Transcript of a Conference Call on the Article IV Consultation with the United KingdomWith Mission Chief and Deputy Director of the IMF’s European Department Ajai Chopra, and Deputy Division Chief Dora Iakova
Washington, D.C., Thursday, July 16
MR. CHOPRA: Good morning. To those of you in Europe, good afternoon. My name is Ajai Chopra. I'm the mission chief for the Article IV Consultation with the United Kingdom. With me is Dora Iakova, who is in charge of the day-to-day work on the UK.
The IMF Executive Board concluded its discussion of this year's Consultation last Friday. I will first summarize our main findings and policy recommendations, following which Dora and I would be happy to answer your questions.
I will organize my remarks around four questions. First, what is our evaluation of the authorities' policy response? The United Kingdom has been hit hard by the global financial crisis. The authorities have responded to the shock with a wide range of forceful policy measures. Public capital has been injected into weak banks and their troubled assets are being ring-fenced. Banking sector liquidity has been shored up, and economic activity is being supported by unprecedented easing of monetary policy and temporary discretionary fiscal stimulus. These aggressive policies have successfully contained the crisis, and there are tentative signs that confidence is returning. Simultaneously, the flexible exchange rate has acted as a shock absorber, depreciating early in the crisis and thus shifting demands to domestically produced goods and services.
The second question is what is our assessment of the outlook for the UK economy? Recent high-frequency indicators suggest that the economy may be stabilizing. We are, of course, happy to see these positive developments, but we nonetheless take a cautious view on the recovery, which we expect will be sluggish and gradual. In fact, cross-country research from earlier recessions shows that recoveries tend to be slower and more subdued when the economy emerges from a financial crisis. This is precisely the situation we have in the UK right now.
Most banks and households are going through a difficult balance sheet adjustment, which is likely to take time. I should say, however, that the timing and strength of the recovery remain highly uncertain, given the unprecedented scale of this crisis and the importance of confidence effects.
The third question is about the risks facing the UK economy. One of the biggest risks remaining is that the financial sector is still fragile. The deepening of the negative feedback loop between the real economy and the financial system remains a key risk. For example, a sharp increase in unemployment or further rapid declines in property prices could lead to greater-than-expected credit losses. This would weaken the health of the financial sector, causing even tighter credit and a deeper downturn.
More generally, underlined vulnerabilities in the UK are sizeable. First and foremost, the financial crisis has brought about a dramatic deterioration in public finances. Public debt started from a relatively low level in the UK but is now projected to double in five years. The various banking sector support measures have also created significant contingent liabilities, for example through the assets protection scheme. In these circumstances, a severe new shock from within the UK or from outside could disrupt domestic and external stability. This makes it all the more important to implement credible and consistent policies that reduce the downside risks and strengthen confidence.
The fourth question is what are the main policy recommendations in our report? The key policy priorities are, first, resolving the problems in the financial sector to ensure stability and promote normalization of credit supply; and, second, setting monetary and fiscal policies consistent with the existing policy goal of price stability and fiscal sustainability.
I will say a little bit more about each of these areas in turn.
On banking sector policy, the authorities' forceful interventions have averted the systemic breakdown in the financial sector. If you allow me to use a metaphor, the patient -- in this case, the banking system -- was deathly ill and had to be rushed to the intensive care unit. The patient has now been stabilized and is out of the ICU. But even though a severe relapse is less likely, the patient is not yet healthy again. In particular, banks may not yet be in a position to provide enough credit for a strong recovery, especially as the recessionary dynamics further increase credit losses in the months ahead. Therefore, it will be important for the authorities to continue with targeted financial sector policies.
Our report provides a number of suggestions, but let me just highlight the most important point, namely, a further strengthening of banks' capital positions. The authorities can achieve this by, first, encouraging banks to augment the capital base in the current more favorable market environment; second, standing ready to provide further public capital support, if necessary; and, third, promoting options to preserve capital cushions and improve capital structures.
Beyond the short term, it is also clear that the authorities need to strengthen the UK prudential framework. The creation of a special resolution regime for failing banks is a welcome improvement. The same goes for the authorities' move to a more hands-on supervisory regime. In our view, these steps should be complemented by enhanced disclosure of financial information to reduce uncertainty and enhance public scrutiny. Aside from better disclosure, it is essential to enhance the regulatory system, especially in the areas of capital adequacy, liquidity management, and reducing procyclicality.
The recent Turner review by the FSA, the Bank of England's Financial Stability Report, and the Treasury's White Paper make a number of important proposals on these issues. The challenge now is to make concrete progress in creating a better regulatory system in close collaboration with international partners.
