## _cr0580 — Executive Summary (IMF Staff Report on the United Kingdom)

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### Macroeconomic performance and outlook
- Recent performance:
  - Growth described as “strong and steady” over the past decade; growth moderated over the past year and “appears to be settling at potential.”
  - Real GDP growth eased by end-2004 to an estimated potential rate of “about 2½ percent.”
  - Household consumption growth slowed due to rising debt service and a sharp diminution in house price appreciation.
  - Business fixed investment growth “held up” supported by strong corporate profitability.
  - Wage growth stabilized and inflation remained subdued.
  - Core CPI inflation (excluding food, beverages, tobacco, and energy) remained “about 1¼ percent”; CPI inflation edged up to “about 1½ percent” at end-2004.
  - House price appreciation slowed, but house prices are “widely seen as overvalued.”
  - Trade deficit widened to “3½ percent of GDP”; a 30 percent real appreciation of sterling in 1996–97 contributed to earlier trade deterioration.
- Near-term and medium-term projections and scenario (percentage change, unless otherwise indicated):
  - Real GDP: 2003 2.2; 2004 3.1; 2005 2.6; 2006 2.6; 2007 2.3; 2008 2.2; 2009 2.2; 2010 2.2.
  - Domestic demand: 2003 2.5; 2004 3.8; 2005 2.9; 2006 2.7; 2007 2.4; 2008 2.2; 2009 2.1; 2010 2.1.
  - Private consumption: 2003 2.3; 2004 3.3; 2005 2.5; 2006 2.3; 2007 2.2; 2008 2.1; 2009 2.0; 2010 2.0.
  - Fixed investment: 2003 2.2; 2004 6.1; 2005 4.9; 2006 4.0; 2007 2.9; 2008 2.7; 2009 2.7; 2010 2.6.
  - Residential investment: 2003 9.0; 2004 8.0; 2005 -6.6; 2006 -0.5; 2007 0.7; 2008 0.9; 2009 1.2; 2010 1.2.
  - Net exports (contribution to GDP growth): 2003 -0.3; 2004 -0.8; 2005 -0.5; 2006 -0.3; 2007 -0.2; 2008 -0.1; 2009 0.0; 2010 0.0.
  - Current account (in percent of GDP): 2003 -1.7; 2004 -2.4; 2005 -2.5; 2006 -2.5; 2007 -2.5; 2008 -2.5; 2009 -2.5; 2010 -2.4.
  - CPI inflation: 2003 1.4; 2004 1.3; 2005 1.5; 2006 1.8; 2007 2.0; 2008 2.0; 2009 2.0; 2010 2.0.
  - Output gap: 2003 -0.8; 2004 -0.2; 2005 0.0; 2006 0.0; 2007 0.0; 2008 0.0; 2009 0.0; 2010 0.0.
  - Unemployment rate (percent of labor force): 2003 5.0; 2004 4.8; 2005 4.6; 2006 4.6; 2007 4.6; 2008 4.6; 2009 4.6; 2010 4.6.
- Staff and authorities’ divergence:
  - Most interlocutors expected growth “at about 2½ percent;” Treasury projected 2005 output growth at “3¼ percent,” seeing output still about “1 percent below potential.”

### Key risks and near-term issues
- Near-term risk:
  - A sharper-than-expected drop in house prices identified as “perhaps the greatest near-term risk,” with debate about consumption sensitivity to house prices.
- Other risks:
  - Disorderly resolution of global imbalances; fiscal credibility if deficits persist; rising demographic pressures and adequacy of private saving for retirement.
  - Widening trade deficit and higher oil prices “were not seen as major concerns.”
- External and commodity influences:
  - The United Kingdom is a small net oil exporter; energy accounts for only about 5 percent of the CPI basket.
  - Higher oil prices could dampen short-term activity less than in other G7 countries; firmly-entrenched inflation expectations and flexible labor market limit second-round effects.

### Monetary policy assessment and recommendations
- Historical stance and current positioning:
  - Policy interest rate increased from “3½ percent in November 2003 to 4¾ percent in August 2004.”
  - With nominal GDP growth in 2005–06 projected to be about 5 percent, the policy interest rate of 4¾ percent was “now in the vicinity of the neutral rate.”
  - BOE and staff judged monetary policy “had been appropriate over the past several years.”
  - “The next move in interest rates could be up or down.”
- Monetary policy response to shocks:
  - BOE and Treasury officials concurred monetary (not fiscal) policy should bear the burden of response to a house price shock given the fiscal position.
  - Staff simulation: even a large house-price shock (30 percent decline and consumption sensitivity in line with historical experience) could be mitigated by large interest rate cuts limiting the negative impact on real GDP; risk of inflation rising more than 1 percentage point above target deemed extremely low in that scenario.
  - If fiscal policy provided temporary stimulus while monetary policy responded endogenously, output impact would be very small but fiscal deterioration could be considerable.
- Transparency and communication:
  - Staff welcomed BOE’s increased emphasis on inflation projections using market expectations and extension of the projection horizon from two to three years.
  - Staff suggested the BOE “publish numerical projections for a broader range of key variables,” while BOE officials noted practical objections (time, MPC agreement, misinterpretation risks).

### Fiscal policy assessment and recommendations
- Recent fiscal developments:
  - Public sector balance deteriorated from a surplus of “1¾ percent of GDP in FY1999/2000” to a deficit of “3¼ percent of GDP in FY2003/04.” (The fiscal year runs from April to March.)
  - Fiscal policy “has been steadily stimulative.”
- Staff concerns and projections:
  - Staff projected an improvement in the overall balance between FY2004/05 and FY2009/10 of ½ percentage point, compared to the Treasury’s 1½ percentage point.
  - On staff’s projection, the golden rule would not be met in the next cycle and the sustainable investment (debt) rule would be broken eventually.
  - Staff projections assume spending in line with the budget and revenue rebound including windfall oil receipts (close to ¼ percent of GDP).
  - Treasury projected the current deficit to fall to about ½ percent of GDP in FY2005/06 based on faster-than-trend growth and improved tax buoyancy; staff considered those assumptions overly optimistic.
- Staff recommendations:
  - Start an “early start to smooth fiscal adjustment, amounting to about 1 percent of GDP over the next five years.”
  - Prefer restraint in current spending to limit absorptive capacity risks and allow assessment of value for money.
  - Broaden the tax base (for example by eliminating VAT zero-rating) rather than raise tax rates; avoid raising labor taxes (income taxes or National Insurance Contribution rates).
  - Increase fiscal transparency: present fiscal projections with uncertainty (fan charts), be explicit about the probability of meeting the golden rule and the implied target for average current surplus, and broaden independent assessment of key assumptions.
- Stochastic safety-margin analysis (Box 5):
  - Safety margin needed to meet the golden rule with a 75 percent chance is ½ percent of GDP; increasing this probability to 99 percent requires a safety margin of 2¼ percent of GDP.
  - Table summary (as reported): Probability of Meeting the Golden Rule 75 percent / 95 percent / 99 percent — Overall safety margin 1/0.60 / 1.50 / 2.30; Output uncertainty only 0.45 / 1.06 / 1.71; Asset price uncertainty only 0.30 / 0.90 / 1.44; Discretionary policy uncertainty only 0.17 / 0.44 / 0.63.

### Structural reforms, pensions, saving, and labor market
- Pensions and saving gap:
  - Interim Report of the Pensions Commission: some 9½ million people (almost half of the working age population over 35) have inadequate saving to meet likely retirement income expectations.
  - Drivers: difficulty making rational long-term saving decisions; complexity of pension system; high cost of selling/administration of private pension products; lack of trust after mis-selling scandals.
  - Policy options discussed: simplify system; promote longer working lives (including increasing pensionable age and greater flexibility to trade off working longer for higher pensions); strengthen voluntary saving (automatic enrolment, tax measures); consider expanding state pension or increasing compulsion if needed.
  - Staff supported development of deeper markets for long-term, fixed-income and longevity-linked instruments.
- Labor market initiatives:
  - Government strategy to boost participation of older workers, people with temporary disabilities, and single parents.
  - More generous/flexible deferral option for state pension available April 2005; new disability benefit system phased for new claimants by 2008; Pathways to Work pilot to be extended to about one-third of the country.
- Productivity and housing:
  - Staff “welcomed the narrowing of the U.K.’s productivity gap” but noted a remaining productivity shortfall of about 10 percent relative to G7 average.
  - Housing market rigidities: Barker Report (supply side) and Miles Report (demand side) recommendations endorsed; government accepted Barker recommendations and planned consultation; FSA to consider Miles recommendations in mortgage review.
  - Staff “urged the implementation of recommendations to reduce house price volatility.”

