United Kingdom - 2008 Article IV Consultation Concluding Statement of the Mission
May 23, 2008
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
1. For over a decade, the United Kingdom has sustained low inflation and rapid economic growth-an exceptional achievement. More recently, the economy grew by 3 percent in 2007, and inflation returned to target after a temporary elevation. All this is the fruit of strong policies and policy frameworks, which provide a strong foundation to weather global shocks.
2. Challenges were evident, however, even before recent global shocks to financial markets and energy and commodity prices. Imbalances had emerged in recent years-inflation, overheating in housing markets, low domestic saving rates, high current account deficits, and sustained declines in the international investment position. Although net debt remains below the G-7 average, fiscal outcomes over the past few years reduced headroom under the sustainable investment and golden rules. The monetary tightening cycle from mid-2006 responded to the immediate inflation risks and began to cool the housing market. But medium-term inflation expectations-which had been rising for some time-remained elevated, and underlying external imbalances increased with the real effective appreciation of sterling .
3. In this context, the recent global shocks have increased the importance of adjusting the policy mix and have brought new issues in the design of the policy frameworks to the surface. If the imbalances and upward drift in inflation expectations-and the associated threats to sustained growth-are to be addressed, three elements are key:
- Activity needs to slow following above-trend growth in 2006 and 2007.
- Risk of an excessive slowdown should be forestalled by continued subdued nominal wage growth and further actions to address vulnerabilities in the financial sector. Initiatives to boost net external demand through rebalancing fiscal and monetary policy could bolster these steps.
- The fiscal and financial policy frameworks need to be strengthened to secure confidence in longer-term prospects.
Near-Term Outlook and Policies
4. Global and UK growth are set to slow during 2008. But downside risks to projections are high, reflecting uncertainties related to ongoing dislocations in global financial markets, associated spillovers across markets, the possibility of adverse feedback loops, and terms of trade shocks. These factors are compounded in the UK by the correction in the housing market and its potential impact on bank credit and household consumption. At the same time, the substantial depreciation of sterling, which has brought the real effective exchange rate closer to its equilibrium level, and the underlying resilience of the economy provide offsets.
5. In our central case projection, the slowdown in 2008 will be followed by a gradual rebound that gathers pace over the course of the following year. Although growth is expected to average about 1¾ percent in each year, the dynamics are more evident in year-on-year growth figures. These are projected to decline to 1 percent in the fourth quarter of 2008 before recovering to 2½ percent a year later. Underlying these forecasts is the view that risks of a credit squeeze are becoming less threatening following various actions, including introduction of the Special Liquidity Scheme and capital raising initiatives by banks, but that conditions nevertheless remain tight as previous strains persist. In this context, shocks to commodity prices alongside sterling depreciation are, as anticipated in the Bank of England Inflation Report, set to keep CPI inflation well above target for much of this period, even in the absence of second round nominal wage pressure. And with improved competitiveness and slower growth, the current account deficit is expected to narrow.
6. The broader economic challenges posed by this outlook are reflected most immediately in monetary policy dilemmas-where risks to the credibility of the inflation targeting regime from sustained overshooting of the inflation target has to be weighed against risks to activity from financial sector and other shocks.
7. Three elements can help respond to these broader challenges.
8. First, continued moderation in nominal earnings growth is essential. If secured even in the face of relative price changes, monetary adjustment and associated sterling depreciation may reduce risks to output, the external balance, and employment without compromising the nominal anchor. But if not, monetary flexibility to address these concerns will be diminished.
9. The risks to nominal wages appear balanced. So far, nominal remuneration has held steady, encouraged by the flexibility of labor market institutions and public sector pay restraint. But key wage settlements remain outstanding, and tolerance for continued low real earnings growth is uncertain.
10. In this context, we see no scope for further near-term monetary easing absent assurances of continued wage moderation, fiscal policy that is tighter than planned, or signs that house price and credit developments are significantly curbing domestic demand, relative to our central case projection for continued growth. Indeed, given the risks to the nominal anchor, monetary policy should stand ready to tighten at the earliest clear signs of emergent nominal wage inflation.
11. Second, as the commodity and consequent relative price shocks have a permanent element, the appropriate focus of the policy response is fiscal. In this context, budget consolidation should rebalance demand-away from domestic in favor of external-to the benefit of the current account balance, activity, and employment.
12. In this light, the 2008 budget judgment was appropriate, as was its commitment to fiscal tightening over the next few years. Absent a major deviation from the central projection for the economy, for 2009 and 2010, the commitment to planned tightening of ½ percentage point of GDP in cyclically-adjusted terms in each year should not waver. Future pre-budget and budget reports should also address any slippage from the anticipated structural adjustment path. And if nominal wage discipline slips or if the medium-term outlook for the current account deteriorates with respect to current official projections, yet further cyclically-adjusted fiscal consolidation may be needed for 2009 and beyond. Any such revisions to budget commitments should be preannounced as early as possible to allow their prompt reflection in monetary policy decisions.
13. Third, efforts to stabilize financial markets remain essential. This will not only reduce lagged effects on credit flows from past strains, but will reduce remaining tail risks and support more efficient pricing of risk in future.
14. The steps outlined in the Financial Stability Report form a good basis for action in this regard. The Special Liquidity Scheme addresses liquidity tail risks while guarding against moral hazard, and has already contributed to an easing in money market pressures. In difficult market conditions, banks can further boost confidence in their resilience through information disclosure and raising capital, as some are already doing. Strengthened risk management practices and regulations on capital and liquidity as envisaged by the Financial Stability Forum are similar priorities.
