United Kingdom - 2009 Article IV Consultation Concluding Statement of the Mission
May 20, 2009
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. The UK authorities’ policy response to the deep recession and global financial crisis has been bold and wide ranging. Public capital has been injected into weak banks and their troubled assets are being ring-fenced. Unprecedented easing of monetary policy and temporary discretionary fiscal stimulus are in place. This response has been commensurate with the particular exposure of the UK economy to global shocks because of its large financial sector relative to the size of the economy, overheated property markets, high household indebtedness, and strong cross-border links.
2. The aggressive actions by the authorities have been successful in containing the crisis and averting a systemic breakdown. Indeed there are tentative signs that confidence is improving and that the output decline is moderating. But the financial system is still under stress. Moreover, the ongoing crisis has given rise to very big fiscal deficits and large contingent government liabilities, although from a starting position of relatively low public debt.
Outlook, Risks and Policy Priorities
3. Looking ahead, output is likely to continue to contract in the near term, although at a decelerating pace. The IMF’s April 2009 World Economic Outlook projected UK GDP to decline by 4.1 percent this year, with quarterly growth picking up gradually through 2010. In this central scenario, the economic recovery is expected to be subdued and gradual as banks and households go through a difficult balance sheet restructuring process. In particular:
• The UK banking system entered the crisis with large and highly leveraged balance sheets. Unprecedented writedowns have weakened capital positions and curtailed banks’ access to term funding. In response, banks have tightened the supply of credit, especially as the economic downturn has heightened the risk of further large credit losses. The withdrawal of some foreign financial institutions from the UK and the drying up of securitization markets have accentuated the credit contraction. It remains to be seen whether the recent efforts to recapitalize banks will be sufficient to sustain credit provision at levels required for a robust economic recovery.
• The high level of household indebtedness constrains the pace of economic recovery. Faced with falling house prices, significant reductions in the value of pensions and other financial assets, a deteriorating and uncertain employment outlook, and reduced access to credit, consumers are likely to retrench spending to reduce debt and rebuild savings.
4. The speed and strength of the recovery, however, is highly uncertain, given the unprecedented nature of the crisis and the importance of confidence effects. On the one hand, the significant economic stimulus in train in the UK and other large countries should support the recovery. In addition, the floating exchange rate has acted as a shock absorber. The depreciation of sterling should shift expenditure towards UK-produced goods and services, offsetting to some extent the weakening of external demand. On the other hand, the synchronized global nature of the recession and strong cross-border links are likely to make it more difficult for any one country to return to rapid growth in isolation. More generally, there is considerable uncertainty about the pace and extent of adjustment of bank and household balance sheets and whether capital market funding can compensate for shortfalls in bank loans.
5. Notwithstanding recent signs of stabilization, the UK economy remains susceptible to potential shocks. The sharp increase in public sector borrowing and contingent government liabilities, together with continued financial sector fragility, are significant vulnerabilities. In these circumstances, a severe shock has the potential to disrupt domestic and external stability. This highlights the need for credible and consistent policies to truncate downside risks and strengthen market confidence. The main policy priorities are:
• First, continued emphasis on resolving the problems in the financial sector to buttress stability and promote normalization of credit supply.
• Second, setting monetary and fiscal policies consistent with a firm commitment to the existing policy objectives of price stability and fiscal sustainability.
At the international level, effectiveness of efforts by the UK authorities in these areas will be enhanced if they are complemented by coordinated multilateral action to repair the financial system, rebalance global demand and achieve more sustainable external positions across countries.
Repairing the Financial System
6. Informed by detailed examination and stress tests for key banks, measures to support financial institutions have included public capital injections and an Asset Protection Scheme (APS) designed to ring-fence bad assets and provide contingent capital. Guarantee schemes for bank debt and asset-backed securities and support for new lending have also been introduced. Further, the Bank of England has moved expeditiously to shore up banking sector liquidity. The choice of measures had to balance a number of sometimes conflicting objectives, such as restoring confidence, containing the immediate cost to taxpayers, protecting property rights, limiting the extent of government involvement in the financial sector, and respecting European competition law.
7. The policy interventions in the UK, together with actions taken by other national authorities, have helped restore systemic stability in the financial sector. Interbank term lending conditions have eased and some large institutions have been able to issue unsecured debt and fresh equity, suggesting improving confidence. To enhance confidence further, it will be important to:
• Release, as planned, more detailed information on the pool of assets covered by the APS once the contracts with banks are finalized.
8. However, the financial system may not yet be repaired to a level where banks are ready to increase lending sufficiently to underpin a strong recovery. Although banks are expected to continue to remain above minimum regulatory capital requirements, further shocks will lead to an erosion of capital buffers. To mitigate this the authorities should continue to:
• Encourage banks to take advantage of improving market conditions to augment their capital base, and also stand ready to provide further public support where needed.
• Promote options to preserve capital cushions and improve capital structures, for example by restraining dividends if required and converting preference shares to common shares.
• Develop contingency plans in the event that further shocks threaten the stability of financial institutions. For banks with strong cross-border links, this will require greater international coordination based on the Financial Stability Board’s principles of crisis management.
9. While banks go through a difficult but necessary balance sheet restructuring, additional efforts to support credit supply are warranted in the short term. The targeted intervention in dysfunctional credit markets through the Bank of England’s Asset Purchase Facility is welcome. Lending guarantee schemes are also appropriate as long as they can be designed to support viable new lending. In the current circumstances, bank-specific lending commitments, as envisaged by the authorities, can serve as a useful coordination device to avert a credit crunch, provided there are safeguards to ensure that the committed new lending is on commercial terms and under sound risk management practices.