### Financial sector stability and payments systems
- Banking and insurance:
  - Banking soundness indicators “remained favorable”; median return on large banks’ equity rose from 24 percent in 2003 to 27 percent in the first half of 2004.
  - Total and tier-I capital ratios well above regulatory minima.
  - Mortgage arrears and corporate insolvencies continued to fall; household debt service ratios low; average loan-to-value ratios declined to 40–50 percent.
  - Insurance sector health improved; solvency margins increased; profitability improved; FSA’s 2004 risk-based capital adequacy regime noted.
- Vulnerabilities:
  - Rapid growth of unsecured debt (credit card and other unsecured borrowing) a concern.
  - Corporate lending related to commercial property and institutions’ search for yield creating potential exposures to illiquid assets.
- Bank credit exposures (end-2004, in percent of bank capital; Bank of England source):
  - Lending to: households 319
  - Secured 265
  - Unsecured 54
  - of which: Credit card 18
  - Private nonfinancial corporations 101
  - of which: Real-estate related 55
- Payments and liquidity:
  - BOE planning to introduce a voluntary reserve system to “reduce volatility in overnight money markets and lower intraday credit exposures”; BOE to publish a Payments Systems Oversight Report in early 2005.
- AML/CFT and oversight:
  - AML/CFT regime “was strengthened”; coverage extended to lawyers and accountants; all suspicious transactions must be reported; steps taken toward implementing EU second AML directive and updated FATF recommendations.
  - FSA to start regulating brokers in 2005.

### External sector, trade policy, and aid
- Exports and competitiveness:
  - Industrial countries generally lost export share; relative to G7, the United Kingdom’s export share remained stable.
  - Increase in the trade deficit in 2004 partly cyclical; level remained below historical highs.
  - United Kingdom’s international investment position only slightly negative—net liabilities about 5–10 percent of GDP.
  - Real effective exchange rate appreciated slightly over past 12 months but remained within recent ranges; staff saw no strong evidence of major overvaluation.
- Trade liberalization and aid:
  - Staff praised U.K. support for trade liberalization in the EU and the July 2004 framework for the Doha Round.
  - Officials advocated reduction of border protection and elimination of export subsidies by 2010.
  - U.K. ODA increase welcomed: 0.47 percent of GNI by FY2007/08 (2004 Spending Review) and goal of 0.7 percent of GNI by 2013.
  - Authorities pursuing an International Finance Facility to boost aid and seeking greater multilateral debt relief.

### Selected macro and fiscal statistics (series and projections highlighted)
- Real GDP (change in percent): 2000 3.9; 2001 2.3; 2002 1.8; 2003 2.2; 2004 3.1; 2005 Proj. 2.6.
- Domestic demand (change in percent): 2000 3.8; 2001 2.9; 2002 2.9; 2003 2.5; 2004 3.8; 2005 Proj. 2.9.
- CPI: 2000 0.8; 2001 1.2; 2002 1.3; 2003 1.4; 2004 1.3; 2005 Proj. 1.5.
- Unemployment rate (in percent)1/: 2000 5.5; 2001 5.1; 2002 5.2; 2003 5.0; 2004 4.8; 2005 Proj. 4.6.
- General government balance: 2000 3.9; 2001 3/ 0.0; 2002 -2.2; 2003 -3.2; 2004 -2.9; 2005 Proj. -3.1.
- Public sector net debt: 2000 32.0; 2001 31.0; 2002 32.3; 2003 33.7; 2004 35.4; 2005 Proj. 37.1.
- Trade balance (in percent of GDP): 2000 -2.1; 2001 -2.8; 2002 -3.0; 2003 -2.9; 2004 -3.4; 2005 Proj. -3.5.
- Current account balance (in percent of GDP): 2000 -2.5; 2001 -2.3; 2002 -1.7; 2003 -1.7; 2004 -2.4; 2005 Proj. -2.5.
- Exports (percent of GDP): 2000 28.1; 2001 27.4; 2002 26.2; 2003 25.4; 2004 24.4; 2005 Proj. 24.1.
- Net exports of oil (in billions of U.S. dollars): 2000 9.9; 2001 8.0; 2002 8.6; 2003 6.7; 2004 3.7.
- Quota (in millions of SDRs): 10,738.5; Fund holdings of currency (SDR Million): 7,176.19 (66.83 percent of quota); Reserve position in Fund (SDR Million): 3,562.41 (33.17 percent of quota).
- Exchange rate regime: Floating; Bilateral rate (December 31, 2004): US$ = £0.5188 (note: sterling exchange rate $1.92 as of December 31, 2004).

### IMF staff appraisal summary and recommendations (concise)
- Monetary policy: Well-positioned to maintain low inflation credibility; BOE should consider expanding the number of macro variables with quantified projections.
- Fiscal policy: Staff view that an early, mild fiscal adjustment totaling about 1 percentage point of GDP spread over time is warranted to reinforce fiscal rules, build a buffer, and reduce the risk of procyclical adjustment; preference for current spending restraint and base-broadening revenue measures over tax rate increases.
- Structural priorities: Implement Miles and Barker reviews to reduce house price volatility and improve housing supply responsiveness; address pension saving shortfalls via simplification, incentives for longer work, and deepening long-term financial markets; continue productivity-enhancing reforms with systematic monitoring and evaluation.
- Financial sector: Continue strengthening AML/CFT, implement BOE payments reforms (voluntary reserve system), monitor unsecured lending growth and commercial property exposures, and sustain insurance sector regulatory enhancements.

*IMF staff executive summary and selected excerpts from the provided document.*

### Executive Summary ......................................................................................................

### _cr0580 - Executive Summary

### Background
- Macroeconomic performance over the past decade has been “strong and steady,” supported by structural reforms and improvements in policy frameworks.
- Growth moderated over the past year and “appears to be settling at potential.”
- Wage growth stabilized and inflation remained subdued.
- The fiscal deficit “stayed at about 3 percent of GDP.”
- House price appreciation slowed, but house prices are “widely seen as overvalued.”
- A 30 percent real appreciation of sterling in 1996–97 contributed to a deterioration in the trade balance.

### Key policy issues and risks
- Outlook: Most interlocutors agreed that the economy was operating “in the vicinity of full capacity” and that growth would remain “at about 2½ percent.” The Treasury expected output to be still below potential and projected higher quarterly growth supported by stronger external demand and government spending.
- Near-term risk: A sharper-than-expected drop in house prices was identified as “perhaps the greatest near-term risk,” with debate about the sensitivity of consumption to house prices.
- Other risks: disorderly resolution of global imbalances; fiscal credibility if deficits persist; rising demographic pressures and questions about adequacy of private saving for retirement.
- Widening trade deficit and higher oil prices “were not seen as major concerns.”

