UK Economic Outlook - PwC...4 UK Economic Outlook July 2014 1 – Summary Recent developments The UK...

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UK Economic Outlook

July 2014

UK house prices – bubble or no bubble?

The UK’s standing in the world

Contents

Highlights and key messages 03

1 Summary 04

2 UK economic prospects 07

2.1 Recent developments and the current situation 08

2.2 Economic growth prospects: national, sectoral and regional 11

2.3Outlookforinflation 14

2.4Monetaryandfiscalpolicyoptions 14

2.5Summaryandconclusions 15

3 UK house prices – bubble or no bubble? 16

3.1 Stagnation to acceleration: recent developments in the UK housing market 17

3.2 House price prospects: UK and regional projections and alternative scenarios 19

3.3 Blowing bubbles: risks of a housing crunch across the UK 21

3.4Coolingoff:Possiblepolicyinterventions 24


Technicalappendix–detailsofhousepricemodellingmethodologyandresults 27

4 The UK’s standing in the world 28

4.1HowdoestheUKfareintheglobaleconomicleague? 29

4.2BeyondGDP:UKperformanceonthePwCESCAPEindex 31


Appendices

A Outlookfortheglobaleconomy 36

B UK economic trends: 1979-2013 37

Contacts and Services 38

Highlights and key messages for business and public policy

Figure 1.1: PwC main scenario for output growth by region

Source: PwC main scenario estimates and projections

Key projections

2014 2015

Real GDP growth 3.0% 2.6%

Inflation (CPI) 1.7% 1.9%

Source: PwC main scenario projections

• Afteraperiodofgenerallydisappointing growth in 2011 and 2012,theUKeconomyshowed clearsignsofrecoveryduring2013thathavecontinuedinthefirst halfof2014.

• InourmainscenarioweexpectGDPgrowth to pick up from 1.7% in 2013 toaround3%in2014,beforeeasingslightlyto2.6%in2015asconsumerspending growth moderates as the run down in savings reaches its limits. Risks to growth are now more balanced, with both upside and downside possibilities.

• The services sector will remain the main engine of UK growth for both outputandemployment,butbothmanufacturing and construction are also now showing positive growth trends.

• We expect London and the South Easttocontinuetoleadtherecovery,butallregionsshouldseerelativelystronggrowthin2014(seeFigure1.1).

• Consumerpriceinflationislikely to remain at or just below target in 2014-15.WeexpecttheMPCtokeepinterest rates on hold in the short term, butthentoincreasethemgraduallyfromlate2014orearly2015onwards,perhapsreturningtoaround4%by2020. Businesses should start to prepare for this upward trend now.

Housing market remains strong for now – but London prices look bubbly

• Ourdetailedanalysisinthisreportsuggests that average UK house pricescouldrisebyaround8%thisyear,withpricesincreasingbyaround13% in London. However, we expect the pace of growth to moderate over thenexttwotothreeyears.

• Under our baseline scenario, our analysissuggeststhat,bytheendof2015,theaveragepropertyinthe UKcouldbewortharound£276,000,upfrom£242,000attheendof2013.By2020,theaverageUKhouse could be worth close to £330,000.

• On balance, we believe that the marketisnotyetoverheatingatanational level, although evidence of a bubble in the London market is stronger as borrowers are more stretched on average in the capital.

UK growing strongly recently, but lags behind G7 peers on social indicators

• We project the UK to be the fastest growingoftheG7economiesthisyear,butwealsobelievethatyouneedtolookbeyondGDPwhenassessing national performance and potential. On the broader range of measurescoveredbyourESCAPEIndex,theUKranksonly5thoftheG7economiesin2013,downfrom3rdplaceintheG7in2000and2007.

• Thisreflectsbothafallinourrelativeeconomic ranking since 2007 and aconsistentlypoorperformancecomparedtoourG7peersonsocialindicators relating to education andincomeinequality.

• Againstthis,theUKscoresslightlyabovetheG7averageonenvironmentalsustainabilityandclearlyabovetheaverageintermsofpoliticalstability,ease of doing business and communications technologies.

• Overall,therefore,ourESCAPEindexshows the UK has important strengths to build on but also some serious structural weaknesses to address.

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3UK Economic Outlook July 2014

4 UK Economic Outlook July 2014

1 – Summary

Recent developmentsTheUKeconomygrewby0.8%inthefirstquarterof2014comparedtothepreviousquarter,andwasupbyjustover3%onayearearlier.Therecoveryhasnow gathered real momentum after a coupleofsluggishyearsin2011and2012.

Growthhasbeendrivenprimarilybyservicesoverthepastfiveyears,but thelatestdatafrombothbusinesssurveysand official sources indicate that manufacturing and construction are also now on an upward trend. This momentum seems to have carried over intothesecondquarteroftheyear.

AcalmersituationintheEurozone hassupportedfinancialmarketssinceautumn2012,whiletheUSeconomystillseemstobeontheroadtorecoverydespitesomedipinactivityinearly2014duetoheavysnowfall.Emergingmarketperformance has been much less strong, however,withChinesegrowthslowing(butremainingfastinabsoluteterms)and more marked downturns in economies suchasIndia,Brazil,SouthAfricaandTurkey.ThesituationwithRussiaandUkraine also remains an important sourceofgeopoliticaluncertainty,asdoesongoingconflictintheMiddleEast.AmarkedincreaseinglobaloilpricescouldhaveasignificantnegativeimpactonUKGDPgrowth.

UKemploymenthascontinuedtorisestrongly,whichhassupportedconsumerspending growth despite persistent subdued rates of real earnings growth. Rising house prices have also supported consumer confidenceandspending,buthavealsoraised concerns about over-heating that we discuss further below.

Business investment has also shown signs ofrecoverysinceearly2013,although it remains well below pre-crisis levels. Publicspendingcutshavesloweddownoverthepastyear,butwillremainadragongrowthformanyyearstocome.

Table 1.1: Summary of UK economic prospects

Indicator (% change on previous year)

OBR forecasts (March 2014)

Independent forecasts (June 2014)

PwC Main scenario (July 2014)

2014 2015 2014 2015 2014 2015

GDP 2.7 2.3 3.0 2.5 3.0 2.6

Consumer spending 2.1 1.8 2.5 2.5 2.7 2.5

CPI 1.9 2.0 1.8 2.1 1.7 1.9

Source: Office for Budget Responsibility (March 2014), HM Treasury survey of independent forecasts (average values in June 2014 survey) and PwC main scenario.

Therateofconsumerpriceinflation(CPI)hasdrifteddownoverthepastyearasimportpriceinflationhasmoderatedand is now somewhat below its 2% target rate.

Future prospectsAsshowninTable1.1,ourmainscenarioisforUKGDPgrowthtoaveragearound3%in2014andaround2.6%in2015.This is similar to the latest consensus forecastsandslightlymoreoptimisticthantheOBRwasinMarch,reflectinggenerallypositiveUKeconomicdatasince then.

ConsumerspendinggrowthisprojectedtofollowabroadlysimilarpatterntoGDP,withsomemoderationovertimeasthe recent fall in the savings ratio bottoms out and spending becomes more reliant on real income growth, which we expect topickuponlyverygradually.However,household incomes will be supported bycontinuedemploymentgrowth.

Investment growth has picked up recentlyfromalowbaseaccordingtobothlatestofficialestimatesandrecentbusinesssurveys.Weexpectafurtheracceleration in investment growth over theremainderofthisyearandinto2015,helpedbyacontinuedrecovery inhousebuildingactivity.

Net exports have been erratic and we do notexpectthemtoleadtherecoveryin2014-15,althoughagradualupturnintheEurozoneshouldatleastavoidthembeingasignificantdragonoverallUKGDPgrowth.Thisshouldbeassociatedwith positive growth in manufacturing outputin2014-15aswellasstronggrowth in services exports.

Asalwaystherearemanyuncertaintiesinherent in our growth projections, as illustratedbythealternativescenariosinFigure1.2.Risksarenowmorebalancedthanforthelastfewyearsbecause, although there are still considerable downside risks relating to trendsintheEurozoneandemergingmarkets(includingUkraine),therearealso upside possibilities if these problems can be avoided and a virtuous circle of risingconfidenceandspendingcanbeestablished as in past economic recoveries.

Inflationhasfallenbelowthe2%targetsinceJanuary2014forthefirsttimeinmorethanfouryears,andweexpectittoremainatorslightlybelowtargetin2014-15(seeTable1.1).Therecouldstillbeupsideriskstothisinflationoutlookin the longer term, however, if stronger globalgrowthpushescommoditypricesup again at some point, or if domestic wages start to recover without a correspondingriseinproductivity.


WedonotexpectanyimmediateriseinofficialUKinterestrates,butagradualupwardtrendseemslikelytobeginduringlate2014orearly2015andpersistthrough the rest of the decade, perhaps returningofficialratestoamorenormallevelofaround4%by2020.

Higher interest rates will help savers andreducepensionfunddeficits,butborrowers(includingbusinessesandthegovernment)mightgainfromlockinginfunding now for long term investments such as infrastructure and housing. Householdsneedtobearinmindlikelyfutureinterestraterisesinanydecisionson mortgages or other longer term loans.

Outlook for house pricesAsdiscussedindetailinSection3ofthisreport, the UK housing market has leapt backintolife.Pricesacrossallregionsare accelerating in stark contrast to the generallyweakpicture(atleastoutsideLondon)seenuntil12-18monthsago.

We project that average UK house prices couldrisebyaround8%thisyear,withpricesincreasingbyaround13%inLondon. However, we expect the pace of growth to moderate over the next two tothreeyears,withthedownsiderisksbeingparticularlypronouncedinthecase of London.

Underourbaselinescenario,ouranalysissuggeststhat,bytheendof2015,theaveragepropertyintheUKcouldbewortharound£276,000,upfrom£242,000attheendof2013.By2020,theaverageUK house could be worth close to £330,000incashterms(seeTable1.2).

Figure 1.2: Alternative UK GDP growth scenarios

Source: ONS, PwC scenarios

Table 1.2: UK nominal house price projections with high and low scenarios (£000s)

Year (annual average prices) Baseline High Low

2013 (actual) 242 242 242

2014 262 266 257

2015 276 283 254

2020 328 344 275

Source: ONS for 2013, PwC projections for 2014-20

On balance, we believe that the market isnotyetoverheatingatanationallevel,although evidence of an emerging bubble is stronger in London as borrowers are more stretched in the capital. However, even at national level, there are important medium-termrisksthatpolicymakersneed to monitor with care.

Recent recommendations from the FinancialPolicyCommittee(FPC)focused in particular on restricting the proportion of new mortgages at high loan-to-income ratios, which seems sensible. Indeed some leading banks havealreadytakenactiontolimittheirexposureshere.Concernsaboutapossible house price bubble could also be one factor causing interest rates to rise sooner rather than later.

There could also be a case for phasing outtheHelptoBuymortgageguaranteeschemebeforetheendofitsthreeyearterm, although its impact on house prices doesnotseemtohavebeensignificantso far. In the longer term, increased housingsupplyistheprioritytokeepprices under control.

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UK growing strongly recently, but lagging behind G7 peers on social indicators

The UK looks set to the fastest growing economyintheG7thisyear,butwhatabout its longer term economic standing intheworld?OurdetailedanalysisinSection41 suggests that:

• The UK could remain the sixth largest economyintheworldin2030whenmeasuredbyGDPatmarketexchangerates2, falling behind India but overtakingFrance(seeTable1.3).

