Market Comment January 6th 2010

Whatever the prospects for the world economy, the UK faces some particularly unpleasant problems. Not the least of these is the need to cut back the public sector, which has manifestly been allowed to run out of control in the last few years, both in terms of numbers employed and cost.  Doug McWilliams, of the Centre for Economic and Business Research, highlights the growing disparity between the pay experience of the public and private sectors in this note.

The official figures for the public sector pay bill (estimated by multiplying the average earnings index for the public sector by the employment numbers) show the public sector pay bill up by 12.5% in the two years to September 2009. This seemed unexpectedly high so we have looked carefully to see if the figures are distorted. It turns out that they are by the inclusion of Lloyds Bank and RBS employees. To get an accurate idea of what has been happening on a like for like basis the number of public sector employees in September 2009 needs to be adjusted down by 220,000, which brings the public sector pay bill increase down to 8.4%.

Meanwhile, the private sector pay bill (again adjusted to take out the distortion from the reclassification of Lloyds and RBS), which essentially creates the tax base to finance the public sector, has risen by only 1.8% over the same period.

Driving the rising relative cost of public sector employment aretwo factors. Employment in the public sector has been rising while that in the private sector has been declining. But in addition, public sector pay rose 3.9% in the year to September 2008 versus a private sector rise of 3.0% and by 2.9% in the year to September 2009 versus a private sector rise of 0.9%.

There is plenty of scope for legitimate argument over the right speed at which fiscal consolidation in the UK should take place, though a serious currency crisis could take this argument out of the hands of the economists.

But with income tax thresholds frozen in April, income tax rates set to rise in April 2010, employers’ and employees’ national insurance contribution rates set to rise in April 2011 and with above inflation rises in council tax projected, an excessive public sector pay bill cannot now be justified on Keynesian grounds. Any justification for the scale of the increase in public sector pay bills has to be based on a view that it makes sense to take resources away from the private sector to give to the public sector.

Had the public sector pay bill risen in line with the private sector pay bill over the past two years, £11 billion would have been saved in public spending, which would have made the entire rise in income tax and national insurance contributions in 2010 and 2011 unnecessary.

Comment: With the UK general election due to be held by May 2010 at the latest, a period of pre-election nervousness in the UK markets seems a virtual certainty. The prospect of a hung parliament, and a new government  forced to horse trade every initiative, is not one that inspires confidence. While a majority Conservative government would be the markets’ preferred outcome, there remain nagging doubts as to whether David Cameron has the necessary drive and support to  force through the changes in the public sector that will be necessary.

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Another big worry that will be preoccupying markets this year is the risk of sovereign debt default. Here is a timely comment on the subject from Jim Leaviss, head of the bond team at M&G.

Over the past couple of weeks, the cost of buying protection to insure against a default by the UK government has risen to exceed the cost of insuring a basket of European investment grade companies.  The chart shows that 5 year Credit Default Swaps (CDS) for the UK sovereign are currently at 83bps per year, compared with 72 bps for the investment grade companies, which are all lower rated than Her Majesty's government and unlike the UK, the last time I looked weren't allowed to print bank notes to repay their debt.  So it doesn't look right.  But noises about a downgrade of the UK continue, and the plans from both the government and the opposition to reduce the debt remain unconvincing.

 

 

 

 

 

 

 

 

 

 

 

 

Elsewhere we've had sovereign debt scares in Dubai and in Greece, and yesterday in Iceland the President exceptionally overruled the legislature and stopped a payment to the UK and the Netherlands of £3.4 billion to cover money lost by savers in the Icelandic banks.  Fitch downgraded Iceland to BB+ yesterday, although the bigger agencies still have the country in investment grade, but only just.  Iceland CDS now trades at 470 bps. 

The decision by the Icelandic people isn't surprising, as the payment amounts to around £10,000 per person - a massive burden.  I can't imagine that UK voters would agree to make such a payment to a foreign government should the table be turned, and the Icelandic economy is in a worse state than ours.  An article in today's Irish Independent by David McWilliams is therefore a little worrying, as it probably does reflect the popular view that default is a better option that a strong credit rating or than having to wear a hair-shirt for a decade. 

Ireland has entered into significant austerity measures (including large pay cuts for civil servants) in order to restore the nation's finances.  McWilliams concludes "Iceland proves there is an alternative - are any (Irish) politicians, from the President down, prepared to listen?".  2010 could be a year of angry populations and wobbly governments.

Comment:  Sovereign default by a developed country is not something that investors have spent a lot of time worrying over much about in the last few years, so if you are a worried, this is definitely one to add to the list.  The central issue raised by the Icelandic situation is also one of political will and political legitimacy. Who pays to get us all out of this mess?