Country Report

United Kingdom

United Kingdom at a glance: 2005-06

OVERVIEW Parliament was dissolved in April and a general election will be held on May 5th. Although the contest is the most open since 1992, the governing Labour Party remains strong favourite to be re-elected. The greatest uncertainty centres on the size of Labourrs parliamentary majority, which will be influenced by the turnout and the incidence of tactical voting. The Economist Intelligence Unit expects Labourrs majority to be cut to around 100 seats. Although this will provide it with a comfortable working majority, the government is likely to encounter mounting political difficulties early in its third term. The most pressing challenge on the economic policy front will be to reconcile Labourrs commitment to increase public spending on health and education with its self-imposed budgetary rules. This will only be possible by proceeding with further increases in taxation. The cycle of monetary tightening is at, or close to, its peak, and official interest rates are likely to fall in late 2005 and 2006. Real GDP growth is forecast to slow from 3.1% in 2004 to 2.3% in 2005 and 1.9% in 2006 as the consumer boom that began in 1996 comes to an end. Higher producer prices exert upward pressure on consumer prices, but the headline rate of inflation will remain below the governmentrs central target of 2% in both 2005 and 2006. The trade deficit will widen in 2005, but decline in 2006 as domestic demand slows.

Key changes from last month Political outlook • Tony Blair should be re-elected on May 5th, but his chances of remaining prime minister beyond 2006 will be enhanced if French voters reject the EU constitution on May 29th. Economic policy outlook • Weak retail sales in early 2005, allied to growing evidence of a slowdown in the housing market, have reduced the likelihood of a further rise in official interest rates in 2005. Economic forecast • Weakening leading indicators have encouraged us to trim our forecast for real GDP growth in 2005 to 2.3% (down from 2.4% last month).

April 2005

The Economist Intelligence Unit 15 Regent St, London SW1Y 4LR United Kingdom The Economist Intelligence Unit The Economist Intelligence Unit is a specialist publisher serving companies establishing and managing operations across national borders. For over 50 years it has been a source of information on business developments, economic and political trends, government regulations and corporate practice worldwide. The Economist Intelligence Unit delivers its information in four ways: through its digital portfolio, where the latest analysis is updated daily; through printed subscription products ranging from newsletters to annual reference works; through research reports; and by organising seminars and presentations. The firm is a member of The Economist Group.

London New York Hong Kong The Economist Intelligence Unit The Economist Intelligence Unit The Economist Intelligence Unit 15 Regent St The Economist Building 60/F, Central Plaza London 111 West 57th Street 18 Harbour Road SW1Y 4LR New York Wanchai United Kingdom NY 10019, US Hong Kong Tel: (44.20) 7830 1007 Tel: (1.212) 554 0600 Tel: (852) 2585 3888 Fax: (44.20) 7830 1023 Fax: (1.212) 586 0248 Fax: (852) 2802 7638 E-mail: [email protected] E-mail: [email protected] E-mail: [email protected]

Website: www.eiu.com

Electronic delivery This publication can be viewed by subscribing online at www.store.eiu.com Reports are also available in various other electronic formats, such as CD-ROM, Lotus Notes, online databases and as direct feeds to corporate intranets. For further information, please contact your nearest Economist Intelligence Unit office

Copyright © 2005 The Economist Intelligence Unit Limited. All rights reserved. Neither this publication nor any part of it may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of The Economist Intelligence Unit Limited. All information in this report is verified to the best of the author's and the publisher's ability. However, the Economist Intelligence Unit does not accept responsibility for any loss arising from reliance on it. ISSN 0269-5472

Symbols for tables “n/a” means not available; “–” means not applicable

Printed and distributed by Patersons Dartford, Questor Trade Park, 151 Avery Way, Dartford, Kent DA1 1JS, UK. United Kingdom 1

Contents

United Kingdom

3 Summary

4 Political structure

5 Economic structure 5 Annual indicators 6 Quarterly indicators

7 Outlook for 2005-06 7 Political outlook 8 Economic policy outlook 10 Economic forecast

13 The political scene

17 Economic policy

20 The domestic economy 20 Output and demand 24 Sectoral trends 25 Employment, wages and prices 28 Financial indicators

30 Foreign trade and payments

List of tables

10 International assumptions summary 11 Gross domestic product by expenditure 13 Forecast summary 18 Summary of public-sector finances 19 Sectoral breakdown of net borrowing 20 Components of gross domestic product 21 Components of gross domestic product 24 Services: gross value added 25 Non-services output 26 Inflation 28 Employment and unemployment 29 Exchange rates 29 Interest rates 30 Stockmarket indicators 31 Trade in goods 32 Current account

Country Report April 2005 www.eiu.com © The Economist Intelligence Unit Limited 2005 2 United Kingdom

List of figures

13 Gross domestic product 13 Consumer price inflation 20 Real GDP growth and household consumption 23 Gross fixed capital formation and capacity utilisation in manufacturing

Country Report April 2005 www.eiu.com © The Economist Intelligence Unit Limited 2005 United Kingdom 3

United Kingdom April 2005 Summary

Outlook for 2005-06 The governing Labour Party is forecast to be re-elected on May 5th, albeit with a reduced parliamentary majority. Public spending will continue to rise faster than GDP as the government strives to improve key services such as health and education, but further increases in taxes will be necessary to prevent a further deterioration in the public finances. Real GDP growth will slow to 2.3% in 2005 and 1.9% in 2006.

The political scene The prime minister, Tony Blair, dissolved parliament in early April, over a year before the end of the full term. The forthcoming general election is the most uncertain since 1992, but constituency boundaries establish a strong bias in Labour’s favour. Labour should be returned to office with a parliamentary majority of around 100.

Economic policy The chancellor the exchequer, Gordon Brown, presented a pre-electoral budget on March 16th. The budget contained some carefully targeted measures aimed at pensioners and working families, which were paid for by fiscal drag and rises in excise duties. The overall macroeconomic impact of the 2005/06 budget is neutral. The Bank of England (the central bank) left official interest rates on hold during the first quarter of 2005.

The domestic economy In the final three months of 2004, real GDP grew by 0.7% quarter on quarter and by 2.9% year on year. This meant that over 2004 as a whole real GDP grew by 3.1%, comfortably the fastest rate among the EU’s four largest member states. However, consumer spending, which has provided the main support to activity since 1996, slowed sharply in the final quarter of 2004 and leading indicators suggest that it remained weak in early 2005. Surging producer prices pushed up inflation up to 1.6% in early 2005. Employment continued to grow in the three months to January 2005, not sufficiently strongly to push down the rate of unemployment which remained at 4.7% (ILO measure). Sterling strengthened in the first quarter of 2005. Although long-term interest rates rose in the first three months of 2005, the yield curve remained inverted. Equity prices rose during the first quarter.

Foreign trade and payments The UK’s trade deficit widened in the final quarter of 2004, but the deficit on the current account fell thanks to higher surpluses on the investment income and services accounts. Over 2004 as a whole, the trade and current-account deficits widened. Editors: Philip Whyte (editor); Dan OrBrien (consulting editor) Editorial closing date: April 15th 2005 All queries: Tel: (44.20) 7830 1007 E-mail: [email protected] Next report: Full schedule on www.eiu.com/schedule

Country Report April 2005 www.eiu.com © The Economist Intelligence Unit Limited 2005 4 United Kingdom

Political structure

Official name United Kingdom of Great Britain and Northern Ireland

Form of state Parliamentary monarchy

Legal system Based on statute and common law; there is no written constitution; Scotland has a separate legal system

National legislature Bicameral; the House of Commons has 659 members directly elected on a first-past-the- post basis; the upper chamber, the House of Lords, was reformed in late 1999, as a result of which most hereditary peers have now lost their seats, but 92 have retained them pending a second stage of reform

Electoral system Universal direct suffrage from age 18

National elections June 7th 2001; next general election due on May 5th, 2005

Head of state Queen Elizabeth II, who acceded to the throne in 1952

National government Cabinet headed by the prime minister; the prime minister is appointed by the monarch on the basis of ability to form a government with the support of the House of Commons; the present Labour government was re-elected to a second term in June 2001

Main political parties Labour Party; Conservative Party; Liberal Democrats; Scottish National Party; Plaid Cymru (Welsh National Party); Northern Ireland parties: Ulster Unionist Party; Democratic Unionist Party; Social Democratic and Labour Party; Sinn Fein

Prime minister Tony Blair Deputy prime minister John Prescott Chancellor of the exchequer Gordon Brown Chancellor of the Duchy of Lancaster Alan Milburn Minister without portfolio Ian McCartney Chief secretary to the Treasury Paul Boateng Leader of the House of Lords Baroness Amos Parliamentary secretary to the Treasury & Chief Whip Hilary Armstrong Secretaries of state Constitutional affairs Lord Falconer of Thoroton Culture, media & sport Tessa Jowell Defence Geoff Hoon Education & skills Ruth Kelly Environment, food & rural affairs Margaret Beckett Foreign & Commonwealth affairs Jack Straw Health John Reid Home office Charles Clarke International development Hilary Benn Northern Ireland Paul Murphy Trade & industry & minister for women Patricia Hewitt Transport & Scotland Alistair Darling Wa l e s Peter Hain Work & pensions Alan Johnson Central bank governor Mervyn King

Country Report April 2005 www.eiu.com © The Economist Intelligence Unit Limited 2005 United Kingdom 5

Economic structure

Annual indicators 2000a 2001a 2002a 2003a 2004a GDP at market prices (£ bn) 950.6 994.3 1,044.1 1,101.1 1,160.3 GDP (US$ bn) 1,438.2 1,431.4 1,564.9 1,797.9 2,124.5 Real GDP growth (%) 3.9 2.3 1.8 2.2 3.1 Consumer price inflation (av; %)b 0.8 1.2 1.3 1.4 1.3 Population (m)c 58.9 59.1 59.3 59.6 59.8d Exports of goods fob (US$ bn) 284.4 273.7 279.9 308.3 349.5 Imports of goods fob (US$ bn) 334.2 332.1 350.1 385.8 455.2 Current-account balance (US$ bn) -36.2 -32.1 -26.2 -30.5 -46.9 Foreign-exchange reserves excl gold (US$ bn) 43.9 37.3 39.4 41.9 – Exchange rate (av) £:US$ 0.661 0.695 0.667 0.612 0.546 a Actual. b Non-seasonally adjusted. c Population breakdowns and projections are derived from Eurostat. d Economist Intelligence Unit estimates.