• The UK has the potential to become thesecondlargestEUeconomyonthis measure, moving ahead of Francebefore2020,andnarrowingthegapwithGermanyby2030.

However, it’s not all good news. We have alsolookedbeyondGDPatbroadermeasuresofperformancebyusinganupdatedversionofourESCAPEIndex3. This shows that, in 2013, the UK ranked only5thoftheG7,downfrom3rdplacein 2000 and 2007. The UK’s performance relativetotheG7was:

• Below average in the economic performanceandstabilitycategory,althoughthiswasattributedlargelytoadversecyclicalvariationsintheeconomysince2007andisexpectedtoimprovegraduallynowthattheUKisrecoveringrelativelyfast.

• SignificantlybelowaveragefortheG7inthesocialprogressandcohesioncategory,whichisdrivenprimarilybyrelativelyhighincomeinequalityintheUKandarelativelypoorperformance on education.

Table 1.3: Actual and projected GDP league table in 2013, 2020 and 2030

2013 2020p 2030p

GDP rank

Country GDP at MER (2013 US$ bn)

GDP rank


GDP rank


1 US 17,528 1 US 20,310 1 US 25,585

2 China 10,028 2 China 15,855 2 China 25,009

3 Japan 4,846 3 Japan 5,209 3 India 6,172

4 Germany 3,876 4 Germany 4,205 4 Japan 5,695

5 France 2,886 5 UK 3,258 5 Germany 4,613

6 UK 2,828 6 France 3,182 6 UK 4,027

7 Brazil 2,216 7 India 3,175 7 Brazil 3,858

8 Italy 2,171 8 Brazil 2,748 8 France 3,846

9 Russia 2,092 9 Russia 2,563 9 Russia 3,659

10 India 1,996 10 Italy 2,323 10 Mexico 2,791

Source: IMF estimates for 2013, PwC baseline projections for 2020 and 2030 at market exchange rates (MERs)

1 WeassumethatScotlandremainspartoftheUKintheseprojectionsandotheranalysisinthisreport,butthisshouldnotbetakenasimplyinganyjudgementonthe outcome of the Scottish independence vote.2 TheUKwouldfallto9thplaceifweinsteadusedpurchasingpowerparity(PPP)exchangerates,asdiscussedinSection4.3 ThePwCESCAPEindexcombines20indicatorsacrossfivedimensions:economicgrowthandstability,socialprogressandcohesion,communicationstechnology, politicalandregulatoryinstitutions,andenvironmentalsustainability.ItthereforeprovidesamuchmoreholisticmeasureofnationalperformancethanGDPalone (seeSection4formoredetails).

• SignificantlybetterthantheG7averageinthepoliticalandregulatoryinstitutions and communications technologycategories,and slightlybetteronenvironmentalsustainability.

Overall, therefore, the UK is growing relativelystronglyatpresentandhassome important strengths, but it also has some deeper structural weaknesses toaddressinthelongerterm,particularlyaroundeducationandinequality.Maintainingrecentrelativelystronggrowth will also require increased productivity,whichalsorequiresimproved education and skills levels, as well as increased business and infrastructure investment.


2 – UK Economic prospects

Key points• TheUKrecoveryremainsontrack

with growth of around 3% in the yeartothefirstquarterof2014.

• Therecoveryisbeingdrivenprimarilybytheservicessector,buttherehasalso been positive news over the pastyearfromtheconstructionandmanufacturing sectors. Business surveysforallthreesectorssuggestthatactivityshouldcontinuetogrowatahealthypaceduringthesecondhalfof2014.

• TheaccelerationinGDPgrowthhasbeendrivenprimarilybyconsumerspendingasemploymentandconfidence haverisen.Fixedinvestmenthasalsopicked up from a low base over the pastyearasbothbusinessinvestment and housebuilding have risen.

• WeexpecttheUKeconomytogrowbyaround3%in2014,buildingon1.7% growth in 2013, but growth maythenmoderateslightlytoaround2.6%in2015.

• We expect all the UK regions to grow atafasterratein2014thanin2013,withLondongrowingfastest(3.4%)and Northern Ireland seeing the slowestgrowthrate(2.2%).

• There are still some important downside risks to the UK economic recoveryincludingaslowdowninactivityintheEurozone,unrestinUkraineandtheMiddleEast,with apotentialimpactonglobalenergyprices, and potential problems in some major emerging markets. But there are also upside possibilities including stronger than expected business investment and a return to real wage growth pushing up consumer spending faster than projected in our main scenario.

• Inflationiscurrentlybelowthe Bank of England’s 2% target and isexpectedtoremainrelativelysubdued over the next 18 months. We would, however, expect interest ratestostartrisinggraduallyfromlate2014orearly2015tohead offlongerterminflationaryrisks,including overheating in the housing market.

IntroductionIn this section of the report we describe recentdevelopmentsintheUKeconomyand review future prospects. The discussion covers:

2.1 Recent developments and the present situation

2.2 Economic growth prospects: national, sectoral and regional

2.3 Outlookforinflation

2.4 Monetaryandfiscalpolicyoptions

2.5 Summaryandconclusions

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Figure 2.1: GDP and key components of domestic demand

Source: ONS


2.1 – Recent developments and the present situationThe UK1economygrewby0.8%inthefirstquarterof2014,buildingongrowthof0.7%inthefinalquarterof2013.GrowthhasnowbeenabovetrendforfourconsecutivequarterswithtotalGDPgrowthofaround3%intheyeartoQ12014.ThelevelofGDP2 looks set to rise backaboveitspre-recessionpeakinQ22014andindeedhasalreadydoneso for output excluding North Sea oil and gas production.

RecentGDPgrowthhasbeendrivenbyconsumer spending, which has followed averysimilarpathtoGDPsince2007, asshownbyFigure2.1Governmentconsumption has also been rising despite themuchtalkedaboutausterity-ithasbeenaboveits2007Q1levelsincethefirstquarterof2008.However,thestoryisdifferentwithfixedinvestment.Itfellsharplyduringthedownturnin2008and2009anddidnotshowaclearrecoveryin 2010-12. But it has been picking up steadilyinrecentquartersdueinlargepart to strong business investment and privatedwellingsinvestment.AsFigure2.1 shows, however, investment still has a lot of ground to make up before it returns to pre-recession levels.

The services sector continues to be the maindriverofUKgrowth.GDPandserviceshavefollowedabroadlysimilarpathsince2007,asshowninFigure2.2.WhereasGDPisonlynowregaining its previous peak, however, the services sectoriscomfortablyaboveitspre-recessionlevelandremainsonasteadyupwardtrajectory.

Figure 2.2: Sectoral output and GDP trends

Source: ONS

Figure 2.3: Employment is rising strongly but productivity is not following

Source: ONSNote: *Estimate for 2014 Q1

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However, other sectors are also bouncing back well. The manufacturing sector has mountedasteadyrecoveryoverthepastyear.Quarter-on-quartergrowthhasbeen more volatile in the construction sector, but has also been on a general upwardtrendandrosestronglyinthefirstquarterof2014.Theoutputoftheoilandminingsectorwasveryweakprior to 2013, but has shown signs of stabilising since then.

WhiletheUKeconomyisrecovering,thisisstillcharacterisedbystrong jobsgrowthoffsetbyrelativelyweakproductivityandpaygrowth.

Figure2.3showsthatemploymenthasincreased well above pre-recession levels,whiletheunemploymentrate inMarch2014was6.6%,aratenot seensinceDecember2008.However,

1 Throughoutthisreport,weassumethatthestatusquocontinuesintermsofScotlandremainingpartoftheUK.Thisispurelyanassumptionandshouldnotbetaken asrepresentinganyjudgementontheoutcomeoftheSeptember2014voteonScottishindependence.2 AsdiscussedinBox2.1,therewillbesignificantrevisionstothelevelofUKGDPinSeptember2014,butforthisreportweusetheexistingnationalaccounts definitionsanddata(aspublishedon27June2014).


Figure 2.5: Equity market indices

Source: Thomson Reuters Datastream

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the latest available data shows that productivityisnotonasimilarpathas it remains well below its pre-recession level. Real earnings have also been falling forsomeyears,althoughdecliningpriceinflationmeansthesqueezeshouldnotbe quite as tough for consumers to bear goingforward.FortheUKrecoverytoremainsustainable,productivityandpaymustrisetogethersothatconsumerspendinggrowthcanbesupportedbyincreased real income, not just lower saving or increased borrowing. If this doesnothappen,thentherecoverycould be at risk in the medium term.

Business surveys suggest recovery continued in second quarterOfficialGDPdataareonlyavailableup toQ12014,butmorerecentbusinesssurveyssuggestthattherelativelystrongUKrecoverycontinuedintothesecondquarter.ThelatestMarkit/CIPSPurchasingManagers’Indices(PMIs) for services and manufacturing were bothsignificantlyabove50meaningthatactivityinthesesectorsisincreasingatarelativelystrongpace(Figure2.4),evenifnotasrapidlyasearlierintheyear.TheconstructionPMI,whichis not shown in the chart, has also been above 50 for a sustained period of time due in particular to stronger housebuildingactivity.

Figure 2.4: Purchasing Managers’ Indices of business activity

Source: Markit/CIPS

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Rising house prices have also been a supporttoconsumerconfidenceandspending, although concerns remain about a bubble developing. We discuss this topic in much more detail in Section 3 below, concluding that there is not yetstrongevidenceofabubbleoutsideLondon,althoughthisisclearlyanareathat the Bank of England will need to watch with care.

Equitymarketindiceshavebeenonagenerallyupwardtrendsincetheend of 2011, although there has been some shorttermvolatility,asshowninFigure2.5.ThischartshowsthatequitymarketsintheUSand(toamuchlesserdegree)the UK, have moved back above pre-crisis levels.Eurozonemarketsremainat lower levels, but have also shown a clear upward trend since autumn 2012.

Box 2.1 ChangestoUKNationalAccounts fromSeptember2014

FromSeptember2014anumberofchangestoUKNationalAccountswillcomeintoeffectforthe2014BlueBook.These changes fall into two categories:

1. ESA2010/BPM6changes– TheEuropeanSystemofAccounts(ESA)2010andBalanceofPaymentsManual(BPM)6changeswillbringthe UK into line with the latest agreed international standards.

2. NonESA2010/BPM6changes–Some other methodological changes will be implemented at the same time.

WithintheESA2010/BPM6changes,there are some changes that will have adirecteffectonGDP.TheseincludeanewtreatmentforR&D,spendingonweaponssystemsandfundeddefinedbenefitpensionschemes.However,there will be some other changes that willnotaffecttheleveloftotalGDP,such as the treatment of goods sent abroad for processing and remote gambling.SimilarESA2010/BPM6changes will be applied across the EU.

WithintheNonESA2010/BPM6changes, one of the most talked about andmostsizablechangesistheinclusionofcertainillegalactivities(drugdealingandprostitution)intheUKNationalAccountsforthefirsttime.TheONShave estimated that these activities will addapproximately£10billionto2009GDP,althoughinevitablythesearesubject to wider margins of error.

The ONS have also estimated the total impact of the methodological changes toUKGDPincurrentpricesfrom1997to2009(SeeFigure2.1.1below),althoughnotyetformorerecentyearsor, at the time of writing, in real terms adjustedforinflation.

In 2009, the combined upward revision toGDPatcurrentpriceswillbeintheregionof£65billion,oraround4.6% ofGDP.ThisshowsthatthesechangescouldhaveasignificantimpactonGDPdata. However, it is important to note thatthisisbasedonnominalGDPandnotrealGDPwhichwillbeofmoreinterest. The impact on average nominal GDPgrowthoverthisperiodisalsonotthatgreatatonlyaround0.06%perannum. The impact on growth going forward is also unclear and, in principle, could be in either direction.


