Economic Outlook --- summer 2011

An uphill struggle

Key points

 Although it is two years since the recession ended, and global growth
Contents
is back to 3%+, the legacy problems are unresolved. The debt-induced
The global
fragility in the advanced economies remains, while emerging economies
are dealing with an inflation problem. Growth should not be derailed, economy 2-3
but the twin speed global economy will continue.
Europe’s
 In Europe, the outlook is dominated by the sovereign debt issue debt crisis 4-5
which has proved stubbornly resistant to the policymakers’ initiatives.
Contagion is a very real risk and overshadows growth issues. Output UK overview:
in indebted countries of the periphery will continue to stagnate while a slow recovery 6-7
Germany and its neighbours maintain a healthy broadly-based recovery.
UK economy: a
 Having clawed back the ground lost at the end of 2010, the UK seems
once again becalmed in mid 2011. The squeeze on the household sector re-balancing act 8-9
is now very evident, with debt, job insecurity and the eroding spending
power by inflation all contributing to a scaling back of growth forecasts The household
for this year and next. And the parlous state of public finances mean the sector feels
government cannot come to the rescue. the strain 10-11

 With both the consumer and public sector constrained, the UK needs Forecasts 12
investment and net trade to drive growth. Progress towards ‘rebalancing’
the economy has been mixed, although there were encouraging signs in
the first half of 2011. Continued sub-trend growth, rather than a slide
back into recession, is the most-likely outcome.

 For the UK authorities, the dilemma between growth and inflation

seems to have been decided in favour of growth. In contrast to the ECB,
the MPC has kept Bank Rate at historically low levels despite consumer
prices rising at twice the target rate. Increasing rates will do more to slow
output growth than price rises, and the loose monetary policy is needed
to offset the government’s tough fiscal stance.

Further information from: Dennis Turner, HSBC Bank plc, Business Economics,
8 Canada Square, London E14 5HQ. Telephone: 020 7991 8567.
2
The global economy: speed bump or road block?
It’s now two years since the global recovery got
under way. But the tenor of the economic news
flow has softened markedly in recent months,
especially in the manufacturing sector. Financial
markets meanwhile remain jittery on account of
the Eurozone’s sovereign debt crisis, and there
are also growing concerns about the possibility
of a hard-landing for China’s economy.
To date, a key driver of the revival has been the
need for manufacturers, distributors, and retailers
to rebuild inventories, which had been run down
to very low levels in the immediate aftermath of
2008’s financial crisis. This process contributed
to a rebound of around 14% in the volume of
global merchandise trade in 2010, thereby making
good the slump of the previous year. Viewed
purely in terms of economic growth, therefore,
last year was one of the best ever for the
global economy. But the process of rebuilding
inventories is only ever a temporary boon for
economies as they emerge from recession.
For those recoveries to be sustained requires
that households have the confidence to spend,
and that businesses have the confidence to invest.
Advanced economies hobbled by debt
It is at this point that the fragility of many
advanced economies is becoming all too apparent.
A sizeable number remain hobbled by
excessive indebtedness, whether in the household
sector, the public sector, or both; and with
governments having exhausted their abilities to
offer fiscal stimuli, the going will get a good deal
tougher from here on. This applies particularly to
the US, Japan, the UK, and the countries on the
periphery of the Eurozone. It applies far less, or
not at all, to those sitting on a stash of valuable
natural resources, those with highly-competitive
export sectors, and those who have managed to
ride out the travails of the past few years without
running up large government budget deficits.
Some slowing was therefore inevitable, once
inventory levels were back to normal and as
governments in the west started to make the
painful transition from fiscal stimulus to fiscal
austerity, and as the large emerging economies
started to fight the inflation that had been
triggered by very rapid growth. The question that
is now obsessing investors and financial markets
is whether the sluggish news flow of the past
few months is simply a hiccup on the long and
winding road to recovery, or whether it is the
result of more sinister forces.
Earthquake damage
The answer, as ever, is not straightforward.
The earthquake and tsunami in Japan caused
substantial temporary disruption to some supply
chains, especially in the automotive industry.
There is also evidence that many businesses
are again paring back their inventories. But the
biggest factor behind the recent soft run of data is
the latest surge in commodity prices. With wage
growth in many advanced economies constrained
by high unemployment rates, real disposable
incomes are either rising very slowly, or falling.
This is putting people off from spending, and is
prolonging the process of paying down debts.
It is likely that the tone of the news flow will
perk up again during the next few months.
The disruptions caused by Japan’s earthquake
have largely been resolved, while commodity
prices have edged down in the past month or so
as evidence mounts that the measures taken by
policymakers in emerging economies to cool their
rapid growth are beginning to bear fruit. In any
Fragile growth keeps the lid on rate rises
6
Policy interest
5 rates:
UK forecast
4 USA
% Euro Area
3
2
1
0
2006 2008 2010 2012
Source: Bank of England / US Federal Reserve /
ECB
 3

case, given the fact that the rebuilding of

inventories still left stocks of finished goods Global economic growth
and raw materials at much lower levels than annual % change in real GDP
before the financial crisis, there is little scope
for further unwinding. 2009 2010 2011 2012

