in line with the evidence of recent years, implying trend productivity growth of 2 per cent;

  • Average hours worked: assumed to decline slightly, by 0.1 per cent a year, in line with the trend over the 1986 to 1997 cycle;

  • Trend employment rate: projected to grow by 0.2 per cent a year (less than has been experienced in recent years) through a combination of a decline in the inactivity rate and modest further falls in the Non-Accelerating Inflation Rate of Unemployment (NAIRU);

  • Population of working age: projections are based on the Government Actuaries Department assumptions. For the trend rate of growth, it is assumed that net migration will be similar to that of the last three years. This implies a contribution to the trend rate of growth of 0.6 per cent a year over the Budget projection period, slightly less than over recent years.

However, the Treasury uses a different trend growth rate for the public finance projections in order to take account of forecast risk. The UK Government deliberately uses a cautious assumption for trend growth for the public finance projections that is 0.25 of a percentage point lower than its neutral view. Therefore, the annual trend growth rate used for public finance projections will be 2.5 per cent, up from its previous rate of 2.25 per cent.

Trade and Balance of Payments

The synchronised slowdown in the world economy has inevitably affected UK trade, with many of our trading partners facing economic hardship. Weak growth in major export markets, along with the slump in demand for highly traded ICT goods, contributed to a marked contraction in UK exports in the second half of 2001. At the same time, imports weakened much more sharply than projected in the 2001 Budget, with the net effect being a moderate widening of the deficit on traded goods and services.

Box 1.7: Two Speed Economy?

The UK economy has been growing strongly in recent years, although for the past four years there has been imbalance between the different sectors of the economy. Much has been written about the continued slump in the manufacturing sector, while the service sector has continued to grow strongly. The impact of the high value of sterling against the Euro, coupled with the recent slowdown in the world economy, have exacerbated the long-run difference between the two sectors, or to be more precise, between the tradable and non-tradable sectors of the economy.

Chart 1.7 illustrates the comparative performance of the UK manufacturing and service sectors, along with the overall growth in output. From 1996 onwards, there is a clear divergence between the two sectors, with the service sector on a continued upward trend, whilst manufacturing growth has remained static. Indeed, over the past year, manufacturing has suffered a sharp decline in its output growth.

Chart 1.7

When looking at differences between sectors, it is important to view them in a long-run context. Productivity increases at a faster rate, on average, in manufacturing than in other parts of the economy. Consequently, other things being equal, employment in manufacturing falls as a share of the total. For example, at the start of the 20 th century there were over 100 blast furnaces along the banks of the River Tees. Today there is only one plant - Corus at Redcar - which produces more iron than all the 106 combined plants a century ago. Such productivity growth will increase the standard of living, but will also result in the share of manufacturing in total employment continuing to decline, unless demand increases, for example from export markets.

Recently, domestic demand has been strong while the trade position has been weak. This year net trade is forecast to make a negative contribution to economic growth for the sixth year in a row. Therefore, it is important that such imbalances should be reduced in order for the UK economy to continue to grow strongly. The recovery in the world economy will help reduce the existing imbalance. However many commentators have suggested that any unwinding of the imbalance between domestic demand and output is likely to involve a slowdown of consumption growth in order to release resources that could be diverted to investment and an improvement in the trade balance. This, it is argued, may lead to a fall in the sterling exchange rate to a more sustainable level. However, when and how these adjustments will occur is extremely difficult to know.

The UK government forecasts that UK exports will pick up through 2002 as the global economic recovery begins to gather pace, but year-on-year growth is projected to be negative for 2002 as a whole, contracting between 1 to 1.5 per cent. Imports are also expected to accelerate this year, although the forecast moderation in household consumption growth, coupled with the increasing share of final expenditure accounted for by government spending, will limit import growth over the medium term.

The trade deficit is forecast to widen slightly in 2002 with the balance of payments current account deficit rising to 2.5 per cent of GDP, from a deficit of 1.75 per cent in 2001. However, the Treasury forecast that the current account deficit will stabilise at 2.25 per cent of GDP, a level which is both readily financeable and which remains well below past peaks.

1.3.5 Budget 2002: Announcements and Economic Impact

The April 2002 Budget outlined the measures and policy decisions taken by the UK government to advance their long-term goals of:

  • Maintaining economic stability, ensuring that the fiscal rules are met, inflation remains low, and the UK has faster productivity growth than its main competitors;

  • Sustaining a higher proportion of people in employment than ever before, while seeking to ensure full employment in every UK region;

  • Eradicating child poverty and tackling pensioner poverty, extending opportunities for all children and providing security for all pensioners;

  • Establishing world-class public services, delivering investment to improve national healthcare for all, raise standards in education, modernise Britain's transport system and tackle crime;

  • Tackling global poverty and climate change, helping to achieve the international community's Millennium Development Goals by 2015, and achieving the UK's commitments under the Kyoto Protocol.

The main announcements in the 2002 Budget are summarised in Box 1.8.

Box 1.8: Main Budget Announcements

  • The Scottish Executive budget will increase by 224 million over 2003-04, and by a cumulative extra 3.2 billion over the next 5 years, as a consequence of the Chancellor's spending announcements;

  • New measures introduced to help small and large businesses: financial assistance for small firms' training needs; automatic relief for VAT on bad debts; plan to extend flat rate VAT to more small firms; corporation tax starting rate reduced from 10 per cent to zero, with corporation tax for small firms reduced from 20 per cent to 19 per cent; and volume-based R&D tax credit for large companies;

  • Help for areas of high unemployment: further exemptions from stamp duty for non-residential property transfers in disadvantaged areas; and a new Community Investment Tax Credit to promote enterprise and wealth creation in under-invested communities;

  • A new Working Tax Credit will be introduced from April 2003 to provide work incentives and help reduce persistent poverty among working people;

  • Basic credit on the Working Families Tax Credit will be increased by 2.50 a week from June 2002, on top of the inflation increase;

  • Extra 1 per cent of National Insurance Contributions (NIC) paid by employers, employees and the self-employed on all earnings above the NICs threshold of 89 a week from 2003;

  • In total, an extra 4 billion for public spending in the UK next year was announced, with the largest ever sustained increase in health spending.

Total public spending 13 is forecast to increase substantially over the next 3 years, rising from 392.1 billion in 2001-02 to 454.6 billion in 2003-04. The Treasury forecast the tax burden to increase modestly from 36.7 per cent of GDP in 2002-03 to 37.6 per cent in 2003-04, with further rises in 2004-05 and 2005-06, leaving the tax burden at 38.3 per cent of GDP.

Chart 1.8

References

European Central Bank, Monthly Bulletin, April 2002

OECD (2002) Economic Outlook, May 2002

IMF (2002) World Economic Outlook, May 2002

SCDI (2001) Survey of Scottish Sales and Exports in 1999

National Institute for Economic and Social Research (2002), Economic Review May 2002

Scottish Executive (2001), Scottish Input-Output Tables

HM Treasury (2002), Budget Report, April 2002

HM Treasury (2002), Forecasts for the UK Economy, March 2002

Page updated: Friday, March 31, 2006