Figure 2.1.1: Revisions to nominal GDP at current prices

Source: ONS

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2.2 – Economic growth prospects: national, sectoral and regionalWeexpecttherecoveryintheUKtocontinueduringthenexttwoyears. In our main scenario, we are projecting GDPgrowthofaround3%in2014following on from 1.7% growth in 2013. Wethenexpectgrowthtoslowslightlyin2015to2.6%asconsumer,investmentand government consumption growth allmoderatesomewhat(seeTable2.1).

We have revised these projections up from ourMarch2014UKEconomicOutlook,whereweprojectedgrowthof2.6%in2014and2.4%in2015.Thisisduetothe improved economic data coming outoftheUKforthefirsthalfof2014,butthebroadprofileofgrowthovertime remains similar.

Our main scenario projection assumes a faster rise in consumer spending growth in2014and2015thanwasseenin2013.However, consumer spending growth isexpectedtomoderateslightlyin2015as the driver of consumption moves from a declining savings rate to rising real wages.

We are projecting a strong return to growthforfixedinvestmentasbusinessinvestment picks up, continuing the trend overthepastyear.Thelowbaselevel offixedinvestmentrelativetotheotherkeycomponentsofdomesticdemand(consumerspendingandgovernmentconsumption),whichwecanseefromFigure2.1above,makesastrongriseinthis element of spending plausible in response to stronger consumer demand andbusinessconfidence.

We are not expecting net exports to contributemuchtoGDPgrowthineither2014or2015.RelativelysluggishgrowthintheEurozone,combinedwiththe

3 Wedefinethisashouseholdconsumptionexpenditurenotincludingconsumptionbynot-for-profitinstitutionsservinghouseholds.

Table 2.1: PwC main scenario for UK growth and inflation

(% real annual growthunless stated otherwise)

2013 2014p 2015p

GDP 1.7% 3.0% 2.6%

Consumer spending3 2.2% 2.7% 2.5%

Government consumption 0.7% 0.6% 0.5%

Fixed investment -0.8% 7.8% 5.8%

Domestic demand 1.8% 2.8% 2.6%

Net exports (% of GDP) 0.1% 0.2% 0.0%

CPI inflation (%: annual average) 2.6% 1.7% 1.9%

Source: ONS for 2013, PwC main scenario projections for 2014-15.

Table 2.2: Official and independent forecasts

(% real YoY growth unless stated otherwise)

Latest estimates

OBR forecasts (March 2014)

Average independent forecast (June 2014)

2013 2014 2015 2014 2015

GDP 1.7% 2.7% 2.3% 3.0% 2.5%

Manufacturing output -0.7% N/A N/A 3.1% 2.2%

Consumer spending 2.2% 2.1% 1.8% 2.5% 2.5%

Fixed investment -0.8% 8.6% 8.2% 7.6% 6.9%

Government consumption 0.7% 1.2% -0.5% 1.0% 0.1%

Domestic demand 1.8% 2.9% 2.2% 2.8% 2.5%

Exports 0.5% 2.6% 4.7% 3.1% 4.5%

Imports 0.2% 3.0% 4.3% 2.5% 4.4%

Current account (£ bn) -73 -40 -34 -63 -57

Unemployment claimant count (Q4 m) 1.3 1.2 1.1 1.1 1.0

Source: ONS for 2013, OBR Economic and Fiscal Outlook (March 2014), HM Treasury Forecasts for the UK economy: a comparison of independent forecasts (June 2014)

uncertaintysurroundingeventsinUkraineandtheMiddleEast,aswellasdecelerating growth in some emerging markets, makes a strong pickup in UK exportsunlikely.Thisleadsustobelievethat domestic demand will remain the mainsourceofUKGDPgrowthin2014and 2015.

ComparingTables2.1and2.2showsthatour main scenario growth projections are higher than the OBR forecasts in March,reflectingrecentstrongerdata.Ourprojectionsare,however,broadlysimilar to the average of the independent forecastscompiledbytheTreasury in June.


Aswithanyeconomicprojections,thereisconsiderableuncertaintyaroundourmain scenario. Therefore, we have developed two additional scenarios for UKgrowthasshowninFigure2.6:

• Our ‘strong recovery’ scenario sees UK growth accelerate further toaround4%onaveragein2015.This scenario assumes that the Eurozoneeconomywillrecovermorequicklyoverthenextyearthaninour main scenario, pushing both consumerandbusinessconfidenceupwards in the UK. This will feed throughtoasignificantincreaseinbusiness investment and consumer spending, as well as increased demand for UK exports. This scenario also assumes a stronger growth rate in other economies.

• Our ‘renewed slowdown’ scenario, bycontrast,seesUKgrowthfallingbackoverthenexttwoyearsduetoadverseshocksfromtheEurozone,problems in some major emerging markets(includingUkraine/Russia),andafallinthesupplyofoil(pushingpricesup)4 due to increased political instabilityintheMiddleEast. These events would have a direct effect on UK businesses and would lead to a fall in business investment, ahalttorisingemploymentandaslowdowninconsumerconfidenceand spending.

4 AnOBRstudyin2010arguedthata20%increaseinworldoilpricescouldreduceUKgrowthby0.34%inthefirstyear.Similarly,thereadyreckonerused byHMTreasuryandtheBankofEnglandisthata10%increaseinoilpricesreducesUKGDPgrowthby0.2%andraisesinflationbyasimilaramount.

Figure 2.6: Alternative UK GDP growth scenarios


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Sectoral prospects Table 2.3 shows actual and projected growthratesfor2013-2015forfivekeysectorsoftheUKeconomy,aswellas asummaryofthekeyissuesandtrendsaffecting these sectors.

Regional prospects AllUKregionsarenowachievingreasonable positive growth but variations remainasshowninFigure2.7. WhencomparedtoourMarch2014 UK Economic Outlook, London is still expectedtogrowthefastestthisyear (at3.4%nowcomparedtothe3.1%rateweprojectedinMarch)andNorthernIreland is still expected to grow the slowest(at2.2%comparedtoourprojectionof1.9%inMarch). However, all regions are expected to showahigherrateofgrowthin2014thantheyachievedin2013.

While we do not think that either of thesetwoscenariosarethemostlikelyoutcomes,theyarecertainlypossible.Businessesshouldconsiderhowtheywouldbeaffectedbyeventslikethisoccurring and stress test their plans accordingly.However,itappearsthatthe upside and downside risks to the UKeconomyarenowquitebalanced,possiblyevenleaningslightlymoretowards the upside in the short term given the recent positive momentum oftherecovery.


Table 2.3: UK sector dashboard

Growth

Sector 2013 2014p 2015p Key issues/trends

Manufacturing -0.7% 4.1% 3.4% Manufacturing PMI surveys have shown increasing activity for some time now.

Sluggish Eurozone growth and a relatively strong pound may hold back manufacturing exports, but UK domestic demand should remain strong in 2014-15.

Construction 1.6% 4.5% 2.0% The construction PMI has also been showing increasing activity in the sector.

Housebuilding has been one of the main drivers of the growth in the construction sector (estimates of which have been revised up in recent national accounts data).

Distribution, hotels & restaurants 3.5% 4.6% 2.9% Retail sales have been growing at a strong pace over the past year, supported by strong price competition from internet sales.

A gradual return to positive real wage growth should boost the demand for retailers, hotels and restaurants.

Business services and finance 2.2% 3.7% 3.4% The UK financial sector remains exposed to external shocks and disappointing economic performance in the Eurozone, but business services remain a strong driver of growth.

Government services 0.6% 1.4% 1.2% Government spending should continue growing over the next two years but at a slower rate after the 2015 election as the new government attempts to balance the books.

Total GDP 1.7% 3.0% 2.6%

Source: ONS for 2013, PwC for 2014 and 2015 main scenario projections and key issues

Figure 2.7: PwC main scenario for output growth by region

Source: PwC analysis

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2.3 – Outlook for inflationIn our main scenario, we expect consumer price index (CPI) inflation to average around 1.7% in 2014, down from 2.6% in 2013. In 2015, we are projecting inflation to rise back towards its 2% target rate, averaging around 1.9%.

However, as mentioned above, all economic projections have a degree ofuncertaintyassociatedwiththem and we have therefore developed twoalternativescenariosforCPIinflation(seeFigure2.8):

• In our ‘high inflation’ scenario, weassumethattherewillbesupplysidecommoditypriceshocks,such asrisingglobalenergyprices,andstronger than expected demand forgoodsandservices.Asaresult,our projections rise to an average of1.9%in2014and2.7%in2015 in this scenario.

• In our ‘low inflation’ scenario, bycontrast,weassumelessdomesticdemand growth, a global economic slowdown and consequent falling commodities demand and prices. These assumptions lower our inflationprojectionsto1.4%in 2014and1.2%in2015.

2.4 – Monetary and fiscal policy optionsThe Monetary Policy Committee (MPC) maintained the Bank Rate at 0.5% and the Quantitative Easing Asset Purchase Programme at £375bn at their latest meeting.

ThecentralMPCestimateisthatsparecapacityintheeconomystoodatapproximately1%-1.5%ofGDPinthesecondquarterof2014,whichwouldsuggestthatwearestillsomewayawayfromthefirstraterise.However,theminutesoftheJuneMPCmeetingemphasised that there is considerable uncertaintyaroundhowmuchslack isintheeconomyandthatthereareanumberofopinionsontheCommittee.

SomeMPCmembershavealsoexpressedconcerns related to potential overheating in the housing market, although the majorityviewseemstobethatthisisbetterdealtwithbymacroprudentialmeasures rather than interest rates rises, as we discuss further in Section 3 below.

Overall, it does seem that the debate is hotting up over when interest rates will starttorise,withMarkCarneysuggestinginhisMansionHousespeechinJunethatthis could be sooner than markets had previouslyexpected(i.e.late2014ratherthanearly2015).

Certainly,withtheeconomycontinuingtogrowstronglyandtheuncertaintyaroundhowmuchsparecapacityexistsin the UK, it is possible that the amount of slack could begin to fall quicker than hadpreviouslybeenexpected.Ifthisoccursandinflationbeginstopickup,while other factors such as high house prices remain a factor, it is quite possible thattheMPCcouldstarttoincreasetheBankRatetowardstheendofthisyear.Businesses should take this into account in their forward planning, as well as factoring in longer term rises in rates toperhapsaround2.5%byearly2017andaround4%by2020.Thepost-crisiseraofexceptionallycheapmoneywillnot last forever.

Therewasnosignificantchangeinthegovernment’sfiscalstanceasaresult of the ‘swings and roundabouts’ Budget inMarch.Ingeneral,wewouldexpectoverallfiscalplanstoremainlargelyunchangedintheAutumnStatementaswell, but we will revisit this in our next UK Economic Outlook in November.

Figure 2.8: Alternative UK inflation (CPI) scenarios


Projections

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2.5 – Summary and conclusionsThe UK economy has continued to grow at an above trend rate during the first half of 2014 according to both official data for the first quarter and business surveys for subsequent months. Consumer spending and housing investment have been driving this growth, but business investment also started to rise strongly from a low base during the course of 2013 and should continue to do so during 2014 and 2015.

Inourmainscenario,weprojectGDPgrowthofaround3%in2014,moderatingslightlyto2.6%in2015butremainingabovetrend.AllUKregionsshouldseestrongergrowthin2014thanin2013,although London will continue to lead the pack.