Origins of gross domestic product 2004 % of total Components of gross domestic product 2004 % of total Business services & finance 25.9 Private consumption 65.1 Government & other services 22.6 Public consumption 21.3 Distribution, hotels & catering 16.9 Fixed investment 16.9 Manufacturing 15.9 Change in stocks 0.1 Transport & communications 8.1 Exports of goods & services 24.7 Construction 6.4 Imports of goods & services 28.0

Principal exports 2004 US$ bn Principal imports 2004 US$ bn Finished manufactures 184.8 Finished manufactures 259.2 Semi-manufactures 103.4 Semi-manufactures 109.9 Oil & other fuels 33.2 Food, beverages & tobacco 40.2 Food, beverages & tobacco 19.4 Oil & other fuels 30.5 Basic materials 6.9 Basic materials 11.7

Main destinations of exports 2004 % of total Main origins of imports 2004 % of total US 15.0 Germany 14.0 Germany 11.6 US 8.8 France 9.8 France 8.0 Ireland 7.0 Netherlands 7.2 Netherlands 6.3 BLEU 5.6 EU25 58.1 EU25 55.9

Country Report April 2005 www.eiu.com © The Economist Intelligence Unit Limited 2005 6 United Kingdom

Quarterly indicators 2003 2004 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr Outputa GDP at chained 2000 prices (£ bn) Household consumptionb 172.1 173.6 175.3 176.2 178.3 179.6 180.7 n/a Government consumption 50.0 50.3 51.1 52.2 52.6 52.9 53.6 n/a Gross fixed investment 42.7 43.3 43.5 44.2 45.5 45.9 46.2 n/a Exports 69.4 67.9 67.8 69.8 68.6 70.0 70.5 n/a Imports 79.9 77.6 78.8 81.2 81.3 82.3 83.4 n/a GDP at market prices 256.1 257.0 259.3 261.8 263.7 266.0 267.2 n/a Industrial production index (2000=100) 97.1 96.9 97.4 97.7 97.3 98.3 97.1 n/a Manufacturing production index (2000=100) 96.7 97.0 97.6 98.1 97.9 99.1 98.1 n/a Employmenta, wages & prices Total workforce employment (m)c 30.1 30.2 30.3 30.4 30.4 30.4 30.4 n/a Manufacturing (m)c 3.75 3.69 3.66 3.61 3.58 3.57 3.53 n/a EU harmonised unemployment rate (% of the labour force)a 5.0 5.0 4.9 4.9 4.7 4.7 4.5 n/a Average earnings (GB; 2000=100)a 110.2 111.2 112.6 113.3 116.0 115.8 116.7 n/a Consumer price index (CPI; % change, year on year)d 1.5 1.3 1.4 1.4 1.3 1.4 1.3 n/a Producer input prices (% change, year on year) 1.8 -0.5 1.2 3.0 -0.4 3.8 5.2 n/a Financial indicators (end-period) Exchange rate US$:£ 1.58 1.65 1.66 1.79 1.84 1.81 1.81 1.92 Exchange rate €:£ 1.45 1.44 1.43 1.42 1.50 1.49 1.46 1.42 3-month Treasury bill rate (%) 3.50 3.50 3.59 3.88 4.03 4.78 4.88 4.88 Bank of England base rate (%) 3.75 3.75 3.50 3.75 4.00 4.50 4.75 4.75 3-month interbank rate (%) 3.66 3.59 3.66 4.00 4.38 4.84 4.92 4.89 10-year government bond yield rate (%) 4.30 4.18 4.56 4.77 4.75 5.09 4.83 4.54 M4 (£ bn)a 1,018.48 1,039.80 1,050.22 1,078.37 1,100.86 1,124.84 1,146.33 n/a M4 (% change, year on year)a 7.1 7.5 6.2 7.2 8.1 8.2 9.2 n/a Stockmarket FTSE-100 index (Jan 1st 1984=1,000) 3,613 4,031 4,091 4,477 4,386 4,464 4,571 4,814 Sectoral trends (Great Britain) New orders for new non-residential work (£ m) 6,304 5,533 6,241 5,061 6,543 6,414 6,151 n/a Retail sales volume (2000=100)ae 114.1 115.7 117.1 119.2 121.2 123.5 124.8 n/a Foreign trade & payments (£ bn)a Goods exports fob 48.13 46.67 46.39 47.41 44.91 46.59 48.18 n/a Goods imports fob -59.43 -57.78 -58.61 -60.20 -59.28 -61.11 -62.84 n/a Trade balance -11.30 -11.10 -12.22 -12.80 -14.37 -14.52 -14.66 n/a Services balance 3.74 4.04 3.93 3.90 4.64 4.93 4.40 n/a Income balance 8.15 4.55 4.64 5.80 6.16 6.12 4.38 n/a Net transfer payments -2.40 -2.84 -2.48 -2.18 -2.91 -2.35 -2.89 n/a Current-account balance -1.81 -5.35 -6.13 -5.28 -6.48 -5.82 -8.77 n/a a Seasonally adjusted. b Including non-profitmaking institutions serving households. c Measures jobs, rather than people; data for March, June, September and December. d EU harmonised index of consumer prices. e Weekly averages, excluding motor trades. Sources: Office for National Statistics, Monthly Digest of Statistics, First Release, Labour Market Trends; Bank of England, Monetary and Financial Statistics; IMF, International Financial Statistics; FT.

Country Report April 2005 www.eiu.com © The Economist Intelligence Unit Limited 2005 United Kingdom 7

Outlook for 2005-06

Political outlook

Domestic politics A general election is set to be held on May 5th, a full year before the end of the current parliamentary term. The forthcoming general election is the most uncertain since 1992, but the governing Labour Party remains strong favourite to be returned to office, albeit with a reduced parliamentary majority. Although the prime minister, Tony Blair, is now widely mistrusted by voters, who believe they were misled over the reasons for British participation in the US-led war on Iraq, several factors favour Labour’s re-election. First, it is widely perceived to have managed the economy well. The economy suffers from imbalances that pose a risk to the medium-term outlook for growth and employment, but these will not become apparent to voters before they cast their ballots. Second, the opposition Conservative Party has signally failed to establish itself as a credible alternative in the eyes of voters. The party needs an unprecedented swing to win the election, but support for it has flatlined at 32% for over a decade. To make matter worse, constituency boundaries are heavily weighted in Labour’s favour: even if the Conservative Party won the same share of the vote as Labour, biases in the electoral system mean that it would end up with around 70 fewer seats. The greatest uncertainty centres on the size of Labour’s parliamentary majority. This will be strongly influenced by two factors. One will be the turnout. Since the electorate of the Conservative Party is older (and hence more likely to vote), a low turnout will tend to depress Labour’s share of the vote. The turnout could be depressed if disillusioned Labour supporters decide not to vote. Set against this, the same voters could be galvanised if the outcome of the election is in doubt as the date of the election approaches. The other major influence on the outcome will be the scale of tactical voting. In both 1997 and 2001, Labour’s victory was underpinned by a strong anti-Conservative front, with Labour and Liberal Democrat supporters voting for the candidate best-placed to defeat the Conservative in their constituencies. This time round, some Liberal Democrat supporters’ wish to punish Mr Blair over the war on Iraq may be stronger than their desire to keep the Conservative Party out of office. If the anti-Conservative tactical vote does unwind, Labour’s parliamentary majority will be greatly reduced. Although the Economist Intelligence Unit expects Labour’s majority to be cut, it should still amount to around 100 seatsmore than enough for a third term in office. Nevertheless, Mr Blair will confront mounting difficulties early in his third term. With the economy set to slow as the consumer boom that began in 1996 comes to an end, the government may have to take unpopular decisions. The most salient on the economic policy front will be to raise taxes to plug the gap that has appeared in the public financesthis at a time when voters may be growing more resistant to further rises in the tax burden. Another challenge will be the ratification of the EU constitution. The government is committed to holding a referendum on the issue in 2006, but there is almost no chance that voters will back the new treaty. Should the UK be the only country to reject the

Country Report April 2005 www.eiu.com © The Economist Intelligence Unit Limited 2005 8 United Kingdom

treaty, its relations with the EU could be plunged into the greatest crisis since its accession in 1973 and Mr Blair would probably have to resign. This risk will pass if French voters reject the EU treaty in a referendum on May 29th. Mr Blair will not stand for re-election in 2008-09, but the precise timing of his departure could be determined by voters outside the UK. Whenever Mr Blair leaves, he is almost certain to be replaced by the current chancellor of the exchequer, Gordon Brown.

International relations As president of the EU in the second half of the year and chair of the group of seven leading industrialised countries (G7), the UKrs international profile in 2005 will be particularly high. The government has already chalked up a notable success by securing the agreement of the G7 to write off the debts of some of the worldrs poorest countries. The rest of the year, however, will be more difficult and will be heavily influenced by events in France. If French voters reject the new EU treaty, Mr Blair will, as EU president in the second half of the year, have to manage the resulting crisis. If, however, French voters ratify the EU constitution, Mr Blair’s domestic position will be intractable given the slim chance of British ratification.

Economic policy outlook

Policy trends Public expenditure will grow faster than overall GDP over the outlook period as the government strives to improve key services such as health and education. As the public finances have deteriorated sharply since 2000, further rises in tax will be necessary to pay for these increases. Some of the money will inevitably be absorbed by higher public-sector salaries, but modest improvements should continue to emerge. The government will continue to launch microeconomic initiatives aimed at improving rates of innovation in the wider economy and closing the UKrs productivity gap with the best-performing EU member states, but it is not yet certain whether it will show the courage needed to tackle the country’s looming pension problem. Mr Blair has not ruled out the possibility of holding a referendum to join economic and monetary union (EMU) during his third term, but political factors mean there is little prospect of this happening. In focus

The UK’s pensions crisis A key issue in Labour’s third term will be whether the government does anything to tackle the UK’s looming pensions crisis. Up to the late 1990s the UK was thought to be well-positioned to face the burden of an ageing population, thanks to the role played by private pension provision. Several developments have since shattered national complacency. Sharp falls in equity prices in 2000-02 created huge holes in company pension schemes. Falling returns from equities were compounded by the chancellor of the exchequerrs decision in 1997 to abolish tax relief worth £5bn annually on the dividends received by company schemes. Finally, life expectancy continued to rise faster than actuaries had expected, increasing the future burden on state-backed and company pensions. Against this backdrop, companies have been scrambling to close their final salary schemes.

Country Report April 2005 www.eiu.com © The Economist Intelligence Unit Limited 2005 United Kingdom 9

A government-appointed Pension Commission is due to deliver its report in late 2005. Its interim report, which was released in late 2004, estimated that between 9m and 12m peopleup to 40% of the workforcewere not saving enough for old age and that pensioners’ income would fall by 30% over the next 30 years unless action was taken. Plugging the savings gap through increased state pensions alone would increase public spending on pensions by 85% (or £57bn at current prices). To achieve the same through private-sector saving would mean raising contributions to pension pots from £40bn to £80bn a year, a figure the Pension Commission thinks neither “feasible nor desirable”. Alternatively, the average retirement age could rise from 62 to 70, with many continuing to work beyond 70. Since each of these adjustments looks too large on its own, the Commission’s final recommendations may consist of a mix of the three elements. Pension reform hardly featured in the general election campaign and it is unclear what, if anything, the government will do in response to the Pension Commission’s final report. Because the costs are immediately apparent while the benefits are not, governments have little incentive to reform pension systems. Until recently, it had been widely assumed that the government would take action once the Pension Commission’s final recommendations had been published, but this no longer looks so certain. In March, 1m public-sector workers threatened to strike in response to government’s plans to raise the retirement age from 60 to 65. Faced with such opposition, the government may decide there is no political advantage to be gained from tackling the issue.

