The implications of the credit crunch

A key uncertainty facing the UK economy at present is how far the effects of the recent credit crunch will spill over from banks and other financial institutions to the rest of the economy. In Section III below we have explored this in more detail, highlighting the way in which this can impact the wider UK economy through:

• reducing the availability and increasing the cost of both bank lending and bond and equity finance;
• depressing house and share prices, with potential adverse wealth and collateral effects on household spending and business investment;
• a general increase in uncertainty feeding through into reduced business and consumer confidence and spending; and
• adverse impacts on UK exports to (and repatriated profits from) the US and other economies hit by the direct and indirect effects of the global credit crunch.

We particularly highlight the potential impact on the business and financial services sector, which now accounts for around 28% of UK GDP and has been the mainstay of economic growth over the past ten years. As shown in Figure 1.3, we expect growth in this sector to drop sharply in 2008 in response to the credit crunch. Compared to the heady growth of recent years, this may feel like a recession to many firms operating in these sectors, even if it is actually just a marked slowdown in growth rather than an actual contraction in output.

Our analysis in this section also highlights the importance of businesses monitoring leading indicators to detect any early warning signs that a more severe downturn scenario is materialising (in addition to the stress testing recommended above). The relevant indicators to consider will vary by business, but general variables that have in the past shown some useful leading indicator properties would include share prices, business and consumer confidence surveys, yield curve slopes, housing starts and company financial balances.

[1] Business investment is the largest component of total fixed investment, which also includes housebuilding and government investment. In recent years, however, government investment has been the fastest growing category within total fixed investment.