World -2.3 3.8 3.0 3.4

So, in all probability the second half of the year
will be marginally stronger than the first half, Developed
-3.7 2.6 1.8 2.3
economies
provided that commodity prices don’t spike
again. But there can be no doubting that for Emerging
2.0 7.6 6.3 6.2
economies
many countries the road to recovery is going
USA -2.6 2.9 2.5 2.9
to be a long hard slog. The combination of high
indebtedness and two decades of offshoring Latin
-3.0 6.6 4.7 4.4
America
and outsourcing to emerging economies have
inhibited the powers of revival, as reflected in Mexico -6.1 5.4 4.1 4.1
lower trend rates of economic growth. This makes Brazil -0.6 7.5 4.1 4.4
it harder for governments and households to pay Argentina 0.9 9.2 8.0 5.0
down their debt burdens. Those governments that Euro Area -4.1 1.7 2.0 1.4
fall by the wayside will risk severe punishment Germany -4.7 3.5 3.3 1.9
from the financial markets. France -2.6 1.4 2.0 1.9
Italy -5.2 1.2 0.8 0.9
Job creation takes priority Spain -3.7 -0.1 0.6 1.0
UK -4.9 1.4 1.2 1.6
For all the woes of the Eurozone’s sovereign E. Europe -- -- --
debt crisis, at least there is tangible evidence Poland 1.6 3.8 4.0 4.2
of deficit reduction, even in Greece. Meanwhile, Russia -7.8 4.0 5.5 4.0
the UK has a plan, but has yet to demonstrate Turkey -4.8 8.9 5.8 3.7
that it can be implemented; America doesn’t
ME & Africa -- -- --
even have a plan, and may not get one for some
Saudi Arabia 0.1 3.8 5.0 4.3
time, possibly not until after the next Presidential
S. Africa -1.7 2.8 3.5 3.6
election; and Japan continues to wallow under
UAE -2.9 1.7 3.9 4.2
the twin hindrances of a huge burden of debt –
Asia-Pacific 0.4 6.6 4.0 5.5
now standing at more than twice its annual GDP –
Japan -6.3 4.0 -0.6 2.4
and a rapidly ageing population.
China 9.2 10.3 8.9 8.6
India 7.0 9.0 7.5 8.1
Against this backdrop, policymakers in the
Australia 1.3 2.7 2.2 4.5
advanced economies will concern themselves
Korea 0.3 6.2 4.1 4.7
more with the absence of decent job-creating
Malaysia -1.6 7.2 5.7 5.8
growth than with strict adherence to inflation
Source: HSBC Global Economics Q3 2011
targets. Certainly, there now seems little chance
of the Bank of England raising interest rates
before the end of this year, while the US Federal
Reserve is unlikely to lift rates from their present
near-zero level until the autumn of 2012. The
European Central Bank takes a different stance,
with the inflation hawks still in the ascendant.
But even here, after delivering two rate hikes in
the past few months, the ECB will now proceed
more cautiously.
4
Europe’s debt crisis: no easy options
It is now more than 18 months since the first
rumblings of the sovereign debt crisis were
detected. Since then, three countries (Greece,
Ireland, and Portugal) have received bail-out
packages financed by the EU and the IMF.
For all the ministerial and summit meetings held
by the politicians, however, a lasting solution
has been elusive. Until one is found, the risk
of a disorderly default by a member of the
Eurozone remains the biggest risk facing
the global economy and the financial system.
Defying expectations
It continues to be a source of some surprise that
the debt crisis hasn’t had a detrimental impact
on the investing and spending behaviour of
businesses and households across the Eurozone.
Indeed, the Euro Area’s economic performance
has persistently exceeded the expectations
of economic forecasters. For 2010 as a whole,
GDP expanded by a respectable-enough 1.7%,
with the seven ‘core’ economies (accounting for
70% of total output) turning in growth of 2.4%.
This momentum was sustained into 2011,
with GDP registering a brisk increase of 0.8%
in the first quarter. But survey-based indicators
of activity and confidence have slipped in the
past few months, with the composite reading from
the Purchasing Managers’ Index (PMI) surveys
covering both the manufacturing and services
sector, falling to its lowest level for 20 months
in June. Survey results often give an exaggerated
impression of what is happening to economic
activity, but it nonetheless seems likely that the
pace of growth slowed in the second quarter.
Moreover, the chances of a rebound later in
the year look slim as policymakers in emerging
economies bear down on inflation, which is
also eating away at the disposable incomes of
households in the Eurozone. But the strong start
to the year means that the Eurozone economy is
still likely to meet the expectations for expansion
of 2% for the whole of 2011.
Germany has reassumed its role as Europe’s
economic locomotive for the first time since the
early 1990s, on the back of impressive export-led
growth and the associated job creation. The value
of goods exports to China rose by more than 40%
in 2010, the unemployment rate is now at its
lowest since reunification, and the number of
people in full-time work has increased by around
half a million in the past year.
Although there has been a clear down-shift in the
pace of manufacturing growth since the spring,
activity in the services sector has so far held up
well. The consumer landscape in Germany can
hardly be described as buoyant, with households
remaining cautious and frugal, and the savings
rate edging lower at a glacial pace. But it’s still a
far cry from the consumer recessions that are the
order of the day on the periphery (and in the UK),
with spending rising modestly as employment
increases. As export demand slackens, the onus
will now shift to households to keep Germany’s
recovery firing on all cylinders.
Harder times at the periphery
Life is far tougher on the periphery. Spain hovers
between minimal growth and mild recession,
the Portuguese economy is again contracting,
and there is still little evidence of a meaningful
recovery getting under way in either Greece or
Ireland, where output has contracted by 10% and
12% respectively from the pre-recession peaks.
The much talked about structural reforms that
are needed to make these economies competitive
again (this doesn’t apply to Ireland) will take
many years to produce tangible results.
Slowing growth in the Eurozone
2 65
60
1
PMI composite index
55
0
50
%
45
-1
GDP quarterly
growth (L axis) 40
-2
Composite PMI 35
(R axis)
-3 30
2007 2008 2009 2010 2011
Source: Eurostat, Markit

