IMF Executive Board Concludes 2005 Article IV Consultation with the United KingdomPublic Information Notice (PIN) No. 06/24
March 3, 2006
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. The staff report (use the free Adobe Acrobat Reader to view this pdf file) for the 2005 Article IV consultation with the United Kingdom is also available.
On March 1, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the United Kingdom.1
Macroeconomic stability remains remarkable, due in part to confidence-enhancing policy frameworks and generally sound implementation. With economic activity above potential in 2004, some easing of real GDP growth and rise of inflation in 2005 were expected. In the event, the slowdown in growth and rise in inflation were sharper than envisaged. The growth slowdown was driven mainly by a fall in private consumption growth, reflecting the cooling of the housing market, previous monetary policy tightening, and rising personal income tax revenues. Employment growth remained surprisingly rapid, owing in part to strong immigration and increased labor force participation by older people. CPI inflation peaked at 2½ percent in September, reflecting the earlier testing of supply constraints and the sharp increase in energy prices.
The simultaneous slowdown in aggregate demand and the large rise in energy prices presented monetary policy with conflicting signals. Higher energy prices produced an increase in the overall price level and a risk of second-round effects on inflation. A further consideration was the strength of immigration, especially from new EU members, which may have boosted labor supply relative to demand for goods and services. The only change in the policy interest rate in 2005 was a ¼ percentage point cut to 4½ percent in August.
Over much of the past decade, fiscal policy managed to contain—even reduce—debt while playing a useful countercyclical role. However, the sharp increase in government spending on public infrastructure and public services that began in FY2000/01 continued in FY2003/04 and FY2004/05. The result, as growth picked up, was procyclical stimulus, a growing deficit, and a rising debt ratio. In FY2004/05, the overall public sector deficit was 3¼ percent of GDP and end-year net debt amounted to almost 35 percent of GDP.
The banking system is strong, though the possible reversal of low global interest rates poses a risk. Ratings agencies continue to rank the U.K. banking system as one of the strongest among G7 countries. However, over the medium term, increasing leverage and the continuing search for yield represent downside risks. These risks, while global, are particularly relevant for the U.K. given the size and openness of its financial sector.
A longer-term question is whether private saving is adequate to support an aging population in the context of a frugal state pension system. Long-term fiscal sustainability in the U.K. is helped by less severe population aging and a less generous state pension system than in other G7 countries. However, if the working generation does not save enough for retirement, future governments may be forced to increase state pensions. There is evidence that a portion of the population is not saving enough to meet likely expectations of retirement income.
Executive Board Assessment
Executive Directors welcomed the U.K. economy's remarkable performance that has lasted more than a decade, and has been marked by continued economic expansion, falling unemployment, and sustained low inflation. Directors attributed this success to sound policies implemented by strong institutions and underpinned by monetary, fiscal, financial, and structural policy frameworks that have increasingly instilled confidence in the authorities' conduct of macroeconomic policies. Developments in 2005 put these policy frameworks to the test, with a slowdown in real GDP growth and a rise in inflation that were the sharpest in a decade, reflecting the economy's advanced cyclical position, the abrupt deceleration in house prices, and the sharp rise in oil prices. Monetary policy faced difficult choices, while fiscal policy needed adjustment in order to meet the authorities' fiscal rules.
Prospects for the U.K. economy going forward are favorable, with growth expected to pick up in 2006-2007 on the strength of private consumption, and inflation remaining stable around the target. Directors observed that the current account deficit and the negative international investment position are not major concerns, and that there is no clear evidence of overvaluation of the exchange rate. At the same time, Directors noted that important uncertainties and risks surround the outlook, to which the authorities will need to remain vigilant. These include the degree of overvaluation of house prices; the impact of high energy prices on potential output; the potential effects of immigration on aggregate supply and demand; and—on the external side—the risk that a disorderly unwinding of global imbalances could affect the value of sterling.
Directors agreed that monetary policy decisions remain delicately balanced. The cut in the policy interest rate last August appropriately acknowledged the downside risks to demand, while maintaining the rate in a neutral range. Looking ahead, Directors concurred that policy rate decisions should be focused in the very near term on averting second-round effects of the energy price increases and—following the pay rounds to be concluded in early 2006—on ensuring that the recovery of demand remains on track to close the output gap.