### Economic outlook (short and medium term)
Findings and projections:
- Recent behavior:
  - Real GDP growth eased by end-2004 to an estimated potential rate of “about 2½ percent.”
  - Household consumption growth slowed due to rising debt service and a sharp diminution in house price appreciation.
  - Business fixed investment growth “held up” supported by strong corporate profitability.
  - Export volume growth disappointed; the trade deficit widened to “3½ percent of GDP.”
  - Core CPI inflation (excluding food, beverages, tobacco, and energy) remained “about 1¼ percent”; CPI inflation edged up to “about 1½ percent” at end-2004.
- Divergent near-term views:
  - BOE officials, private consensus, and staff expected output growth to settle at “about 2½ percent.”
  - Treasury projected output growth in 2005 at “3¼ percent,” seeing output still about “1 percent below potential.”
- Medium-Term Scenario (Percentage change, unless otherwise indicated):
  - Real GDP: 2003 2.2; 2004 3.1; 2005 2.6; 2006 2.6; 2007 2.3; 2008 2.2; 2009 2.2; 2010 2.2.
  - Domestic demand: 2003 2.5; 2004 3.8; 2005 2.9; 2006 2.7; 2007 2.4; 2008 2.2; 2009 2.1; 2010 2.1.
  - Private consumption: 2003 2.3; 2004 3.3; 2005 2.5; 2006 2.3; 2007 2.2; 2008 2.1; 2009 2.0; 2010 2.0.
  - Fixed investment: 2003 2.2; 2004 6.1; 2005 4.9; 2006 4.0; 2007 2.9; 2008 2.7; 2009 2.7; 2010 2.6.
  - Residential investment: 2003 9.0; 2004 8.0; 2005 -6.6; 2006 -0.5; 2007 0.7; 2008 0.9; 2009 1.2; 2010 1.2.
  - Net exports (contribution to GDP growth): 2003 -0.3; 2004 -0.8; 2005 -0.5; 2006 -0.3; 2007 -0.2; 2008 -0.1; 2009 0.0; 2010 0.0.
  - Current account (in percent of GDP): 2003 -1.7; 2004 -2.4; 2005 -2.5; 2006 -2.5; 2007 -2.5; 2008 -2.5; 2009 -2.5; 2010 -2.4.
  - CPI inflation: 2003 1.4; 2004 1.3; 2005 1.5; 2006 1.8; 2007 2.0; 2008 2.0; 2009 2.0; 2010 2.0.
  - Output gap: 2003 -0.8; 2004 -0.2; 2005 0.0; 2006 0.0; 2007 0.0; 2008 0.0; 2009 0.0; 2010 0.0.
  - Unemployment rate (percent of labor force): 2003 5.0; 2004 4.8; 2005 4.6; 2006 4.6; 2007 4.6; 2008 4.6; 2009 4.6; 2010 4.6.

### Monetary policy
- Historical stance: Policy interest rate increased from “3½ percent in November 2003 to 4¾ percent in August 2004” in response to concerns about overheating and property market developments.
- Assessment:
  - BOE and staff judged monetary policy “had been appropriate over the past several years.”
  - With the policy interest rate “now in the neighborhood of the neutral rate” and significant uncertainties, “the next move in interest rates could be up or down.”
  - Monetary policy was characterized as “well-positioned to respond to shocks.”
- Staff recommendations:
  - Welcome increased emphasis on inflation projections using market expectations of future interest rates and extension of projection horizon from two to three years.
  - Suggested the BOE “publish numerical projections for a broader range of key variables.”

### Fiscal policy
- Recent developments:
  - Public sector balance deteriorated from a surplus of “1¾ percent of GDP in FY1999/2000” to a deficit of “3¼ percent of GDP in FY2003/04.” (The fiscal year runs from April to March.)
  - Fiscal policy “has been steadily stimulative.”
- Views:
  - The Treasury expected slower spending growth and a rebound in revenues to reverse fiscal deterioration and ensure respect for fiscal rules.
  - Staff were “less sanguine about the strength of structural revenues and the buoyancy of financial sector taxes over the medium term.”
- Staff recommendations:
  - Call for an “early start to smooth fiscal adjustment, amounting to about 1 percent of GDP over the next five years.”
  - Recommend further enhancing “the transparency and credibility of the fiscal projections.”

### Structural issues
- Pensions and saving:
  - The Interim Report of the Pensions Commission found that “many people were not saving enough for retirement.”
  - There was agreement on some aspects of solutions, but “views differed widely on the appropriate role of government in ensuring adequate private saving.”
- Productivity:
  - Staff “welcomed the narrowing of the U.K.’s productivity gap” and encouraged “systematic evaluation of government initiatives to boost productivity.”
- Housing:
  - Staff “urged the implementation of recommendations to reduce house price volatility.”

### Financial sector stability
- Banking and insurance:
  - Indicators of banking system soundness “remained favorable” and the “health of the insurance sector improved over the past year.”
- Payments and liquidity:
  - The BOE is planning to introduce a voluntary reserve system to “reduce volatility in overnight money markets and lower intraday credit exposures in the payments system.”
- AML/CFT and oversight:
  - The AML/CFT regime “was strengthened,” and authorities are increasing oversight to ensure compliance.

*IMF staff executive summary from the provided document.*

### 9. Staff asked whether the weakness of exports raised concerns about

### _cr0580 - 9. Staff asked whether the weakness of exports raised concerns about

### Exports and competitiveness
- Industrial countries generally had been losing export share, probably reflecting the increasing integration of emerging market countries in the global economy; relative to G7 countries, the United Kingdom’s export share had remained stable.
- The increase in the trade deficit in 2004 was partly due to cyclical factors, and the level remained below historical highs.
- The United Kingdom’s international investment position was only slightly negative—net liabilities were about 5–10 percent of GDP.
- The real effective exchange rate had appreciated slightly over the past 12 months but remained in the range of the past several years.
- Staff view: a further widening of the trade deficit would be a concern, but—consistent with the latest CGER assessment—there was not strong evidence of major overvaluation.

### Oil prices and inflation impact
- The United Kingdom is a small net oil exporter; the oil intensity of output is the lowest among G7 countries.
- Energy accounts for only about 5 percent of the CPI basket.
- Officials and staff agreed that higher oil prices could dampen economic activity in the short term, but less so than in other G7 countries.
- Firmly-entrenched inflation expectations and the flexible labor market would likely limit second-round effects; higher oil prices would likely have only a small direct impact on inflation.

### Global imbalances and exchange rate risks
- Officials saw global imbalances as a risk to the outlook; a disorderly resolution could result in slower global growth, which would hurt U.K. growth.
- BOE officials did not expect a divergence from recent developments in which sterling appreciation against the U.S. dollar had been largely offset by depreciation against the euro, implying little change to the effective exchange rate.

### Monetary policy assessment and positioning
- BOE officials felt monetary policy had been appropriate over the past several years.
- Between 1997 and end-2003 (when the inflation target variable was changed from RPIX to CPI), average RPIX inflation had been almost identical to the 2½ percent target.
- The change in the target variable implied a slight effective increase in the target because index methodology differences and exclusion of house price depreciation together had taken more out of inflation than the ½ percentage point reduction in the target.
- BOE officials and staff agreed that an immediate cut in interest rates to accommodate the increase in the effective target would have been inappropriate; monetary policy was tightened more gradually than it would have been under the old target.
- Policy interest rate and outlook:
  - With nominal GDP growth in 2005–06 projected to be about 5 percent, the policy interest rate of 4¾ percent was now in the vicinity of the neutral rate.
  - The next move in interest rates could be up or down, depending on uncertainties including the degree of spare capacity and the impact of weakening house prices on consumption.
  - BOE officials saw the higher level of the policy interest rate in the United Kingdom as mainly reflecting cyclical differences; implied short-term interest rates 5–10 years out were lower in the United Kingdom than in the United States or the euro area.

### Inflation dynamics and projections
- Staff analysis (Box 2) attributes low inflation in recent years to a combination of downward pressure from external shocks and inflation persistence.
- Key drivers identified: declining import prices and increased competitive pressures, proxied by sterling’s real appreciation; persistence in inflation spread effects over time.
- Based on the estimated expectations-augmented Philips curve, staff forecast that CPI inflation will rise gradually toward the 2 percent target over the next 2–3 years; the upper and lower bounds represent the projected mean squared error of the forecast.
- Factors pushing inflation higher: rising import prices, the closing of the small negative output gap, and well-anchored inflation expectations; persistence expected to slow the rise.

### Monetary policy response to shocks (including house prices)
- BOE and Treasury officials concurred with staff that monetary (and not fiscal) policy should bear the burden of response to a house price shock, especially given the current fiscal position (Box 3).
- Staff simulation results:
  - Even a large house-price shock (30 percent decline and consumption sensitivity in line with historical experience) could be mitigated by large interest rate cuts limiting the negative impact on real GDP.
  - Even if monetary easing led unexpectedly to a burst in inflation, the risk of inflation rising more than 1 percentage point above target is extremely low because inflation is currently below target.
  - Relying exclusively on monetary policy is prudent when inflation is below target but fiscal deficits remain quite large.
  - If fiscal policy provided a temporary stimulus and monetary policy responded endogenously, output impact would be very small but deterioration in the fiscal position could be considerable.
- With the policy rate at 4¾ percent and inflation expected to rise only gradually to target, BOE officials and staff agreed there was ample room to tighten or loosen monetary policy.

