Ernst & Young ITEM Club Autumn Forecast

"Credit Crunch - What Credit Crunch?

This will accelerate the long-awaited "rebalancing" of the economy - says ITEM

London 22 October 2007: The credit crunch is an opportunity to rebalance the economy, which has become overly dependent on lax credit and monetary conditions, according to the Ernst & Young ITEM Club Autumn forecast. Furthermore, ITEM does not believe that the tighter lending conditions for homebuyers - caused by the worldwide squeeze on credit - will lead to a serious correction in UK house prices.

The report warns that growth is set to slow next year as a result of the marked tightening of monetary and credit conditions seen over the summer. Although the UK economy's stability and strength put it in good stead to cope with the credit crunch, ITEM has substantially revised its 2008 GDP forecast down from 2.5% in July to 2.1%.

Professor Peter Spencer, Chief Economic Advisor to the Ernst & Young ITEM Club, explains, "The threat of a major credit crunch seems to be receding at a speed which few people would have anticipated a month or so ago. Yet, the longer-term consequences are difficult to predict. One thing is certain, this is a very timely tightening, targeting parts of the financial sector that were growing too fast and were too dependent on cheap credit. Having to reverse gear may not be such a bad thing."

In this tightening, yesterday's winners are today's losers: notably over-exposed hedge funds, highly leveraged private equity businesses, property purchasers on high loan to value multiples, and of course the Treasury, which will see tax revenues from the City sharply curtailed.

Darling wrestles with ever weakening finances Looking forward, weaker tax receipts from the City will have significant consequences for the Chancellor, boxed in as he is on very tight revenue, borrowing and spending plans.

Spencer adds, "The new Chancellor, Alistair Darling, is operating under very tight constraints. The January tax revenues, which are normally swollen by company profits, will give the first indication of the hit that Darling and Brown will take. If Darling manages to make Government departments stick to the agreements announced in this month's spending review, he will effectively halve the real growth rate of public spending, from 4% since 1999 to just over 2% in 2008-09 and subsequent years."

And in the Pre-Budget report, for the first time, the Treasury itself admitted growth would slow. All this leaves the Chancellor with the prospect of a very gloomy Budget in the spring of 2008.

Housing market will hold up While prices in the housing market have no longer been rising at double-digit rates, demand has been holding up surprisingly well given the increases in interest rates over the last year and the widespread view (until the Northern Rock debacle) that further hikes were pretty much inevitable.

Spencer explains, "But at the same time the change to the interest rate outlook has led to a fall in two-year swap rates, which are key for the pricing of most new mortgages. And with the labour market strong, ITEM still thinks that it is unlikely that there will be a major housing recession.

Activity is likely to fall and prices may stall through 2008. But as interest rates come down and new supply remains restricted, the foundations will be laid for renewed real price growth in the long run."

Spencer says, "Consumer confidence has been knocked by the credit crunch. However, the labour market remains strong and disposable incomes will improve as mortgage costs fall. We therefore expect a fairly modest slowdown in consumer spending growth, from 3.0% in 2007 to 2.0% in 2008, with demand picking up again thereafter. This is unlikely, however, to be sufficient to lead to a significant recovery in the saving ratio."

Risk to London's reputation ITEM also believes that the events of the summer have raised profound questions about the tripartite system of financial sector regulation put in place in 1997.

Spencer explains, "The system that divides financial regulation between the three organisations - the Bank, the Financial Services Authority and the Treasury - needs a lot more scrutiny and a question should be raised about its ability to grapple with a swift crisis such as the one from this summer. The damage to London's ambition to be the world's premier financial centre is still hard to determine. It is now possible to see the City's business seeping away to rival hubs like Paris, Dublin or even Dubai."

Strength of business will pull economy through The surprise is that there have not been more casualties, and that the fall out from the credit crunch has had relatively little effect - so far - on the High Street or the housing market. The rest of the business sector looks remarkably buoyant, with UK manufacturing especially taking advantage of strong global growth.

Spencer adds, "A global increase in profitability helps to explain why UK manufacturing has withstood two gusts, which in the past would have blown it off course: the weaker dollar and higher oil & raw material costs. Profitability in the service sector also remains high and while global growth may not be the heady 5% plus that was expected, a steady

3 - 4% is still respectable."

Spencer concludes, "This global strength of business through the autumn, from which the UK will benefit, should pull the UK economy through any slowdown in consumer or government spending caused by the summer's credit crunch. And in the short term, tighter credit conditions have effectively done the work of the hawks on the Bank of England's Monetary Policy Committee, lowering base rate expectations for next year." "

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