Britain: Nice economy, shame about the politics
While sterling is setting new post-2007 highs almost daily against the euro and on its trade-weighted index, economic optimism seems to outweigh political nervousness as Britain heads towards its most unpredictable election in living memory on May 7. But is Britain’s economic outlook really good enough to compensate for the political mess that almost everyone now expects?
The idea that Britain has recently enjoyed an economic renaissance and been outstandingly successful compared to the eurozone is half-true. While employment in Britain has grown much faster than in any other European economy, this job growth has been secured at the cost of the biggest decline in real wages since the 19th century and an unprecedented collapse in productivity, at least as measured by official statistics. Total GDP is now 3.4% above its early 2008 peak, exactly in line with Germany and almost 2 percentage points ahead of France, but GDP per capita is still 0.4% below its 2008 level. The main reason for this slump in productivity and wages has been the weakening of Britain’s highest value-adding sectors-finance and oil-resulting from both global structural changes and adverse government regulation.
More worrying for the financial markets has been the British economy’s extraordinary reliance on foreign borrowing and the consequent risk of a vicious circle between political instability and a reversal of capital flows, especially if Labour emerges as the dominant force of a coalition government after May 7.
Britain’s 2014 current account deficit is estimated by the IMF at 4.2% of GDP ($120 bln) and the last official figure, for 3Q14, showed the gap at 6% of GDP, a post-war record. Even at 4.2%, Britain would have by far the biggest deficit in the nonUS world in dollar terms and the biggest relative to GDP among all the OECD economies. It was three times larger than the next biggest deficit in Europe, the $41 bln, or 1.4% of GDP, recorded by France. A related statistic, the inflow of short-term foreign capital unconnected with direct or portfolio investment in British companies or property, was an even more extraordinary $210 bln, equivalent to 8% of GDP. This was the largest inflow of “hot money” on record. These unprecedented figures imply that Britain is now more dependent than ever on speculative inflows of foreign capital.
Such hot money is notoriously fickle about politics, taxes and regulation, which means that the capital flows that sustain sterling’s present level could drop off sharply after the May election.
Few investors attach any significant probability to Labour’s Ed Miliband becoming the next prime minister. But opinion polls consistently show Labour in a dead heat with David Cameron’s Tories (both at 33%) despite Miliband’s stridently anti-business rhetoric or perhaps because of it. If the actual voting on May 7 comes anywhere near these numbers then neither major party will be able to secure a parliamentary majority, even in coalition with the Liberals. And if a coalition of more than two parties is needed to achieve a majority, then Scottish Nationalists and Liberals are more likely to join with Labour than the Tories. While Britain’s decent economic performance suggests that many voters should swing back to the incumbent Tories as the election approaches, there has been surprisingly little evidence of any such movement thus far. On balance, Britain’s political bookmakers, who are generally better than pollsters at predicting election outcomes, now offer 40% odds on Miliband becoming the next prime minister, compared with 60% on Cameron. This means that a Labour-led government is not very likely, but if Miliband does become the next prime minister, this will come as an immense shock.
Whoever emerges as the next prime minister, his main political priorities will be unattractive to international investors. A Labour-led government’s main emphasis would be on tax hikes, especially for financial institutions, high earners and the wealthy foreigners who now enjoy extremely generous fiscal privileges in Britain. A Tory-led government’s top priority would be a referendum on EU membership, with the Tories’ large euro-phobic faction trying to force Cameron to demand new membership terms that the other EU countries could not possibly accept.
Whatever happens on May 7, therefore, Britain will become one of Europe’s politically unpredictable countries, instead of a safe haven of political stability amid the chaos of the eurozone. Will this mean that Britain becomes less attractive to foreign capital and needs a substantial devaluation to keep attracting capital flows, as it did in 1992 and 2009? Like any question about exchange rates, the answer will depend on a host of domestic and international factors. But considering that Britain is now more reliant on capital inflows than any other advanced economy, this is a question that investors in sterling assets cannot ignore.