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London’s Economy Today – July 2021 editorial

The economy continues to pick up gradually although difficulties are becoming apparent

Despite increasing COVID-19 infection rates the government lifted most of the remaining social and business restrictions on 19 July. The economy continues to grow following the series of easings of the January lockdown restrictions. According to the latest data from the Office for National Statistics (ONS) the UK economy grew by 0.8% in May, and, although this is the fourth consecutive month of growth, the economy remains 3.1% below its pre-pandemic level in February 2020 (Figure 1). The UK-wide service sector, which is of particular importance to the London economy, grew by 0.9% in May, and remains 3.4% below its February 2020 level. More noticeably, within the service sector, Accommodation and food service activities grew by 37.1% in May as restaurants and pubs welcomed customers back indoors following the easing of coronavirus restrictions on them. Despite the increase, the size of the sector remains 18.3% below its February 2020 level, while Arts, entertainment and recreation remains a quarter smaller. More positively Finance, Public administration, and Wholesale and retail have recovered to their pre-pandemic levels.

Figure 1:

On the day of the lifting of social and business restrictions, European equities had their worst day of the year as the growing threat of the Delta variant triggered falls in global share markets and commodities. The London FTSE 100 shed 2.3%. It is thus becoming less evident that widespread vaccination by itself will be sufficient to contain the impact on the economy of the spread of the virus. The Prime Minister, Boris Johnson, has not ruled out re-introducing a wide range of restrictions.

London remains reliant on the furlough scheme despite labour market improvements

As a first step towards the ending of the Coronavirus Job Retention Scheme, at the end of September, from 1 July employers needed to contribute 10% of the wage of any employees on furlough. This is part of the withdrawal of the package of financial support to help businesses and households through the pandemic crisis. It includes the ending of the £20 weekly uplift in Universal Credit and the stamp duty holiday, and the increase in the VAT rate for hospitality, accommodation and some attractions from 5% to 12.5%.

The UK labour market looks healthy as the number of employee jobs, as measured by the HM Revenue and Customs (HMRC) Real Time Information system, has increased by 1 million between February and June from 28.0m to 29.0m. The corresponding increase for London has been 150,000 to 4.0m employee jobs. However, London is the only country or region of the UK where employee jobs (including people on furlough) is now not higher than pre-pandemic levels in February 2020.

London continues to be more reliant on the furlough scheme than the rest of the UK (Figure 2). The number of furloughs of jobs in London has fallen from 753,000 in mid-January to 419,000 by the end of May, or by less than half. For England the number of furloughs has fallen from 4.0m to 2.0m or by half.

Take-up has been higher in Accommodation and food services, and Arts, entertainment and recreation sectors, and was over half of all employees in these sectors in both London and England in March. While there had been dramatic falls for both geographies in the take-up rate by May, it was still markedly higher than for other sectors, and the fall was larger for England.

Figure 2:

The hospitality sector in London faces particular challenges as international tourists have not been coming in significant numbers, and workers have also been slow to return to the office. Footfall and spend data, collated by the Centre for Cities, reveals that the recovery has lost momentum. London is the city with the lowest footfall recovery. Across the cities of the UK a slow return to the office is associated with a weak recovery in the night time economy.

As a sign of misallocation of resources the sectors where it is most common to use the furlough scheme are also the sectors with fast rising numbers in job vacancies. The ONS notes that in Accommodation and food services, “there is evidence of a shortage of skilled staff and of employees finding alternative areas of employment prior to the reopening”. It is a sector which employed a high proportion of workers from the European Economic Area, some of whom may have returned home rather than face uncertainty around their future prospects in the UK labour market soon after COVID-19 became prevalent.

The number of UK job vacancies in the three months to June has climbed past pre-pandemic levels in the first three months of 2020. The rise was driven by vacancies in Accommodation and food services and Retail, while Arts, entertainment and recreation recorded the sharpest rise in vacancies.

A further challenge for the Accommodation and food services sector is the numbers of people self-isolating after a notification from the Test and Trace system. UK Hospitality said one in five staff in the sector were self-isolating but that businesses were experiencing surges with more than a third of staff missing in some areas. The context is that in the week ending July 14, more than 600,000 contact-tracing alerts were sent to residents in England telling them to self-isolate. The Prime Minister defended the Test and Trace system as individuals identified as contacts of cases were at least five times more likely to eventually contract the virus. This has also caused growing concerns about staff absences in essential industries, and the government has responded by announcing that workers from 16 key sectors including health and transport will not have to isolate if notified.