Inflationiscurrentlybelowitstargetrate of 2% and we expect it to remain at or below target over the next 12-18 months. However, we would expect theMPCtoheadofflongerterminflationrisksbystartingtoraiseinterestratesgraduallyinlate2014 orearly2015.Businessesshould planaccordingly.

Thereisstilladegreeofuncertaintyassociated with UK economic growth. Onthedownside,theUKeconomyremains vulnerable to a slowdown in activityintheEurozoneoranescalationof recent unrest in Ukraine and the MiddleEast(potentiallypushing upglobalenergyprices).Thereare also important risks associated with continueddisappointingproductivitygrowth at home and an overheating housing market.

However, the upside possibilities are arguablyatleastasstrongintheshortterm given the recent forward momentum ofthedomesticeconomy.Forexample,stronglyrisingbusinessinvestmentcould further stimulate growth and a returntomoreconsistentlypositiverealwage growth could make the consumption- drivenrecoverystrongerandmoresustainable.

Insummary,theUKrecoveryshouldremainrelativelyrobustthrough2014and 2015, although its longer term sustainabilitywilldependonavoidingmajor global shocks and raising growth ofproductivityandrealincomes.

The UK recovery should remain relatively robust through 2014 and 2015, although its longer term sustainability will depend on avoiding major global shocks and raising growth of productivity and real incomes.


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3 – UK house prices: bubble or no bubble?

Key points• The UK housing market has leapt backintolife.Pricesacrossallregions are accelerating, a stark contrasttothegenerallyweakpricerises experienced 12-18 months ago everywhereoutsideofLondon.

• We project that average UK house pricescouldrisebyaround8%thisyear,withpricesincreasingbyaround13% in London. However, we expect the pace of growth to moderate over thenexttwotothreeyears.

• Under our baseline scenario, our analysissuggeststhat,bytheend of2015,theaveragepropertyinthe UKcouldbewortharound£276,000,upfrom£242,000attheendof2013.By2020,theaverageUKhousecouldbe worth close to £330,000 in cash terms. On balance, we believe that themarketisnotyetoverheatingat a national level, although evidence of a bubble in the London market is stronger as borrowers are more stretched on average in the capital.

• Recent recommendations from the FinancialPolicyCommittee(FPC)focused on restricting the proportion of new mortgages at high loan-to-income ratios, which seems sensible. Indeed some major banks have alreadytakenactiononthisfront.Concernsaboutapossiblehouseprice bubble could also be one factor causing interest rates to rise sooner rather than later. In the longer term, however, measures to boost housing supplymoredirectlyshouldbe thepriority.

IntroductionThe housing market has been a hot topic ofdebaterecently,withMarkCarney,theIMFandsomegovernmentministersall warning about a possible future bubble,particularlyinLondon. But how concerned should we be about these risks and what can be done to mitigatethem?

In this section of the report we addressthisissuebyreviewingrecentdevelopments in the UK housing market, presenting our own modelling results for future house price trends and discussingpossiblepolicyinterventions.The discussion covers:

3.1 Stagnation to acceleration: recent developments in the UK housing market

3.2 House price prospects: UK and regional projections and alternative scenarios

3.3 Blowing bubbles: risks of a housing crunch across the UK

3.4 Coolingoff:Possiblepolicy interventions

3.5 Summaryandconclusions

Oureconometricmodellingmethodologyand results are described further in the technical appendix.

Figure 3.1: Average real and nominal annual house price growth in the UK since Q1 1999

Source: ONS (using CPI as a deflator to calculate real house price growth)


3.1 – Stagnation to acceleration: recent developments in the UK housing marketThere has been a transformation in the UK housing market over the past twelve to eighteen months. Following a brief spurt of activity in 2010 the market remained subdued through 2011, 2012 and early 2013. New mortgage lending was flat and year on year price changes were close to zero.

However,asshowninFigure3.1, we have now moved out of a phase of stagnation into one of acceleration. AverageUKhousepricesinbothrealterms(adjustingforinflation)andnominal(cash)termsareonastronglyrising trend.

The average UK house price was around 10%higherinApril2014thaninthesamemonththeyearbefore,accordingto the ONS measure of house prices. Other indices have also shown strong increasesoverthepastyear,althoughprecisenumbersvary.Wehaveprimarilyfocused in this article on the ONS measureasthemosttimelyofficialstatistic on house prices, but our views on future trends would not be affected materiallybylookingatotherindices.

This house price growth has been supportedbyarevivalingrossmortgagelendingsinceearly2013,asshowninFigure3.2.Thiswassupportedduring2013bytheFundingforLendingscheme,although this has now been refocused onlendingtosmall-andmedium-sizedbusinesses,andHelptoBuy.

Throughout much of 2013 higher capital repaymentsonexistingmortgagedebthad led to contractions in net borrowing. Butamorerecentupturnintheflowofnew mortgage credit has also led to the overall stock of mortgages growing since late 2013, according to statistics fromtheBritishBankersAssociation.

Figure 3.2: Gross mortgage lending

Source: Council of Mortgage Lenders

Figure 3.3: Year on year growth in house prices by region – September 2012 compared to March 2014

Source: ONS

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Despitecontinuedstronghousepricegrowthoverthepastyear,therehaverecentlybeensomesignsthatthemarket could be starting to level off. NewFinancialConductAuthority(FCA)requirements on lenders to conduct morerigorousaffordabilitychecksonmortgage applicants came into effect inApril2014,whichmayhavebeenonecause for the dip in mortgage approvals inAprilcomparedtoMarch.Butitis tooearlytojudgewhetherthisisa

genuine cooling of the market or just atemporaryblip.Morefundamentally,lowerhousingmarketactivitymay also not prevent further rises in house priceswhilesupplyshortagesremain.

Overall, it is clear that there has been resurgenceinUKhousingmarketactivityandpricesoverthepastyear,buthowevenlyisthisspread?Weinvestigateregional trends below.


1 The Northern Ireland boom echoed that in the Republic of Ireland, and to some degree it was a spill-over from that credit.

The regional perspective

HousepriceswerebroadlyflatinmostregionsexceptLondonuntilearly2013.In contrast, house prices have now been growing across all regions during the pastyear.ThisiscapturedinFigure3.3,which shows a ‘heat map’ of house price growthregionally,comparingfiguresfortheyeartoSeptember2012withthosefortheyeartoMarch2014.

In September 2012 most of our UK heat map was made up of pale shades, indicating that growth was under 2.5%, except for London. When we fast forwardtoMarch2014,themaphasmanymoredarkershades,indicatinghouse price growth of 5% of higher. Even in Northern Ireland, where prices hadbeenfallingverysteeplyin2012,therehasbeenanupwardtrendbyMarch2014.Londonnowhashousepriceinflationwellabove10%,with therecoveryripplingouttoadjacentregions over the past 18 months.

This divergence of London from the rest oftheUKisalsocapturedbyhousepricetoearningsratiosasshowninFigure3.4.London reached a ratio of 8.0 during thefirstquarterof2014,itshighestevervalue since the series began in 1983. Pricetoearningsratiosarelowestoutside of England: Northern Ireland and Scotland both have ratios of under 3.5, although in the case of Northern Ireland this is the result of a dramatic collapse following the pre-2008 boom1, while the ratio has been much more stable in Scotland.

We now investigate possible future paths for house prices at the UK and regional level.

Figure 3.4: House price to earnings ratio by region

Source: Nationwide

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Table 3.1: UK nominal house price projections with high and low scenarios (% change pa)

Year Baseline High Low

2014 8.0% 9.9% 5.9%

2015 5.5% 6.4% -1.0%

2016 - 2020 Average 3.5% 4.0% 1.6%

Source: PwC projections for 2014-20

Table 3.2: UK nominal house price projections with high and low scenarios (£000s)

Year (annual average prices) Baseline High Low

2013 (actual) 242 242 242

2014 262 266 257

2015 276 283 254

2020 328 344 275

Source: ONS for 2013, PwC projections for 2014-20


2 Specificallyweassumemortgageratesrisebyaround250basispointsby2020,whichmightcorrespondtoariseofBankofEnglandbaseratestoaround4%togetherwith some compression of spreads.

3.2 – House price prospects: UK and regional projectionsWe have updated our UK house price model,whichwasfirstpublishedin2006andbeenregularlyreviewedsincethen. Our model uses annual earnings, housingsupply,creditconditionsinthemarket and mortgage interest rates as explanatoryvariablesforhousepricetrendssince1975.Furtherdetailsareprovided in the technical appendix at the end of this article.

We assume in our baseline scenario that average real earnings growth will pick upgraduallyfromcurrentlowlevelstojustunder2%perannumbytheendofthe decade. We also assume that credit conditions improve over the next two years,beforestabilisingatclosetotheirlong-run trend level, while interest rates risefromearly2015onwards2.Lastly,we include a modest upward trend in thegrowthoftheunderlyinghousingstock from 2013 levels, but with growth remainingunder1%peryear.

Under these ‘baseline’ scenario assumptions, and using the model as described above, house prices are projectedtoincreasebyaround8%onaverageinnominaltermsthisyearascomparedto2013.Annualhousepriceinflationisthenexpectedtoslowtoaround 5.5% in 2015 and an average rate of around 3.5% per annum between 2016and2020(seeTable3.1).Thiswouldrepresentarelativelysoftlandingfor the housing market. Under this scenario, ouranalysissuggeststhat,bytheend of2015,theaveragepropertyinthe UKcouldbewortharound£276,000, upfrom£242,000attheendof2013. By2020,theaverageUKhousecould be worth close to £330,000 in cash terms(seeTable3.2).

Asprojectinghousepricesalwaysinvolvessignificantuncertainties, we also consider alternative high and low scenarios for house prices, as shown in Tables 3.1 and 3.2.

Thehighscenarioreflectsamorebuoyantmacroeconomicenvironment.Itassumesastrongerrecoveryincreditconditions,whichisaccompaniedby a somewhat faster increase in interest rates.Employmentandearningsassumptions are also more optimistic, with real earnings growth rising to over 2% in the medium term. Housing stock growth in this scenario is also faster than the long-run trend rate.

Thelowscenarioreflectsamorechallenging macroeconomic environment. Itassumesthattherecoveryweakenssignificantly,withtheeconomyreturningto conditions akin to those seen in 2011 and2012.Itischaracterisedbyfallingreal earnings growth and tight credit conditions as there is more risk aversion from banks, although mortgage rates dostaylowerforlongerinthiscase.

Under our baseline scenario, real house prices(adjustedforCPIinflation)wouldreturn in 2020 to around the levels experienced at their previous peak in 2007,asshowninFigure3.5.Underourhigh scenario, real house prices would exceedtheirpreviouspeakby2018,butour low scenario would see a renewed real house price decline, leaving real house prices more than 15% below their pre-crisis peak in 2020. This illustrates our assessment that, at present, risks to house prices are skewed to the downside in the medium term.

Figure 3.5: UK real house prices relative to previous peak in alternative scenarios

Source: ONS, PwC projections (using CPI as deflator to calculate real house price trends)

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Regional projections

Table 3.3 shows our projections for 2014,2015and2016-2020averagehouse price growth across all UK regions. The projections relate to the baseline scenario set out above, but it should be borne in mind that uncertainties are even greater at the regional than the national level.

The double digit growth expected inLondonthisyearisthemosteye-catching statistic in the table, but we expect this boom to run out of steam overthenextfewyears.Thelowestprojected growth rates are in Scotland and Northern Ireland in the short term.

