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United Kingdom--2010 Article IV Consultation, Concluding Statement of the Mission
September 27, 2010
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.
Overview
1. The UK economy is on the mend. Economic recovery is underway, unemployment has stabilized, and financial sector health has improved. The government’s strong and credible multi-year fiscal deficit reduction plan is essential to ensure debt sustainability. The plan greatly reduces the risk of a costly loss of confidence in public finances and supports a balanced recovery. Fiscal tightening will dampen short-term growth but not stop it as other sectors of the economy emerge as drivers of recovery, supported by continued monetary stimulus. Upside and downside risks around this central scenario of moderate growth and gradually falling inflation are balanced. Monetary policy will need to be nimble if risks materialize, and fiscal automatic stabilizers should operate freely. Meanwhile, the UK authorities should continue to provide leadership and build support for ambitious global reform of financial regulation. Ensuring a smooth transition to a new supervisory architecture at home will also be important to secure a safer post-crisis environment.
Outlook and risks
2. Economic recovery is underway, but will likely proceed at a moderate pace as the economy undergoes a difficult but necessary rebalancing.
• Households are likely to remain thriftier than before the crisis but will be in a position to gradually raise their consumption as labor markets recover.
• Corporates are beginning to draw on their strong financial positions and increase investment as the demand outlook strengthens.
• In the external sector, past sterling depreciation—which has put the currency broadly in line with fundamentals—has so far mainly boosted exporter margins rather than volumes. Over time, however, higher profits should encourage increased production in export and import-competing sectors.
This progressive strengthening of private and external demand should underpin a moderate-paced recovery, even as the public sector retrenches. Our central scenario envisages real GDP growth of 2 percent in 2011, rising gradually to 2½ percent in the medium term.
3. Barring unforeseen shocks, CPI inflation should fall back to target by early 2012. Although recent inflation outturns have exceeded the 2 percent target, this overshoot reflects price level shocks related to the January 2010 VAT increase, rebounding global commodity prices, and continued pass-through from earlier sterling depreciation. Another VAT increase in January 2011 will keep headline inflation above target next year. But over time the existing margin of spare capacity, along with fiscal tightening, will impart a significant disinflationary impulse. As a result, inflation should gradually revert to target as temporary effects dissipate and economic slack keeps underlying wage and price pressures in check.
4. Upside and downside risks are balanced, but uncertainty around the central scenario is considerable:
• On the upside, expansionary impulses from very low real interest rates, past sterling depreciation, and the ongoing recovery of global demand could be greater than expected, boosting the UK economy onto a faster-than-expected growth path. This scenario would likely entail higher global commodity prices and stronger inflationary pressure.
• However, downside risks are also sizeable, given the continued fragility of confidence, still-strained balance sheets among households and banks, signs of renewed housing market weakness, and the possibility that headwinds from fiscal consolidation could turn out to be more powerful than expected. Although it is unlikely and not unique to the UK, an adverse scenario where major new shocks—arising from either external forces or domestic ones—trigger another extended contraction in output cannot be ruled out.
The policy agenda
5. The policy challenge going forward is to promote a balanced and sustainable recovery while healing post-crisis scars:
• With record-high budget deficits, credible fiscal tightening is essential to preserve confidence in debt sustainability and regain fiscal space to cope with future shocks.
• To offset this contractionary impulse and keep inflation close to target over the policy horizon, a highly accommodative monetary stance remains appropriate, supporting private demand and net exports.
• At the same time, financial sector reform is crucial to move to a safer system that features stronger capital and liquidity buffers, supported by tighter regulation and supervision.
At the international level, the effectiveness of efforts by the UK authorities in these areas will be amplified if they are complemented by coordinated EU and multilateral action to strengthen financial regulation and rebalance global demand toward more sustainable external positions across countries.
