Financial Market Turmoil Could Cut UK's 2008 Economic Growth By 1%

The ongoing credit crunch could significantly reduce U.K. economic expansion over the next couple of years, and leave financial services growth looking vulnerable, the Ernst & Young ITEM Club warned Friday.

Despite persistently robust U.K. economic data, ITEM is concerned that the impact of the credit crunch will spread from financial services to the real economy, and the retail and housing markets appear to be most at risk, it said. "A worst case scenario of a full-blown credit crunch could would reduce U.K. GDP (gross domestic product) growth by around 1% in 2008 and 2009," said Peter Spencer, chief economic adviser at the independent forecasting group. Financial institutions could face large losses as a result of the turmoil outright, while the additional need for banks to refinance off-balance sheet entities will result in further pressure on their resources and damp corporate investment. Spencer noted that the credit squeeze has prompted a slowdown in structured product deals and leverage buyout activity, meaning under current conditions "we are unlikely to see mega deals and mega bonuses." This will have a "ripple effect" through the economy, he said. Given the U.S. subprime mortgage market is worth around $1.5 trillion, losses for financial institutions could be $100 billion to $150 billion, and further losses from low-grade debt and leveraged buyout lending will ensue, he said. ITEM also addresses the potential fallout in the U.S. and the euro zone. Stressing the difficulty in predicting the ultimate impact, the report says the euro-zone is likely to be less affected than the U.K., but the U.S. could face a reduction in GDP growth "as high as 1.5%." Spencer said that property markets represented a further risk to world growth. "The U.S. housing sector has been weakening for some time and now faces a double dip depression," Spencer said. "Not only are there direct threats to growth via lower construction activity, but there must be concerns that a further rise in mortgage delinquencies would add to the risk of a generalized credit crunch," he said. While the dynamics of supply and demand are very different in the U.K. compared with the U.S., the slowdown could prove contagious to the housing market this side of the Atlantic, the ITEM report warned. "Two million U.K. fixed-rate borrowers also face a crunch of their own when their cheap fixed-rate mortgages expire towards the end of this year," the report said. "When they do they are likely to see far more stringent conditions around the conditions that U.K. lenders offer as well uplift in the monthly cost," it said. In spite of the risks, ITEM believes the current crisis is manageable. The report suggests governments could consider a temporary relaxation in regulatory capital requirements to ease the impact of balance sheet adjustments and ward off the threat to growth.