Public Information Notice: IMF Concludes Article IV Consultation with the United Kingdom
March 7, 1999
|Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.|
On March 3, 1999, the Executive Board concluded the Article IV consultation with the United Kingdom1.
Despite tensions arising from the weakening of the external sector and robust domestic demand since the last consultation, strong growth continued until mid-1998 while overheating was forestalled. Growth has slowed down sharply to more sustainable rates since then and is set to slow further in 1999. However, private sector fundamentals are strong, and monetary and fiscal policies are in a good position to ensure that the slowdown will be limited and of short duration.
Over the six quarters to mid-1998 real GDP grew at a 3½ percent annual rate. By the third quarter of the year, unemployment had fallen to 4.6 percent, and the U.K. economy was operating above potential by about 1 percent of GDP. Household consumption and business investment grew rapidly as private-sector confidence was underpinned by the authorities’ commitment to stability, and a virtuous circle of rising aggregate demand, employment gains, substantial reductions in unemployment, and higher asset prices. As expected, the foreign balance was not a source of strength, as the high value of sterling and slowing growth in world markets hurt exports and strong domestic demand encouraged imports.
To reduce the risk of overheating and, thereby, to ensure the inflation target of 2.5 percent would be achieved, the Bank of England raised its repo rate by a cumulative 150 basis points between May 1997 and June 1998, to 7.5 percent. The robust cyclical performance of the U.K. economy and anticipation of the associated monetary tightening resulted in an appreciation of sterling by 22 percent in real effective terms between mid-1996 and end-1997.
The fiscal position was also tightened substantially over this period, in accordance with budgetary plans, thus acting to support monetary policy. Consolidation had also been needed to help redress the policy mix imbalance that had developed in the early 1990s and to reverse the effects of a series of deficits. According to Fund staff estimates, the structural deficit fell by 2½ percent of GDP in FY 1997/98 and is expected to fall by a further ½ percent in FY 1998/99, leaving it close to balance.
Although by mid-1998 both labor and product markets were tight, there were few overt signs of inflationary pressure. The RPIX inflation rate fell to the government’s target of 2.5 percent in August and remained there through November, before rising to 2.6 percent in December and January. Wage pressures had been difficult to assess in 1998 because of data revisions, but such evidence as was available, such as wage settlements adjusted for changes in composition, did not suggest strong pressures.
By the second half of 1998 there were increasing, and welcome, indications that the economy was slowing from its unsustainable pace. This slowing can be traced to the lagged effects of the monetary and fiscal tightening, as well as to the progressive weakening of the world economy through the year. Third quarter real GDP rose by only 1.4 percent (annual rate) and preliminary fourth quarter estimates are for growth of only 0.8 percent. Both retail sales and industrial production weakened. In response, the Bank of England lowered its repo rate by 200 basis points to 5.5 percent between October 1998 and February 1999.
The United Kingdom has significantly improved the architecture of macroeconomic policy making. The basic thrust of these changes has been to increase the focus on achieving explicit and stated medium-term goals by clarifying institutional responsibilities and aligning them more closely with objectives, as well as by increasing accountability. Besides explicit and measurable objectives, such an architecture requires transparency in both the process and the result achieved. The first steps in this direction were taken by the previous Government. The current Government has advanced this agenda substantially, most notably by granting the Bank of England operational independence in May 1997, but more generally by reassigning institutional responsibilities and by being more precise about the fiscal and monetary objectives for which policy makers are to be judged accountable. It is also amalgamating the responsibility for the supervision and regulation of financial institutions in the Financial Services Authority (FSA) which replaced nine separate agencies.
Executive Board Assessment
Executive Directors commended the authorities for the United Kingdom’s impressive economic performance in recent years and their skillful management of the economy. Directors observed that a virtuous cycle of rising aggregate demand, employment gains, and higher asset prices had helped the economy sustain a relatively high growth rate, without creating significant inflationary pressures. These accomplishments had been underpinned by a revamping and strengthening of the authorities’ macroeconomic policy framework through a clear medium-term orientation guided by the key principles of transparency, accountability, and credibility. Several Directors considered that the United Kingdom’s experience in this regard could offer useful lessons for other advanced and developing countries, although the particular circumstances of individual countries would have to be taken into account.
Looking ahead, Directors agreed that a period of slower growth was in the offing, following a number of years of good growth performance. However, the soundness of past policies had left fiscal, and especially monetary, policy well placed to deal promptly and decisively with developments. With both public and private sector fundamentals quite strong and structural policies oriented toward strengthening incentives, the slowdown should be short lived. Noting, nonetheless, that the balance of risks remains largely on the downside, relating in particular to the uncertainties about the global outlook, Directors considered that macroeconomic policy should remain supportive of economic activity.
Most Directors agreed that monetary policy was the instrument of choice to promote short-run macroeconomic stability. Directors saw scope for further monetary easing to avoid an excessive weakening of economic activity. As regards fiscal policy, the pronounced consolidation undertaken in recent years had established a sound public finance position. As a result, there was room to allow the automatic stabilizers to operate fully, without risking an unstable fiscal situation or a breach of the Stability and Growth Pact ceiling. However, Directors underscored the importance of adhering to the plans laid out in the budgetary documents. As regards the exchange rate, most Directors believed that it remained somewhat overvalued, but this could well be unwound as cyclical divergences with Europe diminished.