In the meantime, they will struggle to grow and to
deliver jobs and higher living standards for their
people against the headwinds of enforced fiscal
retrenchment. Greece’s recent experience shows
that an over-zealous approach to deficit-reduction
can be counter-productive. Greece slashed its
budget deficit by an impressive five percentage
points of GDP in 2010, but in so doing pushed
its economy deeper into recession which in turn
undermined the government’s ability to garner
tax receipts.
A second bail-out for Greece
Despite both Ireland and Portugal needing
EU/IMF rescue packages, it is the situation in
Greece which is fanning the flames of the debt
crisis. Having received a bail-out worth a nominal
€110 billion last May, it has become apparent
that this will not be enough. It had been assumed
when that deal was put together that Greece
would be able to regain access to the capital
markets to raise the bulk of its medium and
longer term financing needs from the spring
of next year. This now looks unlikely.
The vote in the Greek Parliament at the end
of June, giving approval to another round of
austerity measures and an ambitious programme
of privatisations, allowed the disbursement of
the next tranche (worth €12 billion) of the present
rescue, and was a pre-condition for the EU
considering a further bail-out. But the process
of putting a second support package together
has been fraught and rancorous. There has been
an almighty spat between Germany and the ECB
about the role, if any, that private sector investors
should play in any rescue, with the ratings
agencies debating the technical niceties of
whether this would be regarded as a ‘distressed
transaction’ and therefore qualify as a default.
Much of the discussion about the debt crisis has
taken a pejorative view that the politicians are
simply ‘kicking the can down the road’, delaying
an inevitable disorderly default. Meanwhile, the
view of many protesters on the streets of Athens
is that bankruptcy now would be preferable to
endless austerity. What both viewpoints fail to
take account of is the potential knock-on effects
5
from a disorderly default on the already-fragile
European banking system and on other peripheral
countries. The way the markets turned against
Italy in early July demonstrates how precarious
the situation has become.
Containing the contagion
In the end it is inevitable that Greece will either
have to be forgiven some of its debts, or be
allowed to repay them at rates of interest that
are markedly lower than those that would be set
by the markets. But in the meantime the EU and
the ECB have no option but to keep on bailing
Greece out in the hope that the contagion risks
to other peripheral economies and to the banking
systems in the rest of Europe can be neutralised.
This won’t be a palatable prospect for voters in
‘core’ Eurozone countries, who are becoming
ever-more disgruntled about bailing-out fiscal
miscreants on the periphery. But the alternative
is the high probability that the Eurozone’s
recovery is eventually derailed by a further round
of banking woes which governments now lack
the resources to combat. If Ireland and Portugal,
whose fiscal positions are less parlous than
Greece, can be put back on the straight and
narrow, and if Spain and Italy can keep out of
trouble, then in three or four years time it might
be possible to find a lasting solution for Greece
without bringing down the whole deck of cards.
Deficits: getting back on track in the periphery
18
Deficit* as a
15 share of GDP
* below 0 = surplus
12
9
%
6
3
Euro Area Spain
0
Portugal Greece
-3
2007 2008 2009 2010 2011 2012
Source: Eurostat / IMF / HSBC
6
UK overview: a slow recovery
For much of 2011, the UK economy appears to
have been becalmed. 'Flatlining' is the current
buzzword. As growth has stalled, the authorities
have been split as to whether to tighten policy
to dampen down above-target inflation or keep
it loose to ensure the recovery stays on track.
At the same time, the hoped-for and much-needed
re-balancing of activity is proceeding only very
slowly and opportunities internationally are
threatened by the on-going problems in the
Eurozone.
Yet there are encouraging signs. There has been
no deterioration in the labour market this year
and the key business surveys continue to point
to a positive short-term outlook. Exporters,
moreover, are responding (albeit erratically)
to the competitive pound and global growth,
and manufacturing has been the star performer
since the end of the recession. By the first quarter
of 2011, however, real GDP was still 4% lower
than the pre-recession peak and is unlikely to get
back to the 2008 level before 2013, with the risk
that it could take even longer. Recession may
technically be over but it is not yet ‘business
as usual’.
Slow progress
When GDP dipped into negative territory in the
final three months of last year, there was a sharp
intake of breath amongst policymakers and then a
sigh of relief when the lost ground was clawed
back in the first quarter of 2011. Although the
December weather was clearly a factor, the 0.5%
decline in Q4 GDP highlighted the weakness of
the recovery. A quarter in which growth stalls or
goes backwards is not, however, unusual for an
economy emerging from recession. Output does
not grow in a straight line upwards, and the path
of past upturns has been erratic and unevenly
shared between industry sectors and regions.
This recovery promises to be the same.
The current weakness reflects the depth of the
recession (a fall in real GDP of 6.5% over six
quarters) and the fact that the two principal
contributors to growth up to 2008 remain
constrained by the legacy problems. Over the
ten years to 2007, consumer spending (63% of
final demand) grew by an average of 3.5% a year
in real terms, which was underpinned by record
levels of borrowing. But today, households have
to unwind debt as well as having to cope with
uncertainty about employment prospects and
earnings rising at about half the rate of inflation.
In the first three months of 2011, real household
spending was not only lower (-0.3%) over twelve
months but was 4.3% down on the same period
in 2008, the last pre-recession year.
Public sector spending also grew strongly in the
pre-recession period (by 2.5% pa in the ten years
to 2008) but, like the household sector, relied
heavily on borrowing. After eight years in which
government finances went from a small surplus to
net borrowing of £156bn (and public sector net
debt from 29.7% of GDP to 60% in 2009/10),
the coalition government has called time on
this growth. The Chancellor’s plans to cut the
cost of the public sector by £120bn by 2015/16
have been announced and, although not fully
implemented, are already putting downward
pressure on activity. Although these proposals
have led to protests, a period of fiscal tightening
always follows a recession. When Messrs Healey
(1976), Howe (1979-81) and Lamont/Clarke
(1992-94) squeezed taxes and government
spending, their actions slowed rather than
derailed the recovery.
A slow recovery is under way
6
GDP growth: Quarterly Annual
4
long-term average
2
% 0
-2
-4
forecast
-6
2006 2007 2008 2009 2010 2011 2012
Source: ONS / HSBC

