## _cr10338 ## Source details **Canonical URL:** [_cr10338](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2010/_cr10338.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2010/_cr10338.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2010/_cr10338.pdf.json) --- ### Real Sector Developments - Policy actions and institutional change: - New Conservative-Liberal Democrat coalition launched a multi-year deficit reduction plan (June budget). - Created an independent Office for Budget Responsibility (OBR) to produce macroeconomic and fiscal forecasts. - Plans to revamp financial regulation and supervision, consolidating key responsibilities in the Bank of England (BoE). - Recovery profile and near-term outlook: - After six quarters of deep recession, the economy began growing again in late 2009; initial recovery led by inventory cycle and rebound in final private demand. - Recovery supported by large-scale financial interventions, temporary fiscal stimulus (phasing out in 2010), full operation of automatic stabilizers, and unprecedented monetary easing. - Constraints and risks: sterling depreciation has not yet boosted net exports as expected; global softening; strained household and bank balance sheets; inflationary price shocks offsetting slack. - Policy approach in staff’s central scenario: - Fiscal consolidation to mend fiscal position; continued stimulative monetary policy; automatic stabilizers to operate; monetary policy flexible to expand or withdraw quantitative easing; financial sector policies to strengthen system while ensuring credit supply. ### Household and Labor Market Dynamics - Household saving and balance sheets: - Gross household saving rate peaked at 7¾ percent in mid-2009 (up six percentage points from pre-crisis levels). - Gross household saving rate fell to 4½ percent in the first half of 2010. - Recovery of asset prices bolstered household net worth; gross debt has fallen; record-low interest rates reduced debt service costs. - Compared with OECD peers, UK household saving rates remain low and debt levels high. - Labor market: - Unemployment rose from 5½ percent to 8 percent, then stabilized and edged down slightly. - Employment losses moderate relative to past recessions; factors supporting resilience include lower net immigration, reduced participation, some public sector hiring, labor hoarding, and wage restraint. - Business surveys show continued slack and some decline in average labor productivity. ### Residential Property Prices and Housing Market (Chapter 6) - House prices and valuations: - Prices staged a faster-than-expected recovery in 2009 but recent 3-month change turned negative. - Overall, prices remain some 15 percent below their 2007 peak. - Valuations appear stretched relative to income; exceptionally low interest rates have boosted affordability for now. - Mortgage and financing conditions: - Average loan-to-value ratios on new first mortgages hovering at 75-80 percent. - Mortgage approvals and net lending low; mortgage arrears and repossessions eased from moderate peaks. - Supply and planning: - Restrictive planning laws constrained new construction; housing capacity (dwellings to households) below comparable countries. - Limited excess capacity supports relatively high house prices. - Distributional and fiscal consequences: - High house prices benefited older owners at expense of younger households; housing support outlays exceeded 1 percent of GDP in 2009/10. ### Central Scenario and Outlook (Section 16) - Growth projections: - Annual growth projections: 1.7 percent this year; 2 percent in 2011. - Staff medium-term projection: growth projected to rise gradually to 2½ percent in the medium term. - Drivers and constraints: - Near-term drivers: inventory dynamics and pick-up in fixed business investment; net trade contribution likely modest. - Consumption and residential investment dampened by low real income growth, looming tax hikes, and strained balance sheets; household saving rate projected to stabilize below recent peak but above pre-crisis levels. - Risks: - Upside: very low real interest rates; past sterling depreciation; global demand recovery. - Downside: further rapid deleveraging, sharp housing downturn, euro area weakness, fiscal consolidation headwinds, and severe tail risk from major new shocks. - External banking exposures and spillovers: - UK-owned banks have consolidated foreign assets exceeding 180 percent of GDP. - Claims on Greece, Ireland, Portugal, and Spain account for about 14 percent of GDP; UK banks more strongly concentrated on Ireland. - Indirect exposures via claims on French and German banks around 8 percent of GDP. - Ireland-owned banks operating in the UK account for 7 percent of domestic corporate loans and 3 percent of household loans. - VAR analysis findings (Box 1): - A 100 basis-point increase in foreign TED spread → 0.4 percentage point decline in UK real GDP growth on impact, widening to 1.2 percentage points over two quarters. - A 1 percentage point decline in other countries’ real GDP → about a 0.8 percentage point decline in UK real GDP on impact. ### Fiscal Consolidation: June Budget, Spending Review, and Box 2 Debate - Fiscal mandate and targets: - Fiscal mandate: balance the cyclically-adjusted current budget by end of a five-year rolling horizon—currently by 2015/16—and put net debt-to-GDP ratio on a declining path by 2015/16. - Overall fiscal deficit programmed to fall to 2 percent of GDP by 2014/15 from 11 percent of GDP in 2009/10. - Total planned structural adjustment: 8 percent of GDP in the five years to 2014/15. - Discretionary tightening frontloaded: 1¼ percentage points in 2010/11 and 2½ percentage points in 2011/12. - Under announced plans, feasible to lower debt-to-GDP ratio to 60 percent by 2015/16. - Composition of announced discretionary consolidation between 2009/10 and 2014/15 (Total announced: £128 billion): - VAT and other indirect taxes: 10% - Taxes on income and wealth: 11% - Capital spending cuts: 2% - Other revenue measures: 19% - Other current spending cuts: 9% - Cuts in welfare benefits: 3% - Public sector pay freeze: 47% - Spending Review (Q3/Q4 elements): - Relative to previous announcements, annual spending on social benefits reduced by an additional £7 billion (0.4 