The Green Budget

1. The Green Budget The Economic Outlook January 2006 Professor David Miles +44 20 7425 1820 david.miles@morganstanley.com Melanie Baker +44 20 7425 8607 melanie.baker@morganstanley.com Vladimir Pillonca +44 20 7425 5839 vladimir.pillonca@morganstanley.com Morgan Stanley does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

2. The Economic Outlook • Economic growth has been relatively robust over the past few years, although it slowed substantially in 2005. The Treasury expects the economy to pick up, with growth of between 2¾% and 3¼% by 2007 and the output gap closing in 2008–09. • There are downside risks to the Treasury’s forecasts in the medium term, from a slowdown in productivity growth, inadequate saving and a large and persistent current account deficit. • We do not expect growth to accelerate significantly over the next two to three years. Growth could be slower still if inflationary pressures force the Bank of England to raise interest rates. • Our analysis suggests that there is little spare capacity in the economy. The Treasury identifies longer cycles than we do: it believes that only three have been completed since 1972, whereas we identify five to six.

3. Treasury’s projection of real GDP (% change terms) Note: We assume that the Treasury’s forecast errors follow a normal distribution with mean zero and variance σ2. The absolute forecast error then follows a half-normal distribution with a mean equal to √(2/π) multiplied by σ. Since we know that the Treasury’s mean forecast error is 0.5, we can deduce that σ=0.63 (and σ2=0.39). Using this, we can use the properties of the normal distribution to tell us the probability of the forecast error lying in a given range. The probabilities given in the text may well be somewhat underestimated. This is because the Treasury gives the mean forecast error for the ‘current year and year ahead projections made in autumn forecasts’, when it would already have a significant amount of information to forecast the current year’s GDP growth. We also assume forecast errors are uncorrelated across periods. Sources: HM Treasury; ONS; Morgan Stanley Research.

4. Tentative evidence of rebalancing away from the consumer Source: ONS

5. Balance sheet repair: slower debt, faster asset accumulation Source: ONS

6. Profitability strong, despite slowdown in growth Source: ONS

7. Medium term Risks: The Productivity and Growth Outlook • Saving is low • Productivity has slowed • Much of the slowdown appears to be cyclical. • But a substantial part is structural and that is worrying.

8. UK gross national saving rate low compared with other economies Source: IMF World Economic Outlook database, September 2005

9. Net investment not high enough to sustain 2½% GDP growth Source: ONS and Morgan Stanley Research

10. Saving rate looks too low to sustain 2½% GDP growth Source: ONS and Morgan Stanley Research

11. Real GDP per hour worked (UK=100) Note: Data for 2004 are provisional and subject to revision. Source: ONS, experimental internationally comparable series

12. Real GDP per worker (UK=100) Note: Data for 2004 are provisional and subject to revision. Source: ONS, experimental internationally comparable series.

13. Labour productivity growth has slowed sharply Sources: ONS and Morgan Stanley Research

14. Decomposing GDP per-capita growth – the UK experience Note: The trend rate of TFP growth is calculated with a Christiano-Fitzgerald Band Pass Filter, which aims to decompose output into a permanent (‘trend’) component and a cyclical factor. Source: Morgan Stanley Research.

15. Medium term Risks: The Current Account and Balance of payments • Trade and current account deficits have been rising • This is a reflection of low saving and an exchange rate that makes it tough for producers of traded goods to compete. • All this has generated a decline in net overseas assets • Potential for exchange rate – and terms of trade - adjustment to be substantial

16. UK continues to run a significant trade and current account deficit Sources: ONS; Morgan Stanley Research

17. Net UK overseas liabilities (% of GDP) Sources: ONS; Morgan Stanley Research

18. The Treasury’s projections and the economic cycle

19. Estimates of potential output growth Note: The above estimates are based on statistical filters which separate the level of output into a trend ‘underlying’ component and a cyclical component. The cyclical component is zero on average over long-enough periods, and tends to reflect temporary deviations from the underlying trend. Sources: Morgan Stanley Research; HM Treasury.

20. Business cycles have become less marked, making the dating of the cycle harder Source: Morgan Stanley Research

21. The Treasury has shifted the date of the current cycle back to 1997 and it now predicts that it will last until the end of 2008 Source: Morgan Stanley Research; HM Treasury

22. Dates of UK economic cycles Source: Morgan Stanley Research; HM Treasury

23. The Morgan Stanley forecasts

24. GDP growth forecast

25. Morgan Stanley central case economic projections E = Morgan Stanley Research estimates. Sources: ONS; Morgan Stanley Research.

26. Morgan Stanley ‘worse case’ economic projections E = Morgan Stanley Research estimates. Sources: ONS; Morgan Stanley Research.

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