Against the tide: UK politics – Dependent and independent

By:
David Roche
Published on:

The newly elected Tory party must wrestle with an invigorated SNP and its old bête noire, the EU. The proposed in/out referendum will cast a long shadow over the UK.

The surprise outright victory of the incumbent Conservative party in the UK general election in early May has opened up a Pandora’s box of issues. First, there is the continuing problem of Scotland. 

The landslide for the Scottish National Party will cause uncertainty in markets over time as it raises the issue of whether or not there will be another vote on independence. But there was no majority for Scottish independence last September and there is none for another independence vote (only 36% in favour, according to the latest poll). This is why SNP leader Nicola Sturgeon called her huge victory in Scotland a vote for anti-austerity, not independence. 

UK balance of payments as a percentage of GDP 
UK Balance of Payments As a percentage of GDP  
Source: Instrategy 

But the fiscal problem of how to divide spending and taxation within the UK will continue. Already, considerable fiscal powers have been devolved to Edinburgh from London, but if Scotland gets free rein to use taxes raised in England as it wishes, then there will be growing demands to give regions in England such fiscal powers, while the government introduces legislation to stop Scottish MPs voting on English matters in Westminster. This is a recipe for the possible break-up of the UK down the road. 

Then there is the UK’s future relations with the European Union. Although the Conservatives have an outright majority, it is small. The right wing of the Conservatives (pressured by the eurosceptic UK Independence Party) will be baying for the promised referendum on leaving the EU. Prime minister David Cameron is likely to waste no time in trying to negotiate a better package on EU membership with German Chancellor Angela Merkel and the EU leaders. This may take place within a year or so and not be put off until 2017. This will increase uncertainty about whether the UK will stay in the EU, even if Cameron aims to diffuse the issue as quickly as possible.

The City of London is firmly opposed to leaving the EU and all the big parties will call for staying in. The British public has shown in all polls that it is opposed to leaving. So, as and when the referendum is called, Britons are likely to vote to stay in. But uncertainty about EU membership will weigh upon sterling until this is settled.

The Conservative victory means that economic policy will be unchanged. The drive will continue to achieve a balanced government budget by 2019 and a progressive and sustained reduction in the public sector debt ratio beyond that. Tighter fiscal policy means lower growth and inflation. That will mean the Bank of England will take longer to hike interest rates. 

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Against the tide 
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There are underlying problems with the UK economy, despite its relatively faster growth rate compared with the rest of Europe in the last year or so. The UK is still running large twin deficits on the government (4% of GDP) and external account (6% of GDP). That remains a challenge to fund with capital inflows (FDI and portfolio). Indeed, the risk of the UK leaving the EU will reduce capital inflows until the UK opts to stay in (if it does).

Underlying weak productivity growth – caused by the reduction in investment in the UK’s financial sector since the global financial crash – will not help get real GDP growth much above 2% a year over this next parliament. And this will be at a time when the eurozone economies should be recovering from the depressionary environment in southern Europe. For example, there are now signs that even sclerotic Italy is turning the corner.

So it is just possible that the eurozone will begin to catch up with growth in the UK over the next couple of years, as the ECB ploughs more credit into its financial sector through quantitative easing, while the Bank of England follows the US Fed in hiking rates in 2016. The recent weakness in the dollar will not be sufficient to sustain a strong pound over the medium term. 

UK gilt yields will continue to rise, reflecting the repricing of capital as the impact of global quantitative easing wanes and bond market bubbles deflate, marking a return to credit risk as the setter of global debt yields. UK equities will perform modestly at best. So what happens in Europe will be more pivotal for UK financial assets than has been the case in the last few years.