Turning now to monetary policy, the Bank of England's aggressive policy easing has been appropriate. It is too early to judge the overall effectiveness of the Bank's quantitative easing strategy, but the initial results are moderately encouraging. Government bond rates have been kept low, and liquidity and targeted private credit markets has improved. In our view, diversified further, the Bank's private asset purchases could help to improve the functioning of viable capital markets and sustain the flow of credit to the real economy.
Unconventional policies also come with unusual uncertainties and risks. It is comforting therefore that the UK has a robust institutional framework in place that underpins the central bank's operational independence. In particular, asset purchases by the Bank of England are covered by a comprehensive indemnity from the Treasury, which protect the Central Bank's balance sheet. Similarly, it is reassuring that the Monetary Policy Committee will not need Treasury approval to implement a future exit from quantitative easing. This means the Bank of England will be able to act as required to meet the inflation target.
Ultimately, of course, trust in the central bank's operational independence depends also on the broader situation of public finances. Specifically, policymakers have to avoid any perception that the central bank's purchases of government bonds are leading the UK down a slippery slope to add monetization of the widening fiscal deficits.
This takes us to the final and arguably central policy issue, which is fiscal policy. Indeed, in the current context of the UK, all roads lead to fiscal policy. The various banking sector support measures have created large new borrowing requirements and contingent liabilities for the public sector. At the same time, the Bank of England's unconventional policy can only be successful if the public and markets retain their confidence in the sustainability of public finances.
Debt is rising fast, but recent market conditions in both the government bond market and also the foreign exchange market show that markets continue to give the UK the benefit of the doubt. This benefit of the doubt will not last forever, and the authorities clearly should not test the market's limits. In order to preserve market confidence, it is crucial to demonstrate the strong commitment to reversing the sharp deterioration of the fiscal position within a reasonable time frame. Concretely, once the economic recovery is established, implementing an ambitious consolidation plan will be essential. The focus should be on putting debt on a firmly downward path faster than envisaged in the 2009 budget. In order to make such plans more credible, the authorities should also clarify early the specific measures that are needed to achieve the adjustment.
I think that sums up the key points in our report and also the key points that were made by Executive Directors in their discussion.
QUESTIONER: I have a couple of questions for you. First of all, in terms of the greater detail that you would like on the fiscal side, there is a row going on in the government in your position as whether the government should publish the Comprehensive Spending Review for 2011 to 14. Now, you talk about them putting out in more detail on the spending side what they're going to do. Do you have a view on whether they should be giving quite detailed numbers on spending beyond the current period?
And my second question is just on lending. In your report you seem quite worried about whether banks will be able to increase their lending over the next few months. Do you think the government should be considering nationalizing banks in order to directly control that lending?
MR. CHOPRA: Firstly, on fiscal policy and spending, the key points that I would make are the following. We've been quite clear in the reports that the international experience does show that restraining expenditure brings about longer-lasting adjustment, a more durable adjustment, and has been a feature of most of the larger-adjustment episodes. We have a box in the staff report that goes through the international experience. With that said, I think in the UK context right now, given the magnitude of the adjustment that is going to be needed, and also given the loss in revenues related to asset markets and the financial sector, I think it's fair to say that some of the adjustments will also need to come from the revenue side. But, as I said, the international experience is that expenditure-based consolidations are more durable.
Now, on how precisely to articulate the expenditure-based consolidation, we did say in the report that the comprehensive spending review does provide an opportunity to commit to a concrete expenditure path and associated measures, and that remains our view. But, you know, the timing of specifying these concrete expenditure measures is something that is really a matter for the authorities. They have the details. They need to be sure that they're in a position to make the specific commitments. And I don't think these things should be unduly rushed, but nor should they be unduly delayed. I think there is a balancing act over here that the authorities will need to keep in mind.
On the issue of dealing with the financial sector, I think here the main point I would make is that we have put a lot of stress on capital augmentation. And in this regard, we think that it's best for banks to try to silence the doubters by building up sizeable capital cushions. In the first instance I think it's up to the banks to try to tap markets to augment their capital base. They should also undertake other steps, for example, asset divestitures. I think there have been some positive developments in the recent past, and it will be important for institutions to continue down that route.
Now, what we have also said is that, if circumstances require, then it does become important to put in more public money if needed. This depends very much on circumstances. This is not a blanket recommendation. But we feel that the authorities need to keep this as a part of their arsenal, and in our view, given that restoring the financial sector's health is the key priority, if public funds are needed for this purpose, we feel that this could arguably be the cheapest way for the government to support the economy during a crisis, given the huge cost of letting systemic banks fail. Therefore, if it is needed, we feel that there should be no hesitancy to provide further public capital support where needed.
But I should again say that the asset protection scheme that is being worked on for RBS and the Lloyd's Banking Group do provide contingent public capital.
QUESTIONER: Two questions. First of all, your forecast for GDP growth is notably weaker than many of the others with 0.2 percent of a return to growth penciled in for next year. How concerned are you, given the vulnerabilities that the Fund has identified, that that could give way to a relapse and a potential double-dip, which is a key concern at present?
