Thursday, July 10, 2008

Coming Undone

Britain, one of the big winners from the free flow of capital and services globally in the last decade, is rapidly becoming one of globalization's losers because of its reliance on property and finance.

With financial services contracting and the international flow of capital that financed a debt binge in an almost total freeze, the British economy, housing and financial markets are in a headlong race lower.

Britain's famously open economy has had a stunning run of uninterrupted growth over 15 years as it successfully transformed itself into a services and consumer society. London's financial center boomed, arguably winning pre-eminence over New York, while international capital from Russia, Asia and the Middle East found a base in London.

At the same time, Britain's regions enjoyed smaller-scale but still buoyant growth, much of it connected in one way or another with a near tripling in property prices over a decade.

Now the shutdown of the flow of international capital to its banks and borrowers has brought that growth to a halt, while a spike in the cost of energy and food hurts consumers.

It is really rather difficult to give a sense of exactly how quickly Britain's economy is coming unglued. According to Nationwide, the British mortgage lender, house prices fell by 2.5 percent in June alone, and some economists are forecasting multiyear falls of as much as a third.

Mortgage lending is down by 64 percent year on year in May as banks recoil from lending into a falling market and also because of the simple fact that Britons collectively don't deposit enough to cover their borrowing needs.

John Lewis, a British retailer, said sales at its department stores dropped 8.3 percent in the week that ended June 28, compared with the same week a year earlier, while a rival, Marks & Spencer, also reported disappointing results.

The banking sector is racing to recapitalize, not entirely successfully, with shares of the mortgage specialist Bradford & Bingley well below the level at which a new offering of stock was underwritten.

Construction activity fell at its fastest pace in at least 11 years in June, while the crucial services sector shrank at its sharpest rate since just after the Sept. 11, 2001, attacks in the United States.

Even manufacturing contracted in May, though to be fair it would almost take an industrial revolution for Britain's small sector to make up for shortfalls in property, consumption and finance.

Britain is very likely already in recession, and its financial markets have further to fall.

So how will the British experience of a property bust stack up against the United States?

Karen Ward, chief British. economist at HSBC in London, estimates that the construction, real estate and related sectors account for 10 percent of employment. The U.S. comparison is not exact, but is something on the order of 7 percent or 8 percent.

Britain, in effect, concentrated on those things in which it had a comparative advantage, notably finance, and it outsourced the rest.

Whereas productive industries are essentially flat in growth since 2003, financial intermediation has grown by 50 percent and real estate activity by 35 percent.

Britain's openness and its willingness to adopt innovation, especially financial innovation, allowed it to finance a consumption and property bubble that could persist only so long as money flowed to its consumers from abroad. Its banks, notably Northern Rock, borrowed from abroad, and its house buyers did so, too, through securitized mortgages. That all ended last summer.

Don't get me wrong. I don't blame Britain's problems on perfidious foreigners. It was a free contract that people across the country grasped with both hands.

Now globalization, too, will limit Britain's ability to respond to the end of cheap money.

Financial markets have the power to punish sterling and government bonds if official borrowing becomes more aggressive.

That leaves the government in a poor position to stimulate the economy with additional spending, given that even on its own now optimistic forecasts it will only narrowly avoid breaching its sustainable debt rule.

As for the Bank of England, its ability to soften a downturn with official interest rate cuts is constrained by global food and energy prices that have driven inflation to 3.3 percent, well above its 2 percent target.

Its commitment to that target, and all it implies, will be tested as the year unfolds.

Source - International Herald Tribune


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