This will not include the retail sector, and some supermarkets have faced difficulties stocking some shelves. As an indication of the scale of the problem Iceland, in response to 1,000 staff being notified by the Test and Trace system, plans to hire 2,000 temporary extra store staff to cover absences.

Inflation continues to rise sharply

Inflation rose strongly in the UK and the US in June but fell slightly in the Eurozone. Annual inflation in the UK reached 2.5% in June, above the Bank of England’s central symmetrical target of 2%, up from 2.1% in May, and 0.4% in February. This is the highest annual inflation rate since August 2018, although it remains below the level reached after the exchange rate depreciation following the EU Referendum. Inflation in the United States rose to 5.4% in June, the highest rate since before the financial crisis more than ten years ago (Figure 3). In comparison, annual inflation fell slightly in the Eurozone from 2.0% to 1.9% in June.

Figure 3:

Differences in opinion about whether increases in inflation would be temporary or persistent became prominent when the former Chief Economist at the Bank of England (BoE), Andy Haldane, and the Governor of the BoE, Andrew Bailey offered different perspectives recently.

Andy Haldane argued there were three sources which might lead to persistent price inflation:

  • The opening up of the economy as COVID-19 restrictions are lifted;
  • A powerful fiscal and monetary response to the crisis which was likely to generate more demand than needed for recovery;
  • Spending of private sector savings that people and businesses had hoarded during the crisis.

In favour of this argument is the pace of rising inflation, and that in the UK price rises have been widespread, although other factors may also have played a part:

  • Brexit – the introduction of barriers to trade, even though there are zero tariffs on goods, will have made the imports of goods and services more expensive;
  • The third consecutive month of higher than expected inflation indicates that businesses have responded to the relaxation of restrictions with an effort to build profit margins.

Andrew Bailey gave three reasons why the increase in inflation might be temporary:

  • The recovery from the pandemic was unusual because supply was getting back to normal at the same time as demand so it was likely that there would be temporary imbalances, or bottlenecks, in some sectors. Many of the factors behind these constraints are global in nature, reflecting shortages of products and transport capacity, set against the strength of the recovery to date and expectations of strong future growth;
    • In the US price jumps have so far been most significant for sectors directly affected by the pandemic, and where supply is trying to meet pent-up demand. For example, airfares have soared, while a semi-conductor shortage for new cars has contributed to a jump in used car prices;
    • In the UK there have been price increases for food and for second-hand cars where there are reports of increased demand.
  • Some of the inflation now being measured arose simply because prices had fallen a year ago so the comparison was with the depth of the first wave of the pandemic. This is the case for fuel prices;
  • Spending was likely to be directed at parts of the economy with spare capacity as patterns of demand normalised.
    • In June in the UK there was an increase in prices for clothing and footwear, compared with the normal seasonal pattern of summer sales.

Opec+ responded to the rise in oil prices by agreeing to increase global production by 400,000 barrels a day each month into 2022. This will have a dampening effect on the growth in inflation.

More broadly, and in favour of caution in the pace of tightening monetary policy, UK and US labour markets remain short of pre-pandemic employment levels, the fiscal stimulus is being withdrawn, and fallout from the crisis on a global scale could still pose risks for both economies.

The House of Lords (HoL) economic affairs committee, which includes distinguished economists Mervyn King (also a former governor of the BoE), and Nicholas Stern, has concluded that there were “risks, given where the economy is, that inflation could take off”, and while the BoE says that it will be temporary, it should spell out “the plan if it turns out that is not the case”. If the BoE “does not respond to the inflation threat sufficiently early, it may be substantially more difficult to curb later”. Reining in the government’s fiscal support, such as the furlough scheme, over the coming months will ease inflationary pressures, but the BoE is still planning to extend quantitative easing (QE), which risks being inflationary.

The effect of the UK’s much faster than anticipated rise in inflation is that market expectations of the next interest rate rise have been brought forward to late 2022 from mid-2023. While, the HoL report calls for the BoE to outline a road map that demonstrates how it intends to unwind QE.

