United Kingdom -- 2002 Article IV Consultation, Concluding Statement of the IMF Mission
December 9, 2002
This document contains the conclusions of the IMF mission that visited the United Kingdom during November 21-December 6. The mission team would like to thank the authorities, as well as other participants in the meetings, for their excellent cooperation. The discussion of the staff report for the Article IV consultation with the United Kingdom is expected to be held by the Executive Board of the IMF by end-February 2003.
1. The U.K. economy is performing well. The past decade has witnessed a sustained expansion of output and employment, coupled with low and stable inflation. Although GDP growth fell below expectations in 2002, it remained above that of other large EU countries, and output seems to have recently recovered to its trend growth rate.
2. These economic achievements are due, in no small measure, to the government's sound macroeconomic policies, in the context of a policy framework that has emphasized division of responsibilities, accountability, and transparency. The independence of the Bank of England in pursuing its symmetrical inflation target has allowed it to respond appropriately to cyclical fluctuations, including the recent slowdown in external demand. The fiscal framework has oriented policy to medium-term goals within a sound underlying position, permitting the fiscal expansion that has supported monetary policy since mid-2001. The Financial Services Authority (FSA) has effectively played its role as the single financial regulator. Indeed, the IMF's assessment of the financial sector—undertaken under its Financial Sector Assessment Program (FSAP), at the invitation of the government—found the financial system to be fundamentally sound and supported by a financial stability policy framework that, in many respects, is now at the forefront internationally.
3. No achievement, however, is without its challenges, and two are of particular note:
· The recent buoyancy in consumer demand has partly reflected a surge in credit to households and in house prices. In the short-term, the challenge will be to ensure that strong macroeconomic performance and financial stability are maintained if these developments unwind, regardless of whether they do so gradually or abruptly.
· Over the medium term, the challenge is to raise productivity. In 2001, the United Kingdom ranked only 19th among OECD countries in terms of per capita income—and poverty, while declining, remains high, particularly among children. These outcomes reflect the United Kingdom's low labor productivity. A key task for the government is to bring about the structural changes needed to boost it.
4. Medium and long term economic developments will also depend on whether the United Kingdom will enter EMU. We continue to regard as appropriate the five economic tests that the government has set out to evaluate whether there is a case for joining, and look forward to the assessment of these tests by June 2003.
An Uncertain Short-Run Outlook
5. Uncertainties in the period ahead may make for choppy waters. Against the backdrop of a gradual recovery in global demand, our central projection is for GDP growth to pick up to 2¼-2½ percent in 2003, slightly below the lower end of the government's forecast range (2½-3 percent). There are, however, significant downside risks. They relate to both external factors—in particular whether the global recovery may stall—and domestic factors.
6. The key domestic uncertainty is the strength of consumer spending. Our central projection assumes that household consumption will remain strong enough to support activity until external demand accelerates. But, a less benign scenario may unfold if the house price increases of the recent past unwind rapidly and unemployment starts rising—indeed, the muted response of unemployment to the recent output deceleration suggests some labor hoarding. Although monetary policy would, in these circumstances, play a supportive role, lower-than-expected output growth may be inevitable, given the lags in the monetary policy transmission mechanism. The authorities recognize that the successes of the last decade in containing output volatility should not lead to the belief that business cycles have been eliminated in the United Kingdom.
A Responsive Monetary Policy within a Clear Remit
7. The existing monetary framework has delivered impressive results. The stability of inflation expectations around the inflation target in the five years since the creation of the Monetary Policy Committee (MPC) attests to the credibility of the framework and the MPC's actions within it. With respect to recent developments, we note that the MPC's approach to reflecting asset price considerations in its inflation-targeting framework is properly focused on the behavior of inflation at different time horizons.
8. The present policy stance strikes the right balance between, on the one hand, keeping the policy rate low enough to support demand at a time of cyclical weakness, and, on the other, avoiding fueling an unsustainable rise in credit and house prices that could eventually unwind rapidly, thereby jeopardizing the inflation target further down the road. Looking ahead, monetary policy decisions will continue to be finely balanced. If the global outlook is weaker than anticipated, a rate cut may be needed, but would have to be weighed against the risk of exacerbating economic imbalances, and the fact that fiscal policy has been loosened significantly. Attention will also have to be paid to wage developments. In particular, there is a risk that public sector wage demands may intensify as public spending increases, and that the spillover to the private sector, in a tight labor market, may be greater than in the past. Developments in other cost factors are also uncertain—in particular, import prices, should sterling weaken, or the effect of the forthcoming increase in social security contributions.