10. Beyond the short-term emergency response, the crisis has highlighted the need to improve the UK’s prudential, supervisory and bank resolution framework. The February 2009 Banking Act, which provides a clear blueprint for expeditious resolution of troubled financial institutions, is a critical addition to the toolkit and its effectiveness requires comprehensive information sharing among the tripartite authorities. In addition, the proposals in the Turner Review are an important contribution to the international debate. Progress on the following aspects, pursued in collaboration with international partners, warrants priority:
• Phasing in the introduction of a maximum gross leverage ratio as a backstop discipline against excessive growth in absolute balance sheet size.
• Developing new macro-prudential instruments to mitigate the amplitude of the credit cycle and reduce feedback loops between the financial sector and the real economy.
• Complementing the FSA’s shift to a more intrusive and systemic approach to supervision by more effectively harnessing market forces and public surveillance through (i) in the near term, encouraging financial institutions to provide comparable and fuller disclosure of financial results at quarterly intervals; and (ii) over the medium term, developing systems for publishing non-sensitive bank-by-bank regulatory financial information gathered by the FSA, also at quarterly intervals.
• Continuing to develop, within international fora, arrangements for crisis management and the orderly exit of cross-border banks and to explore greater coordination of deposit guarantee schemes within the EU.
Supporting Unconventional Monetary Policy
11. The inflation outlook is subject to considerable uncertainty, but on balance the prospect is for inflation to fall and stay below the 2 percent target for an extended period. In this context, the Bank of England’s strategy of aggressive monetary easing is appropriate. With policy rates near zero and conventional transmission channels partially impaired, the Bank has adopted a policy of large scale asset purchases financed by issuing central bank reserves (quantitative easing). The effectiveness of this policy is uncertain, depending on the response of private investors and banks to the Bank’s liquidity injection. Initial results have been moderately encouraging: bond rates have come down and liquidity in some markets has improved. But it is too early to tell whether these effects will be strong and durable enough to induce the desired increase in aggregate demand. This uncertainty strengthens the case for:
• Further diversifying the Bank’s asset purchases, with the aim of improving market functioning. We support, in particular, targeted efforts to reduce excessive risk premia in private credit markets that are currently dysfunctional but deemed to be viable in the long term.
12. The success of quantitative easing also depends on the robustness of the institutional framework underpinning the Bank of England’s independence. In this regard, the prudent setup of the Asset Purchase Facility, which operates as a separate legal entity under comprehensive indemnity assurances from the Treasury, is welcome. This protects the integrity of the Bank’s balance sheet, a key prerequisite for monetary policy to remain unequivocally focused on price stability. In the same vein, it is reassuring that Treasury approval will not be required for the Monetary Policy Committee to unwind asset purchases in the future. This puts the MPC in a strong position to determine and implement an exit from quantitative easing as appropriate to meet the inflation target. The exit could include a combination of asset sales, other liquidity-draining operations, and higher interest rates. Transparent communication by the MPC on these aspects of quantitative easing will further help underpin market confidence.
13. At a more fundamental level, the public’s confidence in the Bank of England’s operational independence remains contingent on the stability of public finances. This puts a premium on a path of fiscal policy that restores sustainability.
Restoring Fiscal Sustainability
14. The challenge facing fiscal policymakers is to revitalize the financial sector and support demand, while preserving fiscal sustainability. With the private sector focused on raising savings and mending balance sheets, fiscal policy has the task of facilitating and smoothing the adjustment.
15. This task is not going to be easy. The 2009 Budget has commendably acknowledged the scale of deterioration of the fiscal position and included a cautious judgement on its structural nature. With tax revenue sensitive not only to the economic cycle, but also to asset prices and the level of financial sector activity, some of the reduction in the revenue-to-output ratio is likely to persist even after the economy recovers. Public debt is projected to double in five years, although to a level still in line with other major economies. Contingent liabilities of the government from financial sector interventions have increased sharply, as recognized by the initial provision for the cost of financial sector interventions in the authorities’ fiscal calculations. Against this background, the measured temporary fiscal stimulus implemented in the 2008 Pre-Budget Report and the 2009 Budget, together with the operation of automatic stabilizers, is appropriate.
16. Going forward, the success of the current policy package hinges on the continued trust in the sustainability of the fiscal position. A continued strong commitment to medium-term fiscal consolidation is hence crucial. The Pre-Budget Report and the 2009 Budget already announced consolidation plans through 2013/14, taking account of risks to the outlook. Fiscal commitments would be strengthened by:
• Targeting a more ambitious medium-term fiscal adjustment path for implementation once the economic recovery is established. The focus of this adjustment profile should be to put public debt on a firmly downward path faster than envisaged in the 2009 Budget.
• Providing greater clarity on the specific measures needed to achieve the adjustment path, including in the context of the next Comprehensive Spending Review. The emphasis in current plans to weigh the adjustment toward expenditure reduction is appropriate in light of international experience that expenditure-based consolidations are more durable. In addition, long-term sustainability would be enhanced by implementing structural reforms to address rising costs related to demographic change.
• Allocating any upside surprises to growth or revenue to reduce deficits more aggressively and limit the accumulation of public debt.
• And finally, building a broad public consensus on the critical need for sizeable fiscal adjustment to assist in meeting fiscal challenges.
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In conclusion, with continued effective handling of problems in the financial sector and a firm commitment to the existing policy objectives of price stability and fiscal sustainability, in line with our advice, we expect the authorities to deliver domestic and external stability and set the stage for a sustainable recovery.
We are grateful for the warm welcome by those we have met during our discussions.