percent of GDP) by FY 2014/15. - £2.5 billion from elimination of child benefit for higher-income taxpayers starting in 2013. - £2.0 billion from a one-year time limit on certain disability-related benefits. - Departmental spending (excluding health and foreign aid) reduced by 19 percent in real terms by 2014/15 (less than 25 percent in June budget). - Public employee pension contributions to rise by 3 percentage points on average, yielding 0.1 percent of GDP by 2014/15. - Capital expenditure allocation slight increase by 0.1 percent of GDP by FY 2014/15; public investment real reduction eased from 33 percent to 29 percent. - Fiscal Consolidation Plan (Cumulative £ billion): 2011/12 39; 2012/13 64; 2013/14 87; 2014/15 111. - Total spending reductions (cumulative £ billion): 21; 40; 61; 81 (2011/12–2014/15). - Total tax changes (cumulative £ billion): 18; 24; 27; 29 (2011/12–2014/15). - Box 2 debate and staff view: - Central controversy: timing of tightening—frontload vs delay. - Staff recommends significant fiscal tightening with frontloading in 2011/12 to secure confidence; allow automatic stabilizers to operate; contingency planning for surprises; consider temporary tax cuts targeted to low-income households, employment creation, or investment in a prolonged downturn. - OBR establishment recommended to be fully independent with arms-length relationship with Treasury. ### Monetary Policy and Quantitative Easing (Box 3) - QE program scale: - Between March 2009 and January 2010, BoE bought nearly £200 bn in medium- to long-term gilts, financed by issuing reserve money. - Purchases amount to 14 percent of UK GDP, 25 percent of outstanding gilts, and 40 percent of gilts in the relevant market segment (at end-2009). - Event-study evidence: - Purchases depressed yields by up to 125 basis points over a two-day event window; one-day window effects about half as large. - Largest gilt yield response on March 5, 2009. - Decomposition: most yield decline reflects portfolio balance effects (lower net supply of gilts); OIS rates fell by a small amount only. - Broader effects: - QE supported recovery in financial markets and equities; boosted confidence, positive wealth effects, and improved corporate credit supply via direct and indirect channels. - Inflation context: - January 2010 VAT hike estimated to have added about ¾ of a percentage point to the CPI. - Announced VAT rise in January 2011 set to raise CPI by another 1-1½ percentage points. - Staff projects inflation to remain above 2 percent throughout 2011. - Policy implications: - Highly accommodative monetary stance remains appropriate; MPC required to be nimble. - If stalling recovery heightens disinflation: expand QE (resumption of gilt purchases first option), consider buying private sector assets (possibly framed as fiscal operation). - If inflation prospects rise: MPC ready to start gradual tightening, giving priority to Bank Rate increases over asset sales. ### Financial Sector Reform and Prudential Architecture (Section 41 and Executive Board) - Reform agenda and international coordination: - Authorities broadly satisfied with Basel III proposals; emphasize firming-up liquidity standards and tools to contain systemic risk. - Domestic initiatives include Independent Commission on Banking; Treasury consultation on a new regulatory approach and prompt corrective action regime. - Staff recommendations on prudential measures: - Raise capital buffers, restrain dividend payouts and remuneration budgets. - Unwind crisis-related public interventions per initial design; encourage banks to develop robust funding models with transparent instruments. - Creation of an FPC with explicit macroprudential mandate welcome; requires close coordination with other regulators in the EU. - Supervisory improvements: give PRA authority to supervise at holding-company level; adopt prompt corrective action; regular disclosure of nonconfidential firm-level prudential returns. - Phase in internationally coordinated reforms to minimize regulatory arbitrage and manage transition to avoid strangling near-term credit supply. - Procedural recommendation: next Article IV consultation on a standard 12-month cycle. ### Public Sector Debt Sustainability (Annex A) - Baseline debt path: - General government gross debt projected: 2007 43.1; 2008 55.4; 2009 71.6; 2010 78.5; 2011 82.8; 2012 84.8; 2013 84.6; 2014 82.9; 2015 80.2. - Change in public sector debt: 2008 12.3; 2009 16.2; 2010 7.0; 2011 4.2; 2012 2.1; 2013 -0.2; 2014 -1.7; 2015 -2.7. - Gross financing needs (percent of GDP): 2009 15.8; 2010 16.7; 2011 14.5; 2012 12.9; 2013 11.1; 2014 10.3; 2015 7.3. - Gross financing need (in billions of U.S. dollars): 2009 425.7; 2010 455.9; 2011 415.2; 2012 389.8; 2013 353.7; 2014 348.3; 2015 263.4. - Primary deficit and primary spending: - Primary deficit: 2009 9.1; 2010 6.8; 2011 4.1; 2012 2.3; 2013 0.5; 2014 -1.0; 2015 -2.0. - Primary (noninterest) expenditure: 2009 45.3; 2010 43.4; 2011 41.5; 2012 40.0; 2013 38.5; 2014 37.2; 2015 36.1 (percent of GDP). - Baseline and alternative scenarios: - Absence of consolidation → debt to 110 percent of GDP by 2015/16. - If real interest rates rise by half a standard deviation above baseline → debt 82 percent of GDP by 2015/16 (2 percentage points above baseline). - If medium-term growth persistently lower by 1¼ percentage points → debt-to-GDP could reach 96 percent by 2015/16. - Required adjustment to reach lower long-term targets: - To lower debt ratio to 60 percent by 2030/31: improve CAPB by 7.5 percentage points of GDP between 2009/10 and 2020/21 (CAPB from deficit of 6.1 percent in 2009/10 to surplus of 1.5 percent by 2020/21). - To lower debt ratio to 40 percent by 2030/31: improve CAPB by 9 percentage points of GDP between 2009/10 and 2020/21 and further discretionary tightening of about ¾ percentage point of GDP after 2015/16. ### Q3 2010 Outturn, Selected Indicators, and Executive Board Assessment - Q3 GDP outturn: - Q3 GDP growth: 3.2 percent (q-o-q, saar). - Q3 sector contributions: Construction up 17 percent; services up 2.4 percent; manufacturing up 2.4 percent. - Comparative forecasts for Q3 2010 real GDP growth: Actual outturn 3.2 (SA quarter-on-quarter change, annualized); IMF staff (Oct. 2010 WEO) 2.7; Consensus Forecast (Sep. 