Good news on UK growth — but eurozone casts a shadow

The upward revision, from an initial estimate of 0.2% growth, is welcome but far from spectacular. Growth of 0.3% in the first three months of the year is slower than the 0.4% expansion seen in the final quarter of 2009.

But as today's stock-market falls indicate, the question now is: Can the fragile recovery be sustained?

The Bank of England and the Treasury expect growth of more than 1% this year and more than 3% next year. City economists are more sceptical and predict growth of just 2.3% in 2011.

Headwinds which could blow the recovery off course include:

Europe

Europe is Britain's biggest trading partner and more than half of UK exports (54%) go to the European Union. What happens in Europe, therefore, has a significant impact on what happens here.

The debt crisis in Greece and other Club Med countries such as Spain and Portugal threatens to kill off the fragile economic recovery in the entire eurozone.

Long-term economic stagnation in the eurozone will hit demand for British-made goods and dash hopes of the export-led recovery targeted by the Bank of England and the Government. The weak pound offers some comfort to British manufacturers selling goods abroad. But the euro is even weaker meaning British firms have seen the competitive edge afforded by the depreciation of sterling eroded. It could be worse — if Britain were in the euro it would probably be up to its neck in a Greek-style crisis of its own.

Interest rates

The Bank of England cut interest rates to a record low of 0.5% in March last year to stave off a damaging bout of deflation and stimulate economic growth. It also pumped £200 billion of emergency funding into the economy through quantitative easing.

The medicine seems to have worked so far. The economy is growing again, as today's figures confirm, and inflation dropped no further than its low of 1.1% in September last year.

It is now running at 3.7%, the highest level since November 2008 and well above the 2% target, prompting fears that the Bank will be forced to raise rates before the end of the year to bring it back under control. This poses a serious threat to the economy. A sudden rise in borrowing costs, particularly on mortgages, at a time of low or no wage growth and high unemployment, could derail the recovery.

Spending cuts

The £6.25 billion of immediate spending cuts planned this year by George Osborne is peanuts. It is just 4% of the £156 billion deficit racked up last year and less than 1% of the Government's total debt-mountain of close to £900 billion (excluding off-balance sheet liabilities such as future public sector pension payments). It will do little to reduce the deficit — and little to damage the recovery.

Far more concerning is what follows. The Institute for Fiscal Studies says the cuts announced yesterday represent "less than a tenth of the fiscal repair job that will be needed over the next few years".

The big decisions will come in the emergency Budget next month and the spending review in the autumn. It will be bloody. Hundreds of thousands of public sector workers face the axe, Whitehall budgets will be slashed by as much as 25%, projects will be shelved and taxes will rise. The hope is that a strong recovery in the private sector will pick up the pieces. If it does not, very stormy waters lie ahead.

Bank lending

The recovery in the UK economy depends in no small part to the flow of lending from banks to businesses and consumers. Billions of pounds have been pumped into the banking system to encourage banks to lend and interest rates have been slashed. But lending remains subdued. Businesses are struggling to get the funding they require to grow, and the mortgage market is tight.

The sovereign debt crisis in Europe, fears over further bank failures, and the prospect of draconian regulation mean banks are reluctant to lend.

The cost of lending between banks has also increased sharply in recent weeks as worries mount. Three-month dollar Libor — the rate at which banks lend to each other — is at its highest level since July last year. The sterling rate was last higher in August.

The rise in Libor does not bode well for the recovery.