Inthemediumterm(2016-2020)weexpect London house price growth to be slower than the UK average and also slower than earnings growth, leading toareductionintheveryhighpricetoearningsratiosseeninTable3.4from2015 onwards. In this baseline scenario we are still assuming that foreign interestandconfidenceintheLondonpropertymarketremainsreasonablystrong, without which there could be a sharper correction in London house prices over the period.

InNorthernIreland,bycontrast,medium-term house price growth is projected to exceed the UK average astheregionrecoversfromtheverysteeppricefallsofrecentyears.

Table 3.3: Regional nominal house price projections in baseline scenario (% change pa)

Region 2014 2015 2016-2020 average

Wales 7.4% 5.7% 4.0%

Scotland 4.6% 4.5% 2.8%

Northern Ireland 4.7% 6.1% 4.4%

North East 5.5% 5.9% 4.1%

North West 7.0% 5.9% 4.1%

Yorks & Humber 7.1% 5.7% 3.9%

East Midlands 7.9% 6.2% 4.4%

West Midlands 8.0% 6.0% 4.2%

East 8.2% 5.6% 3.9%

South East 8.7% 5.5% 3.8%

South West 8.2% 6.0% 4.2%

London 13.3% 4.4% 2.7%

UK 8.0% 5.5% 3.5%

Source: PwC baseline projections for 2014-20

Table 3.4: Regional nominal house price projections in baseline scenario (£000s)

Region 2013 (actual) 2014 2015 2020

England 252 273 288 341

Wales 162 174 184 221

Scotland 181 190 198 225

Northern Ireland 130 136 144 177

North East 146 154 163 197

North West 163 174 184 223

Yorks & Humber 166 177 188 225

East Midlands 173 187 198 243

West Midlands 184 199 210 256

East 255 276 292 349

South East 300 326 344 409

South West 229 248 263 319

London 424 480 501 565

UK 242 262 276 328

Source: ONS for 2013, PwC baseline projections for 2014-20


3.3 – Blowing bubbles: risks of an overheating UK housing marketHow big a risk is the kind of renewed house price correction seen in our downsidescenario?Isthereabubblewaitingtoburst?Inthissub-section wereviewtheevidenceonthishighlytopical issue. On balance we conclude that across the whole of the UK talk of a bubble is premature. However, London, wherevaluationsaresignificantlyhigher relative to earnings, offers stronger evidence of an emerging house price bubble.

AsshowninFigure3.6,thenumberofhousing completions across the UK has beenonadownwardtrajectorysince thelate1960s.Theeverdecreasingrateof housing completions has caused a shortage of housing, which has been particularlyacuteintheSouthEastofthe UK. This has been, and remains, oneofthekeydriversofrisinghouseprices.Ashousingsupplycannotadjustquicklytothesignalofhigherprices,this has been one of the perennial features of the UK housing market in recent decades.

Furthermore,cashpurchasesfromforeignbuyershavebeenastrongsourceofdemandforUKhousing,mostnotablyinLondon.In2013,theFTreportedthattheirstudy,withSavillsandHometrack,had found that the share of homes being purchasedentirelywithcashhadrisento more than a third. There is some evidence to suggest that this is driven byhedgingbehaviour3 linked to London propertybeingseenasarelativelysafehavenatatimeofinstabilityinother

Figure 3.6: UK housing completions

Source: DCLG

Figure 3.7: Household debt to income ratio

Source: ONS

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3 BadarinzaandRamadorai(2013),‘Homeawayfromhome?SafehaveneffectsandLondonhouseprice’.

markets, although there could also be a more speculative element to some investment in the London market. These two factors combined, chronic under-supplyandforeigndemand(primarilyinLondon)willactas a support for house prices so long astheypersist.

Particularlyonthesupplyside,this isunlikelytochangeanytimesoon. TheChancellor’srecentannouncementof measures to limit planning restrictions was welcome, but it remains to be seen how effective this will be in practice.


A dive into debt

Thus far, bank losses from UK residential mortgages have been limited; part ofthisisduetoveryaccommodativemonetarypolicyovertheperiod.Asthebase rate rises, interest costs will go up, squeezinghouseholdswithlowmarginsofsafetyontheirmortgageborrowing.While households have paid down somedebtsince2008(seeFigure3.7),household debt to income ratios are still atrelativelyelevatedlevelsofaround140%.Thisissimilartowheretheywereinaround2004andwellabovelevels in the 1990s.

Focusingonnewlending,andthemarginsofsafetyofrecentlyoriginatedloans, while the advances on mortgages arecurrentlyaround80%loantovalueforfirsttimebuyersintheUK,theadvances in London are lower at 75% (seeFigure3.8).Theselevelsarelowerthanhistoricalnorms,reflectingpost- crisis credit constraints. Loan-to-income (LTI)ratiospresentadifferentpicturethough,risingtorecordlevelsrecentlynot just in London and the South East but also on a UK average basis. This suggests that much recent lending mayhaverelativelythinmarginsofsafety,withhouseholdshavingalowtolerance to future interest rate rises. Aspricetoearningsratiosinareassuchas London are now at record or near recordlevels(seefigure3.9),itwillbedifficultfornewbuyerstopurchaseunlesstheyarepreparedtobehighlygeared.TheGovernment’sHelptoBuyscheme was aimed to address this issue, but also has drawbacks as discussed in Box 3.1.

Figure 3.8: Loan to value for first-time buyers

Source: Council of mortgage lenders

Figure 3.9: Loan to income ratios for first-time buyers


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Box 3.1 HelptoBuymortgageguaranteescheme

Figure 3.10: Proportion of mortgage lending at high loan to value and high income multiple

Source: Council of Mortgage Lenders

Note: High income multiple classified as 3.5 times income or more for a single income mortgage, and 2.75 times income or more for joint income.

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Launched in October 2013, the Help toBuymortgageguaranteeschemeoffers lenders the option to purchase a guarantee on mortgage loans where the borrower has a deposit of between 5% to 20%. The scheme compensates participating lenders for a portion of net losses suffered in the event of repossession. The guarantee applied down to 80% of the purchase value oftheguaranteedproperty,covering95% of these net losses.*

Duringthefirstsixmonthsofthescheme,only£1,084mofmortgageloanswerecoveredbythescheme.Thisamounts to just over 1% of total gross advances duringtheperiod.Alargeamountofthis lending was for properties of under £125,000invalue(45%),andjust5%was for properties in London.

Insummary,HelptoBuyislikelytohavemadeonlyaminordifferencetohouseprice trends in the UK to date. However,

since it was designed to stimulate a housingrecoverythatnowseemstohavebeenwellunderwayalready,theschememaywellbephasedoutbeforeitsplannedthreeyeartermcomes to an end.

*HMTreasury(2014),‘HelptoBuymortgageguaranteescheme:QuarterlyStatistics’

Concernsaroundthesustainabilityofmortgagedebtdonotnecessarilyhave tofocusonlyonnewlending.BothLTVand LTI ratios were high before 2008, as showninFigure3.10.Lendingthatmetboth of these categories will have low marginsofsafety,andweretakenout at a time where there was a belief that priceswouldkeeprisingrobustly.Followingthefinancialcrisisin2008,extremelyaccommodativemonetarypolicymayhavekeptsuchborrowingfrom default. Since then there has been a period where borrowers have had an opportunitytopaydowntheprincipalvalueoftheirdebt,butmanycould still be vulnerable to future mortgage raterises.Ontheotherhand,Figure3.10 does suggest that most new lendingoverthepastfiveyearshas hadrelativelyhighmarginsofsafety.


3.4 – Cooling off: Possible policy interventionsOuranalysisabovesuggeststhattherisks of serious future problems in the housing market should not be exaggerated, at least outside London. Nonetheless, the combination of accelerating house prices and mortgage credit,particularlyintheSouthEastandLondon, has caught the attention of policymakersattheBankofEngland(aswellasgovernmentministers andcommentatorssuchastheIMF).There are two channels that intervention inthemarketbytheBankcouldtake:

• TheMonetaryPolicyCommittee(MPC)couldraiseinterestrates totryandcoolthemarket.

• TheFinancialPolicyCommittee(FPC),arelativelynewbodyat the Bank of England, could adjust capital requirements or other ‘macro-prudential’ levers relating to housing market lending.

Figure3.11belowshowsthattheinterest rate burden on households hasfallensignificantlysincethecrisis. In2008,wheninterestpaymentsas a proportion of income were close to 20% across most regions, average mortgagerateswereapproximately7%. However,thedatashowninFigure3.11areaveragefiguresandmayvarysignificantlyaccordingtoparticularhousehold circumstances. Therefore, simplylookingataverageaffordabilityratios does not give a good guide to likelyvulnerabilitytofutureinterestrate rises.

To get a better idea of the risks that interest rate rises could pose, we have lookedata2013surveyconductedbythe Bank of England5thatspecificallyaddressed the topic of rising interest rates. This report highlighted the fact that the extent to which higher interest rates are problematic depends on how much incomes increase before rates goup.Theauthorsdevelopedstylisedscenariosthatattempttoquantify the impact of given rate rises on mortgagerepaymentsasaproportion ofincome.Inonescenario,monthlyrepaymentswereassumedtoincrease in line with a 2.5 percentage point rise in effective mortgage rates, while incomes remain as reported at the timeofthesurvey6.

In this scenario, estimated average mortgagerepaymentgearingincreasesfrom 21% to 28%, and the proportion of vulnerable mortgagors with gearing over 35% would increase from around 8%to16%.However,giventheassumedearningsfreeze,andfullpassthrough of interest rate rises, we consider this to be an upper bound estimate for the risks posedbyfutureraterises.

In conclusion, the impact of rate rises maynotbethatlargeinaggregate, butwillnotbeevenlyspread.Inthoseregions where loan-to-income ratios are highest, borrowers will on average have lowermarginsofsafety.Therefore,risksoftheunderlyingdebtbehindhousingdemand proving to be unsustainable islikelytobegreaterintheseregions,such as London, than elsewhere.

Figure 3.11: Interest payments as a % of income, by region


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5 BankofEngland(2013).‘ThefinancialpositionofBritishhouseholds:evidencefromthe2013NMGConsultingsurvey’6 Thescenariosassumefullpass-throughofraterises.


Gradualinterestraterisesarelikelytobeginineitherlate2014orearly2015,as discussed in Section 2 above. But this would be due to general macroeconomic considerations relating to shrinking sparecapacityintheeconomyandconsequent medium-term concerns aboutinflationpickingupagain,ratherthanbeingspecificallytargetedatthehousingmarket(althoughthisisclearlyone important factor feeding into this widerpicture).

It is the latter area that we focus on in this section. Box 3.2 sets out some more detailsontheFPCandbelowweconsiderfurther the options open to them.

Tosupportitsjudgements,theFPCmonitors a range of information on the economy.Inparticular,theyroutinelyreview a set of core indicators, three of which are related to the housing market:

1. Real estate valuations - residential andcommercialpropertyprices.

2. Real estate lending terms – such as loan-to-value or loan-to-income ratios.

3. Spreads on new UK lending – both on residential mortgages and commercial real estate.

TheFPCalsoconsidersarangeofotherindicators that track developments in thepropertymarket.IntheirrecentFinancialStabilityReport,thiscoveredareassuchasforeigninflowsintoUKcommercialpropertyandmortgagelending. But we focus our attention hereonthesecondcoreindicatortype,whichwealreadydiscussedearlierinsome detail.