### Transparency and communication of monetary policy
- Staff welcomed BOE’s increased emphasis on inflation projections using market expectations of future interest rates and the extension of the projection horizon from two to three years.
- Staff suggested BOE publish numerical projections not just for real GDP and CPI but also for other key macroeconomic variables.
- BOE officials noted practical objections to publishing a wider set of quantitative projections or an illustrative path for interest rates: time-consuming to secure agreement among MPC members and risk of misinterpretation of an illustrative path as a commitment.

### Fiscal framework and recent developments
- Fiscal rules introduced in 1998:
  - Golden rule: public sector’s current balance to be non-negative on average over the business cycle.
  - Sustainable investment rule: net public sector debt to be kept at a stable and prudent level (which the Treasury regards as below 40 percent of GDP).
- Government initiated in 2000 a multi-year increase in spending on health, education, transportation, and law and order.
- The current balance shifted over the current cycle (which the Treasury views as beginning as GDP crossed trend in FY1999/2000 and should end in FY2005/06) from an initial surplus of 2 percent of GDP to a deficit of 2 percent of GDP in FY2003/04.
- Authorities expected tapering off of spending growth and a rebound in the revenue ratio (owing to higher corporate taxes and closing of a still-substantial output gap) to partially reverse the deterioration and ensure the fiscal rules were respected; no plans for discretionary action at this stage, but clear evidence of slippage would prompt immediate action.

### Staff concerns and fiscal projections
- Staff argued that unchanged policies posed considerably greater risks:
  - The cumulative current balance in this cycle is still in small surplus, so the golden rule is likely to be met or missed by an insignificant amount; net public debt is projected to be well below 40 percent of GDP in FY 2004/05.
  - Staff projected an improvement in the overall balance relative to GDP between FY2004/05 and FY2009/10 of ½ percentage point, compared to the Treasury’s 1½ percentage point.
  - On staff’s projection, the golden rule would not be met in the next cycle and the sustainable investment (debt) rule would be broken eventually.
- Treasury vs staff differences for FY2004/05 and FY2005/06:
  - Staff projections assume spending in line with the budget and revenue rebound due to acceleration in corporate income and personal bonuses and windfall oil receipts (close to ¼ percent of GDP).
  - Treasury projected the current deficit to fall to about ½ percent of GDP in FY2005/06 on assumptions of faster-than-trend growth and improved tax buoyancy; staff considered those revenue underpinnings overly optimistic.

### Staff recommendations on fiscal adjustment
- Staff argued for near-term adjustment measures to:
  - Allow smoother adjustment and lower the risk of an eventual procyclical adjustment.
  - Protect against any slippage in the credibility of the fiscal rules.
  - Help build a buffer for future shocks.
- Preferable focus: contain the growth of current spending.
  - Existing plans already incorporate slower current expenditure growth over the coming three fiscal years than in the previous three years, but current spending is still projected to rise by about ½ percentage point of GDP by FY2007/08.
  - Staff noted that an earlier slowing would help guard against risks of inefficiency inherent in recent rapid increases in spending.
- Treasury response:
  - Treasury officials stressed the program to increase spending on public services needed to be seen through to completion.
  - A new framework to monitor the efficiency of spending was being established and detailed plans for achieving 1½ percent of GDP of savings by FY2007/08 already existed.
  - Staff acknowledged scope for efficiency gains (improved procurement, relocating parts of the civil service) but warned that continued rapid spending growth would make achieving gains more difficult and that ploughing back efficiency gains into spending would not reduce the fiscal deficit.

### Public Service Agreements (PSAs) assessment
- PSAs aim to improve quality and cost-effectiveness of public services via specific quantitative performance targets at departmental level (about 130 PSA targets at present).
- Experience and evolution:
  - Progress in attaining PSA targets has been mixed.
  - The Department of Health target to reduce waiting times by end-2005 is on track; Department of Education targets to improve student attainment are more mixed.
  - The framework has been changed: reduce number of PSA targets, increase share of outcome-based targets, increase flexibility in local delivery, and eliminate Service Delivery Agreements.
- Remaining problems:
  - Measurement difficulties for some targets (especially efficiency or quality improvements).
  - Difficulty designing and implementing incentives to motivate service providers.
  - Some targets (e.g., raising U.K. productivity growth) are broad and subject to factors beyond departmental or government control.
  - Focus on certain targets can shift resources toward government priorities and affect other areas of public service delivery.

*IMF staff report excerpt.*

### 23. Staff emphasized that adjustment from revenue increases would need to avoid

### _cr0580 - 23. Staff emphasized that adjustment from revenue increases would need to avoid

### Revenue adjustment and tax policy
- Staff emphasized that adjustment from revenue increases would need to avoid increasing disincentives to work or other distortions.
- Efficiency-enhancing option:
  - Wider application of user fees on public services.
  - Treasury officials were studying the feasibility of national road use fees, but reported no plans to further expand user fees in education or extend user fees to health services.
- Staff recommended broadening the tax base (for example by eliminating VAT zero-rating) rather than raising tax rates.
  - Treasury officials noted the government’s 2001 election manifesto explicitly ruled out raising VAT rates.
- Staff argued against raising labor taxes (income taxes or National Insurance Contribution rates) because of adverse effects on labor supply.
- Planned institutional change:
  - Integration of Inland Revenue and Customs expected to improve tax collection, but not expected to have a significant impact on revenue.

### Fiscal transparency, credibility, and the Golden Rule (Box 5)
- Staff recommended the Treasury be explicit about:
  - The probability of meeting the golden rule (current balance or better over the cycle).
  - The implied target for the average current surplus over the cycle.
- Presentation of uncertainty:
  - Fiscal projections based on central (not “cautious”) assumptions and uncertainty around them should be shown in fan charts.
- Independent assessment:
  - National Audit Office currently audits eleven assumptions used in the revenue projections.
  - Staff recommended broadening the reach of independent assessment of assumptions underlying the fiscal projections, including the timing of the economic cycle.
- Box 5—summary of stochastic analysis of safety margins:
  - Given the golden rule’s asymmetry and inevitable shocks, a sizable average current surplus target is required to raise the probability of meeting the rule.
  - Using a reduced-form stochastic model based on output and asset price shocks experienced by the U.K. economy over the past four decades, staff found:
    - The safety margin needed to meet the golden rule with a 75 percent chance is ½ percent of GDP; increasing this probability to 99 percent requires a safety margin of 2¼ percent of GDP.
  - Table (as reported):
    - Probability of Meeting the Golden Rule75 percent95 percent99 percent
    - Overall safety margin 1/0.601.502.30
    - Output uncertainty only0.451.061.71
    - Asset price uncertainty only0.300.901.44
    - Discretionary policy uncertainty only0.170.440.63
    - 1/ The overall safety margin is smaller than the sum of the individual safety margins because different shocks partly offset each other.

### Structural issues — pensions, saving gap, and labor market
- Population aging:
  - Challenges of population aging had moved to the forefront of public debate.
  - An independent Pensions Commission interim report concluded that, based on a variety of assumptions, some 9½ million people (almost half of the working age population over 35) have inadequate saving to meet their likely expectations about retirement incomes.
- Drivers of the saving gap identified:
  - Difficulty in making rational long-term saving decisions.
  - Complexity of the existing pension system.
  - High cost of selling and administering private pension products.
  - Lack of trust in the retail financial industry after mis-selling scandals.
- Comparisons with earlier work:
  - 2002 Green Paper on Pensions found that 3 million people were seriously undersaving and an additional 5–10 million would have to save more or work longer.
- Robustness and exclusions:
  - Commission acknowledged enormous error bands in central projection but remained confident a substantial saving gap existed.
  - Housing was excluded from the saving-gap calculation for reasons stated by the Commission member (timing of purchases, uncertainty of future house values, mismatch across individuals).
- Range of policy views and potential responses:
  - Most interlocutors (except trade unions) supported increasing pensionable age (in addition to extension to 65 years currently scheduled to be phased in for women between 2010 and 2020) and greater flexibility to trade off working longer for higher pensions.
  - Staff supported development of deeper markets for long-term, fixed-income and longevity-linked financial instruments.
  - Treasury officials favored assessing results of existing measures first (financial education, simplification of taxation of pensions, Pension Protection Fund, reform of stakeholder products).
  - Commission member cautioned that encouragement alone may take too long; options include expanding the state pension system, increasing compulsion, or strengthening voluntary saving (automatic enrolment, tax-system measures to reduce collection costs, government negotiation to lower mutual fund fees).

