United Kingdom -- 2005 Article IV Consultation, Concluding Statement of the IMF Mission
December 19, 2005
This document contains the conclusions of the IMF mission that visited the United Kingdom during December 7-19. We would like to thank our interlocutors for their cooperation. Our work has also benefited from the excellent quality of policy documents, including the Pre-Budget Report and associated publications, the Inflation Report, the Financial Stability Review, and the Pensions Commission's Second Report.
1. Macroeconomic stability in the United Kingdom remains remarkable. Over the past decade, the growth of real GDP per capita has been strong and stable. Unemployment and inflation have been low, and the current account deficit has been moderate. This impressive record owes much to good macroeconomic, financial, and structural policies, underpinned by sound policy frameworks and supported by a generally favorable external environment. Our discussions have focused on recent cyclical and other influences on the economy and on how policies and policy frameworks can continue to support robust and steady macroeconomic performance.
2. The economy hit a soft patch this past year, but growth is expected to pick up in 2006 and 2007. The slowdown in 2005 reflected the relatively strong cyclical position in 2003 and 2004, the stabilization of the housing market, earlier monetary policy tightening, a sharp increase in energy prices, and a rise in tax revenues. Our near-term forecast is similar to those in the PBR and of the Bank of England—a well-balanced recovery with real GDP growth rising to about 2¼ percent in 2006 and about 2¾ percent in 2007. Both consumption and investment should accelerate with the waning of most negative influences at play in 2005, and export growth should continue to be supported by strong external demand. At roughly constant policy interest rates and with inflation expectations well-anchored, we expect CPI inflation to fall below 2 percent during 2006 and to rise to about target in 2007.
3. Uncertainties surrounding the growth forecast are substantial. Apart from the inherent uncertainties in understanding economic interactions, some specific risks to the assumed environment stand out. House prices are still richly-valued by some metrics, though a year of steady prices gives some comfort that risks of an abrupt adjustment have lessened. Immigration could be changing the landscape of the labor market, creating the potential for a larger workforce with stable wage growth. On the external side, a disorderly unwinding of global imbalances or an abrupt adjustment of presently low worldwide risk valuations poses large, though low-probability, downside risks.
4. Monetary policy has been successful in addressing the combined effects of a cyclical slowdown and rising energy prices. Increases in interest rates during 2003 and 2004 helped cool demand and contain, so far, the second-round effects of energy price increases. The small cut in the interest rate in August recognized the faster-than-expected slowdown in demand, which in our view opened a small gap vis-à-vis potential output even after adjusting for the negative effects of oil price increases.
5. Looking ahead, the uncertainties in the forecasts are likely to make monetary decisions finely balanced. An immediate priority is to ensure that monetary conditions continue to prevent any second round effects of energy costs on prices and ensure that demand adjusts to the energy-price-induced slowdown in potential non-oil growth. Once these adjustments are more secure, interest rate decisions should be increasingly guided by whether the gentle pick-up in aggregate demand is proceeding as now forecast. A potentially important source of uncertainty for monetary policy will come from immigration: it will be important to understand the nature of its effect on the economy and assess the possibility that it could boost supply relative to demand.
6. Recent deficits, while not an immediate threat to economic performance in a benign world environment, needed to be reined in. Following surpluses around the turn of the century, the fiscal position shifted into deficit owing to sizable real spending increases—largely current but also capital—and a move off cyclical revenue peaks. These developments must be viewed against the backdrop of relatively low public debt. Nevertheless, at about 3 percent of GDP during the past few years, the overall deficit needs to be reduced to stabilize net debt below the 40 percent ceiling. Accomplishing this adjustment through the current budget is important for avoiding the pitfalls in earlier periods when capital spending often bore the adjustment burden.
7. The PBR contains welcome plans for an appropriate adjustment. The FY2005/06 budget appears to be on track to achieve a modest reduction in the overall deficit relative to GDP and a somewhat larger adjustment in the current deficit. This reflects revenues associated with higher energy prices and strong personal income and corporate tax revenues, especially from the booming financial sector. In addition, the announcement of an increase in the tax rate on oil company profits, combined with increasing resource utilization and fiscal drag, contribute to a further reduction in the deficit over the next few years. And lastly, the PBR reiterates the government's intention to constrain current spending growth starting in FY2008/09. In our central projection, this would round out a reduction in the overall deficit to about 2 percent of GDP by FY2009/10—sufficient to stabilize net debt at about 40 percent of GDP, an objective we strongly endorse. Reaching the government's forecast of an overall deficit of 1½ percent of GDP would, in our view, require better outcomes than in our central projection or measures beyond those included in the PBR.
8. The envisaged spending restraint, a critical ingredient of the planned adjustment, will require careful planning. The 2005 PBR projects that the growth of current expenditure will slow to 1.9 percent in real terms for the three years starting in FY2008/09, and our projections fully incorporate this intention. With Annually Managed Expenditure (AME), such as social security benefits and interest payments, amounting to about 40 percent of total spending, the real growth of discretionary spending (DEL) will need to fall to less than half of recent rates. Such adjustments are difficult, though far from impossible, and can be a catalyst for good changes in the role of the government in the economy. Preparation for the 2007 Comprehensive Spending Review will be the lynchpin in the process of ensuring that the restraint is accomplished and is well prioritized.