Fiscal policy Having deteriorated sharply since 2000, the UKrs cyclically unadjusted public finances are forecast to improve slightly over the outlook period. However, with GDP (and consequenty tax receipts) set to grow more slowly than the Treasury is anticipating in 2005-06, the government will not be able to continue meeting its "golden rule"which prohibits it, over the course of an economic cycle, from borrowing to fund current spendingwithout altering its current plans for tax and spending. Further increases in taxes are therefore all but inevitable after the next general election. Among the measures it will rely on will be rises in national insurance contributions, increases in excise duties and “fiscal drag” (pushing tax payers into higher tax brackets by failing to adjust bands in line with earnings). As it was in the run-up to the previous general election, the government has been reluctant to concede the likelihood of further increases in direct taxes. Instead, it has tried to give the impression that the funding gap can be plugged by “efficiency savings”. A government review headed by Sir Peter Gershon in 2004 reported that annual savings of £20bn (US$38bn) could be found by 2008, notably by streamlining public procurement procedures and cutting civil service staffing numbers. Nevertheless, a dose of scepticism is in order. Past experience suggests that efficiency savings in the public sector are usually more modest than expected; and it remains to be seen whether a government that has presided over a sharp increase in public-sector employment can cut back civil service numbers.

Monetary policy The cycle of monetary tightening, which has seen official interest rates rise by 125 basis points since November 2003, is at or close to its peak. Although one further increase still cannot be ruled out, recent data releases, which point to a slowdown

Country Report April 2005 www.eiu.com © The Economist Intelligence Unit Limited 2005 10 United Kingdom

in consumer spending and the housing market, suggest that this will be unnecessary. In the absence of a sharp fall in house prices (or another such shock), we expect the key repo rate of the Bank of England (the central bank) to remain at its current level of 4.75% for much of 2005, before falling in late 2005 and early 2006. Scope for a modest reduction in official interest rates will be provided by the persistence of inflation below the governmentrs central target of 2%.

Economic forecast

International assumptions International assumptions summary (% unless otherwise indicated) 2003 2004 2005 2006 Real GDP growth World 3.9 5.0 4.2 3.9 OECD 2.0 3.3 2.3 2.3 EU25 1.1 2.4 2.0 2.1 Exchange rates ¥:US$ 115.9 108.1 99.3 92.8 US$:€ 1.132 1.244 1.365 1.400 SDR:US$ 0.714 0.675 0.639 0.626 Financial indicators ¥ 2-month private bill rate 0.03 0.00 0.05 0.34 US$ 3-month commercial paper rate 1.10 1.48 3.29 4.38 Commodity prices Oil (Brent; US$/b) 28.8 38.5 42.0 37.0 Gold (US$/troy oz) 363.3 409.5 435.0 402.5 Food, feedstuffs & beverages (% change in US$ terms) 6.6 9.1 -6.5 -1.4 Industrial raw materials (% change in US$ terms) 13.0 21.0 3.5 -6.7 Note. Regional GDP growth rates weighted using purchasing power parity exchange rates. The world economy, which in 2004 enjoyed its strongest period of growth in 20 years, it is set to slow in 2005-06. Having accelerated from 3.9% in 2003 to 5% in 2004, we expect world GDP growth (on a purchasing power parity basis) to slow to 4.2% in 2005 and 3.9% in 2006. Measured using GDP at market exchange rates (which give greater emphasis to the OECD countries and reflect the exchange rates at which firms trade and repatriate profits), world GDP growth will slow from 3.9% in 2004 to 2.9% in both 2005 and 2006. Although the projected rates of world economic growth in 2005-06 are respectable by historical standards, the balance of risks to our baseline forecast is weighted on the downside. This is because the slowdown will occur at a time when the global economy faces difficult hurdles. High international oil prices could depress GDP growth in oil-importing countries, while rising US official interest rates will reduce international liquidity and exert pressure on emerging economies with large financing needs. Economic imbalances also remain a problem, with many of the worldrs largest economies still nursing significant debt levels from the boom years of the late 1990s. Private-sector debt and public-sector borrowing in the US remain high, and there are still concerns about how the US economy will perform when fiscal policy becomes less stimulatory and monetary policy tightens further. Private savings in the US could rise sharply at some point over

Country Report April 2005 www.eiu.com © The Economist Intelligence Unit Limited 2005 United Kingdom 11

the next two years, provoking a sudden slowdown in consumer spending and delivering a major demand shock to the world economy. Another risk is that the USrs current-account deficit, which is now approaching 6% of GDP, will put further downward pressure on the US dollar. This would help to correct some of the imbalances in the US, but it would depress GDP growth in regions such as western Europe.

Economic growth Gross domestic product by expenditure (£ bn at chained 2001 prices; % change year on year in brackets unless otherwise indicated) 2003a 2004a 2005b 2006b Private consumption 697.3 720.4 734.1 746.4 (2.3) (3.3) (1.9) (1.7) Public consumption 203.2 212.6 219.4 223.6 (3.2) (4.7) (3.2) (1.9) Gross fixed investment 173.8 183.6 190.0 194.0 (2.3) (5.6) (3.5) (2.1) Final domestic demand 1,074.5 1,117.0 1,143.8 1,164.3 (2.5) (4.0) (2.4) (1.8) Stockbuilding 2.5 0.7 2.0 0.0 (0.0)c (-0.2)c (0.1)c (-0.2)c Total domestic demand 1,077.0 1,117.7 1,145.8 1,164.3 (2.5) (3.8) (2.5) (1.6) Exports of goods & services 275.0 283.3 291.0 300.4 (0.9) (3.0) (2.7) (3.2) Imports of goods & services -317.9 -334.5 -345.6 -353.0 (1.9) (5.2) (3.3) (2.1) Foreign balance -42.9 -51.2 -54.6 -52.6 (-0.4)c (-0.8)c (-0.3)c (0.2)c GDP 1,034.1 1,066.5 1,091.2 1,111.7 (2.2) (3.1) (2.3) (1.9) a Actual. b Economist Intelligence Unit forecasts. c Contribution to real GDP growth. Having grown by 3.1% in 2004its fastest rate of GDP growth since 2000the UK economy is set to slow in 2005-06, as the international economic environment weakens and domestic demand loses steam. Real GDP is forecast to grow by 2.3% in 2005 and by 1.9% in 2006. Although growth in the service sector will slow in 2005-06, it will continue to provide the main impetus to economic activity. The pattern of growth over the outlook period will be notable for a significant rebalancing of activity. The consumer boom that has provided the principal support to activity since 1996 will peter out, as employment growth slows, high real interest rates encourage financially overstretched households to rebuild their savings, and rises in taxes eat into household disposable income. Gross fixed investment, which was supported in 2004 by public investment and a recovery in business investment, will also decelerate in 2005 and 2006. Public investment, while still growing robustly, will slow, as will housing investment. The prospects for business investment, meanwhile, are mixed. Company balance sheets have strengthened over the past two years, but debt levels remain high and recent surveys point to weakening investment intentions in the manufacturing sector. With domestic and external demand set to slow in 2005-06, a mood of caution among firms could weigh on business investment.

Country Report April 2005 www.eiu.com © The Economist Intelligence Unit Limited 2005 12 United Kingdom

The foreign balance, which has exerted a drag on GDP growth uninterruptedly since 1996, should make a less negative contribution in 2005, as domestic demand slows. The main domestic risk to the UK economy comes from the household sector. Buoyant consumer spending in recent years has been supported by rising levels of debt, and the ratio of household debt to income now exceeds levels recorded in the late 1980s, just before the last recession. Debt-servicing costs are still manageable, but a rise in unemployment, further increases in interest rates or a collapse in house prices could trigger a sharper consumer retrenchment than we are projecting.

Inflation Despite the buoyancy of the economy and rising international prices, inflation has remained low. Over 2004 as a whole inflation (EU harmonised measure) averaged just 1.3%. With little spare capacity in the economy and with recent increases in producer prices moving down the supply chain, consumer price inflation is forecast to edge up in the first half of 2005. However, competitive pressures on the high street will ensure that increases in producer input and output prices do not feed through fully to consumer prices. As a result, inflation will rise in 2005 and 2006, but will remain below the governmentrs central target of 2%. In the short term the greatest risk to the outlook for inflation probably comes from the labour market. There are three reasons why wage settlements could pick up in 2005. The first is that the labour market is tight, with unemployment at its lowest level since the mid-1970s. The second is that inflation as measured by the retail price indexwhich is commonly used as a benchmark in wage negotiationsreached its highest level for five years in late 2004. The third is that improved profitability in 2004 will make it harder for companies to resist pay demands.

Exchange rates Sterling will continue to trade in an intermediate range between the euro and the US dollar over the forecast period. With UK interest rates at, or close to, their peak, the short-term interest rate differential that has underpinned sterlingrs exchange rate since mid-2003 will narrow, weakening sterlingrs external value against the euro in 2005. However, sterling should still appreciate against the US dollar, the exchange rate of which will be undermined by the USrs massive current-account deficit. Against the US dollar, sterling will average US$1.97:£1 in 2005 and US$2.02:£1 in 2006. That said, sterlingrs exchange-rate path is subject to huge uncertainties over the outlook period and represents one of the main risks to our baseline forecast.

External sector The trade deficit, which has increased sharply since 1997, is expected to widen further in local currency terms in 2005 before falling in 2006, as total domestic demand growth slows. The current-account deficit, however, will be much smaller than the trade deficit, thanks to substantial surpluses on the services and investment income balances. Measured as a proportion of GDP, we expect the UKrs current-account deficit to rise to 2.5% in 2005, before falling back to 2.1% in 2006.

Country Report April 2005 www.eiu.com © The Economist Intelligence Unit Limited 2005 United Kingdom 13

Forecast summary (% unless otherwise indicated) 2003a 2004a 2005b 2006b Real GDP growth 2.2 3.1 2.3 1.9 Industrial production growth -0.2 0.4 0.4 1.2 Unemployment rate (av; EU/OECD harmonised measure) 5.0 4.6 4.7 5.2 Consumer price inflationc 1.4 1.3 1.8 1.9 3-month Treasury rate 3.7 4.6 4.7 4.3 Government balance (% of GDP) -3.2 -2.9 -2.8 -2.7 Exports of goods fob (US$ bn) 308.3 349.5 373.8 388.2 Imports of goods fob (US$ bn) 385.8 455.2 496.4 497.6 Current-account balance (US$ bn) -30.5 -46.9 -58.4 -53.1 Current-account balance (% of GDP) -1.7 -2.2 -2.5 -2.1 Exchange rate £:US$ (av) 0.612 0.546 0.512 0.507 Exchange rate £:¥100 (av) 0.528 0.505 0.516 0.546 Exchange rate £:€ (av) 0.693 0.679 0.699 0.709 a Actual. b Economist Intelligence Unit forecasts. c EU harmonised measure.

Gross domestic product Consumer price inflation % change, year on year av; %

UK EU25 UK EU25 4.0 3.0 3.5 2.5 3.0

2.5 2.0 2.0 1.5 1.5 1.0 1.0 0.5 0.0 0.5 01 02 03 04 05 06 01 02 03 04 05 06 2000 2000

The political scene

A general election is called for On April 5th the prime minister, Tony Blair, asked the Queen to dissolve the May 5th House of Commons (parliament’s lower house) with a view to holding a general election on May 5th, a full year before the end of the parliamentary term. Early general elections in the UK are usually signs of political ascendancy: they are generally called by sitting governments confident of their re-election. The weak Conservative government led by John Major served a full parliamentary term before being defeated in 1997; while the Labour government led by Mr Blair dissolved parliament in 2001, a year before the end of the full term, and was duly re-elected. Mr Blair’s decision to hold an early general election is consequently a sign of the prime minister’s confidence that the governing Labour Party will be returned to office. On balance, his confidence is justified. The Labour Party remains the overwhelming favourite to win the election.

