View from the City: Sir Howard Davies on the UK economy

Sir Howard Davies, Chair, NatWest Group, discusses his thoughts on what will affect growth as the UK ramps up for another general election.

Andrew Putwain: Given current discussions around the UK economy and recessionary conditions, do you see a consensus of monetary and fiscal policy around a stable tax environment across the political spectrum, to encourage spending? How do concerns about unlocking insurance capital to fuel growth fit into the equation? 

Sir Howard Davies: The International Monetary Fund’s (IMF) forecast is that the UK will avoid a recession this year, which matches my experience. Whilst we are seeing a slowdown in spending, the conditions do not suggest that the economy is going into reverse. We're going to see a low-growth environment as opposed to an absolute recession.

Unfortunately, we can expect interest rates to remain high for a while. The IMF also noted that inflationary pressures remain quite strong in the UK, and therefore it will take longer for interest rates to start to go down.

As for fiscal policy, after last September – with the Truss-Kwarteng interlude – we’re in a difficult position. The government has had less flexibility on this issue because markets were scarred by what they saw. So, the government’s priority has been to rebuild credibility.

"The changes will be about reorganising and re-orientating that
 investment in more positive directions."

Eventually, credibility will be rebuilt, and the government has made sensible moves in that direction. But people shouldn’t expect a short-term change in tax because the priority is still to reassure markets and investors that the government is committed to long-term fiscal prudence.

As for how regulation can make a difference, there is a reform of Solvency II in progress. It's being reformed both here, in the UK, and the European Union (EU) in different ways. Regulators across Europe have realised that the current regime imposes too severe constraints on some forms of insurance investment – particularly long-term infrastructure investment, which is effectively penalised under the original version.

We could see a resulting relaxation, but my feeling is that it’s more likely we’ll see a change in investment profile rather than an increase in the quantum, as regulation cannot invent new capital that doesn’t exist. The changes will be about reorganising and re-orientating that investment in more positive directions.

Andrew: Inflation has eased slightly over the past few months; considering this, what should investment teams expect in terms of its impact on growth? How will government policies change to reflect this experience?

Sir Howard: The conventional wisdom, which has a lot of research and analysis behind it, is that interest rate changes take 18 months to two years to have an effect on growth and inflation.

"One thing inflation does is devalue the quantum of your debt, which
is fixed in nominal terms, so the debt interest line is going down in real terms."

The rising interest rates, which began in early 2022, will take effect later this year. So, we will have some downward pressure on investment and spending later this year.

The question then becomes whether the government can afford to offset that by fiscal relaxation. There are grounds to think there could be some room because the government's debt burden has been going down. One thing inflation does is devalue the quantum of your debt, which is fixed in nominal terms, so the debt interest line is going down in real terms – which means flexibility there.

We've also seen a lot of fiscal drag as tax thresholds have been frozen, which brings more people into higher rate taxes and therefore boosts the government's tax receipts. That means that the government may have some flexibility on tax rates.

By later this year, you will start to see more chatter about that in the next budget, which could begin some fiscal relaxation – convenient for the government because there's an election coming up.

Andrew: As the UK ramps up to its next general election do you foresee ‘sweeteners’ for the City – for example, trying to ease the loss of high-value opportunities regarding Domestic Initial Public Offerings (IPOs), or greater access to green bonds – by the government or by the Labour Party? Is there a significant difference between the incentives offered by Conservatives and Labour?

Sir Howard: The problem is that there's not a lot that the government can do; there are only so many levers it can pull.

The government has commissioned reports on capital raising in the City by Lord Hill and others. Sensible changes are being proposed by stakeholders – for example, how to enable retail investors and improve efficiency as well as choice and cost, and a focus on modernising pre-emption rights.

The Financial Conduct Authority (FCA) has proposed some adjustments as well on capital raising from the regulatory perspective.

"As for the difference between the Conservatives and Labour,
it’s difficult to tell because Labour is keeping their powder dry."

