By: Ava Tripathy
“Mankind does not reflect upon questions of the economic and social organization until compelled to do so by the sharp pressure of some practical emergency.” - R.H. Tawney, Religion and the Rise of Capitalism
A superpower from the ancient period to the 21st century under whose reign “Sun never used to set” is on the verge of economic collapse. Prime Minister Liz Truss’s short tenure of 44 days of power is marred by turmoil as the pound fell to record lows, mortgage rates soared, and the huge chaos in the bond markets has threatened the country's financial stability. Now the question that is looming before everyone is – Will Britain survive this economic crisis or will the former superpower collapse?
The economic situation in the United Kingdom is very much grim due to a toxic mix of politics, higher interest rates, and inflation. International Monetary Fund (IMF) has predicted the growth of the UK in 2023 to be less than 0.3% which may be catastrophic for the country, especially in the current wake of high inflation and overall recession. Let us understand what were the reasons for Mighty Britain’s economic collapse.
Effects of Brexit: While the immediate effects of Brexit on the British economy were well anticipated, the situation worsened in April 2019. The drastic reduction of foreign direct investments and the negative growth recorded by one of the most profitable British Property Market led to a steep fall in UK’s economy which further worsen in 2022.
COVID-19 Pandemic: Post-Brexit, the economy of the whole world was crashing in 2020-22 which included Britain too. The covid-19 pandemic caused huge damage to the country’s economy with the overall GDP reduced and the financial burden of the country increasing.
Russia-Ukraine Conflict: Britain being an integral part of NATO was affected by this war in two ways: Impact on the overall economy due to soaring energy prices and a major chunk of $50Bn (in the last 6 months) was donated to Ukraine for help also caused huge damage to Britain’s economy
Wrong decisions by the British government and its officials: Repeatedly, again and again, British officials kept making wrong decisions. One of the examples is the Mini Budget of Sep 2022 where they announced the freezing of energy bills and pledged 45 billion pounds of tax cuts which were practically not possible. The government assumed that the purchasing power will increase if the public has more money in hand. But they were wrong as this step made the markets volatile(FTSE index stood at 6,969.73 points as on October 21, 2022 - below its average value of around 7,500 points in early 2020.), Banks increased their mortgage rates as the currency depreciated.
Why are the Investors Concerned?
While introducing plans on tax cuts and freezing of energy bills the Britain’s Treasury chief did not provide any independent thoughts and analysis of the effects and impact of these moves on public finances and whether the government’s goals are in alignment with it. So, the public started speculating that the government would have to finance the package with borrowing, pushing the public debt to unsustainable levels.
Investors are mainly concerned about:-
The worsening debt conditions (UK general government gross debt was £2,436.7 billion which is equivalent to 101.9% of GDP last quater.) as it will lead Britain to borrow funds from foreigners which will result in a gigantic current account deficit. The more they borrow, the lower the currency has to go.
To attract overseas investors the UK Government will offer higher interest rates compared to them.
The increasing inflation rates (8.8% in September 2022) means that the cost of living in the country is increasing, which leads to low purchasing power.
The falling GDP growth rate means that the UK economy is doing poorly (GDP is estimated to have fallen by 0.6% in September 2022.)
How did Financial Markets React?
Truss’s tax-cutting budget swayed the financial markets largely. The bond market has been unsettled since the government announced large unfunded tax cuts in September with the 30-year government bond yield jumping 0.29 percentage points to 4.68 percent in October. As the yields on government bonds soared amid growing concern about the stability of public finances, government borrowing costs became more expensive. Meanwhile, the pound fell to its lowest point in more than 35 years, at one point reaching near parity with the US dollar.
The emergency bond-buying by the Bank of England was designed to prevent a cycle of forced selling by pension funds which had a direct impact on world markets, pushing up the dollar and Treasury yields and hitting stock and commodity prices which caused the bear market to take another leg down.Since the global financial crisis in 2008-09, activity in the markets that LIBOR measures has reduced. The low volume of underlying transactions means that LIBOR is no longer sustainable, which is also a major reason why the grip of a bear market can be seen. Annual inflation rate in the UK jumped to 11.1% in October of 2022 from 10.1% in September, much higher than market forecasts of 10.7%. Inflation hurts stocks overall because consumer spending drops.The UK stock market is already volatile in 2022 and it should get even more volatile as higher interest rates come to pass. High inflation can make nominal returns negative.
London shares were trading flat with some negative bias in November, with the benchmark FTSE 100 hovering around the 7,350 mark, as losses in the real estate sector offset gains in energy and defense stocks. The sentiment of the market was also somewhat gloomy amid concerns about sky-high inflation and rising geopolitical tensions. The annual inflation rate in Britain jumped to a 41-year high of 11.1% in October, exceeding expectations as upward price pressures persisted despite rapid rate rises.
Conclusion
With the inflation in Britain going through the roof (exceeding 10%), the UK Government needs to come up with a roadmap to help the country shepherd through the financial crisis. Food prices are skyrocketing and Energy tariffs are galloping with consumers facing a cost-of-living crisis because of shrinking real incomes. Strong methods to tame inflation and recession to bring back a stable economy is needed. As the bad government decisions also affected the financial markets seriously, Sunak needs to bring back reassurance in the markets so that investors feel safe to invest in the country.
Well explained!