IMF Executive Board Concludes 2011 Article IV Consultation with the United Kingdom

On July 27, 2011 the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the United Kingdom.¹ This consultation included a Financial System Stability Assessment (FSSA) under the IMF’s Financial Sector Assessment Program, which analyzes financial sector health and associated policies. It also included discussion of the first UK Spillover Report, which analyzes spillovers emanating from UK policies to the rest of the world and is being conducted this year for five systemic economies.

Background

Economic growth has recently been sluggish and inflation has been high in the UK, though both indicators are projected to improve gradually over time. Recent increases in indirect taxes and commodity prices will keep headline inflation well above 4 percent during 2011. However, it should return near the 2 percent target by end-2012 as these transitory factors dissipate and as significant spare capacity keeps underlying inflation in check. Growth, which has also been adversely affected by spiking commodity prices, is expected to gradually accelerate from around 1½ percent in 2011 to 2½ percent in the medium term, as low interest rates and global growth support expansion led by net exports and investment. Nonetheless, there are large risks around this central scenario, including from uncertainties surrounding turmoil in parts of the euro area, headwinds from fiscal consolidation, volatile commodity prices, and the housing market.

A wide-ranging policy program has been put in place to aid the post-crisis repair of the UK economy. The agenda includes restoring confidence in public finances, moving to a safer financial sector, and rebalancing the economy away from public and private consumption and toward more sustainable sources of growth (net exports and investment). As part of this program, the government has undertaken institutional reform to address weaknesses in the policymaking framework. These reforms include moving the microprudential regulator under the Bank of England (BoE), establishing a Financial Policy Committee (FPC) to oversee macroprudential policy, and creating an independent Office for Budget Responsibility (OBR) aimed at strengthening the credibility of fiscal analysis and forecasts.

The government has made progress on its medium-term fiscal consolidation plan, which is a central component of its overall macroeconomic strategy. The cyclically adjusted primary balance (as a percent of potential GDP) is estimated to have improved by about 2 percentage points in FY10/11. Going forward, the pace of adjustment is projected to ease slightly and become increasingly reliant on spending restraint.

The BoE has maintained an accommodative monetary policy stance, with the Bank Rate at 0.5 percent and the stock of outstanding asset purchases at £200 billion. This stance reflects the BoE’s forecast that inflation will return to target over the forecast horizon, taking into account disinflationary forces from fiscal consolidation.

Meanwhile, banks have strengthened their balance sheets and reduced funding vulnerabilities over the last year, with all major banks ahead of schedule in their transition to Basel III rules. Nonetheless, the recovery process is not yet complete. Despite recent progress, funding risks remain a key vulnerability, as highlighted by the FSSA.

Executive Board Assessment

Executive Directors welcomed progress made in repairing the UK economy, including a lower fiscal deficit, higher bank capital, and expanded employment. Nonetheless, they noted that the combination of low growth and above-target headline inflation poses policy challenges.

Directors considered the current mix of accommodative monetary and tight fiscal policy to be appropriate. They noted that such a mix will help keep real interest rates low and sterling competitive, thereby assisting public and private balance sheet repair while rebalancing growth toward investment and net exports. This rebalancing is necessary if robust growth is to be achieved at the same time that private and public consumption are eased to more sustainable levels.

Directors noted that the growth outlook is subject to considerable uncertainties. They agreed that policies may need to adjust in the event of a change in macroeconomic conditions. In particular, if growth and inflation surprise on the upside, monetary tightening would need to accelerate. Conversely, mounting evidence that weak demand is likely to cause the economy to stall and enter a period of prolonged low growth would call for looser macroeconomic policies.

Directors stressed the importance of accelerating structural reforms to promote long-term fiscal sustainability and bolster the growth potential, along the lines outlined in the authorities’ Growth Review. In this regard, they welcomed the creation of a permanent Office for Budget Responsibility and supported the reform of the pension system.

Directors noted that efforts to strengthen the resilience of the financial sector have yielded improvements as bank capital levels have improved significantly and all major banks passed the recent EU stress-tests. They considered, however, that the sector remains vulnerable to risks relating to their funding model and their asset quality.

Directors concurred with the findings of the FSSA and called for implementing its recommendations, including improving the standards for the public disclosure of financial data. In this context, they welcomed the establishment of the FPC, whose explicit mandate for macroprudential oversight should help reduce systemic risk.

Directors agreed with the conclusions of the spillover report that the UK’s potential for spillovers is concentrated in the financial sector. They stressed that, given its central position, the stability and efficiency of the UK financial sector is a global public good, requiring that financial supervision and regulation be strengthened and held to the highest standards. International cooperation between regulatory agencies in ensuring effective cross-border resolution arrangements, group-wide liquidity management, information sharing, and jurisdictional reciprocity will be essential for the UK to fulfill its potential to support global financial stability.

¹ Under 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. An explanation of any qualifiers used in summings up can be found here: http://www.imf.org/external/np/sec/misc/qualifiers.htm.