15. UK policy frameworks are under strain from current economic conditions. The inflation targeting regime faces difficult circumstances and its toughest test to date, margin for error under the fiscal rules has been all but eliminated, and weaknesses in the financial stability framework have come to light. To maintain confidence in medium-term prospects-the foundation of strong macroeconomic performance over the past decade-we recommend selected reforms of the policy frameworks.
16. The inflation targeting regime should remain unaltered. Adjusting the CPI target, its definition, or the remit of the Bank of England would be a serious mistake, not least because it risks unanchoring nominal wage settlements without changing the fundamental challenges facing the economy. Rather, the permanent element of the terms of trade shocks is best addressed through fiscal policy. With the planned fiscal tightening, the current inflation targeting framework has sufficient flexibility in the horizon over which the target can be secured to absorb relative price changes without compromising its long-run credibility.
17. Key elements of the fiscal framework should also be retained, especially the commitment since 2003 to maintain net public debt below 40 percent of GDP in each and every year. The sustainable investment rule has appropriately constrained fiscal discretion within boundaries set by long-term considerations such as demographics and sustainability, thereby also underpinning the credibility of the inflation targeting regime. In this light, we advise against any softening of the ceiling, especially at this juncture given elevated inflation expectations, external trends, the difficulty of establishing the credibility of a higher ceiling, and the ongoing terms of trade losses. If in coming years, public debt-net of stock adjustments-were to breach 40 percent of GDP, plans to bring it back under the ceiling on a sustained basis should be announced promptly. And to improve the operation of the framework and further support automatic stabilizers, procedures to manage headroom under the ceiling should be developed.
18. Beyond this, two elements of the fiscal framework warrant review.
19. First, building on the success of the recent Comprehensive Spending Review (CSR) in slowing the pace of expenditure growth, there are advantages to reversing the relative status of the golden rule and the medium-term spending limits. Incorporating the CSR limits into aggregate nominal formal ceilings for Totally Managed Expenditure could reduce risk of expenditure drift and reinforce the commitment to strong policies. Such an expenditure rule would be transparent, allow automatic stabilizers to operate unfettered on the revenue side and up to the limits to be set in reserves on the expenditure side, and strengthen fiscal resistance to unanticipated inflation. To protect investment, the limits could focus on current expenditure, with an accompanying nominal floor on net capital spending. The implied change in the status of the golden rule would end concern with adjustments to its definitions, which despite having had only modest implications for fiscal space, have eroded confidence in the rule. It would also reflect the success of the broader policy frameworks, which have underpinned reduced economic volatility thereby diminishing the need to define fiscal or other rules "across the cycle."
20. Second, the objectives for public finance should be broadened to encompass external stability in view of the role of fiscal policy in this area. There is no case for adopting current account, exchange rate, or international investment position targets. But including external stability as a fiscal policy objective-consistent with the overarching principles laid down in the Code for Fiscal Stability-would fill a gap in the macroeconomic policy framework.
21. Reforms are also needed in the financial stability framework. The framework of tripartite co-operation among the Bank of England, Financial Services Authority and HM Treasury remains appropriate. It is a model that has been replicated in other countries. However, in recent times, the UK authorities have identified areas in which the framework can be strengthened, including crisis management. These improvements are required in light of the lessons learned during the financial market turmoil since mid-2007. The necessary measures have been spelled out in the consultation document published by the Treasury, the Bank of England, and the Financial Services Authority (FSA), and on which the authorities will be consulting further. In taking these matters forward, focus is required on five key areas.
22. First, improved disclosure by financial institutions, as is being considered by a number of international fora and is underway in the UK as part of the adoption of Basel II, will encourage market discipline. This would complement changes to supervisory processes and the introduction of a special resolution regime (SRR).
23. Second, on the supervisory side, the regime of remedial measures to be applied against weak institutions crossing various thresholds established by the FSA could be further elaborated. Although the existing powers of the FSA to take action against weak institutions suffice, increasing clarity on the outcomes sought by regulators will lead to reduced ambiguity and would encourage early voluntary actions by weak financial institutions, for instance by reducing dividends and augmenting capital.
24. Third, we support the aim of early intervention of distressed institutions in the proposed SRR. It is proposed that intervention be on the basis of regulatory triggers that would include quantitative and qualitative criteria. It is not possible to identify in advance all circumstances under which an institution should be put into the SRR process but a definition of the circumstances likely to give rise to such a judgment would support this aim. An approach whereby the regime is presumed to be triggered when a bank meets this definition strikes an appropriate balance between regulatory forbearance and unnecessary actions. As thresholds for liquidity are hard to identify, discretion remains essential in this context. But whatever the trigger, and however pulled, the SRR should be so designed as to give the maximum legal certainty to decisions taken under it.
25. Fourth, effective operation of the SRR requires that the relevant authorities are provided with access to sufficient resources to enable swift resolution of problem banks while maintaining depositor confidence in the banking system.
26. Finally, even with the steps outlined above, financial stability will require strengthening the capacity of all implementing institutions. Progress to recruit and fill "skills gaps" in the FSA, alongside development of stronger internal management information systems and the associated internal triggers are welcome. For institutions facing difficulties, full access to and use of relevant financial and supervisory bank-specific information by the Bank of England is appropriate to allow it to carry out its lender of last resort function effectively. Intensified cooperation and information exchange between the FSA and the Bank will be important. These are parts of welcome initiatives to strengthen coordination within the tripartite arrangements.
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Recent reforms to IMF surveillance-strongly supported by the UK-emphasize focus on domestic and external stability and associated policy frameworks. Accordingly, our discussions during this mission have focused on these matters.
We have been warmly welcomed by those we have met during our discussions, for which we are grateful.