I'm not opposed to the ideas floated, but whether they will unblock a flood of IPOs in London as a result remains to be seen. I hope that we're in a trough and that things will pick up later in the year, but I doubt if the regulatory changes are going to make a massive amount of difference.

It's going to be a question of mood and whether people think that there are optimistic economic conditions around the corner and it's therefore a good time to begin to float things.

As for the difference between the Conservatives and Labour, it’s difficult to tell because Labour is keeping their powder dry. I don't detect in my conversations with senior Labour people that there's any sense of resentment about the City, but I don't think that the City can expect any particular favours from Labour.

I don't imagine they're going to be taking off the bank levy anytime soon, but then neither are the Conservatives.

The private equity market is concerned about the tax treatment of carried interest, which is a particular issue for them. That may have some effect on the location of private equity houses in London, but, to be blunt, it's not that there are that many more favourable tax regimes elsewhere – though there could be movement there.

Andrew: Looking specifically at the proposed changes to UK Solvency II rules, where are the biggest challenges and opportunities? The Bank of England (BoE) have said they could see an increase by 0.1% of bankruptcies in life insurance firms if capital reserve rules on real assets are loosened, but the Government has speculated that £100 billion in capital would be unleashed. Do you think it’s too risky or a much-needed change to achieve levelling up and Just Transition goals?

Sir Howard: There are opportunities to improve Solvency II without putting the future of the insurance industry at risk.

Some adjustments to the risk matching process to allow longer-term investments and longer-term infrastructure projects make a lot of sense. That has been an unintended consequence of Solvency II: making it difficult for life insurance companies to invest in long-dated infrastructure and similar assets.

The UK needs infrastructure projects that do require long-term capital and life insurance companies are a good source of that because they do have very long-term liabilities.

The BoE may be slightly exaggerating the risks. This is not going to be a radical change in investment in the UK. It will give insurers more flexibility to invest in some longer-term assets, which is important because there are not many investors that are well placed to invest very long term in that way. So it’s good, but it isn't going to create money that doesn't already exist.

Andrew: What other ways should insurers – and specifically investment teams at insurers – be looking at for achieving growth? Are there more regulatory areas that could be curbed, or do you think there are untapped areas of growth opportunity that aren’t being explored?

Sir Howard: Investors need to look at the balance between public and private equity. It's well-tested that private equity investments have done better than public markets – and over a long period, too, which is why the notion of ‘alternatives’ is a peculiar one.

"Private equity and venture capital remain important things that
insurers should be looking hard at."

The name gives you a sense that this is a punt with, say, 1% of a fund – whereas that’s not the way it’s thought of now.

Private equity and venture capital remain important things that insurers should be looking hard at.

One has to note that some of the ways in which insurance and pension fund investments have been orientated have been driven by changes to pension structures compared to when you had defined benefit (DB) schemes with a principle of infinite life.

Andrew: Beyond Solvency, more rules around sustainability and ESG could be established. How would such reforms impact economic growth, investment in the green transition, and the viability of net zero commitments?

Sir Howard: It's going to be more a question of performance than the actual rules. There are changes coming in that are having an impact such as the BoE altering its bond-buying profile to favour ESG funds, which is likely to alter relative yields.

Probably more important is that there's evidence that ESG-type funds have outperformed conventional funds. Market experts have done calculations retrospectively constructing what an ESG fund would have looked like if you'd held it, and those numbers suggest a high degree of performance. As a result, I'm not sure that it's going to be rules that drive change. It's going to be people's perception of which companies are likely to benefit from the move towards net zero, even if that turns out to be somewhat longer than we hope.

We banks have to think about that – along with considering the companies to which we lend – so that we’re not lending to institutions with collateral that is effectively carbon in the ground that they may not be allowed to get out. I'm not sure that the regulation is going to drive this in the capital markets, but it could be more investors’ perceptions of what a sensible positioning for the implications of net zero will be.

Sir Howard Davies will be speaking at the Insurance Investor Live | Europe Summit on 20th September in London, discussing the topic of “Examining the function of monetary and fiscal policy and the role of regulatory oversight – can a relaxation in rules and inflation targets prompt real economic growth?”.