- Incapacity Benefit (IB) and labor market programs:
  - Reforms in 1995 slowed flows into IB.
  - Active labor market policies and a pilot “Pathways to Work” program introduced interventions at job centers (work-focused interviews for IB recipients).
  - Planned extension of Pathways to Work to about one-third of the country.

### Structural issues — productivity and housing
- Productivity:
  - Officials welcomed narrowing of the gap between UK productivity and G7 average but noted a remaining productivity shortfall of about 10 percent.
  - Past reforms and macroeconomic stability credited for rapid productivity growth since the early 1990s; causes of remaining 10 percent shortfall not precisely identified.
  - Multi-pronged approach adopted; officials monitoring and evaluating initiatives (modifying small-firm loan guarantee program, eliminating zero corporate income tax rate for small firms as indicated).
  - Consideration of streamlining business regulation in response to firms’ concerns, despite OECD work suggesting U.K. regulation is light relative to other industrial countries.

- Housing market rigidities:
  - Two government-sponsored reports:
    - Barker Report (supply side): recommended increasing price sensitivity of housing supply and reducing planning delays; government accepted recommendations and planned public consultation mid-2005.
    - Miles Report (demand side): suggested promoting long-term, fixed-rate mortgages by increasing transparency of mortgage pricing and improving funding options for lenders; FSA took on mortgage regulation in 2004 and will consider Miles recommendations in forthcoming review.
  - Legislative and regulatory measures:
    - Legislation before Parliament to remove constraint on building societies owning securitized assets.
    - Government planned to review minimum funding limits for building societies.

- Property taxation:
  - Council Tax based on 1991 property assessments; effective Council Tax rate (tax divided by current market value) has declined as house prices rose, especially where prices rose most.
  - Staff empirical work suggests tax impact on house price appreciation is small.
  - Attempts to mitigate effect (more frequent assessments) could cause volatility in local tax revenues.
  - Lyons review of local government finance to report by end of 2005; reassessment of property values planned for 2005 to come into effect in 2007.

### Financial sector stability
- Banking sector health indicators:
  - Median return on large banks’ equity rose from 24 percent in 2003 to 27 percent in the first half of 2004.
  - Total and tier-I capital ratios remained well above regulatory minima.
  - Mortgage arrears and corporate insolvencies continued to fall.
  - Household debt service ratios were low; average loan-to-value ratios had declined to 40–50 percent.
- Vulnerabilities noted:
  - Rapid growth of unsecured debt (especially credit card debt) was a concern due to high borrowing rates and unequal distribution across households.
  - Corporate lending related to commercial property posed potential vulnerability given rapid growth and signs of a deteriorating office market.
  - Search for yield may have led institutions to build positions in potentially illiquid assets.
- Bank credit exposures (end-2004, in percent of bank capital; Bank of England source):
  - Lending to: households 319
  - Secured 265
  - Unsecured 54
  - of which: Credit card 18
  - Private nonfinancial corporations 101
  - of which: Real-estate related 55
- Payments markets and BOE initiatives:
  - BOE planning to introduce a voluntary reserve system as part of sterling money markets reform to reduce volatility in overnight money markets and improve banks’ liquidity management.
  - Reform may encourage more banks to join the real time gross settlement system, lowering intraday credit exposures, consistent with FSAP recommendations.
  - Early feedback suggested the proposal was welcome and participation would be sufficient.
  - BOE planned to publish in early 2005 a new Payments Systems Oversight Report, in line with FSAP recommendations.

- Insurance sector:
  - Improvements in life and nonlife insurers’ health: solvency margins increased; profitability improved; risk management improving due in part to 2004 risk-based capital adequacy regime beyond EU Solvency I.
  - FSA to start regulating brokers in 2005, expecting improvements in risk management.

- AML/CFT regime:
  - Authorities strengthened the AML/CFT regime in line with FSAP recommendations.
  - Regime coverage included lawyers and accountants; all suspicious transactions must be reported.
  - Steps taken to sensitize senior financial sector managers and to implement the EU second AML directive; regulations under review to ensure compliance with updated FATF recommendations.

### Other issues — euro adoption and external policy considerations
- Euro adoption:
  - Authorities remained in principle in favor of joining the single currency but stressed that economic conditions must be right.
  - Staff noted the current float was satisfactory; given irreversibility of euro entry, authorities needed sufficient certainty before entry.
  - Progress on the reform agenda set out in the 2003 assessment of the five tests would be reviewed in the 2004 Budget and again in the forthcoming Budget.
  - Authorities hoped convergence would occur in both directions (for example, German mortgage market liberalization as U.K. promotes long-term, fixed-rate mortgages).
  - Staff and authorities noted large range of estimates on favorable effects of euro adoption on cross-border trade and agreed further research was needed.

*Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr0580.pdf*

### 37. Staff praised the government’s consistent support for trade liberalization within

### _cr0580 - 37. Staff praised the government’s consistent support for trade liberalization within

### Trade liberalization and aid
- Staff praised the government’s consistent support for trade liberalization within the European Union.
- Officials welcomed the July 2004 framework agreements for the Doha Round, noting detail on domestic support and export subsidies, and regretting that the agricultural market access pillar is the least detailed.
- Officials advocated elimination of trade-distorting effects of the Common Agricultural Policy and urged:
  - border protection be substantially reduced;
  - export subsidies no longer be an issue for world trade by 2010;
  - all agricultural tariff peaks be reduced towards the maximum level for non-agricultural products.
- The United Kingdom has consistently supported in the WTO and the EU the liberalization of services trade and sees itself benefiting from a less restrictive environment.
- Staff welcomed the increase in the U.K. ODA:
  - 0.47 percent of GNI by FY2007/08 (as foreseen in the 2004 Spending Review);
  - goal of reaching the United Nations target of 0.7 percent of GNI by 2013.
- With the United Kingdom’s leadership of the G7 in 2005, the government would press for increasing aid flows by implementing the International Finance Facility and extending debt relief.

### Economic performance and outlook
- Economic performance in the United Kingdom remains impressive after six years of shallow fluctuations and robust expansion, supported by resilient domestic demand and a sharp increase in housing prices.
- Short-term projection highlights:
  - real GDP growth: about 2½ percent through 2006;
  - inflation moving toward the target of 2 percent.
- Key short-term uncertainties:
  - resolution of perceived overvaluation of house prices and effects on private consumption;
  - unwinding of global imbalances and effects on the external sector and value of sterling;
  - gauging resource constraints when traditional yardsticks may be breaking down.
- Medium-term structural uncertainties:
  - will fiscal revenues regain turn-of-the-century peaks;
  - is private saving adequate to support the aging population.

### Monetary policy assessment
- Monetary policy is well-positioned to maintain the credibility of low inflation.
- Increases in interest rates since late 2003 appear to have preempted excess demand and helped cool the housing market.
- With interest rates in a broadly neutral range, easing demand growth, and slowing house price appreciation, interest rates have been appropriately held constant.
- Larger, unexpected changes in house prices in either direction would warrant decisive policy action.
- Recommendation: the BOE should consider expanding the number of key macroeconomic variables for which quantified projections are published.

### Fiscal policy assessment and recommendations
- The deterioration in the fiscal position since FY2000/01 raises questions about timing and size of the necessary correction.
- Staff view: authorities’ projection of a substantial, autonomous rise in revenues and shift of the current balance to surplus over the next few years is too sanguine.
- Staff estimate: need for a fiscal adjustment relative to GDP of about 1 percentage point to:
  - reinforce commitment to fiscal rules;
  - build a buffer to meet rules in face of plausible adverse shocks.
- Adjustment design principles:
  - favor current spending restraint to limit risks from absorptive capacity and to allow assessment of value for money;
  - wider application of user fees to raise efficiency and revenue;
  - if revenue measures are used, broaden the tax base rather than raise tax rates.
- Governance and transparency recommendations:
  - review fiscal framework as the cycle closes;
  - make explicit the link between desired probability of meeting the golden rule and the targeted current surplus (e.g., base projections on central assumptions and map uncertainty in fan charts);
  - consider extending independent assessment of assumptions beyond the eleven variables now audited by the National Audit Office;
  - continue quantitative targets and efficiency targets to monitor public services, procurement, and work-practice flexibility, while assessing how well these meet measurement and incentive challenges.