2010) 2.4; Bank of England (Aug. 2010 Inflation Report) 2.5. - Staff projection: GDP growth expected to moderate to about 2 percent in 2011. - Selected staff and Board numeric projections (preserved exactly): - Real GDP (change in percent): 2005 2.2; 2006 2.8; 2007 2.7; 2008 -0.1; 2009 -5.0; 2010 1.7; 2011 2.0. - Unemployment rate (in percent) 1/: 2005 4.8; 2006 5.4; 2007 5.4; 2008 5.6; 2009 7.5; 2010 7.9; 2011 7.5. - Public sector net debt (percent of GDP): 2005 35.5; 2006 36.0; 2007 36.5; 2008 42.7; 2009 53.5; 2010 61.2; 2011 66.3. - CPI, end period: 2009 2.9; 2010 2.8; 2011 2.5. - Balance of payments current account (percent of GDP): 2009 -1.3; 2010 -2.4; 2011 -2.3 (proj.). - Exchange rate (September 30, 2010): US$ = £0.6347. - Executive Board assessment and guidance: - Recovery underway; recommended frontloaded consolidation to preserve debt sustainability while maintaining highly accommodative monetary stance; nimble monetary policy—raise rates gradually if output recovers apace and inflation surprises on the upside; resume asset purchases if recovery weakens. ### Inflation Outlook, Fiscal Framework, and Financial Policy (Section 2011) - Inflation: - Some risk that a prolonged period of above target inflation may increase medium-term inflation expectations. - Expectation that inflation will fall back below the target given spare capacity. - Fiscal framework and OBR: - OBR to produce independent macroeconomic and fiscal forecasts, judge consistency with fiscal mandate, and assess sustainability. - Adopted fiscal mandate: achieve cyclically-adjusted current balance by end of rolling five-year forecast period; supplementary target: public sector net debt to be falling by 2015-16. - OBR interim since May 2010; legislation introduced on 21 October to establish OBR in statute. - Monetary policy and MPC settings: - Maintain Bank Rate at 0.5%. - Maintain stock of assets financed by reserves at £200bn. - MPC to assess month by month whether a change is warranted. - When tightening begins, most likely via rise in Bank Rate with asset sales later. - Financial framework and reforms: - Bank of England responsibility for macro-prudential regulation and oversight of micro-prudential regulation. - Creation of a Prudential Regulatory Authority as a subsidiary of BoE and a separate Consumer Protection and Markets Authority (CPMA). - Legislate for a Financial Policy Committee with macro-prudential oversight. - Authorities committed to full implementation of Basel III requirements. *Italic: IMF staff report content as provided in the source PDF excerpt.* ### 1. Real Sector Developments .......................................................................................... ### 1. Real Sector Developments ### The Economic Agenda - The new Conservative-Liberal Democrat coalition government launched major policy initiatives in its first months, including: - An ambitious multi-year plan for deficit reduction announced in the June budget. - Creation of an independent Office for Budget Responsibility (OBR) to produce macroeconomic and fiscal forecasts and assess adequacy of budget plans relative to government fiscal targets. - Plans to revamp the UK’s framework for financial regulation and supervision, consolidating key responsibilities in the Bank of England (BoE). - Policy focus has shifted from immediate crisis fire-fighting to post-crisis repair, with priorities to: - Preserve confidence while implementing announced plans to restore fiscal sustainability. - Maintain monetary stimulus to ensure a smooth rebalancing of the economy. - Lay the groundwork for a safer financial system. ### Recovery Profile and Near-Term Outlook - Recovery status and drivers: - After six quarters of deep recession, the economy started growing again in late 2009. - The initial recovery was led by a turn in the inventory cycle; final private demand has rebounded from low levels. - The recovery has been buttressed by large-scale financial system interventions, temporary fiscal stimulus (phasing out in 2010), full operation of automatic stabilizers, and unprecedented monetary easing. - Constraints and risks: - Sterling depreciation has not yet boosted net exports as much as expected. - Signs of a softening global recovery have dampened external demand prospects. - Domestically, still-strained household and bank balance sheets remain headwinds for growth. - Inflation has surprised on the upside as a series of price level shocks more than offset the moderating effect of sizeable economic slack. - Policy approach in staff’s central scenario: - Fiscal consolidation to mend the fiscal position. - Continued stimulative monetary policy to support private- and external-sector-led growth. - Operation of automatic fiscal stabilizers as an important safeguard. - Monetary policy can flexibly increase stimulus via more quantitative easing or withdraw stimulus to deal with shocks. - Financial sector policies must strengthen the financial system while ensuring adequate credit supply during transition. ### Progress in Rebalancing and Deleveraging - Macro rebalancing overview: - The UK entered the crisis with pent-up imbalances: overheated property markets, low household saving, high private sector debt, an overleveraged financial sector, and high external deficits and debt. - These imbalances have corrected to some extent, often at the high cost of a protracted downturn. - Some imbalances shifted from the private to the public sector as the government accommodated a large revenue drop and bailed out banks. - Going forward, the government is set to address its unsustainable financial position, allowing other sectors to reemerge as growth drivers. - Sectoral dynamics and expected adjustments: - Households likely to remain thriftier than before the crisis, but can gradually raise consumption as labor market concerns subside and saving rates settle below recent peaks. - Corporates expected to lessen cash preservation as demand firms and credit constraints ease. - Improved net exports should help stabilize the external balance around a lower and sustainable deficit. - The gradual rebalancing is projected to allow moderate growth, with considerable risks on both sides. ### Sectoral Adjustments and Evolution of Financial Balances - Household deleveraging and