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2007 Green Budget

This report examines the current economic environment, potential growth rates, and short-term outlook for the UK economy, highlighting trends, risks, and forecasts.

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2007 Green Budget

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  1. 2007 Green Budget The Economic Outlook 31 January 2007 Professor David Miles +44 20 7425 1820 david.miles@morganstanley.com Melanie Baker +44 20 7425 8607 melanie.baker@morganstanley.com Vladimir Pillonca +44 20 7425 5839 vladimir.pillonca@morganstanley.com

  2. Summary • Over the past decade growth and inflation have been stable. This may be sowing the seeds of future volatility by encouraging people to borrow more. • The Treasury has recently revised up its estimate of the UK economy’s potential growth rate from 2.5% to 2.75%, but it uses a more ‘cautious’ rate of 2.5%. But 2.5% looks to be a central forecast, rather than a cautious one. • House prices have moved up very sharply in recent years causing affordability problems and driving borrowing higher; disposable income - net of spending on essential items - looks set to grow only modestly. • We are more pessimistic than the Treasury about economic growth in the next couple of years. We expect weaker consumer spending growth through to 2009.

  3. Plan • What is the sustainable rate of growth now? • Where are we in the cycle? • What is the short term economic outlook?

  4. 30 12 10 Retail price index 25 Real GDP 8 20 6 15 4 2 10 % change over year % change over year 0 5 -2 0 -4 -6 -5 Q1 1957 Q1 1961 Q1 1965 Q1 1969 Q1 1973 Q1 1977 Q1 2005 Q1 2001 Q1 1981 Q1 1985 Q1 1989 Q1 1993 Q1 1997 Q1 1977 Q1 1981 Q1 1985 Q1 1989 Q1 1993 Q1 1997 Q1 2001 Q1 2005 Q1 1973 Q1 1969 Q1 1957 Q1 1961 Q1 1965 The economic environment has been unusually stable over the last decade Figure 4.1. Economic growth and inflation less variable than in the past Source: ONS, Morgan Stanley Research

  5. 51 50 49 48 % of population 47 Labour participation 46 45 Q1 1976 Q1 1980 Q1 1984 Q1 1988 Q1 1992 Q1 1996 Q1 2000 Q1 1972 Q1 2004 Labour participation has risen to historical highs But do these favourable developments mean that UK’s sustainable GDP growth is set to rise way into the future? Source: ONS, Morgan Stanley Research Note: We define labour participation as employment plus unemployment (aged 16 years and above) divided by the overall population.

  6. GDP growth — contribution of Capital, Labour and TFP Factors Capital TFP Extra Overall potential Actual (percentage point deepening Growth labour GDP Growth observed contributions) supply from sum of GDP Growth filtered contributions 1972 - 2005 0.5 1.6 0.2 2.3 2.3 1972 - 1985 0.6 1.6 -0.3 1.9 1.8 1985 - 1995 0.3 1.7 0.4 2.4 2.5 1996 - 2005 0.8 1.4 0.6 2.8 2.8 2001 - 2005 0.6 1.4 0.5 2.6 2.4 2003 0.6 1.5 0.5 2.6 2.6 2004 0.4 1.5 0.6 2.5 3.2 2005 0.3 1.4 0.7 2.3 1.8 2006 Q1- Q2 0.2 1.3 0.7 2.2 2.4 Forecasts 2007 0.3 1.4 0.9 2.6 2008 0.3 1.5 0.8 2.6 2009 0.3 1.5 0.6 2.4 2010 0.5 1.6 0.3 2.4 Note: The trend rate of the underlying components from the production functions is calculated using a HP Filter, which aims to decompose output into a permanent (‘trend’) component and a cyclical factor. Source: Morgan Stanley Research

  7. Conclusions: What is the trend rate of growth now? • Using a production function approach, we conclude that sustained population growth and a small pick-up in the rate of technical progress could push UK potential output growth to 2.6% in 2007 and 2008, • Potential growth eases back to around 2.4% after 2008. The temporary acceleration reflects an assumption that population growth remains strong and then slows, while the employment rate recovers and total factor productivity growth picks up. • Capital deepening is assumed to edge back up to its historical average. • None of these underlying assumptions is implausible, but we can certainly see some downside risks, especially in the near term.

  8. What is the trend rate of growth now? (Continued) • Statistical filters suggest a potential growth rate of around 2.5% for 2006–10, only marginally above the UK’s historical real GDP growth. • But, conditional on our GDP forecasts, these filters tend to suggest a gradual deceleration of potential output growth towards the end of the forecast horizon (2009). • Filtering the GDP data suggest that the Treasury’s estimate that the growth of productive potential will remain at 2¾% beyond 2007 is slightly optimistic. The 2½% assumption used to forecast the public finances looks central rather than cautious as the Treasury claims

  9. Plan • What is the sustainable rate of growth now? • Where are we in the cycle? • What is the short term economic outlook?