Policy options
The two key priorities for government are to
ensure the economy recovers and to get public
sector finances back on track. In the first half of
2011, inflation came back on the agenda, as the
CPI was consistently outside the target range.
There were calls, supported at times by a third
of the MPC, to raise Bank Rate but the majority
view that tighter monetary policy would do more
to slow growth and weaken the recovery than
dampen price rises prevailed.
There are two principal sources of inflation.
Firstly, imported food, commodity and oil prices
have fed into retail prices, but these would not
be affected by higher interest rates in the UK.
And secondly, higher taxes (excise duties and
VAT) have contributed to inflation. If the impact
of fiscal policy is excluded, however, CPI has
been within the target range all year. And with
consumer price inflation running well ahead of
earnings growth, purchasing power is already
being eroded – which is exactly what higher
interest rates do.
It does appear that there are enough deflationary
forces already at work to support the MPC view
that inflation will slow without having to raise
interest rates. It might take a little longer, but
a continued loose monetary policy will support
the government’s two primary objectives and
help offset the impact of a tighter fiscal stance.
With the consumer and public sectors boxed
in, getting back to trend growth will depend
to a significant extent on the corporate sector,
with exports and investment spending the keys.
There have been encouraging signs in 2011 about
export trends which have been reflected in the
robust performance of manufacturing over the
past 18 months and in the responses to business
surveys. But a continuing dependence on the
debt-hampered EU (over 50% of exports) and
low level penetration of the key BRIC economy
markets are potential weaknesses. The corporate
sector seems to be in good financial shape but
is reluctant to spend – probably the result of a
lack of confidence.
7
Short-term outlook
Forecasts for growth in 2011 have been reduced
a little but a double dip recession is not on the
agenda. Given the constraints on the consumer
and public sectors, plus the risks to activity in
Europe, the increase in GDP will be of the same
order of magnitude as last year (1.0 to 1.5%) –
positive, but only around half the trend growth
rate. Net trade will be the key to growth. There
is, moreover, a greater probability that output
will be weaker than this, rather than faster.
Above-target inflation will be a feature of the
economic landscape well into next year, while
Bank Rate will be left on hold until 2012.
Next year is likely to be another year of below-
trend (but positive) growth, with investment
showing signs of an upturn and a little more
spending by consumers offsetting a negative
contribution from the public sector. Bank Rate
should start to move up in Q1 (and 2% by year-
end) while inflation comes back to within the
target range in the first half of 2012. More of
the same is obvious conclusion as the economy
inches its way back to normal.
Inflation is expected to fall back
6
CPI inflation* forecast
4
inflation target
2
%
forecast
0
* Consumer Prices Index (CPI):
annual percent change
-2
2009 2010 2011 2012
Source: ONS / HSBC
8
UK economy: a re-balancing act
Madness, according to Einstein, is doing the
same thing over and over again and expecting a
different outcome. Applied to the UK economy,
this means if recovery depends on inflation,
consumer spending and the housing market,
as it has in the past, it might lift activity in the
short term but, as before, it will be a signpost
to the next downturn. To come out of recession,
and stay out, means doing something different
and doing more of what the UK failed to do
enough of in the period up to 2008.
Some 80% of GDP growth during the years from
2001 to 2007 came from 40% of the economy –
financial services, property and construction
and distribution. This clearly reflected the
domestic nature of growth, which depended
heavily on consumer and government spending
(and borrowing). With both these sectors now
constrained, the corporate sector has to look
elsewhere, which means exporting is the key,
together with investment. The scale of the task
is daunting. In the period from 1997 to 2007,
net trade reduced GDP by a fifth whereas from
2011 to 2015, it is expected to account for 30%
of growth. This is is a major challenge given
the uncertainties in the global economy. So far,
progress has been mixed.
Exports on the up
Despite the relatively weak domestic activity,
the UK’s trade position worsened in 2010.
The deficit on the current account of the balance
of payments rose by over £12 billion in 2010,
to £36.2 billion. There was a particularly marked
deterioration in the trade in goods, as well as
a small fall in the surplus in trade in services.
Although overseas investment income made a
dent in the shortfall, the UK’s deficit amounted
to a sizeable but manageable 2.5% of GDP.
A push to increase exports would boost the
balance of payments and underpin recovery.
To succeed in export markets, UK companies
need three things. They need good products
and it seems that across a range of sectors,
British products still have an enviably positive
reputation for quality. The second pre-requisite is
to be competitively priced and the fall in the value
of sterling is helping in this respect. In Q1 2011, a
pound was worth €1.171 and $1.603, down 30%
and 19% respectively on Q1 2008, just before the
start of the recession. Despite the inflationary
consequences on imports, and the inevitable time
lag before exports respond, this effective
‘devaluation’ of the currency, along with low
interest rates, is the key to recovery.
The third factor is growth in the UK’s key
overseas markets. The world economy has picked
up after the first post-1946 year of negative
growth in 2009, with growth in 2011 and 2012
expected to be in the 3.0-3.5% range. There is,
however, a shift taking place in the distribution
of this activity, with increases in output in the
developing countries at least three times faster
than in the traditional economic powerhouses
of the developed world. This is an opportunity
and a vulnerability for the UK.
In 2010, 53% of the UK’s £265 billion exports
found their way to other countries in the EU,
the vast majority of which went to members of the
Eurozone. Given the huge debt-related issues in
the single currency area, growth prospects must
be constrained. The UK’s single largest market
remains the US (14% of the total), also grappling
with debt and emerging slowly from recession.
So, two thirds of the country’s exports go to two
high-income parts of the global economy which
have been under-performing.
Losing market share in the BRICS
20 2.5
UK market share of total
BRIC* imports (R axis)
2.0
15
£bn 1.5
10 * Brazil, Russia, %
India, China 1.0
5
0.5
UK exports to BRIC*
economies (£bn, L axis)
0 0.0
2000 2002 2004 2006 2008 2010
Source: ONS / IMF
 9

