#sectorbalances – Page 2 – Chris Mallin Macro Perspectives

“COVID-19 and the flow of financial funds in the UK”

How did the flow of funds between sectors change?

The key chart

**Change in net aquisition of assets between first 3Qs 2020 and final 3Qs 2019 (£bn)** (Source: OBR; BoE; ONS; CMMP)

The key message

The OBR’s “Economic and fiscal outlook – March 2021” provides valuable insights into the impact of the COVID-19 pandemic on the flow of funds between the different sectors of the economy.

The UK government issued £227bn gilts in the first three quarters of 2020 to finance the support given to HHs and NFCs (and increased it net liability position by £130bn).

The BoE purchased a similar quantity of gilts in the secondary market (via APF) and financed this through the issuance of reserves. These reserves form liquid assets for the rest of the financial sector, counterbalanced by additional deposits from HHs and NFCs. Note that the net asset/liability positions of the money sector (the BoE and FIs) remained broadly unchanged at this point.

HHs increased their deposits by £102bn and their net asset position increased by £111bn. This increase in HH savings was intermediated to the UK government via the money sector, meaning that UK HHs have been the most important source of additional lending during the pandemic.

In contrast, the net lending position of NFCs and the RoW remained broadly unchanged.

Understanding how these flows will be unwound in the post-COVID period is the key to determining the speed and duration of the recovery in the UK economy. My next post will examine the HH sector dynamics in more detail.

Recall that the financial sector balances approach reognises that any net borrowing by one sector must be accompanies by net lending from another sector(s). The table below illustrates this balance in practice during the COVID-19 pandemic.

£ bn	C Bk reserves	Curr. & dep’s	Gilts	Loans and debt	Other	Total
Gov	0	-13	-227	44	65	-130
BoE APF	-259	0	231	28	0	0
FIs ex-APF	259	-204	47	-47	-47	8
HHs	0	102	1	26	-18	111
NFCs	0	123	1	-79	-30	16
RoW	0	-9	-53	27	30	-5
Balance	0	0	0	0	0	0

Net borrowing by one sector must be accompanied by net lending from another sector(s) (Source: OBR; BoE; ONS; CMMP)

COVID-19 and the UK flow of funds

The OBR’s “Economic and fiscal outlook – March 2021” provides valuable insights into the impact of the COVID-19 pandemic on the flow or funds between the different sectors of the economy. The analysis compares the patterns of financial flows between the five key sectors in the economy – HHs, NFCs, FIs, government and the RoW – in the first three quarters of 2020 and the final three quarters of 2019.

Recall that the financial sector balances approach recognises that any net borrowing of one sector must be accompanied by net lending from another sector(s).

As highlighted in my previous post, the UK government has provided unprecedented support to HHs and NFCs during the COVID pandemic. According to the OBR, this was financed (in net terms) by issuance of £227bn in gilts in the first three quarters of 2020. This compares with £34bn issuance in the final three quarters of 2019. The net liabilities of the government increased by £130bn over the period.

A similar quantity of gilts (£231bn) was purchased on the secondary market by the BoE’s Asset Purchase Facilty (APF) as part of quantitative easing (QE). The BoE financed this purchase by issuing an equivalent amount of its own liabilities (reserves). As a result the Bank’s net asset/liability position was unchanged.

The reserves issued by the BoE constitute assets for the rest of the UK financial sector. The counterpart/balance to these reserves is mainly the additional deposits from HH and NFCs that arose from the government’s support measures. Note again, that the net lending position of the financial sector remained broadly unchanged at this point.

The rise in HH deposits has been a consistent message from the money sector in 2020. The OBR notes that HH deposits increased by £102bn in the first three quarters in 2020. These savings have been intermediated to the government via the financial sector and the BoE through the flows described above. The net assets of the HH sector increased by £111bn.

The NFC sector also increased its deposits by £123bn over the period, while increasing net loans and other liabilities by £109bn. In aggregate, the net lending of NFCs changed little as a result but this masks significant differences in the experience of firms in different sectors.

Foreign investors have played a limited role in the financing the increase in UK government borrowing over the period. The net lending positions changed little over the first nine months of 2020.

Conclusion

The COVID-19 pandemic and the associate responses from the UK government led to significant changes in the flow of funds between the key economic agents. The composition of these flows changed for most sectors but the main changes in net assets and liabilities were recorded by the HH and government sectors.