Fiscal Policy Challenges
9. As in the past, the Pre-Budget Report (PBR) provides a transparent and comprehensive account of the government's economic policies. We welcome the enhanced documentation supporting the 2002 PBR, including the end-of-year fiscal report and the long-term public finance report. Our discussions on fiscal policy have encompassed both fiscal framework issues and policy implementation. While the main challenges are in the latter area, it is useful to focus first on the fiscal framework.
10. In the past few years, fiscal policy has been managed prudently within the context of the golden rule and the sustainable investment rule. This approach has served the United Kingdom well: its public debt ratio is now one of the lowest in the EU; and the fiscal deficit-to-GDP ratio, while rising, will remain lower this year than in any other large EU country. Given past surpluses, however, the two fiscal rules are no longer as constraining as at the time of their introduction. Moreover, it is not clear whether the sustainable investment rule should be interpreted as setting a ceiling (on the net public debt ratio) that has to be respected at all times, or only on average over the economic cycle. In the latter case, the rule would currently place very little effective constraint on future debt and deficit paths. We draw two conclusions from these considerations:
· First, almost five years after their introduction, there is a case for a study that takes stock of the experience so far with the two rules. In particular, it would be useful to assess whether the rules could be designed, or calibrated, so as to reduce their dependence on past fiscal overperformance, avoiding the risk that margins accumulated in the past allow excessive leeway in the future. It would also be useful to clarify whether the sustainable investment rule implies a debt ceiling that holds at all times or on average.
· Second, current fiscal policies should be assessed not only against the rules, but also in view of their broader economic effects. The range of policies that are consistent with the rules is, at present, quite large and includes fiscal outcomes that could have very different effects on the economy.
11. Turning to fiscal policy implementation, three developments since our visit last year warrant attention:
· The PBR fiscal outlook is weaker. The weakening is more marked in the short-term, but the medium-term deficit has also been revised up to about 1½ percent of GDP (from about 1 percent in the 2001 PBR).
· The revenue projections underlying this fiscal outlook are more uncertain than in the past. The additional uncertainty relates to three questions. First, whether the higher potential growth rate now underlying the revenue projections will materialize. Second, whether the noncyclical component of the revenue shortfall registered this fiscal year will recover over the medium term. And third, whether revenues could be boosted significantly by improving tax compliance, as assumed in the PBR.
· The 2002 budget and public spending review increased spending significantly from growth rates that were already high, and this was only partly offset by the rise in national insurance contributions. During FY2002/03-2004/05, Departmental Expenditure Limits are targeted to rise, cumulatively and in real terms, by some 27 percent on health, 37 percent on education, and close to 50 percent on transportation. Real primary spending is targeted to increase at the fastest rate in any three year period since the mid-1970s.
These developments raise questions related to both public expenditure management and macroeconomic management.
12. With public spending low relative to both historical and EU averages, it is reasonable to respond to the demand for better public services. But, at the high rate of spending growth currently envisaged, it remains to be proved whether public funds may be spent without incurring significant inefficiencies. Over the past few years, the government has introduced bold and comprehensive public expenditure management reforms. These reforms are, in principle, sensible, but their effectiveness, in practice, remains to be tested. Moreover, some aspects of public spending policies—such as the structure of economic incentives for public sector workers, including the degree of geographic wage differentiation, and arrangements for greater private provision of public services—remain to be developed further. Finally, spending is being increased also in areas (notably education) where, already now, it is comparable to that of other countries, in relation to GDP. In these circumstances, we would encourage the government to make further efforts to ensure that the risk of inefficiencies is minimized, including by speeding up the public spending reform process. Public spending could also be made more efficient through the broader application of user fees, thus containing excessive consumption and avoiding the subsidization of users from middle-to-upper income brackets via tax revenues. Higher income transfers—or, when applicable, means-testing user fees—can offset the negative impact of such fees on the poor.
13. As to macroeconomic management, the short-term widening of the overall deficit is not a source of concern: fiscal policy can play a useful supportive role in a cyclically-weak economy when the underlying fiscal position is sustainable. However, a stronger medium-term fiscal outlook than currently envisaged in the PBR would have advantages as: (i) over the medium term, higher deficits tend to crowd out private spending; (ii) a stronger underlying fiscal position allows more room for fiscal policy to play a counter-cyclical role; and (iii) repeated upward revisions in the deficit outlook, even if small every year, may eventually weaken fiscal credibility. In light of these considerations, there is a case for gradually strengthening the medium-term fiscal target, moving it back to about 1 percent of GDP, in the context of revenue projections less exposed to the downward risks mentioned above. To this end, more moderate spending increases over the medium term would be helpful.
