UK growth is now in China's hands

By Philip Aldrick, Economics Editor

If there was one message to take away from the Bank of England's dramatic Inflation Report yesterday, bar rates being on hold for another two years and growth being weaker than hoped, it was that the global economy is back on the precipice – and it is the world's creditor nations that are holding the rescue lines.

There is only one way for the world to go, said the Bank's Governor Sir Mervyn King: for the pent-up losses caused by the vast debts amassed in the boom to be "shared between creditors and debtors". This, he said, meant "in the world economy between creditors in the East and debtors in the West, and within the euro-area between creditors in the North and debtors in the South".

The problem is that there are two ways the problem can be resolved. Either voluntarily, as surplus countries like China let their currencies appreciate, or violently, "in the context of a downturn in the world economy".

Given the lack of political leadership currently, an ugly denouement looks all too likely.

The issue is, and has always been, "global imbalances". China and Germany export too much and plough their returns back into the financial system, creating bubbles of cheap credit and distortions in behaviour.
 
The US, UK, and many others consume too much and borrow exorbitantly to fund their habits.

Lenders tend to claim the moral high ground because they squirrelled away savings prudently. But China and Germany needed someone to buy their wares, as well as somewhere for their savings to earn a return. Debtor nations have kept creditor nations rich.

As the world adjusts, debtor nations are taking all the pain – making exports more competitive and cutting budget deficits. And growth is now suffering the consequences. As Sir Mervyn put it about Britain yesterday: "The UK has done what it can."

Policy is as stretched as it can be – a fiscal consolidation that, according to the National Institute for Economic & Social Research, is stripping 0.8pc from annual GDP growth; a policy to rebalance towards exports; and record low interest rates. "There is a limit to what UK monetary policy can do when large real adjustments are required," Sir Mervyn said.

Other countries could be doing more, he suggested, arguing that the European Central Bank, "has gone to the outer limit of what a central bank can do" with its emergency bond-buying schemes, and that "any further action has to be carried out by European governments themselves".

But, once policies are in place, creditor nations need to start doing their bit.

They are not innocent parties, after all. China boosted its trade with the world by locking into the dollar, and Germany has been a huge beneficiary of euro membership.

Without the euro, its currency would have appreciated – making German exports less competitive. The imbalances should never have been as stark in the first place.

If creditors are going to contribute, currencies are the first place to start. In an apparent dig at the Chinese, Sir Mervyn said: "In normal circumstances, when you have these enormous imbalances between countries, where you need adjustments to be made, exchange rate movements are the natural mechanism by which adjustments can take place.

"The US has been trying very hard to persuade China to break the link with the dollar, so that the natural stabilisers are allowed to work. But that hasn't happened, and that is one reason why these imbalances have built up to a point where they threaten both sides. One way or another, adjustment will have to occur."

Trapped in the euro, Germany can not appreciate, but it can absorb losses through rescue schemes and writing off sovereign debt held by its banks.

Sir Mervyn will be hoping the issue of global imbalances is back at the top of the agenda at the International Monetary Fund's annual conference next month. Leaders need to rediscover the spirit of co-operation they found during the 2008 crisis, and the love-in the following year in Pittsburgh when the G20 nations agreed to promote "balanced growth".

"2008 was not the end of the crisis – it was merely one stage in a bigger crisis," he said yesterday. "We are going through the next stage now."

For the UK, the future now hinges on creditor nations making the right decisions. Sir Mervyn denied UK policy is paralysed, but conceded: "The big risks facing the UK come from the rest of the world. We must work with our colleagues abroad to tackle the challenge of how to reduce the overhang of private and public debt."

While global growth was sufficient to generate demand for UK exports, it was not such a concern. It is now. The "soft patch" in the global recovery caused the Bank to slash its growth expectations for the UK from 1.8pc to 1.5pc this year and from 2.5pc to 2.1pc next year, and project another two years of interest rates at rock-bottom levels.

"Headwinds [to the recovery] are becoming stronger by the day," Sir Mervyn said. It's now up to others to make sure Britain isn't blown off the cliff. Drawing a link between the riots and public sector cuts would be "irresponsible" before a proper investigation of the causes has been carried out, Sir Mervyn King said.

However, he appeared to dismiss suggestions that job cuts may have fuelled the events. "I will point to one fact," he said. "Over the past year the private sector has created over four times more jobs than have been shed from the public sector."