UK HHs represent an important source of additional lending over this period, with the increase in their liquid savings being intermediated to the government via the money sector (financials and the BoE).

The OBR is forecasting a 4% increase in real GDP in 2021 from a fall of 9.9% in 2022, followed by growth of 7.3%, 1.7%, 1.6% and 1.7% in the next four years out to 2025 respectively. The pace and sustainability of these forecasts depend on how the financial flows described above are unwound. In the next post, I will examine the outlook for the HH and NFC sectors in more detail.

Please note that the summary comments and charts above are extracts from more detailed analysis that is available separately.

“Where is the value…”

…in forecasts that assume unsustainable end-games?

The key chart

**Historic and forecast trends in financial sector balances for the UK private sector, government and the RoW expressed as % GDP** (Source: OBR; CMMP)

The key message

Seen from the perspective of financial sector balances, the latest OBR forecasts for the UK economy and public finances tell us three things.

First, the UK government’s response to the COVID-19 pandemic was timely, necessary and appropriate.
Second, the financial relationship between UK households, corporates, government and the rest-of-the-world will remain broadly unchanged during 2021.
Third, (obvious and familiar) risks to the medium-term forecast remain to the downside and imply persistent and significant fiscal and current account deficits (little has changed since November 2020).

Somewhat surprisingly, given the significant event risk that the Covid-19 pandemic represents, the medium-term outcomes forecast in March 2020, November 2020 and March 2021 are broadly similar – a return to an economy characterised by large and persistent sector imbalances, with combined public and private sector deficits and an increasing reliance on the RoW as a net lender.

This scenario is as unsustainable post-COVID as it was pre-COVID, and leaves the reader wondering about the value of official forecasts in presenting an accurate outlook for the future financial interactions between the key UK economic agents.

Please note that the summary comments and chart above are extracts from more detailed analysis that is available seperately. Please also note that subsequent posts will dig out the “hidden value”!

“If you only read one page”

What to look for in the OBR’s forecasts (and where)

The key chart (from November 2020)

**The chart that said so much last November – historic and forecast trends in financial sector balances for the UK private sector, UK government and RoW expressed as % GDP** (Source: OBR; CMMP)

The key message

The Office for Budget Responsibility (OBR) will publish its latest forecasts in their “Economic and fiscal outlook – March 2021”, alongside the Chancellor’s budget tomorrow (3 March 2021)

The report is typically over 200 pages long and contains much detailed work, analysis and scenario planning. Very helpfully, it also includes one page (typically around page 65/66) that gives the reader immediate insights into the reliance and/or confidence that can be placed on the rest of the forecasts. The page is headed, “sectoral net lending” and, as the name suggests, links directly to CMMP’s preferred financial sector balances framework.

In November last year, this page illustrated clearly the risks to the rest of the OBR’s forecasts for UK growth and for the level of government borrowing. First, they assumed unprecedented levels of dynamism from both the UK household and corporate sectors and behavioural trends from these sectors and from the RoW that contrasted sharply with those seen after the GFC. Second, while they claimed that “sectoral net lending positions return to more usual levels,” this did not make them sustainable.

It is unusual, but equally very helpful, that one page can tell us so much about the truth behind the headlines that will dominate tomorrow’s news and Thursday’s papers…

“Really?”

OBR forecasts from a sector balances perspective

The key chart

**Historic and forecast trends in financial sector balances for the UK private sector, UK government and RoW expressed as % GDP** (Source: OBR; CMMP analysis)

The key message

The latest OBR forecasts for the UK economy and public finances support my argument that recent UK policy responses to the Covid-19 pandemic were timely, necessary and appropriate and that the UK government will maintain an increasingly interventionist role in the UK economy.

However, from my preferred “financial sector balances perspective” there are obvious risks to their forecasts for UK growth and for the level of government borrowing. First, they assume unprecedented levels of dynamism from both the UK household and corporate sectors and behavioural trends from these sectors and from the RoW that contrast sharply with those seen after the GFC. Second, while the OBR claims that “sectoral net lending positons return to more usual levels,” this does not make them sustainable.

In short, the latest forecasts point to a post-Covid, post-Brexit UK economy returning rapidly to persistent private and public sector deficits and an increasing reliance on the RoW as a net lender. Really…?