### Pensions, housing, and productivity
- Pensions:
  - The Interim Report of the Pensions Commission shows many in the middle-class are not saving enough for retirement aspirations.
  - Recommendations: simplify the complex pension system and promote longer active participation in the workforce; weigh costs of measures to motivate or force higher private saving against risks of future demands on public resources.
- Housing:
  - Recent sharp slowing of the housing market underscores importance of reducing house price volatility by implementing the Miles and Barker Reviews.
  - Specific actions: FSA should incorporate Miles recommendations in its review of the statutory regime for mortgage lending; Barker Review recommendations on price signals and planning delays should be formulated into concrete legislative proposals.
- Productivity:
  - Labor productivity remains below the average in other G7 countries despite relatively rapid growth over the past decade.
  - Government’s multi-pronged strategy is appropriate; systematic monitoring and evaluation of programs is essential, aided by introduction of specific performance indicators.

### Financial sector stability
- Indicators remain favorable: bank capitalization, credit quality, and profitability continue to be strong.
- Risks and developments:
  - slower credit growth likely to dampen profitability;
  - downside risks from unsecured lending to households, commercial property–related lending, and the ongoing search for yield.
  - Life insurance sector health has improved substantially over the past year, partly reflecting increases in equity prices.
- Regulatory enhancements:
  - FSA introduced risk-based capital measures in insurance firms and broker regulation in the nonlife insurance sector;
  - BOE strengthened supervisory and institutional aspects of payments and settlement systems.

*IMF staff appraisal as presented in the source text.*

### 51. It is proposed that the next Article IV consultation be held on the standard 12-month

### _cr0580 - 51. It is proposed that the next Article IV consultation be held on the standard 12-month cycle.

### Real Economy
- Real GDP (change in percent): 3.9 2.3 1.8 2.2 3.1 2.6
- Domestic demand (change in percent): 3.8 2.9 2.9 2.5 3.8 2.9
- CPI: 0.8 1.2 1.3 1.4 1.3 1.5
- Unemployment rate (in percent) 1/: 5.5 5.1 5.2 5.0 4.8 4.6
- Gross national saving (percent of GDP): 15.0 15.0 15.0 14.8 14.6 14.8
- Gross domestic investment (percent of GDP): 17.5 17.3 16.7 16.5 17.0 17.2

### Quarterly and Medium-Term Growth (selected series)
- Table 2 quarterly Real GDP (quarter-on-quarter annualized): 1.7 1.5 3.6 4.0 2.7 3.0 3.5 1.8 2.7 2.7 2.7 2.6 2.6 2.6
- Domestic demand (quarter series): -0.6 0.3 5.5 4.4 2.3 4.8 2.9 2.7 2.8 3.3 3.1 3.0 3.0 3.0
- Real GDP (2001–2010, annual): 2.3 1.8 2.2 3.1 2.6 2.6 2.3 2.2 2.2 2.2

### Public Finance and Fiscal Projections
- General government balance: 3.9 3/ 0.0 -2.2 -3.2 -2.9 -3.1
- Public sector balance: 3.9 3/ 0.0 -2.4 -3.2 -3.0 -3.1
- Public sector cyclically adjusted balance 4/: 1.1 -0.6 -2.3 -2.7 -2.8 -3.1
- Public sector net debt: 32.0 31.0 32.3 33.7 35.4 37.1

From Table 5 (Public Sector Budgetary Projections, percent of GDP and percent of potential GDP; selected rows):
- Total revenue series (percent of GDP, selected values): 37.7 38.4 38.9 39.3 39.6 39.7 39.8 37.6 38.5 39.3 39.8 40.3 40.5 40.6
- Total expenditure series (percent of GDP, selected values): 40.9 41.4 42.0 42.1 42.4 42.2 42.2 40.8 41.4 42.0 42.1 42.3 42.1 42.1
- Current balance 3/ (percent of GDP): -1.9 -1.1 -1.0 -0.6 -0.5 -0.2 -0.1 -1.9 -1.1 -0.6 0.0 0.3 0.6 0.8
- Overall balance (percent of GDP): -3.2 -3.0 -3.1 -2.8 -2.8 -2.5 -2.4 -3.1 -2.9 -2.7 -2.2 -2.0 -1.6 -1.5
- Net debt 4/ (percent of GDP): 33.7 35.4 37.1 38.3 39.7 40.6 41.4 33.7 35.3 36.4 37.0 37.6 37.9 38.0

Additional fiscal measures (selected):
- Tax revenue (percent of GDP series): 35.5 36.0 36.5 37.0 37.2 37.4 37.5 35.4 36.1 36.9 37.5 37.9 38.1 38.2
- Interest payments (percent of GDP series): 2.0 2.1 2.1 2.1 2.1 2.2 2.2 2.0 2.1 2.07 2.1 2.1 2.1 2.1

### Money, Credit, and Interest Rates
- M0 (end-period, 12-month percent change): 4.5 8.0 6.1 7.2 5.8 ...
- M4 (end-period, 12-month percent change): 8.2 6.8 7.3 7.2 9.0 ...
- Consumer Credit: 12.5 14.0 15.2 12.1 11.7 5/ ...
- Three-month interbank rate (year average): 6.1 5.0 4.0 3.7 4.6 ...
- Ten-year government bond yield (year average): 5.2 4.9 4.9 4.5 4.9 ...

### Balance of Payments and External Sector
- Trade balance (in percent of GDP): -2.1 -2.8 -3.0 -2.9 -3.4 -3.5
- Current account balance (in percent of GDP): -2.5 -2.3 -1.7 -1.7 -2.4 -2.5
- Exports (percent of GDP): 28.1 27.4 26.2 25.4 24.4 24.1
- Import volume (change in percent): 9.1 4.9 4.1 1.8 4.5 5.1
- Net exports of oil (in billions of U.S. dollars): 9.9 8.0 8.6 6.7 3.7 ...
- Reserves (end of period, in billion of US dollars): 48.2 40.4 42.8 46.0 49.7 ...

From Table 4 (Balance of Payments, selected £ billion series):
- Current account (£ billion): -22.4 -17.6 -18.6 -27.7 -29.9 -31.9 -33.6 -35.2 -36.6
- Trade balance (£ billion): -27.4 -31.1 -31.8 -39.6 -42.7 -45.3 -47.4 -49.6 -51.7
- Exports (goods, £ billion): 190.1 186.5 188.6 188.3 197.8 209.7 223.2 238.2 253.7
- Imports (goods, £ billion): 230.7 233.2 236.0 246.5 259.6 274.9 291.5 309.5 328.0
- Income balance (¥ billion): 11.7 22.0 23.1 22.8 24.0 25.1 26.1 27.4 28.8

### Fund Position and Fund Relations (as of December 31, 2004)
- Quota (in millions of SDRs): 10,738.5
- Holdings of currency (in percent of quota): 66.8
- Holdings of SDRs (in percent of allocation): 11.0
- Fund holdings of currency (SDR Million): 7,176.19 (66.83 percent of quota)
- Reserve position in Fund (SDR Million): 3,562.41 (33.17 percent of quota)
- Net cumulative SDR allocation (SDR Million): 1,913.07; Holdings 211.29 (11.04 percent)
- Outstanding Purchases and Loans: None
- Financial Arrangements: None
- Projected Obligations to Fund: None
- Exchange rate regime: Floating
- Bilateral rate (December 31, 2004): US$ = £0.5188
- Note: The U.K. authorities maintain a floating regime. As of December 31, 2004 the exchange rate for sterling was $1.92.

### Social and Other Indicators
- Income per capita (in US dollars, 2003): 30,904
- Income distribution (ratio of income received by top and bottom quintiles, 2001): 4.9
- Life expectancy at birth (2003): 76.2 (male) and 80.7 (female)
- Automobile ownership (2000): 420 per thousand
- CO2 emissions (ton per capita, 2001): 9.37
- Population (in millions, 2003): 59.3
- Population density (2002): 246 inhabitants per sq. km.
- Area: 94,247 square miles (244,100 sq. km.)
- Infant mortality (per 1,000 live births): 5.3
- Doctors per 1,000 inhabitants: 0.5
- GDP per capita (2001): SDR 18,360

### Statistical Practices and Data Quality
- The United Kingdom subscribes to the Special Data Dissemination Standard (SDDS).
- The UK shifted to ESA95 in September 1997; the timetable for remaining ESA95 implementation extends to 2005.
- 2003 revisions included annual chain-linking, corrections for import fraud, and revisions in some volatile construction data.