saving: - Private consumption declined considerably during the recession due to economic uncertainty and plunging asset prices. - Gross household saving rate surged to a peak of 7¾ percent in mid-2009—up six percentage points from pre-crisis levels. - The gross household saving rate fell back to 4½ percent in the first half of 2010 as asset prices recovered and labor market stabilized. - Record-low interest rates significantly reduced debt service costs for households. - Household balance sheet and debt: - Recovery of asset prices bolstered household net worth while gross debt has fallen. - Compared with OECD peers, UK household saving rates remain low and debt levels high, reflecting widespread home ownership and high house price levels. - Large policy rate cuts provided significant relief to indebted households given the dominance of variable-rate mortgages (figures on share of mortgages at variable rates and policy rate reduction referenced). ### Labor Market Developments - Employment and unemployment: - Employment losses were relatively moderate compared with previous recessions. - Unemployment initially rose from 5½ percent to 8 percent, then stabilized at this level for most of the past year and edged down slightly in recent months. - Factors underpinning resilience: - Lower net immigration, reduced labor force participation, and some public sector hiring supported labor market resilience. - Evidence of labor hoarding in the private sector, induced by wage restraint, firms’ desire to retain talent, and expectations of recovering demand. - Firms have often avoided lay-offs by reducing working hours and/or intensity. - Labor market slack and productivity: - Business surveys show continued slack and generally little difficulty recruiting staff, especially in services. - The downturn implied a comparatively large decline in average labor productivity (output per employed person). - Vacancy data and surveys point to continued slack despite earlier stabilization. *IMF staff report excerpt: "Real Sector Developments" (chapter content provided in the source PDF).* ### 6. Residential property prices have recovered but remain below pre-crisis levels. ### 6. Residential property prices have recovered but remain below pre-crisis levels. ### House price developments and valuations - House prices staged a faster-than-expected recovery in 2009 as financially strong buyers returned to a market still characterized by relatively limited supply. - More recently, the upward momentum has dissipated, with the 3-month change in house prices turning negative. - Overall, prices remain some 15 percent below their 2007 peak. - At this level, valuations continue to appear stretched relative to income, although exceptionally low interest rates have boosted affordability, at least for now. ### Mortgage and financing conditions - Overall financing conditions are still tight. - Average loan-to-value ratios on new first mortgages are hovering at 75-80 percent, well below the ratios observed during the pre-crisis boom. - Mortgage approvals and net lending amounts have stayed at low levels. - Mortgage arrears and repossessions have eased from their (already moderate) peak rates. ### Supply, planning laws, and market structure - The relatively benign performance of the UK housing market partly reflects the restrictiveness of the country’s planning laws. - Although the UK experienced a strong boom in house prices prior to the financial crisis, construction of new units remained comparatively modest. - Employment in the construction sector did not reach the heights observed in countries like Ireland, Spain, or the US. - The UK’s strict planning law has allowed local administrations to severely restrain the designation of new building areas. - Excess capacity in the residential housing market remains limited even today, supporting relatively high house prices. ### Distributional and fiscal consequences - High house prices have benefited older, home-owning generations at the expense of younger households and driven up gross household indebtedness. - Wide-spread affordability problems have given rise to high public outlays for housing support—more than 1 percent of GDP in 2009/10—and reduced labor mobility. ### Housing market activity and indicators (selected points reflected in figures) - UK house prices rebounded strongly in 2009, but the momentum has weakened more recently (Average of Halifax and Nationwide House Price Indices). - Housing completions were relatively limited even during the boom times on account of tight planning laws. - Housing capacity (ratio of dwellings to households) shows the United Kingdom below comparable countries (figure context). - Repossession and mortgage default rates in the UK have remained rather moderate compared with the US, with mortgage entering into possession series shown as percent of outstanding mortgages. ### Contextual macro links (related points from surrounding analysis) - Commercial real estate prices are hovering one-third below pre-crisis levels, representing an area of vulnerability for banks. - Banks face significant rollover/refinancing needs over the next few years, increasing sensitivity to asset quality in mortgage and commercial real estate portfolios. - Lending to households remains weak despite modest growth in mortgage lending; high spreads over risk-free rates persist, and high loan-to-value products remain scarce. *Italicized source: IMF staff report chapter titled "6. Residential property prices have recovered but remain below pre-crisis levels."