The charts that matter

The Office for Budget Responsibility (OBR) published its latest “Economic and Fiscal Outlook” yesterday (25 November 2020) in which it set out its forecasts for the UK economy and public finances to 1Q26. I have analysed these forecasts from the perspective of UK financial sector balances ie, the financial relationship between UK households (HHs), corporates (NFCs), government (GG) and the rest-of-the-world (RoW). As explained in a series of posts earlier this year, this approach builds on the key accounting identity pioneered by the late Wynne Godley that states that:

Domestic private balance + domestic government balance + foreign balance (must) = zero

**Trends in UK financial sector balalances since 2000** (Source: OBS; CMMP analysis)

The OBR’s analysis supports my view that the UK government’s policy response to the Covid-19 pandemic was timely, necessary and appropriate. The OBR expects the cost of government support to total £280bn in 2020, pushing the deficit to £394bn (19% GDP), the highest level since 1944-45 and the debt ratio to 105% GDP, the highest level since 1959-60. Seen through the context of financial sector balances, the OBR concludes that, “The spike in government borrowing [the green line above] …has meant that household and corporate incomes have not fallen nearly as fast as their output or expenditure.” Note that the OBR expects the household financial surplus [the blue line above] to rise to a historically high level of over 11% GDP, and the corporate balance to move from a deficit to a historically high surplus of 2.5% GDP.

The support provided to households and businesses has prevented an even more dramatic fall in output and attenuated the likely longer-term adverse effects of the pandemic on the economy’s supply capacity. And the Government’s furlough scheme has prevented a larger rise in unemployment. Grants, loans, and tax holidays and reliefs to businesses have helped them to hold onto workers, keep up to date with their taxes, and avoid insolvencies.
OBR, November 2020

**Historic and forecast trends for UK government financial sector balances – the bold and dotted lines represent March 2020 and November 2020 forecasts respectively.** (Source: OBR; CMMP analysis)

The OBR forecasts also suggest that the UK government will continue to play an important part in economic activity. They predict that the government’s net borrowing peaks at -19% GDP in 1Q21, falls below -5% by 4Q22 and trends at around -4% GDP to 1Q26. These new forecasts imply higher levels of government borrowing than previously expected (note, there is no mention of balanced budgets or austerity). For government borrowing to fall in line with these expectations, HH and NFC spending have to rise more into line with income.

From a sector balances perspective, this is the point at which alarm bells begin to ring.

**Historic and forecast trends for UK household financial sector balances – the bold and dotted lines represent March 2020 and November 2020 forecasts respectively.** (Source: OBR; CMMP analysis)

Turning to the key HH sector first, the OBR forecasts assume that the financial surplus will peak at just under 14% GDP in 1Q21 and then fall rapidly to under 2% GDP by 3Q22 in line with the previous March 2020 forecasts. The HH savings rate is expected to fall sharply from 28% GDP in 2Q20 to “settle at around 7.5% over the medium term.” This is below the average savings rate of 9% recorded between 1986 and 2019. The OBR argues that forced savings have played a greater role in the rise of HH savings than previously thought. Their new forecasts assume that, “more of the boost to HH finances from forced saving during the lockdown is spent as the economy returns to normality.” On this basis, the OBR now expects private consumption to return to its pre-virus peak by the middle of 2022, much earlier than they forecast in July 2020.

**Historic and forecast trends in UK household savings rate** (Source: ONS; OBR, CMMP analysis)

**How the UK household sector adjusted in the post-GF C period – sector balances % GDP** (Source: OBR; CMMP analysis)

To put these assumptions into a historic context, post the GFC, the HH sector’s financial surplus peaked at 6.1% GDP in 2Q10. It took 25 quarters for the surplus to fall below the 2% GDP level that the OBR now assumes HH will achieve in six quarters and sustain from 3Q22 onwards. Put simply, these forecasts ignore historical evidence from the UK and elsewhere that suggest that HH behaviour takes time to adjust from extreme shocks and implies obvious downside risks to the newly revised consumption and GDP forecasts, in my view.

**Historic and forecast trends for UK corporate financial sector balances – the bold and dotted lines represent March 2020 and November 2020 forecasts respectively.** *(Source: OBR; CMMP analysis)*

Turning now to the NFC sector, businesses reduced investment during the pandemic and moved into financial surplus in 3Q20. The OBR assumes that this surplus will peak at 3.2% GDP in 1Q21 and settle at a deficit of around 2.5% GDP out to 1Q26. In other words, the forecasts assume both (1) relatively high future investment levels and (2) a relatively dynamic adjustment. Again for context, after the GFC, the NFC sector ran net financial surpluses for 17 consecutive quarters between 1Q09 and 1Q13.