Attention in world markets is increasingly being for the rest of this year. The corporate sector is
focused on the emerging countries, with the BRIC in reasonable financial shape, as a result of the
economies of Brazil, Russia, India and China long period of low interest rates, cost cutting,
usually highlighted. These are countries barely reductions in corporation tax and improved
touched by recession and enjoying robust rates profitability, and better placed now than in
of growth. But in 2008 and 2009, the UK’s the past to fund capital expenditure.
combined exports to these four countries
amounted to just under 80% of the exports The OBR forecast
to the Republic of Ireland. To make a reality
The official OBR forecasts separate business
of rebalancing, there is a compelling need to
investment from total investment spending,
re-focus exports, just as Germany has done.
and growth in this vital category is expected
The Germans have shown that Europeans
to accelerate in the next few years, and reach
can sell into China and that China does not
double-digit rates by 2013-14. This implies
necessarily import from low-cost suppliers.
that business investment will match consumer
spending in terms of the contribution to GDP
It takes time, but there were signs that in Q1
growth even though in absolute terms, it is
the rebalancing was starting to happen. In 2010,
about a quarter of the size.
the 5.3% growth in exports of goods and services
lagged the 8.5% rise in imports, but in Q1 2011,
Given the constraints on households and
exports (10.4%) rose at twice the rate of imports
government, this rebalancing is the only
(4.9%). The trend in trade in goods only is even
way for the UK to get back to trend growth
more marked and the slower growth of export
(2.5% pa) in the foreseeable future. This is
prices compared with import prices seems to
essential if a more sustainable distribution
suggest the exchange rate is a benefit. In terms
of growth is to be achieved, but the obstacles
of products, exports of manufactures have been
to changing the way the economy operates
very robust and in terms of markets, growth has
should not be underestimated.
been strongest in non-EU countries.