Ensuring fiscal sustainability
6. The government’s strong deficit reduction plan will ensure fiscal sustainability. The fiscal mandate of balancing the cyclically-adjusted current budget by 2015/16 is appropriately ambitious. The plan’s credibility has been bolstered by a frontloaded path that achieves the mandate one year early and by a suitable mix of concrete spending and revenue measures. The consolidation plan and implementation of early measures to tackle the deficit—one of the highest in the world in 2010—greatly reduces the risk of a costly loss of confidence in fiscal sustainability and will help rebalance the economy. These benefits outweigh the expected costs in terms of adverse effects on near-term growth. Indeed, market reaction to the adjustment plan has been positive. Nonetheless, the magnitude of the growth headwinds from fiscal adjustment is uncertain and could be different than anticipated. In this case, the free operation of automatic stabilizers in both directions, alongside further support from monetary policy, provides an important safeguard even as structural consolidation continues.
7. The upcoming spending review provides an opportunity to further strengthen the composition of adjustment. Though this review will undoubtedly involve many difficult choices, more emphasis should be given to reducing public sector compensation premia and achieving savings in benefits and transfers through better targeting. This would mitigate the growth effects of adjustment—because reducing transfers to the less needy may have a smaller effect on consumption—and help shield the vulnerable.
8. Entitlement reforms would also help cement long-term fiscal sustainability. Potential measures in this area include bringing forward the planned increases in the statutory retirement age for state pensions and gradually aligning the generosity of public sector pensions with those for their counterparts in the private sector. Such reforms would have a limited adverse effect on aggregate demand now, but yield significant fiscal savings over the long run, thereby boosting the credibility of the government’s adjustment package. The initiatives launched by the government to review reform options for state and public sector pensions are therefore welcome.
9. The establishment of a new independent Office for Budget Responsibility (OBR) is a welcome step toward strengthening the budget process. Addressing deficiencies in the previous fiscal framework, the tasks envisaged for the new independent office—including to provide the macroeconomic and fiscal forecasts for the budget and to assess fiscal sustainability and compliance with the fiscal mandate—are apt. The OBR complements the government’s commitment to fiscal discipline by enhancing the transparency and credibility of the budget process and helping inform policy decisions. As the role and remit of the permanent OBR are finalized, it will be important to underpin its independence through an arms-length relationship with Treasury, full-access rights to pertinent information, and multi-year budgets. The current forward-looking fiscal mandate is an appropriate guide for the transition to a more sustainable fiscal position, but in due course should be replaced with a more permanent forward-looking fiscal rule that would continue to be monitored by the OBR.
Maintaining monetary stimulus
10. Unprecedented monetary easing has helped restore confidence and bolster the recovery. Near-zero policy rates have played a key role in supporting demand and facilitating balance sheet repair. The Bank of England’s large-scale asset purchases have provided additional stimulus: although the precise impact of quantitative easing on aggregate demand remains hard to quantify, there is clear evidence that it has lowered bond yields and boosted asset valuations, thereby shoring up market confidence, household net wealth, and corporate credit supply. Meanwhile, medium-term inflation expectations have remained well-anchored.
11. The current monetary stance and data-dependent approach to next steps is appropriate. With inflation projected to fall back to target over the policy horizon, the Bank of England’s accommodative stance reflects the need to maintain overall policy stimulus as fiscal tightening takes hold and financial intermediation normalizes only gradually. However, near-term adjustments might become necessary in response to incoming data. If the recovery were to weaken and increase disinflationary pressure, asset purchases should resume. Conversely, the central bank must stand ready to start a gradual tightening if output recovers apace and inflation continues to surprise on the upside. Developments in labor costs, other input prices, and inflation expectations warrant particularly close monitoring.
Moving to a safer financial system
12. The health of the banking sector has improved over the last year. All major banks have raised capital and lowered leverage. For the system, earnings have been boosted by lower-than-expected impairment charges, wider lending margins, and higher investment banking revenue. The recent EU-wide stress tests and associated disclosure, complementary to the UK’s own earlier stress-testing exercise, confirmed the relatively good health of UK banks, facilitating their efforts to tap longer-term funding markets.
13. Nonetheless, important challenges remain. The ongoing adjustment of bank balance sheets needs to continue, as public support schemes taper off and regulatory requirements tighten. Meanwhile, uncertainty about the sustainability of bank profits and the quality of their assets, especially some banks’ exposure to commercial real estate, remains significant. Faced with such uncertainty, banks have stayed cautious about extending new credit. Tight credit supply, in turn, could curb the pace of recovery once credit demand, which is currently weak, picks up.