* ### 16. The central scenario envisages economic recovery to continue at a moderate ### _cr10338 - 16. The central scenario envisages economic recovery to continue at a moderate ### Outlook and central scenario - Economic recovery is envisaged to continue at a moderate pace as private and external demand progressively gather strength. - Near-term drivers of growth: inventory dynamics and a pick-up in fixed business investment. - Order receipts foreshadow higher exports, but net trade contribution is likely modest. - Private consumption and residential investment are likely dampened by low real income growth, looming tax hikes, and still-strained balance sheets, but should strengthen gradually as labor market conditions improve. - Household saving rate is projected to stabilize below its recent peak, but remain above pre-crisis levels. - Annual growth projections: - 1.7 percent this year - 2 percent in 2011 ### Risks to the central forecast - Risks are unusually large, though broadly balanced. - Upside factors that could boost growth: - Very low real interest rates. - Past depreciation of sterling. - Ongoing recovery of global demand. - Possibility that the rebound could be stronger than historical recoveries given the sharp drop in GDP during the crisis. - Downside factors: - Further rapid deleveraging among households and banks. - Sharp new downturn in the housing market. - Greater-than-expected weakness in parts of the euro area. - Uncertain headwinds from fiscal consolidation (could be more powerful than expected or more modest, as during the 1990s consolidation). - Severe tail risk: major new shocks (external or domestic) could derail confidence, lead to large layoffs, a step increase in unemployment, and adverse macro-financial feedback effects. ### External financial spillovers and banking exposures - A key vulnerability is spillovers from external financial market shocks due to the UK financial sector’s global reach and connectedness. - UK-owned banks have consolidated foreign assets exceeding 180 percent of GDP. - Exposures: - Claims on Greece, Ireland, Portugal, and Spain account for about 14 percent of GDP; UK bank claims are more strongly concentrated on Ireland. - UK banks have indirect exposures via claims on French and German banks (around 8 percent of GDP). - Ireland-owned banks operating in the UK account for 7 percent of domestic corporate loans and 3 percent of household loans. - Potential consequences of negative shocks in these markets: further write-downs and weakened capacity of UK banks to support domestic recovery with adequate credit supply. - Role of foreign banks in the UK (wholesale financial services and retail finance) also creates additional spillover channels; tightening of credit supply owes in part to retrenchment by some foreign banks. ### VAR analysis of inward spillovers (Box 1) - Structural VAR setup: UK real GDP; weighted average real GDP for countries with large UK bank exposures; weighted average TED spread for same countries; TED spread for the UK. Identifying assumptions: UK variables do not affect other countries’ variables contemporaneously; other countries’ variables affect UK variables contemporaneously; within each block real GDP contemporaneously affects TED spread, but not vice-versa. - Estimated effects: - A structural shock that causes an average 100 basis-point increase in the foreign TED spread results in a 0.4 percentage point decline in the UK’s real GDP growth on impact, widening to 1.2 percentage points over the following two quarters before tapering off. - A 1 percentage point decline in other countries’ real GDP results in about a 0.8 percentage point decline in the UK’s real GDP on impact, with the effect persisting for several quarters. - Conclusion: the analysis suggests significant inward spillovers to the UK economy. ### Medium-term growth potential and uncertainties - Staff assesses that the financial crisis has depressed aggregate demand and dented potential supply. - Spare capacity is far more limited than the drop in GDP would suggest; staff estimates the current output gap on the order of 2-4 percent. - Industry surveys point to much-reduced slack within firms, notably in manufacturing. - Staff medium-term projection: - Growth projected to rise gradually to 2½ percent in the medium term, only slowly closing the output gap. - Factors affecting medium-term potential: - Fiscal consolidation: could have favorable effects if it boosts national saving or shifts activity to the private sector and raises productivity; alternatively, prolonged demand weakness could lead to scrapping of idle capital and persistent unemployment, reducing actual and potential output. - Weaker exchange rate: uncertain ultimate growth effect—could support export and import-competing sectors, but net exports might be price-inelastic or global demand may have shifted away from UK specializations; sterling might rebound if credible fiscal consolidation boosts confidence. - Credit supply: considerable uncertainty about future supply and price of credit to businesses given regulatory and financial pressures on banks; financing constraints could become more onerous as demand picks up over the medium run. ### Authorities’ views - Authorities envisaged somewhat higher growth than staff, with no essential difference for 2010 but stronger projections for 2011 and the medium term. - Authorities’ reasons for stronger projections: - Larger contribution from net exports driven by a stronger supply-side response to past sterling depreciation; weak net exports so far partly reflecting temporary factors (e.g., high imports due to car scrappage schemes and restocking). - Stronger fixed investment as corporates respond to a better demand outlook and planned reductions in the corporate tax rate. - Authorities acknowledged both upside and downside risks and stressed that international policy coordination to rebalance global demand and strengthen financial regulation would amplify the effectiveness of their policy efforts. ### Ensuring fiscal sustainability: June budget plans and implications - The June budget sets out an ambitious and comprehensive medium-term fiscal consolidation plan. - Fiscal mandate: balance the cyclically-adjusted current budget by the end of a five-year rolling horizon—currently by 2015/16—and put the net debt-to-GDP ratio on a declining path by 2015/16. - Announced policy plans drawn to meet these goals one year early, providing some margin. - Fiscal figures and timing: - Overall fiscal deficit programmed to fall to 2 percent of GDP by 2014/15, from 11 percent of GDP in 2009/10. - Represents an additional tightening of about 2 percentage points relative to the previous government's plans. - Total planned structural adjustment: 8 percent of GDP in the five years to 2014/15. - Projected adjustment is relatively frontloaded: discretionary tightening of 1¼ percentage points in 2010/11 and 2½ percentage points in 2011/12. - Rationale: painful short-run cost of