Country Report April 2005 www.eiu.com © The Economist Intelligence Unit Limited 2005 14 United Kingdom

Nevertheless, opinion polls suggest that the mood of the British electorate is exceptionally volatile, making the 2005 general election the least predictable since 1992. Indeed, in the weeks running up to the dissolution of the House of Commons, newspaper headlines became increasingly fevered as a spate of opinion polls showed a narrowing of the gap between the Labour Party and the opposition Conservative Party. Against this backdrop, commentators on both sides of the political spectrum could be found who refused to rule out what looked impossible only a few months ago: a victory for the Conservatives. One parallel drawn by some of these commentators was with the 1970 general election, when a Labour prime minister, Harold Wilson, was beaten by an unpopular leader of the Conservative Party, Edward Heath, in defiance of the opinion polls. But how much credence should be attached to this argument? On the surface at least, the thesis has much to commend it. Mr Blair, is widely mistrusted by voters, many of whom believe he misled them over Iraq. Anger over Iraq, public-sector reforms and Mr Blair’s autocratic leadership style has reduced support for, and loyalty to, the prime minister, both among core Labour voters and members of the parliamentary party. Meanwhile, the Conservative Party, led by Michael Howard, has conducted an effective hit-and- run campaign since the beginning of 2005, with opportunistic attacks in policy areas where opinion polls suggest that Labour is most vulnerable, such as immigration and crime. Add to this the possibility that turnout could drop even below its level of 59% in 2001, as well as the likelihood that the incidence of tactical voting, which delivered two massive parliamentary majorities to the Labour Party in 1997 and 2001, will decline in 2005, and the prospect of a Conservative Party victory may not seem far fetched. On closer inspection, however, the evidence on which the thesis rests looks a little too one-sided: it ignores some strong counter-currents.

The governing Labour Party To start with Labour should benefit from the issue that it has placed at the remains in the driving seat centre of its election campaign: the state of the UK economy. The latter actually suffers from imbalances that pose a risk to the outlook for growth and employment, but these will not unwind before the electorate votes. This will allow Labour to boast that it has delivered the longest period of economic growth since records began, along with the lowest rate of unemployment since the 1970s, low and stable inflation and the lowest mortgage rates since the 1960s. Even if there is evidence that voters now take the UK’s recent enviable economic record for granted, it remains one of Labour’s strongest cards. An opinion poll conducted by ICM and published in The Guardian, a daily newspaper, on March 22nd, found that 41% of voters thought Labour was the best party on the “economy generally”, compared with just 24% for the Conservative Party. Indeed, the poll found that Labour was thought to have the better policies of the two main political parties in all eight areas surveyed bar one: immigration. In both the 1997 and 2001 general elections, Mr Blair was an undoubted asset to his own party, capturing the support of voters who would not otherwise have voted Labour. This is no longer the case. The widespreadand largely justifiedperception that the prime minister exaggerated the threat posed by

Country Report April 2005 www.eiu.com © The Economist Intelligence Unit Limited 2005 United Kingdom 15

Iraq to bolster the case for the US-led war in 2003 has durably shattered voters’ trust in him. Even so, this is not as devastating to Labour’s chances as might at first appear. Opinion polls indicate that Mr Howard, whose image remains tainted by his participation in the Major government (1990-97), is held in even lower esteem than Mr Blair. The genial leader of the Liberal Democrats, Charles Kennedy, may be far more popular than either Mr Blair or Mr Howard, but his party still languishes in third place. In any case, however much voters mistrust Mr Blair, opinion polls consistently show that they think he is the best leader of the three. In other words, Mr Blair may no longer be liked or trusted by large sections of the electorate, but he is still grudgingly respected as a strong and experienced leader. Another factor in Labour’s favour is the end of a damaging stand-off between Mr Blair and the chancellor of the exchequer, Gordon Brown. The two men’s always prickly relations reached a nadir in January (January 2005, The political scene), but both have since pulled back from the brink. Mr Brown may want to replace Mr Blair as prime minister, but the two men’s political fates remain closely intertwined. Mr Blair recognises that Mr Brown’s stewardship of the economy is the main reason for Labour’s likely re-election. Mr Brown, for his part, realises that his ambition of replacing Mr Blair as prime minister will not be served if he subordinates his party’s interests to his own, or if he damages his expected inheritance. In the run-up to the launch of the campaign, it had looked as if Mr Blair’s attempts to marginalise Mr Brown’s might leave the latter sulking on the sidelines. In fact, the start of the election campaign has brought the two men together. However contrived, their joint appearances on the campaign trail should demonstrate their ability to work together and provide a sense of common purpose.

The Conservative Party faces The Labour Party, moreover, goes into the general election with a parliamentary an uphill struggle majority of more than a 160 seats, which is underpinned by a strong bias in the voting system. Current constituency boundaries mean that the Labour Party could end up with a parliamentary majority even if its share of the popular vote was the same as the Conservative Party’s. To win the general election, the Conservative Party needs an unprecedented 12 percentage point swing in its favour, but the party’s support has flatlined at around 32% for much of the past decade. Support for the Conservative Party has occasionally risen above this level, but only at local and European elections when the turnout and the incidence of anti-Conservative tactical voting has been lower than at general elections. The Conservative Party’s hope in the forthcoming general election is twofold: that turnout falls even lower than in 2001; and that tactical voting unwinds as a result of disillusion with Labour. The paradox is that the better it does in the opinion polls in the run up to May 5th, the less likely either of these factors actually becomes. The scale of the challenge facing the Conservative Party is highlighted by the electoral map. In 2001 the party won only one seat in Scotland, none in Wales and none in many of the country’s largest cities. Constrained by an old and dwindling membership, the leadership has struggled to broaden the party’s appeal beyond its heartlands in rural England. Attempts to espouse a more modern and tolerant image have usually been half-hearted and have been

Country Report April 2005 www.eiu.com © The Economist Intelligence Unit Limited 2005 16 United Kingdom

subsequently jettisoned as the leadership has scrambled to shore up the party’s core vote. Mr Howard has been true to type. Having spoken of the need to reconnect with voters when he replaced Iain Duncan Smith as leader in late 2003, Mr Howard proceeded within the year to reshuffle his “shadow” cabinet by replacing younger, socially liberal figures such as Damian Green and John Bercow, with an “older guard” of uncompromising right-wingers such as John Redwood. The move was a response to the electoral threat posed by populist, xenophobic parties such as the UK Independence Party (UKIP) and the British National Party (BNP). To steer its campaign, the Conservative Party has enrolled Lynton Crosby, an Australian who made his name masterminding election victories in his home country by mobilising the anti-immigrant vote. The party’s strategy has been to identify voters’ grievances in areas such as crime, immigration, EU integration and the rights of gypsies and promise action to deal with them. The party’s campaign slogan“Are you thinking what we’re thinking?”appeals to many voters’ fears and prejudices, but it does not amount to a coherent programme for government. The party’s policy towards the EU is particularly unconvincing. The party is committed to UK membership of the EU, but it is difficult to see how its policy to renegotiate the terms of membership could result in anything other than the UK’s withdrawal. Mr Howard, moreover, has found it hard to deal with party candidates who have failed to tow the party line. While Howard Flight, an existing member of parliament, was sacked as a candidate in March for suggesting that his party’s plans for public spending were cosmetic, Mr Howard did not dismiss Mr Redwood for suggesting that the UK might have no option but to withdraw from the EUa statement that directly contradicted party policy.

The Liberal Democrats could The performance of the Liberal Democrats will have an important bearing on make gains the outcome of the general electionparticularly the size of Labour’s majority. The Liberal Democrats have little chance of arriving in anything other than third place (let alone winning the general election), but for several reasons they are well placed to improve on the share of 18% that they recorded in 2001. To start with, support for the Liberal Democrats, which has fluctuated around 20% since 2003, is starting from a higher base than in 2001 (when it stood at around 12%). Since support for the Liberal Democrats tends to increase during general election campaigns (when they receive more coverage in the media), the party stands a good chance of capturing more than 20% of the votes cast. As the only party to have opposed en masse the UK’s participation in the US-led war on Iraq, the Liberal Democrats should also benefit from the anger of anti-war voters (particularly in the Muslim community). Finally, Mr Kennedy’s relaxed manner may play better with moderate voters than Mr Howard’s opportunism and taste for confrontation or the perceived self-righteousness and arrogance of the prime minister. The impact of the Liberal Democrats’ performance on the overall result of the general election is difficult to predict. The country’s first-past-the-post voting system will almost certainly ensure that the party’s share of seats in the House of Commons will be smaller than its share of the total vote. Beyond that, there is greater uncertainty. One reason is that it is unclear how Liberal Democrat

Country Report April 2005 www.eiu.com © The Economist Intelligence Unit Limited 2005 United Kingdom 17

supporters who cast tactical votes for Labour to keep the Conservative Party out in 1997 and 2001 will behave in 2005. If these voters’ desire to punish Mr Blair over Iraq turns out to be stronger than their desire to keep the Conservative Party out of office, the Labour Party could lose a lot of seats in constituencies where the Conservative Party is the main challenger. Set against this, the Liberal Democrats could help the Labour Party indirectly by taking seats currently held by the Conservative Party. All but six of the Liberal Democrats’ 35 top target seats are in fact in constituencies currently held by the Conservative Party. In these constituencies, traditional Labour supporters may have a double incentive to support the Liberal Democrats: to record a protest against Mr Blair over the Iraq war and to contribute to the defeat of the Conservative candidate. One such constituency is Folkestone & Hythe, which is currently held by Mr Howard.

Economic policy

The government presents its The chancellor of the exchequer, Gordon Brown, delivered his ninth budget to budget for 2005/06 parliament on March 16th, some three weeks before its dissolution for the general election. For Mr Brown, whose relations with the prime minister, Tony Blair, are notoriously prickly and who had been sidelined from the party’s general election campaign team, the budget presented a twin opportunity: to encourage voters to re-elect Labour without jeopardising the public finances; and to remind everyone within the governing Labour Party of his political indispensability. As ever, Mr Brown pulled off the trick with aplomb. In essence, his solution consisted in getting the unpopular, the unworthy and the inattentive (oil companies, smokers and the better off) to pay for carefully targeted sweeteners to key groups such as pensioners (the most assiduous voters) and the working poor (most of whom still support Labour). In this sense, his budget was both populist and prudent. Mr Brown’s budget was laced with transparently electoral measures. Pensioner households were awarded a one-off payment of £200 (US$366) to cushion the impact of rapidly-rising council tax bills and given free bus passes. Working families on low incomes were handed an increase in child tax credits. And first- time home buyers benefited from a doubling of the stamp duty exemption threshold on residential property transactions from £60,000 (US$109,800)to £120,000. To placate drivers who have had to absorb sharp increases in petrol prices as a result of tight international markets, Mr Brown announced a freeze on petrol duty up to September. To pay for these measures, Mr Brown resorted to some well-worn tricks. Petrol duty was temporarily frozen, but other “sin taxes” were raised: duty was increased by 1p on a pint of beer, 4p on a bottle of wine and 7p on a packet of cigarettes. Mr Brown also pushed more tax payers into higher brackets by failing to adjust any but the lowest tax band in line with earnings (a process known as “fiscal drag”) and leant on the corporate sector by abolishing stamp duty relief for commercial property in disadvantaged areas, cracking down on tax loopholes and bringing forward a £1bn tax payment from the profitable but always unpopular oil companies.