Investment still disappoints A rebalanced economy

Once exports show signs of picking up, it is 2.0
Contributions
consumption

hoped that investment spending will start to to GDP growth

Private

investment
Business

expand. This second key component of the 1.5

rebalancing accounts for 15% of GDP but,
Net trade
percentage points

within this total spend of around £200 billion, 1.0

house building accounts for a significant share
Government

(19%) and the government for a further 20%. 0.5

The business investment element therefore is
around 60% of the total. Capital spending by
0.0
companies fell away markedly in the recession, Average 1999-2008
a near-20% drop in real terms in 2009, and the Average 2011-2015
-0.5
first signs of recovery only started to emerge
in the second half of 2010. Source: OBR

Disappointingly, manufacturing took its share

of the strain, with spending on capital equipment
particularly affected. Comparing the investment
record in this recession/recovery with past cycles,
however, it is clear that spending is picking
up earlier and surveys reveal a positive outlook
10
The household sector feels the strain
For the decade up to 2005, consumer spending
was the major driver of economic growth. In real
terms, spending grew by nearly 4% a year during
this period compared with GDP growth of 3%.
But this buoyant growth was fuelled by a huge
rise in indebtedness. In 1995 the household sector
owed £90 for each £100 of disposable income.
By 2005 this ratio had jumped to £140 for each
£100 of income in the process making consumers
much more sensitive to interest rate changes.
This heightened sensitivity became apparent
in 2004 when a relatively small rise in Bank
Rate saw a jump in servicing costs and a sharp
slowdown in spending growth. Higher interest
rates did not immediately deter borrowers,
however, and by the end of 2007 the household
sector debt income ratio had risen to 160%,
increasing interest rate sensitivity much further.
Recession hits hard
When the Bank of England again raised rates
in 2007, therefore, servicing a debt which had
hit £1.4 trillion escalated further and, with
unemployment rising sharply from the middle
of 2008, consumers were forced to rein in their
spending plans. An added problem arose in
2008, moreover, when the rate of inflation
accelerated past the rate of increase in earnings,
the subsequent squeeze on real earnings adding
to the sector’s woes. After peaking in the first
quarter of 2008, expenditure fell consistently
for the next five quarters, eventually cutting
spending by 5% in real terms.
With households weighed down with debt,
unemployment stuck at close to 8% for much
of the last two years, and earnings growth
consistently running below the rate of inflation,
recovery in spending, not surprisingly, has been
sluggish. In 2010, consumer spending rose by just
0.7% in volume terms before falling back in the
first quarter of 2011. There has been some good
news for consumers in that the private sector has
been creating jobs since the end of the recession
faster than the public sector has been shedding
them. But even that may not last. With growth
expected to continue to disappoint for the rest of
this year and into 2012, there must be some doubt
that the private sector will continue to generate
jobs at quite the rate it has been doing so far.
With public sector job losses expected to
accelerate from now on, overall employment
growth is unlikely to add much to spending
power over the next eighteen months.
Equity withdrawal goes into reverse
For the period up until 2007, the household
sector took advantage of a buoyant housing
market to withdraw equity, thereby adding
hugely to potential spending. Since 2007,
however, the weakness of the housing market
has meant that far from taking further equity out,
households have had to inject large amounts of
cash into housing, thus reducing spending power.
The continuing weakness of the housing market,
meanwhile, means that lenders will continue
to ask for high deposits from prospective
mortgagees for the foreseeable future, meaning
that households will have to continue injecting
money into housing rather than take it out.
The company sector, moreover, remains cost
