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UK Government Under Pressure: Is Sterling Set for Fall?

Friday, 17 Aug 2012 | 9:08 AM ET

The U.K. economy has got economists all a-flutter with a series of confusing data, causing more criticism of the coalition government’s policies as it prepares for a high-profile job swap.

Britain's Prime Minister David Cameron (front 2nd Left) calls an end to a group picture with his new cabinet ministers in the garden of Number 10 Downing Street in London, England.
Getty Images
Britain's Prime Minister David Cameron (front 2nd Left) calls an end to a group picture with his new cabinet ministers in the garden of Number 10 Downing Street in London, England.

The recent rebuking of Chancellor of the Exchequer George Osborne’s deficit-cutting program by members of an influential group of economists who previously supported him is a case in point.

“It’s very difficult to get a serious economist to say that the government did the right thing then and now. That’s no longer an intellectually credible viewpoint,” Jonathan Portes, director of the National Institute of Economic and Social Research, told CNBC Friday.

Osborne has clung on to the U.K.’s maintenance of its triple-A credit rating as a vindication of his policies, but the criticism of cuts to government spending remains.

Ratings agencies Moody’sand Fitch have warned that they may downgrade the UK from triple-A status if government borrowing and debt rose higher than forecast – which looks increasingly plausible.

“It’s not clear that a downgrade will matter. The agencies will merely be stating the obvious: that the UK’s debt and deficit are rather high,” analysts at Credit Suisse wrote in a research note.

The UK’s economy shrank (Read More: Don’t Read Too Much Into UK GDP Gloom: Economist) by 0.7 percent in the second quarter of 2012—but recent data showed better-than expected unemployment (CNBC Explains: What Is Unemployment?) rate of 8 percent and a surprise rise in retail sales, suggesting that the picture is better than first appeared.

Many economists still argue that the Gross Domestic Product (GDP) figures don’t reflect underlying economic activity, but they will still impact forecasts. Credit Suisse argue that growth for the year will be closer to zero than the 0.8 percent forecast by the Office for Budget Responsibility(OBR).

The calls for the government to do more to stimulate job growth, possibly by taking advantage of historically low borrowing rates to fund infrastructure programs, are growing. The divisions between the two parts of the coalition government seem to be growing, as speculation about a reshuffle of the Cabinet increases.

“It’s basic common sense to say that when borrowing rates are at historically low levels and you have lots of unemployed people, creaking transport infrastructure and a low in housebuilding, you should put these people and resources to work,” Portes said.

“The fiscal consolidation plan was a mistake two years ago, and we can now see in retrospect that is was.”

One of the arguments against job creation programs was that the U.K. might suffer on the bonds markets if it was borrowing more to fund new building.

“This government is now borrowing even more, yet these bond market vigilantes haven’t emerged.

That’s because the people who talked about the gilts markets going up didn’t know basic economics,” Portes said.

“We have a structural shortage of housing supply and the biggest drag on GDP (CNBC Explains : What Is GDP?) in the last two quarters has been construction. This isn’t the euro zone crisis—it’s the direct result of the fall in public sector investment.”

Portes argued that the government also needs to introduce more supply-side reforms—and highlighted the government’s introduction of restrictions on skilled labor.

“Supply side reform is always important. It’s important whether you’re in a recession or not. That determines long-run prosperity. We need to work out the most important things. Planning reform matters a lot; transport infrastructure, especially in aviation and immigration,” he said.

The risks for sterling are growing as the Bank of England continues in “wait and see mode,” according to currency strategists at HSBC. (Read More: BoE Chief Urged to Widen Recovery Measures)

The U.K’s currency has gone close to four year highs against the euro in recent weeks, and remained stable against the dollar – a substantial rise from the lows hit last July.

Weakening exports, leading to a widening trade deficit, in the second quarter are also cause for concern.

Foreign investors and even UK banks are cutting some of their exposure to gilts, suggesting that the Bank of Englandis propping up the market. Lower mergers & acquisitions inflows also suggest an increasing negativity about investing in the UK.

With the growing storm of bad news around the banking sector, come fears that the government’s liabilities in that area may increase, too.