**The complete picture – usual perhaps, but is this really sustainable?** (Source: OBR; CMMP analysis)

Finally, the OBR observes that, “over the medium term, sectoral net lending positions return to more usual levels.” While they may be usual in the sense that they are not new, that is not the same as saying that they are sustainable. The latest forecasts not only assume dynamic adjustments by the HH and NFC sectors but they also assume a sustained period during which combined private and public sector deficits are offset by increasing Row surpluses.

**Historic and forecast trends for RoW financial sector balances – the bold and dotted lines represent March 2020 and November 2020 forecasts respectively.** *(Source: OBR; CMMP analysis)*

In other words, the current forecasts imply a return to persistent sector imbalances with the UK increasingly reliant on the RoW as a net lender (see Imbalances and dependencies).

Conclusion

If we assume that the OBR forecasts become the base case priced into UK assets, then financial sector balances point to downside risks to growth expectations, upside risks to the level of borrowing, inflation staying below target out to 1Q26 and rates remaining lower for longer. Plus ca change…

Please note that the summary comments and charts above are extracts from more detailed analysis that is available separately.

“Extraordinary responses to extraordinary times”

UK policy responses seen from a money sector perspective

The key chart

**UK private sector and general government net lending/borrowing positions from the capital account expressed as a percentage of GDP** (Source: ONS; CMMP analysis)

The key message

In this post, I consider last week’s coordinated policy responses from the UK government and the Bank of England in the context of UK financial sector balances and recent “messages from the money sector”.

Large and persistent sector imbalances, an over-reliance on the RoW as a net lender and a household sector that was already poised to disappoint were challenging the economy even before Covid-19 hit. The immediate “Covid-19” response from the private sector was to increase its net lending position to a record 22% of GDP, almost 3x the equivalent response after the GFC. The HH savings ratio increased to a record 29% and HH consumption fell by the largest amount ever recorded (£81bn). In direct response to this negative shock, the UK government increased its net borrowing position to negative 23% of GDP – a timely and appropriate response.

Since then, the message from the UK money sector has remained one of high uncertainty and slowing consumption even before the latest round of restrictions began. Hence, the latest coordinated responses are also timely, necessary and appropriate. Looking ahead, current trends also suggest that: (1) the UK government will maintain an increasingly interventionist role; (2) the Bank of England will remain committed to keeping nominal and real rates “lower for longer”; and (3) investors hoping for a shift away from long duration fixed income and equity trades may require considerable patience.

Seven charts that matter

On 5 November 2020, the UK government and the Bank of England coordinated a larger-than-expected fiscal and monetary response to the latest Covid-19 wave and the second national lockdown. Rishi Sunak, the Chancellor of the Exchequer announced the extension of the furlough scheme until March 2021 and the Bank of England increases its bond-buying programme by £150bn. In the latest CMMP analysis, I consider this joint policy response in the context of (1) UK financial sector balances and (2) recent messages from the money sector.

**The challenging starting point – trends in net lending/net borrowing expressed as a % GDP before the Covid-19 pandemic hit** (Source: ONS; CMMP analysis)

Large and persistent sector imbalances, an over-reliance on the RoW as a net lender (see graph above) and a household sector that was already poised to disappoint were challenging the economy even before Covid-19 hit. Up until the 4Q19, the UK private and public sectors were running net borrowing positions at the same time that were offset by the RoW’s persistent net lending. The HH sector was funding consumption by dramatically reducing its savings rate and accumulation of net financial assets. With real growth in disposable income slowing and the savings rare close to historic lows, the risks to the UK economy already lay to the downside and at odds with previous government forecasts.

**Trends in private sector net lending comparing the early-1990s recession and the GFC with 2020** (Source: ONS; CMMP analysis)

The immediate “Covid-19” response from the private sector was to increase its net lending position to a record 23% of GDP in 2Q20. In other words, the amount of money that the private sector had “left over” after all its spending and investment in 2Q20 was approximately 3x the equivalent amounts after the GFC and the recession of the early 1990s (expressed as a % of GDP).