14. In view of this environment, continued progress is needed to enhance financial sector resilience and reduce risks to the economy and taxpayer. Toward these ends:
• Capital buffers should be strengthened further, notably by restraining dividend payouts and remuneration budgets, taking into account bank-specific circumstances. Although higher capitalization will decrease expected returns on equity in the banking sector, this should be compensated by lower risks for bank stakeholders and society at large. Larger capital buffers will also enhance banks’ ability to raise longer-term funds at reasonable costs and maintain adequate credit supply to the private sector at all times.
• Crisis-related public interventions should be unwound in line with initial program design to gradually reduce taxpayer risk and restore private sector responsibility. Against this backdrop, supervisors need to keep up the pressure on banks to develop robust new funding models based upon a sound mix of simpler and more transparent instruments. Progress in this direction would benefit from timely clarification of how international and EU regulators will treat different capital and funding instruments in the future.
Beyond these efforts, the case for deeper structural changes to the UK financial sector needs to be examined. The public debate on possible reforms, informed by the Independent Commission on Banking, is welcome.
15. Building on the recent Basel III and Financial Stability Board proposals, the UK authorities should continue their constructive efforts to secure an ambitious international package of regulatory reform and rigorous implementation of this package in the EU:
• The UK is home to a number of very large financial institutions. Thus, the authorities have rightly emphasized the need for concrete tools, such as capital and liquidity surcharges, to address the resulting systemic risk. They should continue to provide intellectual leadership in this debate while cooperating closely with their international partners to reach agreement on a suitable set of reforms.
• In the same vein, additional work is needed to facilitate the resolution of complex, cross-border financial institutions, as envisaged under the authorities’ pilot exercise on “living wills.” The UK’s 2009 Banking Act has provided an effective national special resolution regime for banks. However, greater international cooperation is indispensable to develop credible policy tools for handling the failure of systemically important entities with complex, cross-border activities.
16. The development of macroprudential instruments to mitigate the amplitude of credit cycles is another key policy priority. The creation of a Financial Policy Committee (FPC) with an explicit macroprudential mandate is a welcome step. In their relevant consultation document, the authorities have rightly laid out a wide range of tools that would give the FPC flexibility to respond to the build-up of risks. However, more work on the calibration of these tools will be required. To be effective, some macroprudential measures will also need to be coordinated closely with regulators in other countries, notably within the EU.
17. Continued emphasis on proactive microprudential oversight is also critical as the UK moves to a new regulatory architecture. The new setup should facilitate the integration of micro- and macroprudential oversight, but institutional changes alone are no guarantee for superior outcomes. It will thus be crucial to continue enhancing the more intrusive, judgment-based, and strategic approach to supervision adopted since the crisis. In this context:
• The Prudential Regulation Authority should have the power to supervise and, if necessary, give formal directions at the financial holding company level in order to enhance consolidated supervision.
• Adoption of a “prompt corrective action” regime would further strengthen the supervisor’s capacity to address emerging risks at an early stage.
• Prudential oversight should be supported by market discipline. A useful tool in this regard would be the regular public disclosure by the supervisor of non-confidential firm-level prudential returns.
• The tightening of banking sector regulation might cause risks to migrate into less regulated parts of the financial system. A critical task for the FPC, therefore, will be to identify such risk migration and ensure a commensurate widening of the regulatory perimeter.
18. The IMF staff will conduct a comprehensive financial system stability assessment for the UK in 2011. This assessment, to be prepared under the IMF’s “Financial Sector Assessment Program” (FSAP), will provide an opportunity to further review key issues in the financial sector.
Conclusion
19. With steadfast fiscal adjustment, forward-looking monetary policy aimed at achieving the inflation target, and gradual implementation of strong financial sector reforms, economic fundamentals should strengthen and establish the basis for sustainable recovery.
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We are grateful for the warm welcome by those we have met during our discussions.
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