Thursday, May 5, 2011

Why U.K. Has Little Real Alternative

Thursday, May 5, 2011

One of the U.K.'s greatest strengths is the robustness of its constitution. Rarely has this been so clear as during the financial crisis. The British parliamentary system tends to deliver strong governments able to exercise enormous power. Even the current coalition government—a rarity in modern British politics—enjoys a commanding majority in the House of Commons. British prime ministers wield considerable powers of patronage and face few checks other than respect for precedent and the scrutiny of a lively free press. While President Barack Obama is forced to enter protracted negotiations with both houses of Congress to pass his budget and Belgium languishes for months without any government at all, the U.K. constitution allows for quick and effective decision-making.

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U.K. Prime Minister David Cameron, right, and his deputy, Nick Clegg.

That is why markets have kept faith with the U.K. despite the country having one of the highest total debt to GDP ratios in the world, one of the biggest budget deficits and one of the most over-inflated housing markets. It is why the markets continued to absorb record issuance of U.K. government bonds, even during the long run-up to a closely-contested general election last year in which none of the major parties would say how it planned to tackle the deficit. And it is why the markets have continued to allow the U.K. to enjoy remarkably low borrowing costs even as other highly-indebted European countries have spiraled into crisis despite growing tensions in the coalition.

So investors should be hugely relieved that opinion polls currently point to a resounding defeat for the Yes campaign in Thursday's referendum to scrap the country's traditional voting system in favor of the so-called Alternative Vote in which candidates are ranked in order of preference. British voters clearly recognize that, at a time when the country still faces huge economic challenges, it would be extraordinarily reckless to experiment with a voting system that would make unstable coalition governments a permanent feature of the U.K. political landscape and likely entrench the influence of the Liberal Democrats, the left-wing junior partners in the current government.

True, some commentators have argued a No vote in Thursday's referendum would be the worse outcome for investors. Citigroup, for example, fears that a defeat for the Lib-Dems on such a long-cherished policy goal would cause them to abandon the coalition, throwing the UK's fiscal strategy into doubt. Others fear that Prime Minister David Cameron will feel compelled to offer policy concessions to the Lib-Dems to keep them on board in the wake of a defeat, such as watering down proposed health reforms.

But these fears seem overblown: true, the referendum campaign has exposed tensions in the coalition and opened wounds that will be hard to heal. But a No vote will leave the Lib-Dems with nowhere to go: they can hardly bring down the government over a policy that has just been roundly rejected by voters; nor would it make sense for them to trigger an election at a time when the polls suggest they would face electoral annihilation. To fight a fresh election they would need to first find an alternative economic strategy and an alternative leader. Even if some Lib-Dems break away to join ranks with Labour, it seems likely enough will remain loyal to the coalition to enable it to continue to stay in power.

But even the British constitution may not be enough to shield the U.K. from the daunting challenges that lie ahead. The reality is that the U.K. economy is in much weaker shape than many people appreciated until recently. The combination of very low interest rates, a low exchange rate, booming emerging market economies, aggressive corporate restocking and intense efforts by the government and banks to shield people from the worst impact of the 2008 crash helped drive a modest rebound in 2009 and 2010.

Since the start of the year, however, the scale of the U.K.'s debt woes have started to catch up with the economy. Consumer spending—for far too long the engine of the economy—has slowed dramatically as disposable incomes are squeezed by inflation and rising taxes. Bank lending remains weak, reflecting lack of demand for credit and the need for banks to conserve capital to meet new regulatory requirements and guard against future shocks. The mortgage famine is taking its toll on house prices, which still look overvalued. The economy flat-lined in the six months to the end of March.

The risk is that the worst is yet to come: tax rises and public spending cuts announced last June have barely started to kick in. Already the Office for Budget Responsibility's March forecast for GDP growth this year of 0.8% is starting to look optimistic. Morgan Stanley doesn't rule out the possibility the economy contracts this year. Meanwhile the U.K. banks are still sitting on £243 billion ($400 billion) of commercial real estate that may need to be written down further and they are heavily exposed to further turmoil in the euro zone. And while talk of an interest rate rise has rightly receded for now, it could quickly resurface if evidence emerged that high inflation was feeding through to wages.

In due course, the coalition may find itself needing a Plan B—not the Plan B cynically and recklessly advocated by Ed Balls, the opposition Labour party's populist Treasury spokesman, who has called for slower spending cuts: the markets would be sure to crush the U.K. economy at the first sign of back-sliding on its fiscal commitments. Unfortunately for the coalition, a Plan B will require further, much deeper and more painful fiscal austerity measures than anything so far contemplated. It is that moment—
should it arise— not Thursday's referendum that will present the moment of maximum danger for Mr. Cameron's coalition—and investors in U.K. assets.

Write to Simon Nixon at

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