**Trends in HH gross savings and the HH savings ratio** (Source: ONS; CMMP analysis)

The HH sector was the main driver here. HH gross savings rose to £104bn in 2Q20 and the savings rate increased to a record 29% compared with 10% in 1Q20 and 7% a year earlier. HH consumption fell by the largest amount ever recorded (£81bn), driven by large declines in spending on hotels, restaurants, travel, recreation and cultural services. The HH net lending position accounted for 20ppt of the total 23% private sector net lending in 2Q20, another record.

**Trends in HH final consumption expenditure – the largest quarterly decline ever** (Source: ONS; CMMP analysis)

In direct response to this negative shock, the UK government increased its net borrowing position to negative 23% of GDP – a timely and appropriate response. The main drivers here were the continuation of the Coronavirus Job Retention Scheme (CJRS), the introduction of the Coronavirus Self Employment Income Support Scheme (SEISS) and the Small Business Grant Fund.

**A timely and appropriate response from the UK government** (Spurce: ONS; CMMP analysis)

Since then, the message from the UK money sector has remained one of high uncertainty and slowing consumption even before the latest round of restrictions began. The latest Bank of England data showed that HH deposits increased by £7bn in September 2020. While this flow was below the £14bn, £16bn and £27bn monthly flows seen at the peak of uncertainty in March, April and June respectively it was still 1.5x the average 2019 monthly flows. Co-incidentally, September’s YoY growth rate in consumer credit was the weakest since records began (-4.6% YoY).

**Monthly HH deposit flows since January 2019** (Source: Bank of England; CMMP analysis)

2020 trends in HH consumer credit – flows and growth rates. (Source: Bank of England; CMMP analysis)

Conclusion

In summary, the latest coordinated fiscal and policy responses are timely, necessary and appropriate. Looking ahead, current trends also suggest that: (1) the UK government will maintain an increasingly interventionist role; (2) the Bank of England will remain committed to keeping nominal and real rates “lower for longer”; and (3) investors hoping for a shift away from long duration fixed income and equity trades may require considerable patience.

Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.

“1992 revisited”

History often rhymes and occassionally repeats itself

In his 1992 analysis “Maastricht and All That”, the late economist Wynne Godley argued that, “the present situation is screaming aloud for co-ordinated reflation, but there exists neither the institutions nor an agreed framework of thought which will bring about this obviously desirable result.” Yesterday, and almost thirty years later, Fabio Panetta, a member of the ECB’s Executive Board, called for a “strong and symmetric fiscal response that offsets the economic damage from the pandemic.” Echoing Godley, Panetta stressed the risks of the current, asymmetric fiscal responses, argued why a new framework was required and made the threat to the future of the single market very clear.

From a corporate, rather than an investment perspective, one of his most interesting observations was that, “uneven fiscal support implies that a firm’s location, rather than its business model, will be the decisive factor in determining whether it survives the crisis.” A new angle?

What links Godley and Panetta’s observations is the fact that by design, the nation states of the euro area (EA) have given up sovereignty of their national currencies – they have become users rather than issuers of currency – and have, in effect, limited policy options to controlling money supply and balancing budgets. Why does this matter? In previous posts, I have argued that: (1) monetary policy has been only partially successful, at best, but also carries hidden risks; (2) asymmetric rules that are tough on deficits but weak on surpluses are inappropriate in the current situation; and (3) this is the time for co-ordinated, counter-cyclical fiscal policy across the EA.

One of Godley’s criticisms of the Maastricht Treaty was that it created no new institutions other than the ECB and yet, somewhat ironically, it is the ECB that is now leading the arguments for a new and more appropriate policy framework (see also “Fiscal, first and foremost“). Panetta concluded that, “Acting now to create the conditions for a symmetric fiscal response will help all member countries to shorten the duration of the crisis period, protect the economic base on which their future production structures and exports rely, and – perhaps most importantly – uphold the premise of a shared and indivisible European destiny.”

I would concur up until the final point – most importantly acting now will minimise the appalling human costs not only of the pandemic itself but also of the subsequent economic downturn. This should be the top priority for all. EU leaders meet tomorrow (23 April 2020) to debate their response and to consider possible funding models. Their responsibilty is immense.

Please note that summary comments above are extracts from more detailed analysis (including extended links to Modern Monetary Theory and Balance Sheet Theory) that is available separately.