Challening times for sterling

2005 was an interesting year for the UK economy, one full of contradictions. Business surveys improved but GDP growth weakened. As headline inflation rose, core inflation slowed. Even as the year came to a close, housing transactions rebounded in a background of rising personal insolvencies and mortgage arrears. No wonder, therefore, that the UK enters 2006 shrouded in uncertainty.

Where will the growth come from? The public sector has played a substantial role in supporting the UK economy, contributing almost one percentage point a year to GDP growth since 2002. That boost has now passed and it is up to the private sector to fill the void. Policy-makers and most independent forecasters believe that the consumer outlook has improved, the investment recovery is imminent and better European growth will boost exports.

Consumer and housing activity rebounded at the end of 2005. However, a record house price to income ratio and a high debt servicing burden at a time when banks are tightening lending standards, should provide an obstacle to a sustained recovery.

Going forward, the expectation is for a squeeze on disposable income growth from higher energy bills, and higher unemployment. At a time when households are less willing to use credit to finance spending, that squeeze will mean the soft patch in consumer spending resumes and extends through 2006.

The conditions for an investment recovery are in place: low cost of capital, a profit recovery, a rising equity market and an abundance of internal finance. Yet these conditions have been in place for some time and investment is still subdued.

Profit expectations and investment intentions are now falling, which suggests that there will be a longer wait before a recovery gathers momentum. Many companies are more concerned with reducing future liabilities, especially pension deficits, rather than investing for future growth.

Can exports save the day? Global growth remains strong. Although there has been an upward revision for the Eurozone, growth in UK export markets in 2006 should be similar to that recorded last year.

The UK is likely to be a relative loser in the race for global trade, as it is less exposed to rapid growth in emerging markets and increasing demand for capital goods. In short, exports should continue to recover but it is questionable whether the boost will be sufficient to offset weaker domestic demand, as it was during the early to mid-1990s.

The question of whether inflation is set to rise will be resolved during the imminent pay round. HSBC Research expects wage growth to stay subdued.

That will help ease the Bank of England's inflationary fears and shift attention back to the lack of growth. HSBC Research also predicts that that the next move in interest rates will eventually be down, with a base rate at four per cent by the end of 2006. The interest rate gap between the UK and Eurozone should narrow and the differences on GDP growth should drag sterling lower against the euro.

The main upside risks are companies starting to spend their excess cash and/or exporters starting to benefit from stronger Eurozone growth. On the downside, the main risks also relate to global demand and the risk that the US consumer starts to fade and/or policymakers in the Eurozone tighten policy too much, suffocating the recovery.

The other downside risk, however, still rests with the UK consumer. Perhaps the possibility of a major consumer/housing market correction has diminished but the risk of such a potentially disastrous scenario has certainly not disappeared.

The main risk in the medium term is that the period of UK outperformance has come to an end. There are three worrying aspects to the UK's recent performance.

Firstly, persistently weak productivity growth means that the UK is losing competitiveness, which may increasingly be felt through a deteriorating underlying trade position.

Second, the tax burden on the UK private sector is set to rise. Total tax receipts as a percentage of GDP are set to rise above Germany's for the first time since 1982.

Third, at a time when households have been encouraged to liquidate their assets, through mortgage equity withdrawal, and raise their liabilities, through a higher stock of debt, companies have done the opposite. This, over the medium term, may actually have a detrimental impact on UK trend GDP growth.

These are the challenges the UK faces during 2006 but worryingly this may prove the start of an ongoing challenge for growth. Unless the UK corrects the low levels of productivity and rising tax burden, and encourages businesses to invest for future growth rather than plug liabilities, the prospects for trend growth will deteriorate.

This will exacerbate the already large public sector and trade deficits and undermine the sterling currency.

This report was compiled by Peter Calleya, manager Corporate Strategy and Research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.