Country Report April 2005 www.eiu.com © The Economist Intelligence Unit Limited 2005 18 United Kingdom

Despite the sweeteners offered, the overall fiscal impact of the latest budget is marginally restrictive. Overall, the package amounts to a tightening of £265m (US$485m) in 2005-06. Although this amounts to just 0.02% of GDP, it is in marked contrast to Mr Brown’s previous pre-electoral budget in 2001 (when the chancellor of the exchequer admittedly had more room for fiscal manoeuvre). The budget for 2005/06 assumes that real GDP will grow by 3-3.5% in 2005. However, this is above the UK’s long-term trend, so the Treasury is assuming that there is spare capacity in the economy that can still be absorbedan assumption that does not square with the current concern of the Bank of England (the central bank) about pay pressures in the labour market.

Summary of public-sector finances (% of GDP) 2003/04a 2004/05b 2005/06 2006/07 2007/08 2008/09 2009/10 Balance on current budget -1.8 -1.4 -0.5 0.0 0.3 0.6 0.8 Cyclically adjusted balance on current budget -1.0 -0.8 -0.3 0.1 0.3 0.6 0.8 Primary budget balance -1.5 -1.3 -0.9 -0.5 -0.2 0.1 0.3 Public-sector net investment 1.3 1.6 2.1 2.3 2.3 2.3 2.3 Public-sector net borrowing (PSNB) 3.2 2.9 2.6 2.2 2.0 1.6 1.5 Maastricht treaty indicators General government budget balance -3.2 -2.9 -2.6 -2.2 -2.0 -1.7 -1.6 Cyclically adjusted budget balance -2.3 -2.3 -2.4 -2.2 -2.0 -1.7 -1.6 General government debt 39.5 41.0 42.0 42.4 42.8 42.9 42.9 a Outturn. b Official estimate. Source: H.M. Treasury, Budget 2005.

Mr Brown’s budget for 2005-06 may have been politically clever, but his fiscal projections continue to meet with scepticism. Mr Brown likes to crow that the Treasury’s projections for economic growth have regularly confounded independent forecasters (who have consistently dismissed them for being too optimistic). What he neglects to mention is that this makes the deterioration of the public finances since 2000 all the more glaring: even though the economy has grown in line with its projections the fiscal outturn has been consistently weaker than the Treasury was expecting. As a result the government is now close to breaking its fiscal “golden rule” (which prohibits it, over the course of a cycle, from borrowing to fund current spending); and it looks increasingly unlikely that Mr Brown can continue to meet his self-imposed rule without further rises in taxation. It is, of course, worth keeping a sense of perspective. The UK’s public finances may have deteriorated more rapidly than in any other major EU country since 2001. However, with a markedly lower ratio of general government debt to GDP than in Italy, France and Germany, the UK’s starting position was quite different. The UK’s overall fiscal position is, in fact, still enviable compared with many of its EU peers. The UK posted a general government budget deficit of 3.1% of GDP in 2004, but this was still a markedly lower ratio than in Germany, France and Italy (the euro area’s three largest member states). In addition, the UK’s ratio of general government debt to GDP remains much lower than the EU average (even if the UK’s position is flattered because the figures do not include the Private Finance Initiative, which is currently playing a major role in funding public investment).

Country Report April 2005 www.eiu.com © The Economist Intelligence Unit Limited 2005 United Kingdom 19

Public finances improve in Figures released by the National Statistics office suggest that the deficit on the 2004-05 current budget in 2004-05 will be lower than in the previous fiscal year. This is unsurprising, however, given the strength of the cyclical upturn in 2004. For the first 11 months of the fiscal year ending March 2005, the deficit on the current budget totalled £15.8bn, £2.9bn less than a year earlier. However, with public- sector net investment increasing by £3.1bn to £15bn between the two periods, public-sector net borrowing rose by £200m to 30.8bn. As a result, net borrowing stood at £401.8bn in February 2005, up from £31.7bn a year earlier. A breakdown of the public-sector finances shows that central government net borrowing fell in 2004-05 relative t0 a year earlier, but that local government finances deteriorated.

Sectoral breakdown of net borrowing (£ bn; not seasonally adjusted) 2004 2005 2003-04 2004-05 Feb Feb Apr-Feb Apr-Feb Difference Central government -0.5 1.6 33.6 32.1 -1.5 Local government -1.5 -1.5 -2.5 -1.1 1.4 General government -2.0 0.1 31.1 30.9 -0.2 Public corporations -0.3 -0.2 -0.5 -0.2 0.3 Public sector -2.2 -0.1 30.6 30.8 0.2

Source: National Statistics, First Release.

Monetary policy remains Following the budget the Monetary Policy Committee (MPC) of the Bank of on hold England decided at its meeting in April to leave its key repo rate on hold at 4.75%. This was the eighth consecutive month that monetary policy had been left on hold. The MPC’s decision had been widely expected, given the budget’s broadly neutral fiscal stance and the relative weakness of economic data in the run-up to the meeting. Although consumer and producer prices have picked up in recent months and the labour market remains tight, there are growing signs that a consumer retrenchment may finally be underway (see The domestic economy). Retailers have reported particularly weak trading conditions since the beginning of the yearin early 2005 retail sales volumes actually fell relative to the previous quarterand house price inflation has been slowing sharply. With official interest rates at, or near, their peak, the MPC’s decisions over the months ahead are likely to be finely balanced. In early March the interest rate futures markets were pricing in one final 25-basis point rise before the current cycle of monetary tightening came to an end. The markets’ expectation was that the Bank of England’s repo rate would finish the year at 5%. Since early March, expectations in the money markets have shifted. In mid-April contracts in the Treasury bill market implied official interest rates of around 4.75% at the end of 2005.

Country Report April 2005 www.eiu.com © The Economist Intelligence Unit Limited 2005 20 United Kingdom

The domestic economy

Output and demand

Real GDP growth remains Chained volume data indicate that real GDP grew by 0.7% quarter on quarter in robust in the fourth quarter the final three months of 2004 and by 2.9% year on year. This meant that the UK was once again comfortably the fastest-growing of the EU’s four largest member states. Weighed down by sluggish activity in Germany, France and Italy, real GDP in the euro area expanded during the same period by just 0.2% quarter on quarter and by 1.6% year on year. The UK’s performance in the final quarter of 2004 meant that over the year as a whole, real GDP grew by a robust 3.1%. By contrast, preliminary estimates suggest that real GDP in the euro area grew by just 1.8%.

Components of gross domestic product (% change, quarter on quarter; chained volume measures at 2001 reference prices unless otherwise indicated; seasonally adjusted) 2003 2004 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr Household consumptiona -0.2 0.9 0.8 0.6 1.2 0.8 0.8 0.3 General government consumption 0.8 0.7 1.7 1.8 0.9 0.7 1.2 0.9 Gross fixed investmentb -2.0 0.7 0.8 2.8 0.2 2.6 1.0 0.6 Final domestic demand -0.3 0.8 1.0 1.2 1.0 1.1 0.9 0.4 Stockbuildingcd -0.3 -0.5 0.6 0.2 -0.6 -0.2 0.3 0.4 Total domestic demand -0.5 0.4 1.5 1.4 0.5 0.8 1.2 0.9 Exports of goods and services 6.7 -3.5 -0.3 1.9 0.6 2.2 -0.1 1.6 Imports of goods and services 2.6 -3.0 1.6 3.3 -0.1 1.5 2.1 2.2 GDP at market prices 0.4 0.4 1.0 0.9 0.7 1.0 0.6 0.7 a Includes non-profit-making institutions serving households. b Excludes net acquisition of valuables. c Includes statistical discrepancy. d Change as a percentage of GDP in the previous quarter. Source: National Statistics, First Release.

Real GDP growth and household consumption % change, year on year 6 Real GDP growth 5 Household consumption

4

3

2

1

0 1993 94 95 96 97 98 99 2000 01 02 03 04

Source: Office for National Statistics.

The components of GDP, however, suggest that there was a marked change in the pattern of economic activity, with final domestic demand slowing sharply. Over the fourth quarter as a whole, final domestic demand expanded by just

Country Report April 2005 www.eiu.com © The Economist Intelligence Unit Limited 2005 United Kingdom 21

0.4% quarter on quarter. Although this translated into a buoyant year-on-year growth rate of 3.4%, this reflected the strength of activity in the previous three quarters. Total domestic demand expanded by a more rapid 0.9% quarter on quarter (3.4% year on year), but this reflected a huge contribution from stockbuilding (which added 0.4 percentage points to growth). Since part of the build up in inventories may have been involuntary (given moderating demand at home and abroad), the stock cycle is likely to exert a drag on growth in early 2005. The inventory build-up in the final quarter played a part in the surge in imports of goods and services. Exports recovered after contracting in the third quarter of the year, but the foreign balance still made a negative contribution to GDP growth.

Components of gross domestic product (% change, year on year; chained volume measures at 2001 reference prices unless otherwise indicated; seasonally adjusted) 2003 2004 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr Household consumptiona 2.2 2.3 2.5 2.1 3.5 3.4 3.3 3.0 General government consumption 0.9 3.0 3.8 5.1 5.2 5.2 4.6 3.6 Gross fixed investmentb 3.9 2.1 0.9 2.3 4.6 6.6 6.8 4.5 Final domestic demand 2.3 2.4 2.5 2.7 4.0 4.2 4.1 3.4 Stockbuildingcd -0.1 0.0 0.1 0.0 -0.4 0.0 -0.3 0.0 Total domestic demand 2.1 2.4 2.5 2.7 3.7 4.2 3.9 3.4 Exports of goods and services 4.7 -3.3 -2.2 4.7 -1.3 4.4 4.7 4.4 Imports of goods and services 4.9 -1.4 -0.3 4.5 1.7 6.4 7.0 5.7 GDP at market prices 2.0 2.0 2.1 2.7 3.0 3.6 3.1 2.9 a Includes non-profit-making institutions serving households. b Excludes net acquisition of valuables. c Includes statistical discrepancy. d Change as a percentage of GDP in the previous year. Source: National Statistics, First Release.