conscious and is, in most situations, able to use
the unemployment argument for keeping pay
awards modest. More importantly pay awards
are likely to stay well below the rate of inflation
which is expected to remain above 4% for the rest
of this year before falling back towards the 2%
target by the end of next year. Public sector pay
meanwhile is likely to remain frozen.
Getting poorer
6 6
Earnings Inflation
4 4
annual % growth
annual % growth
2 2
0 0
Real* household income
-2 -2
* adjusted for inflation
-4 -4
2001 2003 2005 2007 2009 2011
Source: ONS

The upshot is that disposable income growth
in nominal terms will remain subdued. Average
earnings growth is expected to remain below 2%
for this year before accelerating to the heady
heights of 2.5% in 2012 at which time it might
match the rate of inflation on the way down.
The upshot is that consumers will remain under
pressure for at least the next eighteen months.
Spending is as likely to fall this year as rise
and will only see a very modest improvement
next year.
The mortgage market remains comatose
As economic recovery began, the housing market
shared in the pick up. Banks began to approve
more loans through the second half of 2009,
albeit from a very low level, and house prices
started to rise. But the bounce back proved short-
lived. After peaking at a modest 59,000 a month
at the beginning of 2010, well below the 70-80K
monthly rate that is thought to be the level needed
to keep house prices steady, approvals started
to drift downwards. For much of the last year,
approvals have strained to hit 48,000 a month
and house price inflation, having risen to 8% in
mid- 2010 has fallen back into negative territory.
Given the high levels of existing debt, high
unemployment and negative earnings growth,
it is hardly surprising that consumer confidence
is at historic lows and the appetite for taking
on a new mortgage or increasing an existing
mortgage is subdued. Even where there is a
potential demand, lenders’ preference for low
loan-to-value ratios is limiting take up, especially
amongst first time buyers. That is unlikely to
improve until well into 2012 at the earliest.
But the weakness of the consumer sector is
only one side of the coin. Chunks of the banking
sector will need to re-finance large amounts of
wholesale deposits over the next eighteen months
or so, and repay a good proportion of the funding
they have received from the Bank of England.
But the drive to reduce dependence on wholesale
deposits by increasing holdings of retail deposit
is coming at a time when household finances are
under strain. With real earnings growth still
negative, the only way that individuals can
11
maintain spending patterns is by saving less,
meaning that the deposit pot will be limited.
Meanwhile, the Government’s decision to
resurrect its index linked National Savings
product will undoubtedly siphon off some
of the available deposits, and competition
for what is left will be intense.
With high loan-to-value loans requiring
higher capital and that capital in short supply,
the Financial Services Authority’s keenness on
conservative lending policies and sheer economic
uncertainty, banks will continue to offer low loan
to deposit products over the forecast period.
The hidden problem of ‘forbearance’
So far, given the scale of the downturn and the
subdued nature of the recovery, arrears and
repossessions have been modest in the UK.
Partly this has been caused by banks supporting
customers with problem loans in the hope that
as the economy improved these loans would
come right. The Bank of England in its latest
Financial Stability Report notes that forbearance
means that the arrears data is underestimating
underlying household distress. The worry is that
an exceptionally slow and drawn-out recovery
would cause these problem loans to worsen rather
than improve. In short, the housing market is in
no danger of waking from its coma any time soon.
Indeed there may be more deterioration before
the patient begins to recover.
Stuck in a rut
200 30
Mortgage approvals
(L axis)
House prices (R axis)
20
150
annual % change
000s per month
10
100
mortgage approvals
0
80K / month
50
-10
0 -20
2001 2003 2005 2007 2009 2011
Source: Bank of England / Halifax / Nationwide
12

