Sunday, March 07, 2010
Sterling's election woes are a vote against Brown
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


The storm has subsided, for now at least, but nobody believes it is over. If it were still raging as hard as a few days ago I would have to acknowledge our part in the pound's downfall. Last Sunday's poll in this newspaper showing a lead of just two points for the Tories, the narrowest on a comparable basis since October 2007, produced a good old-fashioned sterling slide on Monday. It was almost nostalgic.

We can expect a few more weeks of this. Markets hate uncertainty, and there is plenty of it. We do not even know the date of the budget, though that is likely to be announced as March 24 this week, let alone the election date, though it will be a surprise if it is not May 6.

Political uncertainty somewhere is the norm. Other countries' elections produce inconclusive outcomes. Hung parliaments, and coalition governments, are commonplace elsewhere in Europe.

So why do the markets have such a downer on Britain? The simple explanation is that, along with America, the UK suffered a sharper deterioration in public finances than other big advanced economies. A budget deficit of an eighth of gross domestic product is enormous in anybody's book.

That, however, has been in the market for some time. It was as long ago as April 2009 that Alistair Darling told the world that the government would borrow 175 billion this year (a figure nudged up to 178 billion in the December pre-budget report). The only news there has been on this in recent weeks has been to suggest that this figure will be undershot slightly.

Britain's economy is doing better. It may be too soon to declare outright victory over recession but normal service is being restored in one respect: Britain is growing faster than the eurozone. That began in the final quarter of last year, when UK growth of 0.3% exceeded the eurozone's 0.1%. It has continued this year, according to surveys. Britain's services sector surged ahead last month on the purchasing managers' survey, while growth in the eurozone slipped back. Britain's manufacturers are outperforming their European counterparts.

Of course it is easy to exaggerate the extent of the "crisis" for sterling and financial markets. The pound has been lower against the dollar and euro than it is now, though sterling will be clouded by uncertainty for at least the next few weeks.

In fundamental terms, sterling is undervalued against both the dollar where the long-run rate is $1.68 and the euro. Simon Derrick, currency economist at Bank of New York Mellon, thinks fair value for the euro is 70p, which translates to roughly 1.40 to the pound. I would put it a bit lower than that, but well above current levels. Capital Economics predicts that, once the current uncertainty is over, sterling will rise to 1.25, by the end of the year.

Even the widening of the gilt-bund spread the extra cost of funding Britain's debt compared with that of Germany is not what it seems. Philip Shaw, economist at Investec Securities, describes as "hopelessly simplistic" the idea that this in any way measures the likelihood of a British debt default.

The spread, roughly 90 basis points (0.9 percentage points) for 10-year gilts-bunds, was higher in the months leading up to the global financial crisis in 2007 and in 2004-5, when borrowing was a fraction of today's levels. The recent widening reflects a number of factors, most obviously the pause in gilt purchases under the Bank of England's 200 billion quantitative easing programme.

Some facts get lodged in the minds of the markets. One comes from a report by McKinsey, the consultants, pointing out that in 2008 Britain's total debt, at 469% of GDP, exceeded that of Japan, at 459%. Go beyond the executive summary, however, and McKinsey points out that a chunk of that debt reflects Britain's position as a global financial hub. Adjust for that, and total UK debt is higher than France, Germany and Switzerland but not enormously so. Without the benefit of a global financial centre, Iceland's debts rose to 1,200% of GDP and Ireland's 700%, according to McKinsey.

A significantly bigger proportion of UK debt is domestically held than in any other leading European country. The average maturity of UK government debt, 12.7 years, is twice the OECD average and well ahead of other countries. Britain could still suffer a funding crisis but debt maturity and the low starting point for UK public-sector debt are significant counterweights.

So it must come down to where we started: political risk. Hung parliaments are rare. The last was in February 1974, followed eight months later by another election that gave Labour a majority of three.

We may not get a hung parliament this time, though that is where the polls are pointing. The obvious riposte is that all three parties are committed to cutting the budget deficit, that the differences between them are small, and that threatened with a fiscal crisis they would find ways of working together to ensure a rapid drop in borrowing to keep the markets sweet.

That is where the problem lies. A 1974 scenario could mean the comprehensive spending review planned to start soon after the forthcoming election would be delayed, possibly for a year. If parties have been coy about precise plans now, that coyness will last beyond the election if another is looming.

The particular problem here is Gordon Brown. I believe the chancellor when he says he wants to cut the deficit. I believe George Osborne and Vince Cable, the shadow chancellors. The prime minister, however, does not seem to believe it, even if he is occasionally persuaded to say it. He cannot believe what he saw as a transformation of Britain's public services during his chancellorship, "prudence for a purpose", has to be followed by more savage cuts than anything Margaret Thatcher tried.

Until he believes it, and can convince everybody he does, the markets will continue to harbour extreme doubts. And they will continue to believe a Labour victory, particularly a minority Labour government, would be very bad for Britain.

PS: Everybody hates paying tax, not least Britain's biggest companies. But are they really paying 57% of profits in tax, as reports last week suggested? The Hundred Group of FTSE 100 finance directors, on whose calculations the 57% figure was based, did not even claim that for itself.

It said that all the taxes they paid went up from 38.2% of total earnings (profits) in 2008 to 41.6% last year. The Treasury apparently succeeded in squeezing ever larger amounts of tax out of big companies even in the recession.

Or not. Had the Treasury done so, the public finances would be a lot healthier. As it was, businesses paid less in corporation tax in 2008-9 than 2007-8, and will have paid a lot less in 2009-10. The total tax paid by business was roughly the same between the two years, the apparent increase in the tax burden being due to a drop in the denominator, profits.

The total tax contribution exercise, worked out by Price Waterhouse Coopers, is a useful one. Britain's biggest businesses "paid or collected" 66.6 billion in tax last year. We should be clear what is being measured, though. One tax that firms hate paying is National Insurance contributions. How big the NI burden is for a business depends on how many people it employs and the wages it pays.

Because of this, it is not impossible a big employer would have a total tax burden close to 100% of its profits. Would that mean the Treasury was taking all the profits in taxes? No. The NI contributions would be part of the cost of doing business. We would all like it, of course, if those costs were lower.

From The Sunday Times, March 7 2010