Directors praised the government’s efforts to strengthen the framework of monetary and fiscal policy in recent years, which had contributed to enhancing the credibility of macroeconomic policy. The revamping of the framework was most advanced with respect to monetary policy. Directors generally agreed that this framework—notably the clear and symmetric target in the transparent process—had worked well in the United Kingdom, and had led to timely and judicious changes in policy interest rates. Several Directors noted the important role that the operational independence granted to the Bank of England had played in enhancing policy credibility.
On the transparency of the monetary framework, Directors considered the United Kingdom to be close to the frontier. A few went further and urged even greater transparency regarding the likely course of future monetary policy, but others felt that such a degree of transparency ran the risk of impairing the quality of the Monetary Policy Committee’s decisions and possibly undermining its independence. On the appropriate inflation measure for the inflation target, several Directors took note of the authorities’ preference to first develop a solid track record with the existing RPIX-based target, but noting the advantages of a HICP-based target, encouraged a shift to this target at an appropriate time in the future. Some also pointed out that, on an HICP measure of inflation, the United Kingdom already displayed a greater degree of convergence on inflation with the euro area. Some Directors expressed concern about the recent interruption of data on earnings, especially in view of their importance for inflation targeting, but took note that publication of the data had now resumed.
Directors noted that the new fiscal policy framework should, when fully in place, increase the transparency and accountability of fiscal decisions. While Directors generally considered that the golden and debt sustainability rules provided a reasonable operational basis for fiscal policy, they felt that these rules did not impose clear enough limits on future policies. Most Directors agreed that the authorities should adhere to budget plans of sustaining approximate structural balance, while shifting the composition of spending toward investment. As regards fiscal transparency, Directors welcomed the authorities’ many steps in this direction, including the institution of the pre-budget report which allowed for informed discussion prior to the budget’s finalization, and a new public reporting framework. The authorities were also commended for taking the lead in publishing a self-assessment of fiscal transparency, in line with the Fund’s Code of Good Practices on this subject. Among further such steps, the authorities should consider including in the main documents more refined and functional breakdowns of expenditures, as well as the cost of existing tax expenditures.
Directors considered the creation of a unified financial supervisory authority (the Financial Services Authority) an appropriate response to the uneven quality of supervision and consumer protection across various financial sectors, and to the increasing importance of large financial institutions operating across traditional lines of business. They noted that it would be important in the forthcoming legislation to ensure that the regulatory and supervisory activities of the FSA are transparent and accountable. In addition, while the collaboration between the FSA and the Bank of England on matters of common interest—in particular the Bank’s lender of last resort function—seemed adequate at present, the issue would need to be kept under careful review, with an eye to avoiding possible coordination problems.
Directors welcomed the initiatives to extend the basic "welfare to work" thrust started by the government in its first year in office. Broadly, these initiatives should enhance the working of the labor market. Directors underscored the need for reducing further high marginal effective tax rates at the low end, but recognized that doing so would involve larger budgetary costs. A number of Directors expressed concern that the national minimum wage could have an adverse effect on employment.
Directors agreed that, while the decision regarding the euro was in large part political, it would have extensive macroeconomic and structural ramifications either way. Assuming the decision was to join, one of the main economic imponderables was whether the exchange rate would be sufficiently well behaved to permit a viable entry rate. Most Directors shared the view that the prudent and stable monetary and fiscal policies being pursued by the government should help to reduce exchange rate volatility and promote greater convergence with the euro area economies. To further facilitate the transition, Directors encouraged the authorities to continue with reforms to enhance the economy’s flexibility, especially as regards real wages.
Directors commended the authorities’ initiatives to relieve the poorest countries’ debt problem and their commitment to reverse the downward trend in the United Kingdom’s overseas aid spending. They encouraged the authorities to accelerate progress toward the United Nation’s target for overseas aid spending of 0.7 percent of GDP.
|United Kingdom: Selected Economic Indicators|
|Real Economy (change in percent)|
|CPI (excluding mortgage interest)||2.8||2.9||2.8||2.6||2.5|
|Unemployment rate (claimant count, in percent)||8.0||7.3||5.5||4.7||5.0|
|Gross national saving (percent of GDP)||17.2||16.4||16.9||17/3||17/1|
|Gross domestic investment (percent of GDP)||15.9||15.5||15.4||16.2||16.5|
|Public Finance (in percent of GDP)|
|General government balance||-1.9||-1.1||-1.9||0.0||-0.8|
|Public sector borrowing requirement2||4.8||3.6||0.4||-0.3||0.8|
|General government debt2||50.5||53.8||54.5||48.2||47.7|
|Money and Credit (end-year, percent change)|
|Interest Rates (year average)|
|Three-month Interbank rate||6.7||6.0||6.9||6.55||...|
|Ten-year government bond yield||8.2||7.8||7.0||4.55||...|
|Balance of Payments (in percent of GDP)|
|Reserves (national valuation of gold, end of
period, in billlions of SDRs)
|Reserves cover (months of imports of G&S)||1.2||1.6||1.2||...||...|
|Fund Position (As of November 1998)|
|Holdings of currency (in percent of quota)||64.5|
|Holdings of SDRs (in percent of allocation)||13.1|
|Quota (in millions of SDRs)||7,414.6|
|Exchange rate regime||
Floating exchange rate
US$1 = 0.6169
|Present rate (March 3, 1999)|
|Nominal effective rate (1990 = 100)||99.4||99.7||100.6||100.66||......|
|Real effective rate (1990 = 100)7||87.6||90.7||110.1||118.86||......|
1IMF staff estimates/projections, except where noted.
2Fiscal year beginning April 1; PSBR excludes privatization.
4Third quarter 1998.
7Based on relative normalized united labor costs in manufacturing.
1Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities. In this PIN, the main features of the Board's discussion are described.