### Statement by the IMF Staff Representative (March 2, 2005) — Key Developments and Projections
- The developments since the staff report do not alter the thrust of the staff appraisal.
- Growth and near-term outlook:
  - Economic growth increased somewhat in Q4 2004; household consumption growth was slightly weaker than projected, government expenditure growth was a little stronger.
  - Coincident and leading indicators suggest growth will settle at about 2½ percent in 2005–06, in line with potential growth.
  - Housing market indicators: house prices rose a little in January, raising the three-month on three-month rate of change to about 3 percent; mortgage approvals increased a little in December.
  - Real retail sales growth rebounded in January, though average monthly growth has slowed substantially since mid-2004.
  - Composite output PMI remained close to its ten-year average in January; a fall in the manufacturing PMI was offset by a rise in the services PMI.
- Inflation and labor costs:
  - CPI inflation remained at 1.6 percent in January.
  - Core CPI inflation (excluding food, beverages, tobacco, and energy) stayed subdued at around 1¼ percent.
  - Growth in private sector earnings excluding bonuses remained stable at about 4½ percent.
- Monetary policy:
  - Bank of England policy rate unchanged at 4¾ percent in early February.
  - MPC lifted a little its forecasts for CPI inflation in the February Inflation Report relative to November; under the MPC’s central projection, inflation will rise gradually to about 2 percent over the next two years; risks skewed somewhat to the downside.
- Fiscal developments:
  - Fiscal data for January were in line with the Pre-Budget Report and staff projections for FY2004/05.
  - Over the first ten months of the fiscal year, central government current receipts growth was in line with PBR and staff projections.
  - Central government current spending was a little higher than expected while net investment spending was slightly lower than projected.
  - The Budget for FY2005/06 was scheduled to be released on March 16.

*IMF staff report content as provided in the source document.*

### 6.      The government announced in early February a strategy to boost labor

### 6.      The government announced in early February a strategy to boost labor

### Labor participation initiatives
- A strategy was announced to boost labor participation of older workers, people with temporary disabilities, and single parents.
- To encourage working past the state pension age of 59/64, a more generous and flexible option for deferring state pension will become available in April 2005.
- For people with disabilities, a new benefit system will be in place for new claimants by 2008.
  - In the new system, benefits will depend on whether a person is assessed to have a manageable or severe condition.
  - There will be financial incentives for those with manageable conditions to attend work-focused interviews.
- For single parents, a new pilot program will be introduced to provide additional support and financial incentives to move back into work.
- These initiatives are consistent with the staff’s recommendations.

### Bank of England Payment Systems Oversight Report
- The Bank of England issued its first Payment Systems Oversight Report, as anticipated in the staff report.
- The report:
  - Clarifies the rationale and objectives of the BOE’s oversight.
  - Gives an account of the BOE’s activities during 2004.
  - Identifies priorities for 2005.
- Observations:
  - The U.K. payment systems exhibits a high level of robustness by international standards.
  - The BOE continued to address systemic risks linked to tiering and worked toward improving liquidity funding and collateralization agreements.
  - Progress was made on implementing FSAP recommendations.
  - A priority for 2005 is to strengthen arrangements for cooperative oversight of cross-border infrastructures.
  - The Report appears to extend international best practice with respect to transparency about payment systems oversight and assessment.

### Statement by Tom Scholar, Executive Director for the United Kingdom (March 2, 2005)

#### Authorities' overall view
- My authorities are most grateful to staff for their work and will take careful note of their comments.
- There is a broad measure of agreement between staff and the authorities on most aspects of economic policy.

#### Economic prospects
- Economic fundamentals cited:
  - 50 consecutive quarters of growth, the longest unbroken expansion on record.
  - Growth in 2004 of 3.1 percent.
  - CPI inflation currently at 1.6 percent.
  - Short term interest rates at 4.75 percent.
  - Employment at record levels of 75 percent.
- Growth forecasts (in the 2004 Pre-Budget Report):
  - Remain at 3 percent to 3½ percent in 2005.
  - Return to trend (2.5 percent to 3 percent) in 2006.
  - With inflation at or close to target.
- Authorities acknowledge risks and agree on the need for cautious macroeconomic polices.

#### Monetary and fiscal policy
- Policy set on the basis of the policy framework established in 1997, based on transparency, responsibility and accountability.
- Fiscal policy set according to two fiscal rules:
  - the Golden Rule—over the cycle, the Government will borrow only to invest;
  - the Sustainable Investment Rule—over the cycle, public sector net debt will be held at a stable and prudent level, defined as 40 percent or less;
- Monetary policy set by the Bank of England’s Monetary Policy Committee (MPC) to meet a symmetric inflation target.
- Authorities’ assessment:
  - The fiscal and monetary policy frameworks have served the UK well, anchoring expectations and sustaining stability.
  - The fiscal framework is based on strict rules backed by cautious, audited assumptions.
  - Rules are set over the cycle to allow automatic stabilisers to operate freely and fully and fiscal policy to support monetary policy when the economy is below trend.
  - The current fiscal stance remains consistent with these rules and appropriate for this point in the economic cycle.
- Fiscal projections (from the Pre-Budget Report):
  - Gradual reduction in the deficit to 1½ percent of GDP;
  - Average annual surplus on the current budget of 0.1 percent in this cycle, and ¼ percent from 2005-06 to 2009-10;
  - Net debt stabilising at 37 percent of GDP.
- Authorities are on course to meet the fiscal rules in this cycle and the next.
- Differences with staff:
  - Staff see downside risks to the revenue projections.
  - Authorities are confident about the projections and note they are based on deliberately cautious assumptions (e.g. growth at the lower end of the forecast range, and trend growth 0.25 percent below the neutral view).
  - Data released since the IMF mission supports the view that there remains a significant output gap, and that above trend growth is continuing, with rising real incomes and a sizeable pick-up in tax revenues including in corporation tax.
  - Authorities do not agree with staff that there is a need for ‘an early correction’ and believe that the latest data confirms this view.
- On suggested modifications:
  - Authorities noted staff’s suggestions for minor modifications to the fiscal and monetary framework and welcome discussion, but are not attracted to these specific proposals.
  - In particular, they see considerable costs in the publication by the MPC of quantitative projections (and error bands) for a further set of variables.
  - They doubt whether a probabilistic approach to fiscal policy would improve public understanding or confidence in the framework.
  - They regard the use of cautious (rather than central) assumptions as key to the prudent conduct of fiscal policy.
  - They agree on the importance of external scrutiny of macroeconomic policy, achieved through independent auditing of key economic assumptions, high level of transparency in the fiscal framework through publications like the End of Year Fiscal Report and Long-term Public Finances Report, and continuous public debate including contributions from expert commentators such as the IMF.

#### Structural issues
- Recognition of legacy of under-investment in public services:
  - Public sector net investment fell by 15 percent annually in real terms between 1991-92 and 1996-97 leaving the UK with the lowest level of public investment of any large EU country.
- Authorities aim to raise public sector net investment to 2¼ percent of GDP by 2007-08.
- Efficiency and value for money:
  - A broad agenda for reform with focus on outcomes, extra investment linked to reforms, civil service reform, and stretching efficiency targets.
  - Improvements in central government procurement delivered £2 billion of savings in 2003-04 alone.
  - Plans to achieve £20 billion of efficiency gains (or 1½ percent of GDP) by 2007-08.
- Microeconomic reform program to raise productivity:
  - Measures aim to improve competition, promote enterprise, support science and innovation, raise skills and encourage investment.
  - A major review of regulation is underway.
  - The Budget will set out proposals to remove barriers that are not justified.
- Policy on membership of the single currency remains unchanged.
  - The June 2003 assessment set out a reform agenda to promote convergence and flexibility, and progress on this will be reviewed in the Budget.
- Authorities agree with staff on:
  - The importance of the work of the Pensions Commission;
  - The need to address housing market reform through implementation of the Miles and Barker Reviews;
  - Their overall assessment on the UK financial system.