Forecasts

World economy
GDP growth Inflation
2009 2010 2011 2012 2009 2010 2011 2012
World -2.3 3.8 3.0 3.4 1.1 2.4 3.4 2.5
USA -2.6 2.9 2.5 2.9 -0.3 1.6 2.9 1.5
Euro Area -4.1 1.7 2.0 1.4 0.3 1.6 2.7 1.9
Japan -6.3 4.0 -0.6 2.4 -1.3 -1.0 -0.1 -0.3
China 9.2 10.3 8.9 8.6 -0.7 3.3 4.8 2.9
India 7.0 9.0 7.5 8.1 12.4 10.4 8.0 7.7

UK economy
annual % change, adjusted for inflation
2011 2012
2010 2011 2012 Q1 Q2 Q3 Q4 Q1 Q2
GDP 1.4 1.2 1.6 1.6 0.9 0.6 1.6 1.5 1.5
GDP (quarterly % ) - - - 0.5 0.3 0.4 0.4 0.4 0.3
Consumer spending 0.7 -0.7 1.5 -0.6 -1.1 -0.7 -0.1 0.9 1.5
Government spending 1.0 0.8 -1.4 1.1 0.8 0.8 0.5 -0.5 -1.2
Investment 3.6 1.1 4.2 0.0 2.8 0.0 1.6 4.3 3.8
Stockbuilding (% GDP) 1.5 0.0 -0.1 0.7 0.0 -0.2 -0.3 0.1 -0.1
Domestic demand 2.7 0.0 1.2 0.5 -0.1 -0.5 0.0 1.2 1.2
Exports 5.2 6.5 3.7 9.3 6.6 5.7 4.4 2.9 3.4
Imports 8.8 1.7 2.2 4.2 2.5 1.4 -1.0 1.9 2.1
Manufacturing output 3.6 3.0 1.4 0.9 -0.2 0.4 0.4 0.4 0.4
Unemployment rate (%) 7.9 7.9 8.2 7.7 7.9 8.0 8.1 8.2 8.3
Average earnings 1.9 1.9 2.5 2.5 1.6 2.0 1.6 2.1 2.5
Inflation - RPI 4.6 5.1 3.3 5.3 5.1 5.0 4.8 3.4 3.1
Inflation - CPI 3.3 4.3 2.2 4.1 4.4 4.4 4.2 2.7 2.1
Current account (% of GDP) -3.2 -2.1 -1.6 - - - - - -
PSNB1 (% of GDP) 10.0 7.9 6.2 - - - - - -
Exchange rate2 US$ / £ 1.57 1.66 1.61 1.60 1.65 1.65 1.66 1.66 1.66
Exchange rate2 £ / € 0.86 0.87 0.87 0.89 0.86 0.86 0.87 0.87 0.87
UK Bank Rate2 (%) 0.50 0.50 1.50 0.50 0.50 0.50 0.50 0.75 1.00
10-year bond yield (%) 3.7 3.0 3.6 3.6 3.1 2.9 3.0 3.2 3.4
1 fiscal years, where 2010 = FY10/11, 2011 = FY11/12, and 2012 = FY12/13
2 estimate at end-period
Forecast as at 30 June 2011; data and forecasts are subject to revision
Source: HSBC Global Economics Q3 2011
This document is published by HSBC Bank plc (“HSBC Bank”) as a piece of economic research for information purposes only. It is
not intended to constitute investment advice, and no liability can be accepted by HSBC for recipients acting independently on this
content. The information presented here is based on sources believed to be reliable, but HSBC Bank accepts no liability for any
errors or omissions. Unless otherwise stated, any views, forecasts, or estimates are those of the Business Economics Department
of HSBC Bank, which are subject to change without notice.

Issued by HSBC Bank plc. We are a principal member of the HSBC Group, HSBC Bank plc
one of the world’s largest banking and financial services organisations with Business Economics
8 Canada Square
around 7,500 offices in 87 countries and territories. London
E14 5HQ
 HSBC Bank plc 2011 All rights reserved