Banks continue to have the capital and liquidity to support the UK economy

The Bank of England published its latest Financial Stability Report in July with its current view on the stability of the UK financial system. Support from the financial system and the government has helped to keep business insolvencies relatively low. UK debt vulnerabilities have increased modestly. The increase in indebtedness has been more substantial among Small and Medium sized Enterprises (SMEs), and in some sectors, particularly those most affected by restrictions on economic activity – these firms may be more vulnerable to increases in financing costs. A large part of the additional debt has been issued at relatively low interest rates via government sponsored loan schemes. Households and businesses, though, are likely to need continuing support from the financial system as the economy recovers and the government’s exceptional support measures unwind over the coming months. There is a risk that banks may cut lending to defend capital ratios rather than support viable, productive businesses with an adverse effect on the economy, and perversely banks’ capital ratios.

Ministers prepare for a tough spending round

The Chancellor, Rishi Sunak, is due to announce a three-year spending settlement for government departments in the Autumn. The Exchequer has a £300bn deficit at a time of huge pressures on public services. Higher inflation will reduce the value of cash settlements and rising interest rates would increase public borrowing costs. The NHS, schools and defence have already secured long-term spending settlements. After a decade of austerity, the spending envelope announced at the Spring Budget indicates that other departments face a real-terms cut in their budgets for 2022/23 and only a 1% increase in the following years. The Institute for Fiscal Studies (IFS) has noted that this would mean spending up to £17bn less on services than what was planned prior to the pandemic, despite rising costs and rising demands. Paul Johnson, the director of the IFS, has commented, “The chancellor’s medium-term spending plans simply look implausibly low”. The Office for Budget Responsibility has said that there was at least £10bn a year of additional spending arising from the pandemic. There are also spending pressures on the NHS, schools, courts and social care.

International agreement to set global minimum corporate tax rate

One hundred and thirty economies, including the world’s leading economies, have signed up to a plan to require multi-national companies to pay a global minimum corporate tax rate of at least 15%. This will ensure that the largest companies, including Big Tech, luxury goods groups, and pharmaceutical companies, pay at least $100bn a year more in taxes, with more of that money going to the countries where they do most of their business. The Organisation for Economic Cooperation and Development (OECD), where the talks were held, said the rules should be put in place next year and implemented in 2023.

Certain industries will be exempt from the agreement, including of particular relevance to London, the financial services sector. It is already the case that regulation forces banks to be separately capitalised in every jurisdiction in which they operate, so that they declare profits and pay tax in the countries where they do business. In return, the UK has agreed to dismantle its digital services tax which is focused on American technology companies.

The process of decoupling the UK and EU economies continues after Brexit

There continues to be political tensions between the UK and EU around Brexit. The UK government has put forward new proposals to adapt the Northern Ireland protocol, which the EU has rejected. The EU has suggested that the UK would be obliged to pay €47.5bn (£40.8bn) for past commitments. This is a higher sum than previously thought, and HM Treasury has insisted that the settlement remains within its previous central range as there are differences in methodologies employed.

The process of some companies re-locating some or all of their businesses from the UK to the EU continues. JP Morgan has made Paris its hub for EU financial trading in the absence of an EU-UK equivalence agreement for trading in financial services. While, OpenStreetMap is looking to move part of its operation to the EU due to the lack of agreement for mutual recognition of database rights.

Foreign Direct Investment in London had been growing

For the first time the ONS has published at a sub-national level experimental statistics of the UK stock of Foreign Direct Investment (FDI), that is the sum of investment flows over time less depreciation. The UK stock of FDI increased by over 50% between 2015 and 2019 from £1,030bn to £1,560bn. London, of the UK countries and regions, benefits the most receiving 40% of the investment over each year of the period, with the total rising from £415bn in 2015 to £660bn in 2019. The South East of England is the next most important destination for this investment, and with London, accounts for over half of the stock of FDI in the UK (Figure 4). There was, however, a slight dip in the stock for London and the UK in 2019.

Figure 4:

Higher investment in London is not simply a matter of the relative size of London’s economy. London also had the highest inward stock of FDI per job in 2019. For every job in London, there is £109,000 of FDI stock, followed by the South East, which has £40,000 of FDI per job.

For the UK, and nine of the twelve of its countries and regions, the EU is the most important source of the FDI stock, at 44% of the total stock. For London, the value of the FDI stock from the Americas (37% of the total) was higher than for the EU (30%). Some of this investment in the past may have been to use the UK as a gateway to EU markets.

We will continue to review how London’s economy develops, and examine impacts and recovery from the COVID-19 crisis in our research, which can be found on our publications page and on the London Datastore.