Household consumption One of the most striking features of the final quarter of 2004 was the sharp slows sharply slowdown in consumer spending. Household consumption, which accounts for almost two-thirds of GDP in the UK, has provided the main impetus to activity since 1996. In the final three months of 2004, however, household consumption (including non-profit institutions) expanded by just 0.3% quarter on quarter, its slowest rate of growth since the first quarter of 2003. This still amounted to respectable growth of 3% in year-on-year terms, but only because of the strength of consumer spending in the previous three quarters. The reason for the slowdown was a 0.5% quarter-on-quarter fall in household disposable income. The household sector savings ratio, at 5.8%, was broadly unchanged on the previous quarter. The largest increases in spending compared with the previous quarter were on services such as education, health and transport. By contrast, spending on communication, recreation and household goods and services contracted. Leading indicators suggest that the slowdown in consumer spending continued in early 2005. Indeed, in the three months to February, the seasonally adjusted volume of retail sales actually contracted by 0.6% compared with the previous three-month period. Annual comparisons show that retail sales volumes were still 3.4% higher than a year earlier, but this was the lowest rate of growth since March 2003 (the month of the outbreak of the US-led war in Iraq). The fall in retail sales in early 2005 was concentrated in non-food stores. Sales volumes in

Country Report April 2005 www.eiu.com © The Economist Intelligence Unit Limited 2005 22 United Kingdom

non-food stores fell by 1.7% quarter on quarter, the sharpest decline since March 1992. A survey by the employers’ organisation, the Confederation of British Industry (CBI), found that trading conditions remained depressed in March. Asked about their volume of sales for the time of the year, only 10% reported good sales while 47% reported poor sales. The resulting balance of e37 was the lowest reading since November 1992. Even if cold weather contributed to poor trading conditions, leading indicators suggest that a consumer slowdown is now underway. Other evidence for an ongoing consumer retrenchment is provided by data on bank lending to individuals. According to data published in late March by the Bank of England (the central bank), total net lending to individuals grew by 12.4% year on year in February. Although this still represents a robust rate of growth, it was nevertheless weaker than the average for the previous six months. Interestingly, given the role played by mortgage equity withdrawal in supporting consumption in recent years, the number of loans approved for remortgaging and other purposes fell in February. Figures from the Council of Mortgage Lenders (CML) provide further evidence for a cooling of the housing market. According to the CML, mortgage completions dropped from 63,000 in January to 59,000 in February, the lowest number since monthly records began in 1998. The slowdown in consumer spending and the housing market is unsurprising given current levels of household indebtedness. In February the total stock of lending to individuals stood at £1.07trn, or 136% of household disposable income. Of this, £887.8bn was secured on dwellings and £185.3bn was unsecured. Although debt-servicing costs measured as a share of personal income are still modest by historical standards (because nominal interest rates are low), the rapid accumulation of debt over the past few years has increased the sensitivity of the household sector to rises in interest rates (particularly as floating rate mortgages still account for two-thirds of outstanding mortgages). However, with house prices beginning to weaken in many parts of the country and mortgage approvals falling, interest rates look as if they might have peaked (reducing the likelihood of households facing further rises in debt-servicing costs). Should house prices stabilise at their current levels or fall modestly in real terms over the next two years, the UK should escape a sizeable retrenchment in consumer spending. However, with the ratio of house prices to average earnings close to all-time highs, a sharp correction in house prices cannot be ruled out. A large fall in house prices could provoke an abrupt adjustment in consumer spending as financially overstretched households move to strengthen balance sheets hit by falling property values.

Gross fixed investment Gross fixed investment, which has recovered strongly since the second quarter moderates of 2003, slowed in the final quarter of 2004. Over the final three months of the year, gross fixed investment expanded by 0.6% quarter on quarter, down from 1% in the previous three-month period. On a year-on-year basis, gross fixed investment grew by 4.5%, down from 6.8% in the previous quarter. Relative to the previous quarter, the fastest-growing component of gross fixed investment was capital spending by general government, which was 1.9% higher than in the previous quarter (and up by 3.1% on a year earlier). However, capital spending

Country Report April 2005 www.eiu.com © The Economist Intelligence Unit Limited 2005 United Kingdom 23

by general government accounts for just over 10% of total investment spending across the economy as a whole. Business investment, which accounts for 64% of total investment spending, grew by just 0.2% quarter on quarter, down from 1.6% in the July-September period. This still left business investment 4.4% higher than a year earlier. A closer look at trends in capital spending within the business sector shows marked variations across sectors. Interestingly, given the protracted weakness of the sector, capital spending by private-sector manufacturing companies grew strongly, rising by 3% quarter on quarter and by 5% year on year. However, these apparently strong figures need to be seen in context. Capital spending in the manufacturing sector contracted sharply between 2000 and 2002 and has not recovered durably since then. At constant prices, manufacturing investment in the final quarter of 2004 was still 23% lower than in the fourth quarter of 2000. Business investment outside the manufacturing sector actually contracted by 0.1% quarter on quarter in the final three months of 2004, although it was still 4.4% higher than a year earlier. This drop was the responsibility of a sharp contraction in the construction sector, where investment spending fell by 19.8% quarter on quarter and by 35.6% year on year. Investment spending in other sectors, however, was more buoyant. This was particularly true of distribution services, where capital spending expanded by a robust 3.1% quarter on quarter and by 39.4% year on year.

Gross fixed capital formation and capacity utilisation in manufacturing

Gross fixed capital formation; % real change, year on year; left scale Capacity utilisation rates in manufacturing; right scale Capacity utilisation rate historical average; right scale 16 90 14 88 12 86 10 84 8 82 6 80 4 78 2 76 0 74 -2 72 -4 70 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 1996 97 98 99 2000 01 02 03 04 05 Source: Office for National Statistics.

The recovery in business investment since 2003, while uneven across sectors, has essentially been supported by three factors: recovering rates of capacity utilisation, improved corporate balance sheets following sustained programmes of debt reduction in 2001-03, and an upturn in profits that has helped British firms’ ability to fund investment projects without having to rely on external finance. Despite these supportive factors, the outlook for business investment looks mixed. Not only have pressures on capacity eased slightly since the third quarter of 2004, but levels of corporate debt remain quite high by historical standards (despite recent improvements in corporate balance sheets). With demand set to slow at home and abroad in 2005, British companies could be deterred from exploiting exceptionally favourable financing conditions to raise capital spending.

Country Report April 2005 www.eiu.com © The Economist Intelligence Unit Limited 2005 24 United Kingdom

Sectoral trends

Services sector underpins Data for the output side of the economy suggests that economic growth in the activity final quarter of 2004 was once again highly uneven across sectors, with robust growth in the services and construction sectors offsetting weak activity in the industrial sector. One again, it was the services sector that provided the main impetus to GDP growth. In the October-December period, gross value added across the services sector as a whole expanded by 0.8% quarter on quarter and by 4% year on year. Within services, the most buoyant sub-sector by far was financial services, which expanded by 2.3% quarter on quarter and by 6.7% year on year. Other sectors that grew strongly were transport and storage (which expanded by 2.1% quarter on quarter and 6.2% year on year), and post and telecommunications (where gross value added rose by 1% quarter on quarter and by 6.2% year on year). The weakest service sector in the final quarter of 2004 was the wholesale and retail trade sector, where gross value added rose by just 0.1% quarter on quarter (although strong activity earlier in 2004 still left it 3.8% higher than a year earlier).

Services: gross value added (% change, quarter on quarter) 2003 2004 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr Wholesale & retail trade -0.9 1.1 1.6 1.3 1.6 1.3 0.8 0.1 Hotels & restaurants 1.0 1.9 0.3 0.5 1.9 1.9 0.3 0.6 Transport & storage -1.0 -1.0 1.6 -0.2 2.4 1.4 0.2 2.1 Post & telecommunications 1.7 1.8 -1.6 0.9 -0.6 1.3 4.4 1.0 Financial intermediation -0.4 0.4 0.4 1.5 3.1 -0.9 2.1 2.3 Real estate, renting & business activities 2.6 0.9 2.2 3.1 2.0 1.3 1.5 1.6 Ownership of dwellings 0.7 0.2 0.4 0.8 0.4 0.3 0.2 0.6 Government & other services 0.3 0.2 0.4 0.6 0.3 1.0 0.7 0.7 Total services 0.5 0.4 1.0 1.1 1.2 0.9 1.0 0.8

Source: National Statistics, First Release.

Industrial sector tips into As has often been the case in recent years, the resilience of the services sector recession in the final quarter of 2004 masked the weakness of the industrial sector, which tipped back into recession after suffering its second consecutive quarter of contracting output. Output across the industrial sector as a whole declined by 0.1% quarter on quarter after falling by 1.2% in the previous quarter. This left industrial output 0.5% lower than a year earlier. The weakness of the industrial sector was broadly based, but was particularly marked in the utilities and the extractive industries. Output in the oil and gas sector contracted by 3.7% quarter on quarter and by 10% year on year, while output in the mining and quarrying sector dropped by a barely more modest 2.7% quarter on quarter and 8.5% year on year. Since output in the gas, electricity and water distribution sector also fell compared with the previous sector, industrial production would have contracted even more sharply than it did had it not been for a modest rebound in the manufacturing sector.

Country Report April 2005 www.eiu.com © The Economist Intelligence Unit Limited 2005 United Kingdom 25

Manufacturing activity was hardly buoyant, but output across the sector as a whole grew by a modest 0.3% quarter on quarter and 0.6% year on year. Within manufacturing, the most buoyant sectors were the chemicals sector (where production rose by 1.1% quarter on quarter) and the food and drinks sector (where production was up by 0.7%). Both sectors, however, were emerging from a period of sluggish activity. As a result, the year-earlier comparisons were less impressive: output in the chemicals sector was only 0.4% higher than in the corresponding period in 2003, while output in the food and drinks sector was only 1.5% higher. In addition, activity in several manufacturing sub-sectors contracted. Production in the textiles sector, which is in long-term secular decline because of the growth in competition from lower cost producers in the developing world, fell by 1.8% quarter on quarter and by 13% year on year. Output in the important engineering sector, meanwhile, fell by 0.8% quarter on quarter; compared with the year-earlier period, however, production was still 2.7% higher.

Non-services output (% change, quarter on quarter) 2003 2004 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr Total industry 0.1 -0.3 0.5 0.5 -0.4 1.2 -1.2 -0.1 Mining & quarrying -0.2 -4.2 -1.9 -2.6 -1.4 1.5 -6.0 -2.7 Gas, electricity & water distribution -0.9 0.8 1.3 2.0 0.4 -0.4 0.5 -0.4 Oil & gas extraction -0.3 -4.7 -1.6 -3.0 -1.0 1.1 -6.6 -3.7 Manufacturing 0.2 0.3 0.7 0.8 -0.4 1.4 -0.7 0.3 Engineering 1.2 1.2 0.4 1.3 -0.8 4.1 0.3 -0.8 Textiles & textile products 3.6 0.8 1.4 -2.6 -6.6 -3.8 -1.5 -1.8 Food, drinks & tobacco 0.5 -0.4 0.6 -0.1 -0.3 2.3 -1.2 0.7 Metals & metal products -2.7 -0.7 0.1 1.1 0.5 2.8 0.2 0.1 Chemicals & allied -0.6 1.7 0.7 2.7 1.3 -0.2 -1.7 1.1 Agriculture, forestry & fishing -2.5 0.2 1.1 0.5 0.3 -0.2 0.7 0.9 Construction 0.3 1.9 3.1 0.5 0.3 0.2 1.2 1.1

Source: National Statistics, First Release.

Construction sector grows One of the fastest-growing sector outside the services sector was construction, which expanded by 1.1% quarter on quarter and by 2.8% year on year. Although the number of new homes being built remains lowhighlighting the scale of supply-side constraints facing the residential construction sectoractivity has continued to be supported by public investment in new schools, hospitals and roads, as well as by household spending on the repair and maintenance of existing homes.

Employment, wages and prices

Inflation edges up in Inflation as measured by the EU’s harmonised index of consumer prices rose to early 2005 1.6% in January-February, up from 1.1% in September. Despite the recent pick up in price pressures, inflation remains below the Bank of England’s central target of 2%. The main factors exerting upward pressure on inflation in February were transport costs and seasonal food prices, with fresh vegetables in particular rising following poor winter weather. Relative to a year earlier, the fastest-rising

Country Report April 2005 www.eiu.com © The Economist Intelligence Unit Limited 2005 26 United Kingdom

items in the consumer price index remained housing and household services (which account for around 14% of the index). Rising tariffs for water, electricity, gas and other fuels helped to push the price of housing and household services 5.9% higher than a year earlier. The price of education and transport also rose quite sharply. As has been the case for several years, the aggregate rate of inflation concealed divergent price trends in the service and goods sectors. In the goods sector, which is most exposed to international trade, prices fell by 0.2% year on year in February (despite the continued upward pressure exerted by international oil prices). The price of clothing and footwear, like that of audio-visual equipment and toys, continued to fall in early 2005 as a result of, among other things, the downward pressure exerted by rising imports from low-countries in Asia (particularly China). Inflation in the more sheltered service sector, by contrast, stood at 3.8% in February. Within services, the highest rates of increase were recorded by health, education and transport services. Price rises in the services sector have been consistently above the government’s central inflation target since 1997.