consolidation is necessary to enhance credibility, ensure debt sustainability, avoid tail risk of a costly loss of sovereign confidence, and regain fiscal space for future shocks and demographic pressures. - Under announced policy plans, it should be feasible to lower the debt-to-GDP ratio to 60 percent by 2015/16. *IMF staff report excerpt* ### Box 2. To Tighten, or Not to Tighten—UK Fiscal Policy in the Public Debate ### Box 2. To Tighten, or Not to Tighten—UK Fiscal Policy in the Public Debate ### Debate overview - Consensus on the need for medium-term fiscal consolidation, with pre-election proposals and the March 2010 and June 2010 budgets featuring significant fiscal tightening from 2010 onward; differences in envisaged fiscal effort do not exceed ½ percent of GDP in any year. - The central controversy is timing: whether to tighten immediately (frontload) or delay to avoid choking off a fragile recovery. ### Arguments against immediate fiscal tightening (critics) - Risk that government retrenchment will not be offset by expansion in other sectors; additional monetary stimulus may not be powerful enough to offset this risk. - Excessive tightening could destroy supply capacity: early tightening based on pessimistic assessments of potential output could be self-fulfilling, causing capital scrapping and human capital losses. - Need to placate bond markets is overstated: long-term UK interest rates show no sign of market panic; commitments to future consolidation may be more important than immediate cuts. Tying consolidation to the political cycle imposes unnecessary pain. ### Counterarguments and risks of delay (staff and proponents) - Signs of a private-sector-led recovery exist; consensus forecast for solid growth next year partly reflecting cyclical momentum. Loose monetary policy should support rebalancing, including higher net exports. - Evidence points to an output gap not far from the estimate underlying the June budget; historical financial crises point to lasting and large drops in potential GDP—“Is this time really different?” - Current low gilt yields are influenced by large-scale BoE purchases; market assessments can change quickly (e.g., Eurozone surges). UK spreads rose early in the year and improved in May/June after budget announcements. - Political credibility matters: promises of future consolidation alone may not persuade, especially when commitments extend beyond the current parliamentary term; coalition novelty may heighten credibility concerns. ### Staff view and recommendation - Staff’s view: a significant fiscal tightening with frontloading in 2011/12 is appropriate to secure confidence in the UK’s debt sustainability. - Emphasis on contingency planning: authorities need to be prepared to tackle surprises on either side of the central forecast. - Automatic stabilizers should be allowed to operate freely in both directions to preserve targeted structural adjustment and help stabilize the economy. - In an unexpected but significant and prolonged downturn, alongside further monetary support, temporary tax cuts should be considered; they are faster to implement and more credibly temporary than expenditure shifts and should be targeted to low-income households, employment creation, or investment. - Simultaneous adoption of entitlement reforms would be desirable to safeguard fiscal sustainability and market credibility. ### Composition of the consolidation and fiscal measures announced - Budget measures include significant spending and revenue actions; about half of required discretionary spending cuts were identified. - Key revenue and tax measures: - Rise in the standard VAT rate from 17½ percent to 20 percent from January 2011. - Capital gains tax hike from 18 percent to 28 percent. - Small bank levy on selected wholesale liabilities. - Corporate income tax to be lowered gradually. - Personal income tax allowance to be raised. - Expenditure measures: - Two-year pay freeze for most public sector employees. - Reductions in social benefits. - Discretionary Consolidation between 2009/10 and 2014/15 (Total announced: £128 billion) — composition (%): - VAT and other indirect taxes: 10% - Taxes on income and wealth: 11% - Capital spending cuts: 2% - Other revenue measures: 19% - Other current spending cuts: 9% - Cuts in welfare benefits: 3% - Public sector pay freeze: 47% ### Aggregate spending and composition concerns - Total managed expenditure (TME) is set to decline by 7.7 percentage points of GDP over the next six years to 2015/16. - Annual managed expenditure (AME; the nondiscretionary component) will contribute just 0.1 percentage points to the adjustment, as debt interest payments are projected to rise. - The bulk of the adjustment falls on departmental expenditure limits (DEL; discretionary component): all government functions, except for health and foreign aid, are projected to face real cuts of 25 percent on average over the next four years. - Public investment projected to fall by one-third in real terms. - Staff recommendation: put greater emphasis on reducing public sector compensation premia and achieving savings in benefits and transfers through better targeting to avoid excessive squeeze on investment and shield the vulnerable. ### Risks, multipliers, and scenarios - OBR assumptions on fiscal multipliers (source: OBR): - VAT rate: 0.35 - Income tax: 0.3 - Welfare benefits: 0.6 - Public consumption: 0.6 - Public investment: 1 - Under staff’s central scenario, fiscal tightening is expected to dampen growth, though without stopping the ongoing recovery; frontloaded measures were chosen to use instruments with smaller multipliers (e.g., VAT hike). - Consolidation could be tested if growth risks materialize on the downside (calls for stimulus) or upside (cyclical revenues rise and reduce perceived need for structural adjustment). Spending cuts should generally proceed on schedule to maintain credibility; temporary tax cuts can be used if a significant prolonged downturn occurs. ### Long-term reform needs and institutions - Entitlement reforms: - Staff estimates age-related spending will increase by about 4 percentage points of GDP over the next 20 years under current policies. - More than three quarters of this increase is due to higher health and long-term care