IMF Executive Board Concludes 2006 Article IV Consultation with the United KingdomPublic Information Notice (PIN) No. 07/28
March 5, 2007
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 2006 Article IV Consultation with United Kingdom is also available.
On February 28, 2007, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the United Kingdom.1
Macroeconomic performance in the United Kingdom remains impressive. After softer growth in 2005, the acceleration in GDP in 2006 was broadly based. Business investment was boosted by high net rates of return; residential investment by a pickup in house price appreciation; private consumption by robust employment growth, steady wage growth, and rising household wealth; and exports by the recovery in the euro area. Most indicators suggest little economic slack as of end-2006. CPI inflation rose above the 2 percent target in May 2006, mostly due to higher energy prices, and reached 3 percent in December. Although the current account deficit and the international investment position deteriorated in 2006, neither is a significant vulnerability and competitiveness is broadly appropriate.
In light of diminishing spare capacity, concerns about second-round effects of cost pressures, and rapid broad money growth, the Bank of England began raising the policy interest rate in mid-2006. The policy rate was raised on three occasions to 5¼ percent in January 2007. Given projected nominal GDP growth of about 5½ percent over the medium term, the current policy interest rate is broadly neutral.
A substantial fiscal expansion in 2001-04 led to a sharp deterioration in the fiscal balance and rising net public debt. A reversal of the deficit started in 2005-06, with the cyclically-adjusted overall balance relative to GDP estimated to have improved by ¾ percentage points over two years. This reflected primarily higher financial sector-related revenues, windfall energy-price-related revenues, and a higher tax rate on North Sea firms. The growth rate of current spending in 2006 is estimated to have been in line with nominal GDP growth.
The financial sector continues to thrive and linkages with financial systems in other countries continue to grow. Net exports of financial services have risen steadily over the past decade and increased sharply in recent years. Ratings agencies rank the highly profitable banking system as one of the strongest in the world. Linkages between the main UK and non-UK banks are getting stronger. Bank regulation and supervision have responded well to these developments. The life insurance industry has returned to a more stable outlook.
Executive Board Assessment
The Executive Directors welcomed the economy's continued impressive performance, which they attributed in part to policy frameworks that guide policies in ways that are responsive to the requirements for sustained strong growth, low inflation, a stable value for sterling, and continuing growth of London as a global financial center with sound institutions.
With the rebound in growth in 2006, Directors considered that increases in inflation and the current account deficit need to be watched as possible signs of capacity constraints, though going forward net immigration is likely to support capacity growth in line with demand. The near- and medium-term outlook is for continued strong and stable growth with a return of inflation to target. A number of Directors considered, however, that vulnerabilities, including those associated with high housing prices, warrant vigilance.
Directors agreed that openness and flexibility position the United Kingdom to continue to benefit from the opportunities of globalization and to absorb shocks. The recent rapid growth of the world economy has boosted demand for exports, especially of financial services. The combination of benign global financial conditions and openness to capital flows has contributed to record levels of foreign direct investment inflows. Admission of workers from most new EU member states has boosted the flow of immigrants and helped fill skills gaps. Openness may also increase exposure to downside global risks. And, although the flexibility of an open economy helps smooth the absorption of global shocks, macroeconomic and financial policies also have a role. In this vein, understanding the influences of globalization and ensuring adequate cushions for policies to respond to adverse shocks are crucial.
Directors noted that monetary policy is well-positioned to respond to shocks, though taming the energy-price-related increase in inflation remains a challenge. They agreed that the exchange rate may be slightly overvalued, though well within the bounds of uncertainty associated with such estimates, and in any case by a small enough margin not to be a concern. With diminishing economic slack and possibly rising inflation expectations, incentives are weakening for a timely adjustment in real wages to permanently higher energy prices. The tightening of monetary policy since August 2006 has therefore been appropriate to help ensure that inflation returns to target. For the immediate future, continuing to communicate the importance of wage restraint will help minimize the need for additional increases in interest rates. Depending on evolving prospects for wage growth, some further tightening of monetary policy may be required. More broadly, the Bank of England's efforts to disentangle the influences of globalization on inflation and monetary policy, and to communicate them to the public and financial markets, are appropriate.
Directors welcomed the government's plans for fiscal consolidation. Given the favorable medium-term outlook and the possibility that financial-sector and housing-related revenues may be temporarily high, Directors agreed that building the fiscal cushions needed to respond to adverse shocks should be a priority. Over the next few years, reducing the overall fiscal deficit will be essential to halt the increase in the ratio of net debt to GDP. Beyond that, maintaining a low deficit would build the cushion required for automatic stabilizers to operate in a downturn without allowing debt to exceed 40 percent of GDP, a limit that has served the economy well. The plan to focus this consolidation on spending restraint is appropriate, given that further increases in tax rates would risk adversely affecting incentives to work and invest. This will require disciplined choices in the forthcoming Comprehensive Spending Review. Regarding the long term, the proposed pension reform appropriately addresses the challenges to the pension system without jeopardizing fiscal sustainability.
Directors commended the fiscal framework for supporting the improvement in public finances. Continuing commitment to the framework during the prospective period of strong growth will help ensure that good times are indeed used to reduce the underlying fiscal deficit. As experience grows, further steps to strengthen the framework may be desirable, though with due regard to the cost of changes. One area where change would enhance confidence in the fiscal projections is broadening the reach of the National Audit Office audit of key fiscal assumptions.
Directors praised the financial authorities' efforts to further enhance the resilience of the financial system. With the financial sector in a strong position, the key vulnerabilities are to low-probability events with potentially severe consequences. In addressing these risks, the authorities are right to insist on balancing the costs and benefits of regulation. Plans to further enhance stress-testing and international crisis prevention and management arrangements are welcome.