Directors noted that the structural fiscal deficit in the current fiscal year is on track to narrow substantially, reflecting windfall revenues from higher energy prices and strong personal income and corporate tax revenues, especially from the booming financial sector. They underscored the importance of full implementation of the authorities' plans to reduce the deficit further, including through the announced rise in the tax rate on North Sea oil and gas company profits, and restraint in the growth of current expenditure from FY2008/09. Directors agreed with the view that these measures should be sufficient to stabilize net debt. At the same time, they noted the uncertainties surrounding the estimates of the output gap, and the associated risk of the authorities' fiscal projections being somewhat more optimistic than warranted.
Directors observed that the envisaged expenditure restraint will involve difficult decisions and require careful planning, given the small share of discretionary spending in total spending and the authorities' intention to maintain the share of capital spending in GDP. They stressed the need to target the least productive expenditures, and looked forward to specific recommendations from the Comprehensive Spending Review, due for completion in mid-2007.
Directors agreed that the U.K fiscal framework is at the forefront of international best practice, particularly in terms of clarity and transparency. They observed that one particular strength of the framework is its use of independent audit of key assumptions and conventions underlying the fiscal projections. They welcomed the expansion of the role of the National Audit Office (NAO) over the past year and the authorities' intention to keep this issue under review. Several Directors saw merit in further broadening the scope of the NAO audit.
Directors agreed that the fiscal rules have played an important role in constraining discretion and disciplining fiscal policy. However, many Directors saw room for improving the credibility of the framework further in light of the unusually muted cyclical behavior of the economy and concerns regarding the redating of the economic cycle, although a number of Directors noted that the framework continues to serve the United Kingdom well. Directors noted the suggestion that, once current balance is regained, the authorities consider adopting a more forward-looking formulation that requires fiscal policy to be positioned to attain current balance in a set number of years. To bolster credibility, this could be accompanied by an independent audit of assumptions concerning the economy's cyclical position. A number of Directors, however, expressed reservations about these proposals.
Directors commended the supervisory authorities for skillfully meeting the challenge of overseeing a global financial center, and in particular for staying abreast of financial innovations in an environment marked by concerns about possible global underpricing of risk. They agreed that the banking system is well-capitalized and cost-efficient, and hence is well-positioned to absorb potential losses from financial market disturbances. Directors noted that specific risks—including exposures to commercial property, a possible loosening of corporate lending standards, and the growth of sub-prime lending—appear to be manageable. The rapid growth of credit risk transfer instruments, while providing important diversification benefits, has also created new risks. Directors therefore welcomed the authorities' efforts to publicize these risks and to address the transactions backlog. Going forward, it will be important to ensure that the development of market infrastructure and of financial institutions' risk management systems keeps pace with these innovations. Directors encouraged the authorities to continue to strengthen market surveillance and encourage market initiatives to improve disclosure, while paying due attention to the costs and benefits of new regulatory burdens. They welcomed the FSAP follow-up report and the impressive progress in implementing the 2002 FSAP recommendations.
Directors noted with concern the evidence that a portion of the population is not saving enough to meet retirement income expectations, and underlined the importance of strengthening incentives for private saving. They welcomed the findings and recommendations of the independent Pensions Commission as a key first step in developing a consensus on the extent of the problem and measures to address it. Directors recognized that increasing the generosity of the currently frugal state pension system would come at the cost of other public expenditures, and ensuring that the trade-offs are accurately and circumspectly considered will be critical.
Directors noted that the flexible and dynamic labor market is one of the U.K. economy's key strengths. They commended the policy of allowing new members of the EU full access to the labor market, which has relieved specific skill shortages and helped mitigate inflationary pressures. Directors considered that the authorities' strategy to stimulate productivity growth is appropriate, including the current emphasis on reducing the regulatory burden and improving the skills base. They welcomed the authorities' aspiration to increase the already high employment rate further, including through innovative measures to help incapacity benefit recipients find work.
Directors praised the United Kingdom for its leadership role in promoting trade liberalization, especially of agricultural trade. They also commended the government for the recent and planned increases in overseas development assistance.