spending, highlighting importance of healthcare cost containment and efficiency reforms. - Pension measures: accelerate planned increases in the statutory retirement age and gradually align generosity of public pensions with private-sector counterparts. - Retirement age schedule under current law: currently 60 for women and 65 for men; equalized at 65 for those retiring in 2020; increase to 66 between 2024 and 2028; to 67 between 2034 and 2036; and to 68 between 2044 and 46. - Institutional reforms: - Establishment of a new independent Office for Budget Responsibility (OBR) to provide macroeconomic and fiscal forecasts, assess fiscal sustainability, and assess compliance with the fiscal mandate. June budget was the first based on interim OBR forecasts. - OBR should be fully independent, have arms-length relationship with Treasury, full-access rights to pertinent information, multi-year budgets, adequate staffing, and broad remit. - In due course, replace temporary fiscal mandate with more permanent rule-based framework (e.g., a structural balance rule or a rule responding to deviations in output growth relative to trend growth) to anchor medium-term debt sustainability and promote countercyclical policies. ### Selected public sector finance projections (percent of GDP; staff projections, June 2010 Budget) - Fiscal years: 2009/10, 2010/11, 2011/12, 2012/13, 2013/14, 2014/15, 2015/16 - Overall balance: -11.0, -10.1, -7.5, -5.5, -3.5, -2.1, -1.1 - Cyclically adjusted overall balance: -8.7, -7.4, -5.0, -3.4, -1.8, -0.8, -0.3 - Current balance: -7.5, -7.5, -5.8, -4.1, -2.4, -1.0, 0.1 - Cyclically adjusted current balance: -5.3, -4.8, -3.3, -2.0, -0.7, 0.3, 0.8 - Fiscal stance (negative of the change in cyclically adjusted balance): 2/2.4, -1.3, -2.4, -1.7, -1.6, -1.0, -0.6 - General government gross debt: 71.2, 78.9, 83.6, 85.5, 84.9, 83.1, 80.4 ### Authorities’ views - Authorities emphasized frontloaded adjustment as necessary to bolster credibility amid rising sovereign solvency concerns in parts of Europe and rising gilt spreads earlier in 2010. - Frontloading requires some near-term tax increases, though the bulk of multi-year consolidation comes from spending cuts. - Authorities agreed automatic stabilizers are an important safeguard and saw merit in many staff recommendations on quality of adjustment and entitlement reform. - Authorities view the new OBR as a critical improvement; they intend to tighten the fiscal mandate (by shortening its horizon) once public finances are closer to balance. _Italic: Source: IMF staff report (Box 2) contained in the provided PDF content._ ### Box 3. Effectiveness of the Bank of England’s Quantitative Easing ### Box 3. Effectiveness of the Bank of England’s Quantitative Easing ### Summary of the QE program and scale - Between March 2009 and January 2010, the BoE bought nearly £200 bn in medium- to long-term gilts, financed by issuing reserve money. - These purchases amount to 14 percent of UK GDP, 25 percent of outstanding gilts, and 40 percent of gilts in the relevant market segment (at end-2009). ### Event-study evidence on yields and channels - Event-study analysis suggests that the purchases have depressed yields by up to 125 basis points. - Judging from a two-day event window around key announcement dates, the gilt yield curve has shifted downward by between 20 and 125 basis points, with the largest drop for long maturities. - Using a one-day window, the effects are only half as large, but still significant. - The strongest yield response is found for March 5, 2009, when the first set of purchases was announced. - Decomposition analysis indicates most of the decline in yields appears to reflect portfolio balance effects caused by a lower net supply of gilts; OIS rates, which capture market expectations about future interest rate policy, fell by a small amount only. ### Broader financial market and economy effects - Lower long-term interest rates have supported the broader recovery in financial markets since March 2009. - The launch of QE in the UK—along with similar announcements in the US—coincided with the turn-around in UK and global equities. - QE has boosted confidence, created positive wealth effects, and improved the supply of credit to corporates. - Direct effects: small-scale BoE purchases of commercial paper and corporate bonds. - Indirect effects: large-scale gilt purchases induced investors to shift funds into other assets, including corporate bonds. - The ultimate impact of QE on demand and inflation remains difficult to quantify. ### Inflation context and related numeric findings (from adjacent analysis) - The January 2010 VAT hike was preannounced and is estimated to have added about ¾ of a percentage point to the CPI. - Cross-country evidence suggests pass-through on the order of 0.17 could explain much of inflation variation since mid-2007. - The announced rise in the VAT rate in January 2011 is set to raise the CPI by another 1-1½ percentage points. - Staff projects inflation to remain above 2 percent throughout 2011. - Reserves are fully remunerated (noted in discussion of monetary control). ### Policy implications and recommendations for monetary authorities - A highly accommodative monetary stance remains appropriate for now, with the MPC required to be nimble in responding to incoming data. - If a stalling recovery heightens disinflationary forces: - Quantitative easing should be expanded; resumption of gilt purchases is a natural first option. - Authorities should consider buying larger amounts of private sector assets to target market dysfunctions or valuation anomalies in a sharp downturn—such purchases may be best framed as a fiscal operation (financed by issuance of gilts, which the BoE could separately decide to buy) to ensure accountability for financial and political risk. - Decisions on further QE must consider effects on the risk profile of the consolidated public sector balance sheet, since QE involves issuing a short-term liability (bank reserves) in exchange for extinguishing a long-term liability (gilts) or acquiring a risky private-sector asset. - Conversely, if incoming data raise the prospect of above-target inflation over the policy horizon: - The MPC must stand ready to start a gradual tightening. - The MPC intends