#### Other issues
- Authorities will continue to support trade liberalization, a successful completion of the Doha Round, and common agricultural policy (CAP) reform.
- They will increase ODA.

*Source: Statement by Tom Scholar, Executive Director for the United Kingdom, March 2, 2005 (content extracted from the IMF staff report excerpt).*

### 0.47 percent of GNI in 2007-08, with a timetable to reach 0.7 percent of GNI by 2013.  They

### _cr0580 - 0.47 percent of GNI in 2007-08, with a timetable to reach 0.7 percent of GNI by 2013.  They

### Aid, debt relief, and international proposals
- Authorities are seeking international agreement on a doubling of global aid flows through a proposal for an International Finance Facility.
- Authorities seek greater debt relief for the poorest countries, with multilateral debt cancellation of up to 100 percent.
- The United Kingdom has committed to increases in official development assistance, aimed at reaching the goal of 0.7 percent of GNI by 2013.
- Current and projected UK aid levels include 0.47 percent of GNI in 2007-08.

### Macroeconomic performance and outlook
- Recent growth and stability:
  - Real GDP growth is estimated at about 3 percent in 2004 and is expected to stay stable at about 2½ percent in 2005–06.
  - Domestic demand remains the key driver of growth.
  - Unemployment rate fell to a 30-year low; wage growth stabilized and inflation remained subdued.
  - House prices are widely seen as overvalued despite a recent cooling of the housing market.
- Inflation and monetary policy:
  - Policy interest rate was raised to 4¾ percent in August 2004 and has been stable since.
  - Headline CPI inflation edged up to 1½ percent at end-2004; core inflation remained at 1¼ percent.
  - Rising import prices expected to push inflation toward the 2 percent target over the coming 2–3 years.
  - Directors judged that the next move in interest rates could be in either direction given balanced uncertainties.
- Risks and uncertainties highlighted:
  - Resolution of perceived house price overvaluation and effects on private consumption.
  - How and when global imbalances will be unwound and their impact on the external sector and the value of sterling.
  - Assessing resource constraints when standard yardsticks may be breaking down.
  - Uncertainty whether fiscal revenues will recover to turn-of-the-century peaks, and whether private saving will be adequate for an aging population.

### Fiscal position and policy recommendations
- Recent deterioration and outlook:
  - The fiscal position deteriorated sharply over the past five years, though the overall deficit is not large compared to other major industrial countries and the debt burden is relatively low.
  - The December 2004 Pre-Budget Report projects slower spending growth and a rebound in revenues will reverse this deterioration.
  - Many Directors viewed the authorities’ revenue projections as somewhat more optimistic than warranted.
- Recommended fiscal approach:
  - Many Directors recommended that a mild fiscal adjustment be started expeditiously in the current favorable economic conditions to spread consolidation over time.
  - Fiscal adjustment measures should minimize adverse effects on efficiency, work effort, and growth; restraint in current spending was suggested.
  - Several Directors favored wider application of user fees to raise efficiency and revenue.
  - If relying more on revenue measures, broadening the tax base was preferred to raising tax rates.
- Discussions on fiscal framework modifications:
  - Consideration of publishing fiscal projections based on central assumptions with an explicit margin for adverse developments or a fan chart of fiscal outcomes was discussed; many Directors doubted the benefit.
  - A few Directors saw merit in broadening independent assessment of fiscal projections by the National Audit Office.
  - Directors welcomed recently established efficiency targets at the departmental level.

### Structural issues: pensions, savings, and productivity
- Pensions and saving:
  - The October 2004 Interim Report of the Pensions Commission found some 9½ million people (about half of the working-age population over 35) have inadequate saving to meet likely retirement income expectations.
  - Causes of the saving gap include difficulties in long-term saving decisions, complexity of the pension system, high cost of selling/administering private pension products, and lack of trust after mis-selling scandals.
  - Directors concurred that simplifying the pension system and encouraging longer active participation in the workforce make sense, while weighing costs of higher private saving against risks of future demands on public resources.
- Productivity and housing:
  - Directors supported the authorities’ multi-pronged strategy for raising productivity and emphasized systematic monitoring and evaluation, including specific performance indicators.
  - Authorities intend to address structural rigidities in the housing market by implementing recommendations of the Miles and Barker reviews.

### Financial sector assessment
- Overall health:
  - Indicators of the financial sector remain quite favorable: capitalization, credit quality, and profitability in the banking sector continue to be strong.
  - Signs of improved health in the life insurance sector over the past year.
- Risks and supervisory improvements:
  - Slower credit growth likely to dampen profitability; downside risks from unsecured lending to households, lending related to commercial property, and the search for yield.
  - Introduction of risk-based capital measures in insurance firms and broker regulation in the non-life insurance sector.
  - Strengthening of supervisory and institutional aspects of payment and settlement systems.
  - Strengthening of the Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT) regime in line with Financial Sector Assessment Program (FSAP) recommendations.

### Trade, external sector, and balance-sheet indicators
- Selected indicators and staff projections:
  - Real GDP (change in percent): 2000: 3.9; 2001: 2.3; 2002: 1.8; 2003: 2.2; 2004: 3.1; 2005 Proj.: 2.6.
  - Domestic demand (change in percent): 2000: 3.8; 2001: 2.9; 2002: 2.9; 2003: 2.5; 2004: 3.8; 2005 Proj.: 2.9.
  - CPI: 2000: 0.8; 2001: 1.2; 2002: 1.3; 2003: 1.4; 2004: 1.3; 2005 Proj.: 1.5.
  - Unemployment rate (in percent)1/: 2000: 5.5; 2001: 5.1; 2002: 5.2; 2003: 5.0; 2004: 4.8; 2005 Proj.: 4.6.
  - Gross national saving (percent of GDP): 2000: 15.0; 2001: 15.0; 2002: 15.0; 2003: 14.8; 2004: 14.6; 2005 Proj.: 14.8.
  - General government balance: 2000: 3.9; 2001: 3/ 0.0; 2002: -2.2; 2003: -3.2; 2004: -2.9; 2005 Proj.: -3.1.
  - Public sector net debt: 2000: 32.0; 2001: 31.0; 2002: 32.3; 2003: 33.7; 2004: 35.4; 2005 Proj.: 37.1.
  - Trade balance (in percent of GDP): 2000: -2.1; 2001: -2.8; 2002: -3.0; 2003: -2.9; 2004: -3.4; 2005 Proj.: -3.5.
  - Current account balance (in percent of GDP): 2000: -2.5; 2001: -2.3; 2002: -1.7; 2003: -1.7; 2004: -2.4; 2005 Proj.: -2.5.
  - Exports (percent of GDP): 2000: 28.1; 2001: 27.4; 2002: 26.2; 2003: 25.4; 2004: 24.4; 2005 Proj.: 24.1.
  - Imports (percent of GDP): 2000: 30.1; 2001: 30.2; 2002: 29.2; 2003: 28.3; 2004: 27.8; 2005 Proj.: 27.6.
  - Reserves (end of period, in billion of US dollars): 2000: 48.2; 2001: 40.4; 2002: 42.8; 2003: 46.0; 2004: 49.7.
  - Ten-year government bond yield (year average): 2000: 5.2; 2001: 4.9; 2002: 4.9; 2003: 4.5; 2004: 4.9.
  - Three-month interbank rate (year average): 2000: 6.1; 2001: 5.0; 2002: 4.0; 2003: 3.7; 2004: 4.6.
- Exchange rates and competitiveness:
  - Exchange rate regime: Floating.
  - Bilateral rate (December 31, 2004): US$ = £0.5188.
  - Nominal effective rate (1995=100)5/: 2000: 126.8; 2001: 124.7; 2002: 125.0; 2003: 118.1; 2004: 122.8.
  - Real effective rate (1995=100)5/6/: 2000: 139.6; 2001: 139.0; 2002: 141.9; 2003: 136.9; 2004: 144.3.

### Social indicators (selected)
- Income per capita (in US dollars, 2003): 30,904.
- Income distribution (ratio of income received by top and bottom quintiles, 2001): 4.9.
- Life expectancy at birth (2003): 76.2 (male) and 80.7 (female).
- Population (in millions, 2003): 59.3.

*Public Information Notice (PIN) No. 05/27 — March 8, 2005. IMF Executive Board Concludes 2004 Article IV Consultation with the United Kingdom.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr0580.pdf_