Figure3.9aboveshowsthattherehasbeen a clear upward trend in loan-to-income ratios since 1995. While there was a slight fall in the ratios across the UK, London and the South East in 2008-9, the ratios have now risen back abovetheir2007peaks.InGreaterLondon, where LTI ratios are highest,

Box 3.2 TheFinancialPolicyCommittee(FPC)and its recent recommendations

TheprimaryresponsibilityoftheFPCis‘protecting and enhancing the resilience oftheUKfinancialsystem’*.However,thisresiliencecannotbeachievedatanycost.TheFPC’sactionsmustnothave‘asignificantadverseeffectonthecapacityofthefinancialsectortocontributetothegrowthoftheUKeconomyinthemedium or long term’.

Inordertoachievethisgoal,theFPCoriginallyhadtwomainpowers:

1. The power to make recommendations, inparticulartothePrudentialRegulationAuthority(PRA)andtheFinancialConductAuthority(FCA).

2. The power to direct regulators to adjustspecificmacroprudentialtools.The most relevant of which for the housing market at present relate to loan-to-income ratios and stress tests.

FollowingtheChancellor’sMansionHouse Speech on 12 June, the Bank of England is being given extended powers todirectlylimitloan-to-incomeandloan-to-value ratios on mortgages. Althoughthiswilltakesometimetoenactinlegislation,theFPChasalreadymadearecommendation(on26June)that no more than 15% of new mortgages should be at loan-to-income ratios greaterthan4.5,whichwillbeenactedbytheFCAandthePRA.Thisconstraintwillnotbiteimmediately,sincecurrently

suchhighLTIloansonlyaccountforaround 10% of new mortgages, but will act as a limiting factor against asignificantfutureriseinlending at high LTIs, which could be a sourceoffinancialinstabilityin the longer term.

TheFPCalsorecommendedasomewhattougher interest rate stress test when assessingmortgageaffordability,basedon assuming a 3% point rise in Bank Rateatsomepointoverthefirstfiveyearsoftheloan.Thisisslightlyhigherthancurrentindustrynormsofusing2.5-3% point stress tests, so it is not itwillprobablynothavealargeimpactbut does provide an additional prudential safeguard.

*BankofEngland,FinancialStabilityReport(June2014)


theyreached3.83onaverageinthefirstquarterof2014.Bycontrast,loan- to-valueratiosfellsharplyafterthe crisis and, despite having rising again somewhatrecentlyasthemarkethasrecovered, do not appear to be at worryinglevels(atleastonaverage).

Overall, therefore, the evidence of stabilityproblemsinthehousingmarketismixed.ThissuggeststhattheFPCshould continue to monitor the situation carefullybutshouldnotoverreact,bearing in mind the limited recent experience with macroprudential tools and their mixed historical record in earlierperiodslikethe1970sandearly1980s.Therelativelymodestmeasuresannouncedon26June2014seemsensibleinthiscontext,particularly in their focus on limiting high LTI ratios and highlighting the importance ofinterestratestresstests(seeBox3.2).

It is worth noting here that some major bankshavealreadybeenmakingchangesintheseareas.On20May2014,LloydsBankingGroupannouncedthat,onloansworthmorethan£500,000,theywould limit mortgage lending to four times income. On 3 June, RBS followed suitwithasimilarpolicy.AsnotedinBox3.2,theindustrynormforinterestratestresstestsalsoalreadyseemsto bebroadlysimilartowhattheFPC is recommending.

3.5 – Summary and conclusionsThe UK housing market has leapt back intolife.Pricesacrossallregionsareaccelerating in stark contrast to the generallyweakpicture(atleastoutsideLondon)seenuntil12-18monthsago.

We project that average UK house prices couldrisebyaround8%thisyear,withpricesincreasingbyaround13%inLondon. However, we expect the pace of growth to moderate over the next two tothreeyears,withthedownsiderisksbeingparticularlypronouncedinthecase of London.

Under our baseline scenario, our analysissuggeststhat,bytheendof2015,theaveragepropertyintheUKcouldbewortharound£276,000,upfrom£242,000attheendof2013. By2020,theaverageUKhousecould be worth close to £330,000.

On balance, we believe that the market isnotyetoverheatingatanational level, although evidence of an emerging bubble is stronger in London as borrowers are more stretched in the capital. However, even at a national level, there are important medium-term risks that policymakersneedtomonitorwithcare.

Recent recommendations from the FinancialPolicyCommittee(FPC)focused on restricting the proportion of new mortgages at high loan-to-income ratios, which seems sensible. Indeed someleadingbankshavealreadytakenaction to limit their exposures here. Concernsaboutapossiblehousepricebubble could also be one factor causing interest rates to rise sooner rather than later. There is also a case for phasing outtheHelptoBuymortgageguaranteeschemebeforetheendofitsthreeyearterm, although its impact on house prices doesnotseemtobesignificantsofar.

In the longer term, however, increased housingsupplyisthepriority.TheChancellorhasrecentlyannounced new policies here to reduce planning restrictions, but there are also other blockages to be addressed, including skills shortages in the construction industry.Itwillbethereforebea slowprocesstoproduceasignificantboost to housebuilding in the UK.

The housing market is not overheating at national level, but evidence of a bubble is stronger in London.


Technical appendix Detailsofhousepricemodellingmethodologyandresults

Ouranalysispredominantlyfocusesonthe ONS house price indices. We focus ontheONSdataastheycoveralargersamplesizethantheNationwideandHalifax statistics, which are based onlyontheirownmortgageapprovals. TheONSdataisalsomoretimelythanthatpublishedbytheLandRegistry,andis better adjusted for changes in the mix ofhousessoldovertime(althoughdoingthisisnoteasy,sonoindexisperfect).

ThePwChousepricemodelconsists of two parts: a long run equilibrium equation and a short run error correction model that indicates how house prices adjust back towards this equilibrium level over time.

In the long run equilibrium equation, realhousepricesaredrivenbythreekeyvariables: real annual earnings, the ratio of the housing stock to the population (‘supply’)andavariablewhichreflectsgeneralcreditconditions.Monetaryvaluesaredeflatedtorealtermsusingtheconsumerpriceindex(CPI).

In the short run, changes in real house pricesaredrivenby:deviationsfromthelong run equilibrium; changes in real annual earnings; changes in the credit conditions variable; and the previous period’smortgageinterestrate(costofborrowing).Thecoefficientsforthesemodelvariablesandothersummarystatistics for both models are shown in the tables above.

The parameters of the model were estimatedusingthestandardordinaryleastsquares(OLS)econometrictechnique based on annual data from 1975-2013. In the process, we investigatedthepossibilityofusingvariables in nominal rather than real terms as well as different variables (includinglagsanddifferenceswhereappropriate)suchasunemployment, the share of the population aged between25and44,theexchange rate,andgovernmentbondyields, but these were not found to be significantatthe5%level.

Long run model (Cointegrating equation)

R-squared = 0.92

Dependent variable: Real house prices No. of observations=39

Coefficient t-statistics

Real earnings 17.8 8.83

Supply -1377.4 -3.70

Credit 10660.4 1.34

Constant 297599.1 2.62

Short run model

R-squared = 0.65

Dependent variable: Change in real house prices No. of observations=38

Coefficient t-statistics

L. co-integrating equation residual -0.12 -1.84

D.Credit 18764.3 4.34

D.Real earnings 7.0 3.51

L.Mortgage rate -555.0 -2.22

Constant 6522.5 2.56

Note: ‘D’ refers to the first difference of a variable (i.e. change on previous year). ‘L’ refers to the lagged value of a variable in the previous year. A t-statistic above around 2 in absolute terms shows the explanatory variable is statistically significant at the 5% level. Mortgage interest rate defined in nominal terms as this fitted the data better than a real interest rate.


4 – The UK’s standing in the world

Key points• By2030,theUKisprojectedtoremainthesixthlargesteconomyintheworld(atmarketexchangerates),falling behind India but moving aheadofFrance.

• On a regional scale, we expect the UK to become the second largest EU economybefore2020,asitovertakesFrance,andtonarrowthegapwithGermanyby2030.

• OurupdatedESCAPEIndexfor2013showsthattheUKranksfifthintheG7in2013,downfrom3rdin2000and2007.ThisreflectstherelativelydeeprecessionsufferedbytheUK in 2008-9 and, prior to 2013, its relativelyslowrecovery.

• TheUK’skeystrengthsrelativetootherG7countriesareinthepoliticalinstitutions and communications technologyfields.

• Incontrast,theUKconsistentlyunderperforms in the social progress andcohesioncategory.Improvementin this area requires longer term structural weaknesses in education andincomeinequalitytobeaddressed.

IntroductionAsdiscussedinSection2,theUKeconomyis on track to exceed its pre-recession peak(inrealterms)inthesecondquarterofthisyear.Thisisakeymilestonefortherecovery,butwhatabout the wider standing of the UK in theglobaleconomy?Fromabusinessperspective this is important when decidingwheretolocatekeycommercialactivities(e.g.whenmovingproductionorsalesactivitiestoanewcountry orregion).Forpolicymakersamoreholisticanalysisofacountry’sstandingin the world could be useful as a starting pointinidentifyingitsprogressovertime and relative to other nations, and in assessing areas where there is room for improvement.

The discussion in this article addresses these issues as follows:

4.1 PresentssomeglobalGDPleague tables and assesses the standing of theUKrelativetotheG7andE7 bothnowandprospectively in 2030;

4.2 UsesthePwCESCAPEIndex1 to identifythebroaderstrengthsand weaknesses of the UK compared totherestoftheG7;and

4.3 Summarisesthekeymessages comingoutoftheanalysis and concludes.

Table 4.1: GDP league table, 2013

2013

MER rank


1 US 17,528

2 China 10,028

3 Japan 4,846

4 Germany 3,876

5 France 2,886

6 UK 2,828

7 Brazil 2,216

8 Italy 2,171

9 Russia 2,092

10 India 1,996

11 Canada 1,769

12 Mexico 1,288

13 Indonesia 859

14 Turkey 767

Source: IMF estimates

1 WefirstpublishedthisindexinFebruaryusingdataupto2012andhavenowupdatedthisto2013wherenewdataarenowavailable.Asdescribedfurtherbelow, the index looks at performance across 20 different economic and non-economic indicators.


2 Throughouttheanalysisinthissection,wehaveassumedthatScotlandremainspartoftheUKandhavenottakenintoaccounttheimpactoftheforthcomingESA2010 changesonestimatedGDP.BothofthesefactorswouldhaveamaterialimpactonthelevelofUKGDPalthoughthemovetoESA2010wouldalsoaffectotherlarge economies(seeBox2.1inprevioussectionformoredetailsofexpectedUKGDPrevisions).3 NotethatanalternativewaytomeasureeconomicsizeisbycalculatingGDPinPurchasingPowerParity(PPP)terms.Thismeasuretakesintoaccountthedifferences inpricesbetweeneconomies.Wehavecarriedoutthisanalysisinasubsequentsectionofthearticle.4 PleaseseeourreportWorld in 2050: The BRICs and beyond: prospects and challenges and opportunitieswhichyoucanfindat: http://www.pwc.com/en_GX/gx/world-2050/assets/pwc-world-in-2050-report-january-2013.pdf5 Specifically,theyallowforemergingmarketexchangeratestoconvergegraduallywithPPPlevelsintheverylongrunataratedependentonrelative productivitygrowth.Thisreflectspastempiricalrelationships,althoughtheexactpathofrealexchangeratesremainshighlyuncertaininpractice.

