How have world shocks affected the UK economy?

Shiv Chowla, Lucia Quaglietti, Łukasz Rachel 26 November 2014

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The importance of world shocks for the UK since 2007

The importance of world shocks for the UK economy is well illustrated by the period since 2007. Over that time, world shocks such as the stresses in global financial markets over 2007–09, the steep fall and rise in global commodity prices over 2008–11 and, and since 2010 – the Eurozone crisis – have shaped macroeconomic developments in the UK (Armstrong et al. 2014).

In a recent Quarterly Bulletin article (Chowla et al. 2014) we estimate four different structural Vector Autoregressive (VAR) models in order to gauge the relative importance of world shocks on UK output over time. All the variants are based on two ‘blocks’, a UK block and a world block. This setting allows us to identify three different shocks and their impact on UK output:

  • World demand shocks;
  • World supply/price shocks, and
  • World financial shocks.  

We find that the UK’s early 1990s downturn was mostly driven by domestic, rather than external factors. During the ‘Great Moderation’ world shocks generally exerted a positive impact on the UK, possibly reflecting loose global credit conditions and a low perception of risk, as well as healthy growth in overseas demand. Focusing on the influence of world shocks in the period 2007-2013, we find that UK’s GDP growth has largely been shaped by global developments. World shocks deducted over 6 percentage points from annual UK’s GDP growth at the height of the recession (Chart 1). The subsequent recovery was held back by world shocks too. This result is consistent with Hackworth et al. (2013), who find that disappointing global growth and high commodity prices accounted for a significant part of the unexpected weakness in UK’s GDP after mid-2010. Interestingly, a large part of the pickup in UK growth since 2012 appears to have been driven by a waning of the drag from world shocks.

Figure 1. Estimates of the historical impact of world shocks on UK activity

Source: Bloomberg, Bureau for Economic Policy Analysis, IMF, OECD, ONS, Thomson Reuters DataStream and Bank calculations

(a) World shocks are average estimates across the four variants of the structural vector autoregression modes.

(b) The line for UK GDP shows UK growth relative to average over the period 1988-2007, which is 3.1%. The contributions of world shocks are relative to model consistent trend growth rates.

We also find that the identified world shocks can explain why level of UK’s GDP at end-2013 was around 11% lower than a simple counterfactual of a continuation of the pre-crisis trend would have predicted.

These results, therefore, suggest that around two-thirds of the current shortfall in output in the UK relative to pre-crisis trend came about as a result of world shocks.

Chart 2 sets out estimates for the individual contribution of world demand, world supply/price, and world financial shocks to the shortfall on the level of UK’s GDP in the period 2007-2013, relative to the simple counterfactual of the pre-crisis trend.  The models suggest that two shocks – world supply/price shocks and world financial shocks – were particularly important. The world demand shocks played a role in the early stages of the financial crisis, but their impact has since diminished.  As the width of the swathes illustrates, there is substantial uncertainty about the ‘source’ of the shocks; some variants suggest that world financial shocks played a bigger role than world supply/price shocks, while others suggest that the two had a similar impact.

Figure 2. Estimates of the impact of three world shocks on the level of UK’s GDP since 2007, relative to trend

Source: Bloomberg, Bureau for Economic Policy Analysis, IMF, OECD, ONS, Thomson Reuters DataStream and Bank calculations
Notes: Charts show the estimated impact of the shock on the level of UK GDP, with separate lines for each of the four estimated models. The swathe illustrates the range of impact across the models. Pre-crisis trend estimated over the period 1988-2007 is 3.1%. The model estimates are relative to model-consistent trend rates

Through which channels do world shocks affected the UK?

It is UK’s trade and other linkages with the rest of the world that allow for the transmission of world shocks. We find that three channels are likely to have been particularly important since 2007.  

First, some of the impact of world shocks has come through the trade channel, as demand for UK exports weakened and UK import prices increased.  
Second, world shocks led to a tighter supply of credit and more volatile asset prices in the UK — the key mechanisms of the financial channel.  
Third, the close comovement of measures of UK economic uncertainty with those of other countries suggests that the uncertainty channel has also played a role in the transmission of world shocks.

The Bank’s main forecasting model COMPASS suggests that, at its peak, the collapse in world trade detracted significantly from annual UK growth (Chart 3). Around 2% of the total shortfall, relative to trend, in the level of the GDP by end-2013 was due to world shocks being transmitted to the UK through the trade channel. While clearly significant, this represents only around one-fifth of the total weakness in UK’s GDP allocated to world shocks in our VAR estimates. Four-fifths of world shocks since 2007, therefore, appear to have affected the UK economy through other, ‘non-trade’ channels (Table A), mainly through financial channels and uncertainty.