  10. Data revisions and changes in GDP forecasts will lead to different estimates of where we are in the cycle…. Source: HM Treasury, Morgan Stanley Research

  11. Dating the cycle under different approaches compared to the Treasury’s Table 4.3. Dates of UK economic cycles HM Treasury Statistical filters HP 1 , 600 BK CF 1972Q4 – 1978Q1 1972Q4 – 1977Q3 1972Q3 – 1977Q4 1972Q3 – 1977Q3 (22Q s ) ( 2 0 Qs ) (2 2 Q s ) (21Q s ) 1978Q1 – 1986Q2 1977Q4 – 1987Q2 1978Q1 – 1982Q4 1977Q4 – 1987Q1 (34Q s ) (39Q s ) (20Q s ) (38Q s ) 1986Q2 – 1997Q2 1987Q3 – 1994Q1 1983Q1 – 1987Q3 1987Q2 – 1994Q1 (45Q s ) (27Q s ) (19Q s ) (28Q s ) 1997Q 2 – F2007H1 1994Q2 – 2003Q3 1987Q4 – 1993Q4 1994Q2 – 1 999Q2 (41Q s ) (38Q s ) (25Q s ) (21Q s ) 2003Q4 – F2009Q2 1994Q1 – 1999Q4 1999Q 3 – 2003Q3 (23Q s ) (24Q s ) ( 1 7 Qs ) 2000Q1 – F2009Q1 2003Q4 – n/a (37Q s ) Sources: Morgan Stanley Research; HM Treasury.

  12. Plan • What is the sustainable rate of growth now? • Where are we in the cycle? • What is the short term economic outlook?

  13. The short term outlook, some specific risks Figure 4.8. UK goods, services and current account balances 3 2 1 0 -1 -2 % change over year -3 Goods balance -4 Services balance -5 Current account balance -6 1997 1998 1999 2000 2001 2002 1993 1994 1995 1996 2003 2004 2005 Source: ONS

  14. 18 Profitability of non-financial private companies, gross of depreciation 16 Profitability of non-financial private companies, net of depreciation 14 12 % ratio of profits to capital 10 8 Q1-98 Q1-99 Q1-00 Q1-01 Q1-02 Q1-03 Q1-94 Q1-95 Q1-96 Q1-97 Q1-89 Q1-90 Q1-91 Q1-92 Q1-93 Q1-04 Q1-05 Q1-06 Corporate profits are healthy… Source: ONS

  15. 16 14 12 10 % 8 WACC (using a 4% equity risk premium; gross of tax) 6 Rate of return on capital (PNFC's) after depreciation 4 1996 1997 1998 1999 2000 2001 2002 2003 1993 1994 1995 2004 2005 Investment rewards: big gap between return to and cost of capital Source: ONS, Morgan Stanley Research; Note: WACC (weighted average cost of capital) is for UK private non-financial corporations (PNFCs).

  16. Here’s what consumers’ balance sheet looks like Household financial balance sheet GBP billions Q4 2004 Q4 2005 Q3 2006 Total financial assets 3,152 3,591 3,745 Currency & deposits 855 921 976 Share & other equity 506 586 574 Insurance technical reserves 1,641 1,933 2,034 Other 143 144 154 Total financial liabilities 1,172 1,249 1,338 Loans 1,083 1,158 1,246 Secured on dwellings 876 938 1,017 Total net financial assets 1,980 2,342 2,407 Source: ONS

  17. 160 1995 2004 120 80 % disposable income 40 0 US UK Italy Spain France Germany Gross financial liabilities have risen to comparatively high levels Source: Eurostat, Federal Reserve, BEA, Morgan Stanley Research

  18. 12 Overall savings rate 10 Savings rate (excluding change in net equity of households in pension schemes) 8 6 % 4 2 0 Q1-99 Q1-00 Q1-01 Q1-02 Q1-03 Q1-04 Q1-96 Q1-97 Q1-98 Q1-95 Q1-05 Q1-06 The saving rate is low, especially after adjusting for contributions to corporate pensions Source: ONS, Morgan Stanley Research; Note: Net equity of households in pension schemes is the balance of contributions to and pensions paid by private funded pension schemes..

  19. Debt servicing levels and costs are both relatively high now 18 Debt servicing as % disposable 16 income MIRAS adjusted 14 Bank of England base rate 12 10 % 8 6 4 Debt servicing is interest payments by households 2 and regular payment of mortgage principal 0 1994 1996 1998 2000 2002 1988 1990 1992 2004 2006 Source: ONS, Inland Revenue and Morgan Stanley Research; Note: MIRAS is mortgage interest tax relief (phased out during the 1990s).

  20. 200.0 % changes since November 180.0 1996/Q3 1996 (depending on the frequency of the data) 160.0 140.0 120.0 100.0 80.0 60.0 40.0 20.0 0.0 Nominal Household Real house Real Real GDP Real house prices mortgage prices consumer household debt spending disposable outstanding income Ten years of house price rises in context Source: Haver, HBoS, ONS, BoE, Morgan Stanley Research

  21. Explaining the change in house prices since 1996 Percentage point contribution to change in real house prices Model I Model II Rise in income per capita 28 44 Increase in number of persons 9 15 Change in real interest rate 14 33 Change in expected capital gains 62 39 Change in housing supply - -16 Total change explained by model 113 114 Source: Morgan Stanley Research

  22. Link from housing market to consumption not entirely clear….but risks seem skewed to the downside for real consumer spending growth, relative to Treasury view Figure 4.17. Real consumer spending growth close to average 7 Real household consumer spending 6 Average since 1996 5 4 % change over year 3 2 1 0 Q1-00 Q1-01 Q1-02 Q1-03 Q1-04 Q1-96 Q1-97 Q1-98 Q1-99 Q1-05 Q1-06 Source: ONS, Morgan Stanley Research

  23. 3.0 2.5 2.0 % change year-on-year 1.5 Morgan Stanley pessimistic case GDP projection Morgan Stanley central case real GDP projection HM Treasury (Real GDP growth assumption used in fiscal projections) 1.0 2006-07 2007-08 2008-09 2009-10 2004-05 2005-06 2010-11 2011-12 GDP growth forecasts compared under alternative scenarios Source: HM Treasury, Morgan Stanley Research

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