Bri­tain: Nice econ­omy, shame about the pol­i­tics

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

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.

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