Figure 3. Estimated impact of world shocks on UK’s GDP through the trade channel

Source: IMF, OECD, ONS, Thomson Reuters Datastream and Bank calculations

Notes: Green bars are differences between orange and blue lines and show estimates from Compass that capture the trade effects of shocks that originate outside the United Kingdom. And while they do not capture the direct effects on UK GDP of any other shocks that are common to both the United Kingdom and other economies, they do include the “second-round” trade spillover effect of those common shocks.

Table A. Channels through which world shocks have impacted UK’s GDP

 

Note: Average of structural vector autoregressive models discussed above

Stylised evidence and previous studies corroborate these findings. For example, there is strong evidence that banking channels played an important role in the transmission of world shocks to the UK economy during the Global Financial Crisis. Broadbent (2012) points out that major UK banks’ losses were, in large part, on their non-UK portfolios (Chart 4) which, in turn, is likely to have led them to restrict their lending to the UK economy. Furthermore, lending from non-resident UK banks to the UK weakened more sharply than credit from resident UK banks over 2007–09. And Aiyar (2011) argues that every 1% reduction in UK banks’ external funding was associated with a 0.5%–0.6% contraction in the flow of domestic lending. 

The close correlation of uncertainty measures across the UK and its main trade and financial partners since 2007 (Chart 5) suggests that this may also have been a channel for the transmission of world shocks to the UK. The start of the US sub-prime crisis in 2007 and Eurozone crisis from 2010, for example, are likely to have increased the uncertainty of UK households and firms about the domestic economy and prospects for their own income and revenue.

Figure 4. Losses of major UK-owned banks by portfolio, 2008-11

Figure 5. Measures of uncertainty across countries

Sources: FSA regulatory returns, published accounts and Bank calculations

Notes: Losses are defined as sum of impairment, write-off, trading book and goodwill losses. Impairments and write-offs are taken from FSA regulatory returns. These data are indicative. Goodwill impairments are calculated on a pro-forma basis and may be subject to error. Non-UK entities include banks and other financial institutions. Due to sampling and definitional differences, these may not match these disclosed in published accounts or in the Bank of England’s Bank.stats. Banks covered in the chart are Barclays, Co-operative Bank, HSBC, Nationwide, Royal Bank of Scotland and Santander.

Sources: Eurostat, ONS, Thomson Reuters Datastream and Bank calculations

Notes: Uncertainty indicators for the UK, Eurozone and US include option-implied volatility of exchange rates and equity prices, survey measures of confidence, and measures of the dispersion of earning growth expectations over the next twelve months. The uncertainty indicator for the UK also includes: dispersion of annual GDP growth forecast, measures obtained from press articles citing ‘economic uncertainty’, and measures from the Confederation of British Industry’s Quarterly Industrial Trends and Service Sector surveys related to companies’ capital expenditure.

Conclusion

The global economy has been an important influence on UK’s output and inflation over the recent past. Model-based estimates suggest that world shocks played a very important part in the 2008–09 downturn in the UK, and account for around two-thirds of the weakness in the level of UK’s GDP since 2007, relative to its pre-crisis trend. Transmission through the trade channel, however, can only account for around a fifth of the impact of these shocks on the UK. Financial channels and uncertainty are likely to have been more important.

References

Armstrong A, F Caselli, J  Chadha, W den Haan (2014), “UK macroeconomists see potential for higher growth”, VoxEU.org, 14 April

Broadbent, B (2012), “Deleveraging”. 

Chowla, S, Quaglietti, L, Rachel, L (2014), “How have world shocks affected the UK economy?”, Bank of England Quarterly Bulletin, Vol. 54, No. 2, pages 167-79

Hackworth, C, Radia, A and Roberts, N (2013), “Understanding the MPC’s forecast performance since mid-2010”, Bank of England Quarterly Bulletin, Vol. 53, No. 4, pages 336–50

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Topics:  Europe's nations and regions Global crisis

Tags:  UK, output shocks, world shocks, VAR models

Economist in the UK Forecast Team of the Monetary Analysis directorate, Bank of England

Economist in the International Surveillance Division in the International Directorate, Bank of England

Senior Economist, Bank of England; PhD candidate, London School of Economics

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