14. Turning to tax policy, national insurance contributions will be raised in the spring of 2003. As we argued last year, broadening the tax base, particularly of indirect taxes, would have been a more efficient way to raise revenues, as it would have improved the neutrality of the tax system. As with user fees, targeted transfers could offset the adverse effects of base broadening on low-income groups. Regarding other tax policy issues, we welcome the authorities' intention to reform the corporation tax regime with a view to simplifying it and bringing it closer to standard business accounting practices. Further in this direction, the several special favorable tax treatments and deductions introduced in recent years may usefully be streamlined. Although a case can be made for special tax measures to address specific market failures, their proliferation reduces the efficiency of the overall tax system and increases compliance costs.
15. Over the long-term, the U.K. public finances appear in a better position than those of many other advanced economies. Underpinning fiscal sustainability are the low level of public debt, less unfavorable demographics and, most importantly, limited future public pension obligations. The limited nature of these obligations depends on maintaining a largely privately-funded pension system and ensuring that individuals save sufficiently for retirement. Thus, a commitment to policies that facilitate private saving and curb the expansion of public liabilities will need to be sustained. In this respect, simplifying the existing array of tax-supported long-term saving and pension schemes may help increase take up among the target group of low-to-middle income individuals. Transparency should also be improved, with consideration given to establishing standardized life insurance products, along the lines recommended by the Sandler Report.
Boosting Long-Term Growth
16. Productivity per hour worked in the United Kingdom is one of the lowest among advanced economies, reflecting both a low capital stock and low efficiency in the use of factors of production (so-called total factor productivity). We support the thrust of the authorities' strategy to raise the capital stock. Maintaining a stable macroeconomic and financial environment—as reflected in low long-term interest rates-is the best way to elicit private sector investment in capital and new technologies. Higher public investment—targeted at cost-effective projects—is also useful as the United Kingdom has fallen behind on public infrastructure.
17. But the key challenge is to raise total factor productivity, as this would allow output to increase without diverting resources from consumption to investment. Government's policies seem broadly appropriate also in this area. The focus has been on increasing competition and entrepreneurship; improving work force skills; and facilitating R&D and the adoption of new technologies:
· We welcome the strengthening of the competition framework in recent years. The Enterprise Act, and the enhanced powers of the Office of Fair Trade and the Competition Commission, will foster a more competitive environment and more innovative and cost-effective business practices. However, more needs to be done to reform planning restrictions, which are hampering competition in important segments of the economy (including wholesale and retail distribution and housing).
· Regarding skills, the focus should be on improving delivery. This is particularly crucial in secondary school education and the development of intermediate skills and vocational training—areas where the United Kingdom is behind comparable economies. Current efforts to increase in-work training and effective apprenticeships should also enhance the skills of those that have already joined the workforce and ease skill shortages.
· The recently-introduced tax credit should provide a boost to R&D spending, which has been lagging. More R&D, coupled with a competitive and entrepreneurial business environment, should facilitate the adoption of new technologies.
18. The U.K. labor markets are more flexible than those of other European economies. This flexibility has significantly contributed to low unemployment and high participation rates. Some of the authorities' active labor market policies, notably the New Deal for the young unemployed, appear to have met with considerable success. However, programs aimed at the unemployed aged 25 and over, as well as at some other groups, have yet to prove their effectiveness and may need to include stronger job-seeking incentives.
A Well-Regulated and Stable Financial System
19. Continued financial system stability will be key to macroeconomic stability and sustained growth. The FSAP team found that, despite a recent weakening, U.K. banks generally appear sufficiently profitable and well-capitalized to be able to absorb the effects of likely macroeconomic shocks without systemic distress. This partly reflects the profits and capital accumulated during the past decade of strong economic performance, as well as the diversified range of bank activities and continuing improvements in risk management practices. The financial stability policy framework is also sound. The FSA's supervisory practices are strong and in line with the various internationally-accepted standards and codes. Down the road, a key challenge for banks will be to maintain their resilience to adverse shocks in the presence of structural trends, such as increased competition, that may lead to a gradual narrowing of their profit margins.
20. Insurance companies—most notably life insurers—are under considerable stress, partly reflecting a decline in investment returns. However, the difficulties in this sector are not expected to undermine the stability of the financial system as a whole. Ownership links and credit exposures between banks and insurance companies, including through risk-transfer markets, are manageable, and less important in the United Kingdom than in some other countries. In addition, life insurers are able to pass on to policyholders some of the weakening in investment yields. Nevertheless, close monitoring of the situation is required, and the FSA is moving quickly to strengthen significantly its supervision of the insurance sector.