Secondly, on the banking issue, Adam Posen from Peterson Institute, who's joining the Bank of England, has said in the last few days that Britain is a ahead of most of its competitors, including the United States, Germany and most of the Euro zone, in restoring stability to the banks. Do you agree with that verdict?
MR. CHOPRA: On the forecast, I come back to the point that I made right at the beginning. I think there's a tremendous amount of uncertainty right now on the outlook, and one can face a number of different scenarios. What we put forward in our report is our central scenario, but there are risks on both sides of this. Certain things could be better, things could be worse.
Now, on the possibility of a double-dip, I'm going to ask my colleague, Dora Iakova, to answer that. But before getting to that let me also touch on your reference to Adam Posen's testimony in front of the Treasury Select Committee. I would agree with Mr. Posen. As I said right at the beginning, the government has done a lot to inject public capital into weak banks, and the troubled assets are being ring-fenced through the asset protection scheme. I think in both these actions, the government was ahead of the curve in terms of what was happening internationally. I think these were very bold policies. They were very important policies. We do think it’s going to be important that the APS deals are finalized reasonably soon so that one can then see exactly what was in the pool of assets that are being insured. I think that's an important recommendation that we've made, and I think the authorities agree that once these deals are completed there will be considerable transparency so that we can all come to a judgment as to what precisely has been done in terms of ring-fencing these assets.
But let me now turn back to Ms. Iakova regarding our forecast.
MS. IAKOVA: On our GDP growth forecast, the 4.2 percent for this year does not assume a double-dip. In fact, it assumes flattening of growth in the second half of the year, and then we have a steady pickup in 2010. I just wanted to clarify this point. Our projections for 2009 appear to be more pessimistic than what the forecasters have, but that simply reflects the fact that others have not reflected the new data for Q1 in their forecast yet.
That said, as Jai emphasized, there is significant uncertainty going forward, both on the upside and on the downside. The key uncertainty, I think, is the pace and extent of adjustment of bank and household balance sheets, as both bank and households still have highly leveraged balance sheets, despite some de-leveraging having taken place. The extent of further de-leveraging would determine, to a large extent, the pace of the recovery.
QUESTIONER: I wanted to follow-up a little bit on the initial question about the timing within which you'd like to see some clear indication of the past to bring about a more sustainable fiscal plan. I understand that you are of the opinion that you think this is something that's a matter for the authorities. So, by the same token, it does seem like you really are pressing for something more specific, and I want to know if you'd be happy to wait as long as next year, in other words, once the next election will have to have been called.
My second question is on your point about the Bank of England's asset purchase scheme. You had mentioned that there is scope, you think, for providing greater improvement in capital markets by broadening the range of assets that may be purchased. Have you anything specific in mind as to the kinds of variance where the Bank ought to be expanding its purchases?
MR. CHOPRA: On the first question about the specificity of fiscal adjustment measures, I think right now it would be premature to start tightening fiscal policy, so that's really the first point. We have said very clearly that the consolidation should begin once a recovery is established. So, from our forecast you'll see that we are some distance away from that. But that doesn't mean that it's too early to start thinking about the nature of the adjustment. My sense is that this is going to be very much a part of the political debate in the UK over the next year, and at this point we don't have anything further to say on this. But, you know, the critical point is that the UK authorities will need to come up with specific consolidation plans and that these plans should not be unduly delayed, but nor can these be unduly rushed. I think there will have to be a public discussion of this. In our report we also said that a broad consensus in the public will be very important, given the size of fiscal adjustment that needs to take place.
On the question of specific markets, again I'll turn to my colleague, Dora Iakova, to answer that, but I think the key points that we make in our report are that the idea should be to target private credit markets that are currently dysfunctional but are deemed to be viable in the long term. We think that's the basic principle that needs to be followed, but let me check with Ms. Iakova as to whether she has something to add on that.
MS. IAKOVA: You have a specific question on which other markets we suggest that the Bank of England should target? The Bank of England currently purchases commercial paper and corporate bonds with the explicit goal of improving the functioning of these markets, and it's currently examining the possibility of buying asset-backed commercial paper.
According to the Treasury's initial authorization for the APS, the Bank of England can also invest in other asset-backed securities and in syndicated loans, and we think that both of these markets could be considered for expansion of the credit-easing operation. They have taken a significant hit since the beginning of the crisis, and targeted interventions can produce significant benefits. QUESTIONER: Very simply, I didn't quite hear what Dora said about which assets she thinks the Bank should look to purchase. I couldn't quite hear.
MS. IAKOVA: The Bank of England is currently examining the possibility of bank asset-backed commercial paper, and the other markets that we suggest it could look into are other asset-backed securities and syndicated loans.