Inflation (period averages; % change, year on year) 2003 2004 2005 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr Retail prices 3.0 2.9 2.6 2.6 2.8 3.1 3.4 3.2a Excl mortgage interest payments (RPIX) 2.9 2.9 2.6 2.3 2.2 2.1 2.3 2.1a Excl mortgage interest payments & indirect taxes (RPIY) 2.8 2.7 2.3 1.9 2.1 1.9 2.2 2.0a Consumer price index (CPI)b 1.3 1.4 1.4 1.3 1.4 1.3 1.4 1.6a Producer prices Output prices 1.3 1.4 1.7 1.5 2.3 2.8 3.3 2.7 Input prices -0.5 1.2 2.9 -0.4 3.9 5.6 6.7 10.7 Average earningsc Whole economy (excl bonuses) 3.4 3.7 3.6 3.9 4.2 4.3 4.4 4.4d Whole economy (incl bonuses) 3.0 3.6 3.4 5.2 4.3 3.8 4.4 4.4d Private sector (excl bonuses) 3.0 3.2 3.4 3.9 4.1 4.3 4.4 4.3d Private sector (incl bonuses) 2.5 3.1 3.2 5.5 4.3 3.7 4.3 4.4d Public sector (excl bonuses) 5.1 5.6 4.4 4.3 4.5 4.2 4.7 4.7d Public sector (incl bonuses) 5.0 5.6 4.4 4.3 4.4 4.2 4.7 4.6d a January-February; b EU harmonised index of consumer prices (HICP); c Great Britain only; seasonally adjusted; d Three months to January. Source: National Statistics, First Release.

Producer price inflation Although the impact on the consumer price index has so far been offset by continues to rise falling prices in parts of the goods sector, the sharp increase in international oil prices, allied to the surging price of steel and scrap metal, has continued to exert upward pressure on producer prices. In the first quarter of 2005 the input price index for materials and fuels purchased by the manufacturing industry rose by 10.7% year on year, up from 6.7% in the previous quarter. So far, the increases in producer input prices have had only a limited impact on prices at the factory gate. Indeed, despite the sharp increase in producer input prices, producer output price inflation eased to 2.7% in the first quarter, down from 3.3% in the previous quarter.

Country Report April 2005 www.eiu.com © The Economist Intelligence Unit Limited 2005 United Kingdom 27

Despite the slight pull-back in factory gate inflation, the Bank of England is still concerned that rising input prices could move down the supply chain and find their way into consumer prices. This risk should not be exaggerated, however, because producer input prices form only a small part of many manufacturing companies’ total costs.

Average earnings growth One of the Bank of England’s main concerns is that inflationary pressures could remains stable build up in the labour market. Seasonally adjusted average earnings growth has picked up since the third quarter of 2004. In the three months to January whole economy average earnings (including bonuses) grew by 4.4% year on year, up from 3.8% in the third quarter. However, much of the acceleration was driven by the pattern of bonus payments (a reflection of improved corporate profitability in 2004). If the effect of bonuses is excluded, the pick up in average earnings growth since the third quarter of 2003 has been less marked. In the three months to January, average earnings excluding bonuses grew by 4.4% year on year, up from 4.3% in the three months to September 2004. As has been the case for the past two years or so, the rate of average earnings growth in the public sector continued to outstrip that in the private sector. In the three months to January 2005 average earnings (excluding bonuses) in the public sector grew by 4.7% year on year. The rapid growth in average earnings in the public sector has coincided with a concerted recruitment drive in key services such as education, health and policing. That said, the gap between rates of average earnings growth in the public and private sectors has narrowed since the middle of 2004 (when it peaked at 2 percentage points). In the three months to January average earnings (excluding bonuses) in the private sector grew by 4.3%.

Employment continues A further sign of tightening conditions in the labour market was the continued to grow rise in employment. In the three months to January 2005 employment across the economy totalled a seasonally adjusted 28.6m, 127,000 (or 0.4%) more than in the previous quarter and 219,000 (or 0.8%) more than a year earlier. Two features of this increase are particularly worth highlighting. First, it was mainly supported by a rise in the number of employees, rather than the self-employed. The number of employees rose by 116,000 (0.5%) quarter on quarter and by 242,000 (1%) year on year, while the number of self-employed rose by a more modest 11,000 (0.3%) quarter on quarter and declined by 35,000 (0.9%) compared with a year earlier. Second, it reflected an increase in full-time rather than part-time employment. Among employees (rather than the self-employed), part-time employment actually declined by 35,000 (0.6%) quarter on quarter and by 58,000 (0.9%) year on year. The number of people on government- supported training and employment programmes also declined compared with the previous quarter, although numbers were still higher than in the year- earlier period. Labour market trends continued to display wide variations across sectors, with rising employment in the services sector offsetting further declines in the manufacturing sector. Across services as a whole, employment rose by 64,000 (0.3%) quarter on quarter and by 140,000 (0.6%) year on year. Within services, the most buoyant growth was in the distribution, hotel and restaurant trades.

Country Report April 2005 www.eiu.com © The Economist Intelligence Unit Limited 2005 28 United Kingdom

By contrast, public-sector employment, which has expanded strongly in recent years on the back of the government’s increases in spending on the education, health and law-enforcement services, actually fell slightly compared with the previous quarter (although it was still 110,000 higher than a year earlier). The other main recruiter in the three months to January was the construction sector, where employment grew by 58,000 (2.7%) quarter on quarter and by 78,000 (3.7%) year on year. Employment in the manufacturing sector, by contrast, fell by 14,000 (0.4%) relative to the previous three months and by 93,000 (2.6%) relative to a year earlier.

Employment and unemployment (seasonally adjusted; period averages unless otherwise indicated) 2003 2004 2005 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr Unemployment (% of total workforce) Claimant counta 3.1 3.1 3.0 2.9 2.7 2.7 2.7 2.6b Labour force surveyc 5.0 5.0 4.9 4.7 4.8 4.7 4.7 4.7d Total employment (‘000) Labour force surveyc 28,177 28,200 28,225 28,425 28,376 28,431 28,521 28,567d No. of unemployed (‘000) Claimant count 948 930 906 882 849 836 824 813d Labour force survey 1,473 1,484 1,462 1,413 1,440 1,380 1,411 1,410d No. inactive but wanting work (‘000) 2,132 2,104 2,113 2,043 2,020 2,059 2,000 2,004d a Final month of the quarter. b January. c International Labour Organisation (ILO) definitions. d Three months to January. Source: National Statistics, First Release.

The rate of unemployment An increase in labour force participation meant that employment growth was remains stable not sufficient to reduce the number of people out of work. In the three months to January 2005, the number of unemployedas measured by the Labour Force Survey which is compiled according to International Labour Organisation (ILO) standards and is hence most appropriate for international comparisons totalled 1.4m, an increase of 22,000 compared with the previous three-month period. As a result, the unemployment rate remained unchanged at 4.7%. As measured by the national “claimant count”, which does not include job seekers who are not entitled to unemployment benefit, the number of unemployed fell to 813,000 in February. This pushed the claimant count unemployment rate down to 2.6%.

Financial indicators

Sterling strengthens in the first Sterling’s effective exchange rate appreciated in the first quarter of 2005, ending quarter of 2005 the quarter on 103.7. This represented an increase of 2.2% compared with the end of the previous quarter. With sterling weakening slightly against the US dollar, the appreciation reflected rises against both the euro and the Japanese yen. Exchange rates during the first quarter were primarily influenced by the impact of interest-rate expectations. With short-term interest rates rising sharply in the US and the weakness of activity across much of western Europe ruling out any immediate rise in official euro area interest rates, the euro weakened against the US dollar. As is often the case, sterling traded in an intermediate range between the US dollar and the euro. However, the Economist Intelligence

Country Report April 2005 www.eiu.com © The Economist Intelligence Unit Limited 2005 United Kingdom 29

Unit believes that the recent recovery in the US dollar will be short-lived. The US dollar is likely to come under renewed selling pressure during the course of 2005 as the US struggles to attract the capital inflows needed to fund its huge current-account deficit.

Exchange rates (end-period) 2003 2004 2005 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr US$:€ 1.58 1.65 1.66 1.79 1.84 1.81 1.81 1.92 1.89 €:£ 187.4 198.1 185.6 191.8 191.2 197.9 199.4 196.8 202.1 €:£ 1.45 1.44 1.43 1.42 1.50 1.49 1.46 1.42 1.45 Effective exchange rate (1990=100) 99.7 100.4 99.4 100.6 105.1 104.8 103.0 101.5 103.7

Sources: Bank of England; IMF, International Financial Statistics; Financial Times.

The yield curve remains Although the Bank of England left its key repo rate on hold at 4.75%, the yield inverted curve remained inverted throughout the first quarter of 2005. However, the gap between short and long-term interest rates narrowed as the yield on ten-year government bonds edged up from 4.54% at the end of the previous quarter to 4.69% at the end of March. With long-term interest rates falling in the euro area, the small rise in UK long-term interest rates increased the yield differential between UK and German ten-year government bonds from 86 basis points at the end of the previous quarter to 107 basis points at the end of March. The widening of the long-term interest rate differential between UK and German long-term government debt was driven by the financial markets’ more bullish view of economic prospects in the UK, rather than by concern for the state of the public finances. The rise in the UK’s yield gap with the euro area was a factor behind sterling’s appreciation against the euro in the first three months of the year.

Interest rates (%; end-period) 2003 2004 2005 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr Base rate 3.75 3.75 3.50 3.75 4.00 4.50 4.75 4.75 4.75 3-month interbank rate (mid rate) 3.66 3.59 3.66 4.00 4.38 4.84 4.92 4.89 4.98 Differential with euro area 1.14 1.46 1.53 1.88 2.42 2.72 2.77 2.75 2.84 3-month Treasury bill 3.50 3.50 3.59 3.88 4.03 4.78 4.88 4.88 4.75 10-year government bond yield 4.30 4.18 4.56 4.77 4.75 5.09 4.83 4.54 4.69 Differential with Germany 0.26 0.38 0.56 0.47 0.83 0.78 0.84 0.86 1.07

Sources: Bank of England; Financial Times.

Equities continue to rise The stockmarket posted further gains in the first quarter of 2005. The FTSE 100 index of leading blue chip stocks ended the quarter on 4,984.4, a modest rise of 1.7% from its level at the end of December 2004. As they have done for much of the past three years, small- and medium-cap stocks outperformed the large caps. The FTSE 250 index of medium sized companies finished the first quarter 2.8% higher than at the end of the previous quarter. The FTSE SmallCap index fared even better, rising by 5.4% over the same period. One consequence of the recent period of outperformance by small and medium-sized companies is that they are now trading on higher price/earnings ratios than large companies. For

Country Report April 2005 www.eiu.com © The Economist Intelligence Unit Limited 2005 30 United Kingdom

some observers, this is justified by their potential for faster growth. A more plausible explanation is that markets are underpricing the risk of failure for certain small and medium-sized companies. Small and medium-sized company stocks are therefore likely to suffer a sharper downward correction than large- cap stocks if risk aversion increases.

