Comment: Why QE3 could be last chance for the Chancellor

By BILL JAMIESON
Published on 01/07/2012 00:00

FOR Chancellor George Osborne the past week has seen a serious unravelling. Fresh figures from the Office for National Statistics show the economy is in a deeper recession than previously thought.

Public finance figures for May were appalling. The budget deficit, far from narrowing, has yawned wider. Service sector data point to continuing stagnation. And now a decision to postpone the scheduled rise in fuel duty, while welcome for business and motorists, is widely seen as yet another U-turn by a Chancellor whose budget three months ago is memorable only for the all subsequent reversals, revisions, abandonments and re-thinks. “Hapless” would be a kind description.

I am reluctant to lose faith in the twin-track strategy to cut the budget deficit while pushing through measures to generate growth. And I still believe cutting the debt burden is key to our recovery prospects. But Osborne’s credibility – his ability to take the country with him through this stormy north-west passage of economics and his future as Chancellor – now looks perilous.

Now he looks vulnerable to a reversal that may prove his undoing. A relapse into recession and a serious slippage in the government’s deficit reduction target form the toxic ingredients for a rating agency downgrade of the UK’s coveted triple-A credit rating.

Back in February, Moody’s put the UK’s AAA credit rating on negative outlook – that is, a 30 per cent prospect of the UK being downgraded within the next 18 months. Fitch then also moved the UK’s AAA rating to negative – for this agency a slightly greater than 50 per cent chance of a downgrade within the next two years. Since then the growth outlook has deteriorated while government borrowing is overshooting. In May the UK borrowed £18 billion, compared with an expectation of £14.5bn. This is £3bn more than in May 2011 and was driven both by weakness in tax receipts – down 7 per cent year on year – and higher government spending, up 8 per cent year on year. So much for “austerity”.

Add to this the £550 million of revenue foregone by postponing the planned 3p a litre rise in fuel duty, and the triple-A rating looks ever more vulnerable. That in itself may not alter Britain’s current relative safe haven status amid the twists and turns of the Eurozone crisis. But it would deal a blow to Osborne’s credibility and to public confidence in his ability to lead the country out of the current morass.

Much now critically depends on the further monetary stimulus from the Bank of England this week to breathe some wind into the sails of an economy trapped in stagnation.

Bank of England Governor Sir Mervyn King did nothing to lift the gloom last week with his observation that the international background had changed for the worse over the past six weeks and that the Bank’s most recent forecasts had now been overtaken. Indeed, many private sector economists now warn that the UK economy may be lucky to see any growth at all in 2012.

Nor can Scotland count itself immune. The latest Lloyds TSB Scotland Business Monitor shows the Scottish economy stagnating. In the three months ending May, just under a third (32 per cent) of firms surveyed increased turnover, 35 per cent experienced static turnover, and a third experienced a decrease – a net balance of minus 1 per cent.

The strong expectation is that this week’s MPC meeting will see the Bank setting sail with QE3 – a further £50bn of quantitative easing. The last meeting saw a narrow 5-4 split vote to hold asset purchases by the Bank at £325bn. One member voted for a £25bn increase while three others, including the Governor, voted in favour of a rise of £50bn.

Subsequent signs have pointed to growing support for more QE. Sir Mervyn, in his Mansion House speech of June 14, presented a gloomy picture of the UK economy. Subsequently, MPC members appeared before the Commons Treasury Committee where Sir Mervyn spoke of how far conditions had deteriorated over the previous six weeks.

It will certainly help that inflationary pressures are easing and that the oil price has fallen further. But there has been evident concern within the MPC that even with no disorderly outcome to the euro crisis, the threat of disorder would weigh on UK banks’ ability and willingness to lend.

However, there is also a growing view that more QE on its own will not suffice. The past month has brought forth various initiatives to lubricate bank lending to business. Details are now awaited of the “funding for lending (F4L)” scheme under which cheap collateralised loans will be made available to the banks to enable them to lend to the corporate and household sectors.

This is particularly important for the small and medium sized enterprises (SME) sector which, as Investec economist Philip Shaw admits, is often under-estimated in macro-economic analysis: SMEs account for close to 50 per cent of UK turnover and 60 per cent of private sector employment.

The Bank’s latest Credit Conditions Survey highlighted that the supply of credit to SMEs, and indeed larger companies, is likely to remain unchanged over the next quarter and that in terms of pricing, lending spreads to firms of all sizes seemed likely to widen. Increasing the potential supply of credit would, he argues, “improve the chances of cementing a long-term recovery”. There is, however, no guarantee of effectiveness, and it does not change the fact that the credit risks of enhanced lending to SMEs will remain with the banks.

Two other measures should also help. There is the baroquely entitled “Extended Collateral Term Repo” facility which provides banks with a standby facility to obviate any sudden contraction in their balance sheets. And last week brought a Bank recommendation to the Financial Services Authority to relax the size of the liquidity buffers which banks are required to hold. This is also intended to help increase the volume of bank lending.

Even assuming these measures work in the manner intended, they will take time to show through. And what business needs right now is a significant and credible breakthrough in the Eurozone crisis to help lift confidence.

If business is on bended knee for such a breakthrough, imagine the posture of George Osborne as he prays desperately for a break in his clattering chain of misfortune.