Table 4.2: Actual and projected GDP league table in 2013, 2020 and 2030

2013 2020p 2030p

MER rank


MER rank

Country Projected GDP at MER (2013 US$ bn)

MER rank

Country Projected GDP at MER (2013 US$ bn)

1 US 17,528 1 US 20,310 1 US 25,585

2 China 10,028 2 China 15,855 2 China 25,009

3 Japan 4,846 3 Japan 5,209 3 India 6,172

4 Germany 3,876 4 Germany 4,205 4 Japan 5,695

5 France 2,886 5 UK 3,258 5 Germany 4,613

6 UK 2,828 6 France 3,182 6 UK 4,027

7 Brazil 2,216 7 India 3,175 7 Brazil 3,858

8 Italy 2,171 8 Brazil 2,748 8 France 3,846

9 Russia 2,092 9 Russia 2,563 9 Russia 3,659

10 India 1,996 10 Italy 2,323 10 Mexico 2,791

11 Canada 1,769 11 Canada 2,015 11 Italy 2,715

12 Mexico 1,288 12 Mexico 1,711 12 Canada 2,399

13 Indonesia 859 13 Indonesia 1,264 13 Indonesia 2,074

14 Turkey 767 14 Turkey 1,057 14 Turkey 1,694

Source: IMF estimates for 2013, PwC projections for 2020 and 2030

4.1 – How does the UK fare in the global economic league?Where does the UK rank currently in the global economic league?

ThemostcommonlyusedmeasureofeconomicsizeisGrossDomesticProduct(GDP),whichisthetotalvalueofthegoods and services produced in an economy.TheIMF’sWorldEconomicOutlook database contains standardised informationonGDP2levelsbycountryand we can use this to derive the league tableshowninTable4.1,whichlistslatestestimatesofGDPlevelsforthe G7andE7countriesatmarketexchangerates(MERs)3 in 2013.

The most important points to note are that:

• In 2013, the UK was the sixth largest economyintheworldanditseconomywassignificantlybiggerthanthose ofBrazil,RussiaandIndiabasedonGDPatmarketexchangerates.

• On a regional basis, the UK remained thethirdlargestEuropeaneconomybehindGermanyand,byaverynarrowmargin,France.

Will the UK still be an important global economic player in 2030?

Ouranalysisaboveshowsthat,intermsofsize,theUKremainsasignificantmemberoftheglobaleconomic‘A-list’.

But as emerging market economies might be expected to grow faster in the long term, how long will the UK retainthatstatus?

To address this question, we extend the aboveanalysisbyprojectingGDPlevelsfortheG7andE7to2030.Todothis we combine short- and medium-term projections from our latest Global Economy Watch report with long-term projectionsofpotentialGDPfortheperiodbeyond2020fromourlastWorld in 2050 report4. The results presented inTable4.2areexpressedatconstant2013 US dollars and allow for projected variations in real exchange rates according to our model5.


We can see from this table that:

• By2020,theUKovertakesFrance tobecomethe5thlargesteconomy6 butlaterdropsbackinto6th,duetobeingovertakenbyIndiabefore2030.

• The UK is projected to gain ground against its major Western European rivals.NotonlydoweexpectittoovertakeFrancewithinthenextfewyears,butwealsoexpectittonarrowthegapwithGermany.Ouranalysissuggeststhatby2030theUKcouldbeonlyaround12%smallerthanGermanycomparedtoaround30%smallerin2013.ThisprimarilyreflectsrelativelystrongUKpopulationgrowthcomparedtoGermany,however, rather than faster productivitygrowth.

• On average during the period to 2030, the UK is expected to be the secondfastestgrowingG7economy.In absolute terms, we expect the UK to generate additional real output by2030roughlyequivalenttothecurrentsizeoftheMexicaneconomy.

• By2030aclear‘ClubofTwo’developswiththeUSandChinaclosetogetherat the top of the global economic order,accountingforthemajorityofcombinedE7andG7output(54%in2030comparedtoaround50%now).Chinawouldalmostcertainlyovertake the US soon after 2030 onthisbasis(orpossiblyshortlybefore that date depending on howexchangeratesevolve).

Overall,ouranalysissuggeststheUK isexpectedtoretainitscurrentA-liststatusintheworldeconomyatleastupto 2030, despite more rapid growth in the E7. On a regional scale, the UK is expectedtoovertakeFranceandbecomethesecondlargestEUeconomyby2020.

6 ThismirrorstheprojectioninarecentblogpostbyAndrewSentance,oursenioreconomicadviser: http://pwc.blogs.com/economics_in_business/2014/04/uk-set-to-recover-5th-place-in-global-economic-league.html

7 Thereareexceptions,suchasBrazilinrecentyears,whereemergingmarketexchangerateshavebeenpushedupclosetoPPPlevels,butgenerallyasignificantdifference exists.

Table 4.3: GDP and GDP per capita in 2011 at PPP rates

2011 2011

GDP rank

Country GDP at PPP (2011 US$ bn)

GDP per capita rank vs G7/E7

Country GDP per capita at PPP (2011 US$ bn)

1 US 15,539 1 US 49,782

2 China 13,496 2 Canada 41,069

3 India 5,758 3 Germany 40,990

4 Japan 4,380 4 France 36,391

5 Germany 3,352 5 UK 35,091

6 Russia 3,217 6 Japan 34,262

7 Brazil 2,816 7 Italy 33,870

8 France 2,369 8 Russia 22,502

9 UK 2,201 9 Turkey 17,781

10 Indonesia 2,058 10 Mexico 16,377

11 Italy 2,057 11 Brazil 14,639

12 Mexico 1,895 12 China 10,057

13 Canada 1,416 13 Indonesia 8,539

14 Turkey 1,315 14 India 4,735

Source: World Bank, 2011 ICP

Measuring UK economic size in PPP terms

Ouranalysisaboveassesseseconomicsizeusingmarketexchangerates.Thisisarguablythemostrelevantmeasurefrom a business perspective as most commercial transactions across borders take place at market-determined exchange rates.

Analternativewaytomeasureeconomicactivityisinpurchasingpowerparity(PPP)terms.GDPatPPPsisabetterindicator of average living standards or volumes of economic output because it corrects for price differences between countries at different levels of economic development. In general, price levels

aresignificantlylowerinemergingeconomiessuchasChinaandIndia, so PPPsarewellabovecurrent MERsformostemergingeconomies7. LookingatGDPatPPPsthereforesignificantlynarrowstheincome gap with the advanced economies comparedtousingGDPatMERs.

InTable4.3weshowGDPandGDP percapitainPPPtermsfortheG7andE7 economies using the latest available data from the World Bank’s latest InternationalPriceComparison(ICP)project, which is for 2011.


WecanseefromTable4.3that:

• UsingthePPPmeasureofGDP,Chinawas not far behind the US in 2011 andmightovertakeitasearlyas2014or 2015. This occurs much earlier thanwhenusingMERs,asinTable4.2above,sincePPPscorrectfor the much lower average price level inChinathanintheUStogiveanindication of the relative volumes of goods and services produced, rather than their current market value.

• OnaPPPbasis,theUKfallsdown to ninth place in the global economic league table. Even on this measure, the UK remains the third largest EuropeaneconomyandisonlymarginallysmallerthanFrance (andmightovertakeitsoon).

• Generallyspeaking,E7GDPlevelsarehigheratPPPswhencompared toTable4.2.However,theydotrailsignificantlybehindtheG7intermsoflevelsofGDPpercapitaatPPPs.TheUKhasonlythefifthhighestaverageincomeleveloftheG7 on this measure, but is well ahead ofanyoftheE7.

Thisanalysismakesitclearwhybusinesses should not abandon their home markets in countries like the UK because, even though their economic sizewillbesmallerinfuturecomparedtosomeoftheE7,theG7economieswillstill maintain much higher levels of income per capita. These mature, high- income markets will remain attractive giventheiraffluentconsumerbaseand(ingeneral)lowerrisksandgreater ease of doing business.

8 ForfurtherdetailsofthePwCESCAPEIndexpleasesee:http://www.pwc.co.uk/economic-services/issues/escape-index-mapping-how-markets-emerge.jhtml

Figure 4.1: Composition of the PwC ESCAPE Index

Source: PwC ESCAPE Index

Economic1. GDP per capita, PPP2. GDP per capita (previous 10 year CAGR %)3. Annual inflation 4. General government gross debt5. Adjusted trade openness6. Total investment7. Unemployment rate8. Current account balance (% of GDP)

20 variables5% weight each

Normalised

40%

Social1. Life expectancy at birth2. Average years of total schooling3. GINI Index4. Most people can be trusted (%)

20%

Political1. Political stability 2. Control of corruption3. Rule of law4. Ease of doing business index

20%

Environmental1. Access to an improved water source2. CO2 emissions

10%

Communication1. Internet users2. Mobile cellular subscriptions

10%

42 countries

ESCAPEIndex

What is the ESCAPE Index?

TheESCAPEIndex8 provides a holistic measureofacountry’sperformanceacrossfivekeydimensionsrelevanttofutureprogressasshowninFigure4.1.It combines 20 individual variables in the following areas:

• Economicperformanceandstability;

• Social progress and cohesion;

• Communicationstechnology;

• Political,legalandregulatoryinstitutions; and

• Environmentalsustainability.

The economics component of the Index hasa40%weight,whiletheothershavea60%weightintotal.

4.2 – Beyond GDP: UK performance on the PwC ESCAPE Index GDPisausefulindicatortoassesseconomicsizeandgrowthovertime.However, it has some limitations asitdoesnotdirectlycapturethenon-economicaspectsofaneconomylikethequalityofitsinstitutions,theease of doing business, and measures ofenvironmentalsustainabilityandsocial cohesion. We have therefore used ourESCAPEIndextobetterunderstandthe UK’s standing in the world on a broader set of indicators.


Where does the UK rank?

Forthepurposeofthisarticlewehaveupdated the economic variables in the ESCAPEindexusingnewlyavailabledata for 2013. We have also updated other variables for which we could findmoreup-to-datedata(e.g.CO2emissions).NotethatinTable4.4wehaveonlypresentedtheresultsfor theG7economiesasthesearethemostnatural peer group against which to benchmarktheUK(theoverallindexcontains42countries,butcoveringall of these here would distract from the keyconclusionsrelatingtotheUK).

Basedonthisanalysiswecansee that the UK:

• RankedthirdoutoftheG7economiesfortheyearsbeforethefinancialcrisis, but had slipped back into fifthpositionby2013;

• RemainedaboveFranceandItalyforthe entire period, but did not manage toovertakeGermany,whichhasbeenatthetopoftheG7leaguetableonour index since 2000; and

• ManagedtooutperformtheUSandJapanintheyearspriortothefinancialcrisis, but lagged behind in the latest set of results for 2013.

Table4.5providesfurtherdetailsoftheUK’s relative strength and weaknesses byrankingtheUKagainsttherestof theG7in2013forthefivekeycategoriesthatmakeuptheESCAPEIndex.

Table4.5showsthattheUK’sperformanceismixedacrossthefivecategories. In particular:

• UK economic performance is the secondworstamongsttheG7afterItaly.ThisisnotsurprisingasthemomentumofUKgrowthonlypickedup speed in 2013, which is not enough tomakeupfortherelativelydeeprecession that the UK suffered in2008-9anditsslowrecovery in 2011-12.

• Italy’sweakperformanceisconsistentwiththefactthatitseconomyhasvirtuallynotgrown(onaverage inrealterms)since2000.