Stockmarket indicators (end-period) 2003 2004 2005 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr FTSE-100 3,613.3 4,031.2 4,091.3 4,476.9 4,385.7 4,464.1 4,570.8 4,814.3 4,894.4 FTSE-250 3,959.8 4,963.4 5,457.8 5,802.3 6,259.4 6,277.9 6,269.1 6,936.8 7,130.5 FTSE SmallCap 1,647.3 2,102.2 2,354.9 2,457.1 2,632.9 2,582.8 2,556.4 2,758.1 2,907.3 FTSE All-Share 1,735.7 1,971.3 2,027.7 2,207.4 2,197.0 2,228.7 2,271.7 2,410.8 2,457.7

Source: Bloomberg.

Foreign trade and payments

Export earnings rise in the The UK’s earnings from goods exports in the final quarter of 2004 rose for the final quarter of 2004 third consecutive quarter. Over the October-December period as a whole, the value of UK goods exports totalled £49.5bn (US$90.6bn), £1.2bn more than in the previous quarter and £3bn more than a year earlier. If oil and other erratic items are excluded, UK earnings from goods exports also increase. The rise in earnings reflected an increase in both the price and underlying volume of sales abroad. Export prices rose by 1.2% quarter on quarter and by 2.4% year on year, while export volumes were 1.9% higher than in the previous quarter and 3.9% higher than a year earlier. Data on the direction of trade indicate that the UK’s earnings from goods exports rose in both EU and non-EU markets. The value of exports to the EU25 totalled £28.9bn in the final quarter of 2004, £786m more than in the previous three-month period and £1.6bn more than a year earlier. Interestingly, given the sluggishness of the EU’s largest members, earnings from exports to the euro area were buoyant in late 2004. The value of exports to the euro area totalled £26.2bn in the final quarter of 2004, £752m more than in the previous quarter and £1.6bn more than a year earlier. Within the euro area, a particularly large increase in earnings was recorded from exports to Germany (up £408m compared with the previous quarter and £744m compared with a year earlier). By contrast, earnings from exports to France and Belgium-Luxembourg were lower than in the third quarter of 2004. Outside the EU, the UK benefited from strong growth in the US and in large Asian markets such as China, Hong Kong and Japan. Breakdowns by commodities suggest that the strongest-performing sector by far in the final quarter was the oil sector. The value of fuel exports totalled 5.3bn in the final quarter of 2004, £676m more than in the previous quarter and £1.5bn more than a year earlier. In other words, around half of the increase in export earnings in the final quarter of the year was accounted for by a sector that only represents around 10% of the total value of British visible exports. The value of exports of manufactured goods, which typically account for a share over 80%

Country Report April 2005 www.eiu.com © The Economist Intelligence Unit Limited 2005 United Kingdom 31

of the UK’s total earnings, totalled 41.1bn in the October-December period, £1bn more than in the previous three-month period and £1.3bn more than a year earlier. The UK’s performance in the final quarter of 2004 meant that over the year as a whole earnings from visible exports amounted to £190.7bn, £2.1bn more than in 2003.

Trade in goods (£m; seasonally adjusted) 2002 2003 2004 Year 1 Qtr 2 Qtr 3 Qtr 4 Qtr Year 1 Qtr 2 Qtr 3 Qtr 4 Qtr Year Trade in goods Exports 186,517 48,928 46,795 46,349 46,543 188,615 45,743 47,126 48,289 49,530 190,688 Imports -233,192 -59,485 -57,744 -58,573 -60,478 -236,280 -59,299 -61,236 -63,213 -64,884 -248,632 Balance -46,675 -10,557 -10,949 -12,224 -13,935 -47,665 -13,556 -14,110 -14,924 -15,354 -57,944 Trade with EU 25 countries Exports 114,129 28,962 27,308 26,979 27,318 110,567 26,644 27,216 28,102 28,888 110,850 Imports -135,794 -34,773 -33,258 -33,497 -34,715 -136,243 -33,947 -34,531 -34,802 -35,669 -138,949 Balance -21,665 -5,811 -5,950 -6,518 -7,397 -25,676 -7,303 -7,315 -6,700 -6,781 -28,099 Trade with non-EU countries Exports 72,388 19,171 19,363 19,411 20,090 78,035 18,395 19,582 20,403 21,493 79,873 Imports -97,398 -24,659 -24,517 -25,111 -25,488 -99,775 -25,450 -26,667 -28,293 -28,993 -109,403 Balance -25,010 -5,488 -5,154 -5,700 -5,398 -21,740 -7,055 -7,085 -7,890 -7,500 -29,530 Trade excluding oil & erratics Exports 160,963 40,987 40,200 39,765 40,774 161,726 38,648 40,061 41,006 42,435 162,150 Imports -210,824 -53,410 -52,485 -52,421 -54,577 -212,893 -53,632 -54,879 -56,215 -57,598 -222,324 Balance -49,861 -12,423 -12,285 -12,656 -13,803 -51,167 -14,984 -14,818 -15,209 -15,163 -60,174

Source: Office for National Statistics, First Release.

A rising import bill widens the With domestic demand growing strongly and import prices rising for the third trade deficit consecutive quarter, the value of goods bought by the UK rose in the final three months of 2004. Over the fourth quarter as a whole, the UK’s import bill totalled £64.9bn, an increase of £1.7bn compared with the previous quarter and of £4.4bn compared with a year earlier. As with exports, much of the increase in the UK’s import bill in the final quarter of 2004 was driven by international energy prices. The value of fuel imports into the UK amounted to £5bn in the final quarter, an increase of £556m on the previous quarter and of a staggering £2bn on a year earlier. Put differently, fuels, which account for just 7.7% of the total value of goods entering the UK, accounted for almost half of the increase in the import bill compared with the corresponding period in 2003. The rise in the import bill in the final three months of 2004 meant that over the year as a whole the value of goods entering the UK totalled £248.6bn, £12.4bn more than in 2003. With the import bill continuing to rise by more than export earnings, the trade balance deteriorated further in late 2004. Over the fourth quarter as a whole, the UK recorded a visible trade deficit of £15.4bn. In absolute terms, this was the UK’s largest ever quarterly trade deficit. Over 2004 as a whole, the trade deficit amounted to £57.9bn. In absolute terms, this was the UK’s largest annual trade deficit ever recorded. The UK’s deficit on trade in goods in 2004 represented 5% of GDP.

Country Report April 2005 www.eiu.com © The Economist Intelligence Unit Limited 2005 32 United Kingdom

The current-account deficit Despite the rise in the visible trade deficit, the current-account deficit actually narrows in late 2004 narrowed in the final quarter of 2004. Over the final three months of 2004 the UK posted a seasonally adjusted current-account deficit of £5bn. This was the UK’s lowest quarterly external deficit since the first quarter of 2003. The main factor behind the narrowing of the current-account deficit was a sharp increase in the UK’s surplus on investment income, which amounted to £8.2bn in the final quarter of 2004. This was the UK’s highest quarterly surplus ever posted and was £4.3bn more than in the previous quarter. The reflected higher income from direct and portfolio investments abroad, as well as lower foreign earnings on portfolio investments in the UK. Another factor contributing to the fall in the current-account deficit in the final quarter of 2004 was an increase in the UK’s surplus on services. This totalled £4.8bn, £488m more than in the previous quarter. The UK’s external position was also helped by a small fall in the deficit on transfers.

Current account (£m; seasonally adjusted) 2003 2004 1 Qtr 2 Qtr 3 Qtr 4 Qtr Year 1 Qtr 2 Qtr 3 Qtr 4 Qtr Year Goods exports 48,928 46,795 46,349 46,543 188,615 45,743 47,126 48,289 49,530 190,688 Goods imports -59,485 -57,744 -58,573 -60,478 -236,280 -59,299 -61,236 -63,213 -64,884 -248,632 Goods balance -10,557 -10,949 -12,224 -13,935 -47,665 -13,556 -14,110 -14,924 -15,354 -57,944 Service exports 22,439 22,418 22,973 23,291 91,121 23,486 24,174 23,757 24,455 95,872 Service imports -18,664 -18,461 -19,055 -19,330 -75,510 -18,807 -18,937 -19,400 -19,610 -76,754 Services balance 3,775 3,957 3,918 3,961 15,611 4,679 5,237 4,357 4,845 19,118 Income credits 32,453 31,400 30,650 31,760 126,263 32,377 33,333 34,108 38,105 137,923 Income debits -24,369 -26,838 -26,041 -25,802 -103,050 -26,322 -27,547 -30,153 -29,897 -113,919 Income balance 8,084 4,562 4,609 5,958 23,213 6,055 5,786 3,955 8,208 24,004 Transfers credits 2,982 2,890 3,135 3,224 12,231 3,211 2,942 3,171 3,258 12,582 Transfers debits -5,368 -5,723 -5,608 -5,430 -22,129 -6,144 -5,291 -6,004 -6,003 -23,442 Transfers balance -2,386 -2,833 -2,473 -2,206 -9,898 -2,933 -2,349 -2,833 -2,745 -10,860 Current account balance -1,084 -5,263 -6,170 -6,222 -18,739 -5,755 -5,436 -9,445 -5,046 -25,682

Source: Office for National statistics, First Release.

The narrowing of the current-account deficit in the final quarter of 2004 was not sufficient, however, to prevent the UK from recording its largest ever annual deficit in absolute terms. Over 2004 as a whole the UK’s current-account deficit totalled £25.7bn, £6.9bn more than in 2003. The deficit is not particularly large, however, when measured as a share of GDP. The UK’s current-account deficit in 2004 represented just 2.2% of GDP. This was slightly higher than in either of the previous two years, but still lower than the share of 2.7% posted in 1999 and well below the shares of 4-5% recorded during the balance-of-payments crises of the late 1980s. Unlike the US, there are no signs that the UK is encountering difficulties attracting the capital inflows needed to fund its external deficit at current levels.

The financial account records a The financial account recorded a net inflow (i.e. inward investment) of £10.3bn net inflow in the final quarter of 2004, compared with a net inflow of £8.9bn in the third quarter. Direct investment abroad showed that there was a net disinvestment of £3bn, compared with net investment in the previous three-month period. Part

Country Report April 2005 www.eiu.com © The Economist Intelligence Unit Limited 2005 United Kingdom 33

of this disinvestment reflected the sale of GKNrs (a technology and engineering firm) 50% shareholding in the helicopter manufacturer, AgustaWestland, for a publicly reported value of £1bn. Foreign direct investment in the UK, meanwhile, showed net investment of £13.3bn, compared with net investment of £7.5bn in the previous quarter. A large share of this was accounted for by the acquisition of Abbey National, a UK bank, by Banco Santander Central Hispanico of Spain. UK portfolio investment abroad over the fourth quarter amounted to £45.9bn, down from £47.7bn in the previous quarter, while foreign portfolio investment into the UK totalled £15.2bn, down from £8.6bn in the third quarter. Over 2004 as a whole, the financial account recorded a net inflow of £27bn, compared with a net inflow of £16bn in 2003.

Country Report April 2005 www.eiu.com © The Economist Intelligence Unit Limited 2005