9. A strength of the fiscal framework is a system of auditing by the National Audit Office. The NAO, which is independent of the government, now audits on a rolling basis 11 assumptions in the budget forecasts and this year the list was expanded to include the change in the dating of the starting point of the current economic cycle. This reliance on independent audit puts the United Kingdom, along with some other countries, on the frontier of institutional development. That frontier is moving, however, and we urge the government to further expand the role of the NAO in auditing the assumptions and methodologies underlying the preparation of the fiscal projections.
10. The fiscal rules are playing an important role in disciplining fiscal policy, although at times this role is overshadowed by peripheral controversies. We strongly endorse the objectives of the golden rule—within the net debt ceiling of 40 percent of GDP—to avoid pro-cyclical policy and to ensure adequate capital spending. This is particularly important in view of the United Kingdom's significant infrastructure needs, including in the transport sector. However, the current form of the golden rule requires a precise dating of the cycle. Not only is this difficult, but the adjustments in the definition of the cycle have proved an unhelpful distraction from the more important considerations of what a sustainable fiscal policy is and how it should be achieved. And assuming the broad stability in economic performance continues, dating cycles will become even less meaningful and more difficult. Therefore, once the current budget has moved back into balance, the government should consider an implementation of the golden rule that replaces the constraint now coming from measuring performance over the cycle with expanded NAO audits.
11. The financial sector is well-regulated and the outlook for the banking system is favorable, though there are risks. Banks are well-capitalized, highly profitable, and highly cost efficient. Levels of non-performing loans are very low. That said, retail asset quality has deteriorated somewhat with the uptick in personal insolvency rates and the growth in sub-prime lending. Banks' exposures to commercial property have grown rapidly as concerns about overvaluation in this sector rise. There are also some signs of a loosening of corporate lending standards, as banks compete with each other and with capital markets to provide funding in a low-yield environment.
12. Credit risk transfer (CRT) instruments are providing important diversification benefits, but their rapid growth is also creating risks. A key concern is that the pace of innovation may have exceeded the development of market infrastructure and banks' risk management systems. Consequently, any shock to the financial system could be exacerbated by financial institutions' increased exposures to these instruments. Therefore, we welcome the efforts of the Bank of England and the FSA to publicize the risks associated with these instruments and the more general evidence that risk may be underpriced. While we appreciate the need for cost-benefit analyses of new regulatory burdens, we encourage supervisors to continue to enhance their surveillance of the CRT market and to encourage private sector initiatives to increase disclosure of exposures to these instruments. We welcome the efforts by the FSA to address the transactions backlog problem in collaboration with the Federal Reserve Bank of New York and market participants.
13. Building on strengthened payment and settlements systems, the authorities should further improve risk mitigation in clearing arrangements within banks. Over the past two years, the authorities have taken actions to reduce the level of intraday interbank exposures and reduce settlement risk in money market instruments and retail payments. However, as greater clearing activities are undertaken within banks, for example in the processing of transactions related to credit risk transfer instruments, these are becoming important for financial sector stability.
14. While the health of the insurance sector has improved substantially over the past two years, supervisors should continue to push for a strengthening of core capital. Insurance companies have reduced their portfolio risk and have been helped by the recovery in equity prices. However, the quality of capital remains suspect for some firms. The introduction of the Individual Capital Assessment regime in January 2005 is aimed at improving risk assessment through an interactive process between insurance companies and the FSA.
15. The current debate on pensions brings to the fore a number of key questions. In approaching these questions, an important objective will be to maintain a state pension system that does not place an undue burden on public finances. There is evidence that a portion of the population is not saving enough to ensure retirement income that will meet its aspirations. Future governments may therefore be forced to increase the generosity of the state pension system. Obstacles to adequate private saving appear to be the difficulty of making rational decisions about long-term saving, the high cost of private pension products, the complexity of the state pension system and uncertainty about how it will evolve. These obstacles could be addressed through changes that create a simpler and more coherent system of public and private pension provision. These could include the introduction of a national, defined-contribution scheme with automatic enrolment and low operating costs, changes to the state pension system that simplify it and strengthen incentives for private saving, and increases in the state pensionable age as life expectancy rises. Options such as these involve important social choices that need to be debated to form a consensus on the share of scarce public resources devoted to pensions.
16. The authorities' efforts to create a flexible and dynamic labor market are welcome and should continue. The United Kingdom is one of only three countries to have relaxed border regulations in May 2004 to allow new members of the EU full access to its labor market. This is likely to have helped relieve specific skills shortages and thus acted to reduce inflationary pressures. The government's strategy of stimulating productivity growth by addressing five issues—innovation, enterprise, competition, investment, and skills—is appropriate. Priorities will be, first, to reduce the regulatory burden from an already relatively low level by implementing the recommendations of the Hampton Review and, second, to further develop policies to improve the skills base, building on the forthcoming final report of the Leitch Review. With the employment rate already high by international standards, the aspiration of increasing it to 80 percent is ambitious. In this context, the Pathways to Work pilots for incapacity benefit claimants have been successful and their planned rollout to one-third of the country by October 2006 is welcome.
17. The United Kingdom has fared well in a year of large increases in oil prices alongside a sharp slowing in house price appreciation. The mild impact of these developments is another marker in the enormous change in economic performance relative to that in periods even as recent as 15 years ago. Yet efforts to improve institutions—for fiscal transparency, financial sector oversight, and labor market flexibility—continue. Pushing ahead with such objectives will help protect a vibrant economic performance and set an international standard for economic policymaking.