• The UK ranks at the top of the communicationstechnologycategory.Thisreflectsrelativelyhightake-upof broadband and mobile phones in thiscountry.ThismightpartlybeexplainedbythefactthattheUKisoneofthesmallerG7countriesinterms of land area, which makes it somewhat easier and cheaper tobuildahighqualitytele-communication network. It also reflectsarelativelyliberalandcompetitive telecommunications policyregimeintheUK(notablyrelativetotheUS).

Table 4.5: G7 league table using 2013 data from PwC’s ESCAPE Index

Rank Economic Social Communications Political Environmental Overall

1 Germany Canada UK Canada France Germany

2 Canada Germany Germany Germany Italy Canada

3 US Japan Italy US UK Japan

4 Japan US Japan UK Germany US

5 France France France Japan Japan UK

6 UK Italy US France Canada France

7 Italy UK Canada Italy US Italy

Source: PwC analysis using ESCAPE Index

Table 4.4: PwC ESCAPE Index league table (restricted to G7 economies)

Rank 2000 2007 2013

1 Germany Germany Germany

2 Canada Canada Canada

3 UK UK Japan

4 US US US

5 Japan Japan UK

6 France France France

7 Italy Italy Italy



• The UK’s worst performance is in thesocialcohesioncategory,where itcomeslastintheG7rankings. One important factor that explains thisistheaveragenumbersofyearsspentinschoolingbythegeneralpopulation(9.4yearsintheUKcompared with 10.9 in advanced economiesonaverage).Thiscould,however,partlybeskewedbythefactthatundergraduateuniversitycourses in the UK are shorter compared to most other advanced economies. However, there are also otherelementswithinthiscategoryin which the UK does not perform particularlywelle.g.incomeinequality,whichishigherinthe UKthaninotherG7countries except the US.

• TheUKranksreasonablywellin thepoliticalinstitutionscategory,placingaheadofJapan,FranceandItaly.However,thiscouldbeaffectedintheshorttermbyuncertainty over the two upcoming referenda on Scottish independence and the possible ‘in-out’ vote on the European Union.

• Finally,theUK’senvironmentalperformance is somewhat better thanthatofmostoftheG7andespeciallytheUS,whichisbottom ofthepackinthisregard,notably onCO2emissions.

• The biggest inherent weakness of the UKremainsinthesocialcategorywhere there has not been much improvement since 2000. This requires longer term structural weaknesses in relation to education and income inequalitytobeaddressed.

• Thecommunicationstechnology and political categories are areas wheretheUKdoesconsistentlywell over time compared to the other G7countries.TheUKisalsoslightlyabovetheG7averageonenvironmentalmeasures,althoughthereisclearlyroom for further improvement here.

Figure 4.2: UK performance on elements of the PwC ESCAPE Index relative to the average for the rest of the G7


-2.5

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UK u

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Theaboveanalysisprovidesasnapshotof the UK’s relative strengths and weaknesses in relation to the rest of the G7.InFigure4.2welookattrendssince2000,whichisthefirstyearforwhichwehavecalculatedtheESCAPEIndex.

We can see from this chart that:

• UK economic performance has been graduallydecliningwhencomparedagainstotherG7economies,particularlysince2007.Asdiscussedabove, this is expected given that theUKsuffereddisproportionatelymorefromthefinancialcrisis.However, going forward, we expect the UK to improve its relative performanceinthiscategoryasitsgrowthin2014isprojectedtobethefastestintheG7(seeAppendixA).


The UK is growing relatively strongly at present and has some important strengths, but it also has some deeper structural weaknesses to address in the longer term.

4.3 – Summary and conclusionsEver since the Industrial Revolution, theUKhasbeenanimportantplayerintheworldeconomy(evenifnolongerthedominantplayersincetheUStookoverthatroleintheearly20thcentury). One of the megatrends we expect9 to besignificantincomingdecadesisthegradual shift of economic power from the West to the East. However, despite thistrend,ouranalysisshowsthattheUKisexpectedtoremainasizeable and important member of the world economic elite at least up to 2030.

Specifically,inourbaselinescenario we project that:

• The UK could remain the sixth largesteconomyintheworldin2030whenmeasuredbyGDPatmarketexchange rates, falling behind India butovertakingFrance.

• The UK has the potential to become thesecondlargestEUeconomy on this measure, moving ahead of Francebefore2020,andnarrowingthegapwithGermanyby2030.

However, it’s not all good news. We have alsolookedbeyondGDPatbroadermeasuresofperformancebyusinganupdatedversionofourESCAPEIndex.This shows that, in 2013, the UK ranked only5thoftheG7,downfrom3rdplacein 2000 and 2007. The UK’s performance relativetotheG7was:

• Below average in the economic performanceandstabilitycategory,althoughthiswasattributedlargelytoadversecyclicalvariationsintheeconomysince2007andisexpectedtoimprovegraduallynowthattheUKisrecoveringrelativelyfast.

• Significantlybelowaveragefor theG7inthesocialprogress andcohesioncategory,whichhas beendrivenbyrelativelyhighincomeinequalityandlesstime onaveragespentbythepopulation in education.

• SignificantlybetterthantheG7average in the political institutions andcommunicationstechnologycategories,andslightlybetter onenvironmentalsustainability.

Overall, therefore, the UK is growing relativelystronglyatpresentandhassome important strengths, but it also has some deeper structural weaknesses to addressinthelongerterm,particularlyaroundeducationandinequality.Maintainingrecentrelativestronggrowth will also require increased productivity,whichalsorequiresimproved education and skills levels, as well as increased business and infrastructure investment.

9 Seeourmegatrendswebsiteformoredetails:http://www.pwc.co.uk/issues/megatrends/index.jhtml


Appendix A Outlookfortheglobaleconomy

TableA.1presentsourlatestmainscenario projections for a selection of economies across the world.

WeexpecttheEurozoneandtheUSeconomytogrowin2014,withevenfaster growth projected for both in 2015astheeconomicrecoveryinadvanced economies continues. Emerging economies will continue tomakeasignificantcontribution to global growth, but there are potential downside risks in some of these countries.

Theseprojections(includingthose fortheUK)areupdatedmonthly inourGlobalEconomyWatchpublication, which can be found atwww.pwc.com/gew

Table A.1: Global economic prospects

Share of World GDP

Real GDP growth (%) Inflation (%)

2012 at MERs 2014p 2015p 2014p 2015p

United States 22.5% 2.3 3.0 1.8 2.2

China 11.4% 7.4 7.3 2.5 2.6

Japan 8.3% 1.5 1.5 2.1 2.1

UK 3.4% 3.0 2.6 1.7 1.9

France 3.6% 0.9 1.1 1.1 1.2

Germany 4.7% 2.0 1.9 1.2 1.4

Greece 0.3% 0.3 2.1 -0.4 0.1

Ireland 0.3% 1.7 2.5 0.2 1.2

Italy 2.8% 0.1 0.9 0.7 1.0

Netherlands 1.1% 0.2 1.5 0.8 1.2

Portugal 0.3% 0.1 1.4 0.5 1.1

Spain 1.8% 0.9 1.3 0.3 0.8

Poland 0.7% 2.7 3.2 0.6 2.2

Russia 2.8% 0.5 1.5 6.7 5.8

Turkey 1.1% 2.4 3.8 8.0 6.7

Australia 2.1% 2.6 2.2 2.8 2.6

India 2.6% 5.3 6.6 5.6 6.1

Indonesia 1.2% 5.4 5.8 6.2 5.3

South Korea 1.6% 3.5 3.7 2.3 3.0

Argentina 0.7% 0.7 1.8 11.9 13.3

Brazil 3.1% 1.8 2.5 6.6 5.7

Canada 2.5% 2.2 2.5 1.7 1.8

Mexico 1.6% 2.6 3.7 3.9 3.7

South Africa 0.5% 1.8 2.5 6.1 5.5

Saudi Arabia 1.0% 4.1 4.3 3.1 3.5

World (PPP) 3.3 3.7

World (market rates) 100% 2.8 3.2 5.2 5.6

Eurozone 16.9% 1.0 1.4 0.9 1.2

Source: PwC main scenario for 2014 and 2015; IMF for GDP shares in 2012 at market exchange rates (MERs).


Appendix B UK economic trends: 1979 – 2013

Annual averages GDP growth Household expenditure growth

Manufacturing output growth

Inflation (CPI*)

3 month interest rate (% annual average)

Current account balance (% of GDP)

PSNB** (% of GDP)

1979 2.8 5.0 -0.2 13.7 -0.5 4.7

1980 -2.0 0.1 -8.6 16.6 0.8 4.3

1981 -1.3 0.0 -6.1 13.9 1.9 3.4

1982 2.2 1.2 -0.1 12.2 0.8 2.6

1983 3.8 4.6 2.1 10.1 0.4 3.4

1984 2.9 2.8 3.7 10.0 -0.4 3.7

1985 3.9 4.3 2.9 12.2 -0.2 2.8

1986 4.3 7.1 1.4 10.9 -0.9 2.2

1987 5.2 6.2 4.8 9.7 -1.6 1.5

1988 5.6 8.4 7.3 10.4 -3.9 -0.8

1989 2.6 3.9 4.0 5.2 13.9 -4.6 -0.8

1990 1.8 2.4 -0.1 7.0 14.8 -3.5 0.7

1991 -1.3 -2.2 -4.9 7.5 11.5 -1.4 3.0

1992 1.3 1.6 -0.1 4.3 9.6 -1.7 6.4

1993 3.5 4.1 1.4 2.5 5.9 -1.4 7.7

1994 5.0 3.4 4.9 2.0 5.5 -0.5 6.5

1995 3.5 2.1 1.5 2.6 6.7 -0.7 5.2

1996 3.5 5.0 1.2 2.5 6.0 -0.6 3.7

1997 4.4 4.9 1.9 1.8 6.8 -0.1 1.9

1998 3.6 4.1 0.6 1.6 7.3 -0.4 0.0

1999 2.9 5.2 0.5 1.3 5.4 -2.7 -1.2

2000 4.4 5.5 2.2 0.8 6.1 -2.9 -1.7

2001 2.2 3.8 -1.7 1.2 5.0 -2.3 -0.6

2002 2.3 4.0 -2.4 1.3 4.0 -2.1 2.0

2003 3.9 3.8 -0.5 1.4 3.7 -1.7 3.2

2004 3.2 3.2 1.9 1.3 4.6 -2.0 3.2

2005 3.2 2.9 -0.2 2.1 4.7 -1.8 3.4

2006 2.8 1.8 1.8 2.3 4.8 -2.8 2.5

2007 3.4 2.8 0.8 2.3 6.0 -2.2 2.6

2008 -0.8 -0.9 -2.7 3.6 5.5 -0.9 4.8

2009 -5.2 -3.6 -10.2 2.2 1.2 -1.4 11.0

2010 1.7 1.0 4.2 3.3 0.7 -2.7 9.9

2011 1.1 -0.5 1.8 4.5 0.9 -1.5 7.7

2012 0.3 1.5 -1.7 2.8 0.8 -3.8 7.8

2013 1.7 2.2 -0.7 2.6 0.5 -4.5 6.8

Average over economic cycles***

1979 - 1989 2.7 4.0 1.0 7.9 12.2 -0.7 2.5

1989 - 2000 2.9 3.3 1.1 3.3 8.3 -1.7 2.6

2000 - 2007 3.2 3.5 0.2 1.6 4.8 -2.2 1.8

* Pre-1997 data estimated ** Public Sector Net Borrowing (calendar years excluding special factors) *** Peak-to-peak for GDP relative to trend Source: ONS, Bank of England


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