to give standard Bank Rate increases priority over asset sales; staff concurs, noting policy rates are easier to fine-tune and best understood in terms of effects. - Asset sales can be programmed at a pace that does not interfere with stable gilt market conditions. - Overall, near-term adjustments to the monetary stance should be guided by incoming data, with close monitoring of effective labor costs, other input prices, and inflation expectations. ### Authorities’ and MPC views (as reported) - The authorities generally agreed with staff’s views on the inflation outlook and monetary stance. - MPC views were divided: - Majority: current policy stance appropriate; data-dependent approach favored. - One MPC member: balance of risks warranted withdrawing some exceptional monetary stimulus. - Another MPC member: argued for expanding the asset purchase program to engineer a faster recovery and avoid medium-term undershooting of inflation. - Divergent views on the likely effectiveness of further gilt purchases, with some citing “diminishing returns” and others more optimistic. *Source: IMF staff summary of Box 3, “Effectiveness of the Bank of England’s Quantitative Easing.”* ### 41. There was agreement on the reform agenda, although specific outcomes will ### _cr10338 - 41. There was agreement on the reform agenda, although specific outcomes will ### Reform agenda and international coordination - Authorities expressed broad satisfaction with the initial set of Basel III proposals, while stressing the need to: - make swift progress on outstanding items, notably a firming-up of liquidity standards; - create robust tools to contain systemic risk. - The UK’s policy line: push for ambitious reform while seeking broad-based international agreement to limit scope for regulatory arbitrage. - Domestic process: government has issued consultation papers and set up the Independent Commission on Banking; authorities await outcomes and noted they would consider staff’s specific proposals on enhancing supervision. - Treasury consultation paper (“A New Approach to Financial Regulation: Judgement, Focus and Stability.”) cited adoption of a prompt corrective action regime as one option to enhance the regulator’s intervention powers. ### Staff appraisal: macroeconomic assessment - Recovery status and drivers: - UK economy is on the mend; economic recovery is underway, unemployment has stabilized, and financial sector health has improved. - Improvements reflect cyclical rebound and authorities’ forceful policy actions: large-scale financial-sector interventions, temporary fiscal stimulus, unprecedented monetary easing, and announcement of a strong and credible multi-year fiscal consolidation strategy. - Policy challenge: support sustainable economic recovery as focus shifts from crisis management to post-crisis repair; gradual rebalancing toward private and external sector-led demand is required given private sector financial surpluses and record-high public deficits. ### Fiscal consolidation: assessment and recommendations - Fiscal plans: - Fiscal mandate: balancing the cyclically-adjusted current budget over a five-year rolling horizon—currently by 2015/16—is described as ambitious but feasible. - Credibility bolstered by frontloaded actions to achieve the mandate one year early. - Benefits and trade-offs: - Consolidation preserves confidence in debt sustainability and regains fiscal space to cope with future shocks. - Market reaction positive; benefits outweigh expected near-term growth costs. - Quality of adjustment (recommendations): - Use current spending and pension reviews to strengthen the quality of fiscal adjustment. - Within spending envelope, give more weight to reducing public sector compensation premia and achieving savings in benefits and transfers through better targeting to: - shield the vulnerable; - mitigate growth effects of adjustment (cuts likely have smaller fiscal multipliers); - allow relatively more spending on infrastructure investments to boost potential growth. - Entitlement reforms recommended: accelerate retirement age increases for state pensions and gradually align public sector pension generosity with private sector. - Fiscal institutions: - Establishment of a new independent OBR welcomed; should enhance transparency and credibility. - As OBR role/remit are finalized, independence should be underpinned by sufficient legal authority and safeguards. - In due course, replace current fiscal mandate with a more permanent rule-based framework to be monitored by the OBR. ### Monetary policy stance - Recommendation: maintain a highly accommodative monetary stance to offset contractionary impulse from fiscal policy and keep inflation close to target over the policy horizon. - Rationale: - One-off price level shocks will dissipate; disinflationary forces (spare capacity and public sector wage restraint) will keep underlying price pressures in check. - BoE accommodative stance supports overall policy stimulus as fiscal tightening takes hold and financial intermediation normalizes gradually. - Policy flexibility: - Asset purchases should resume if the recovery weakens and disinflationary pressures mount. - Policy rates should tighten gradually if output recovers apace and inflation surprises on the upside. - In a significant and prolonged downturn, consider temporary targeted tax cuts (alongside further monetary easing), ideally combined with longer-term entitlement reforms to safeguard fiscal sustainability and market credibility. ### Risks to the central scenario - Downside risks: - Continued fragility of confidence; - Still-strained balance sheets among households and banks; - Possible resurgence of sovereign and banking market turmoil in the euro area markets; - Fiscal consolidation headwinds could be stronger than expected. - Upside risks: - Expansionary impulses from very low real interest rates, past sterling depreciation, and global demand recovery could be greater than expected—boosting growth but potentially increasing inflationary pressure. - Safeguards: - Free operation of automatic fiscal stabilizers in both directions. - Nimble monetary policy as outlined above. - Consider temporary targeted tax cuts and entitlement reform in the unexpected case of a significant prolonged downturn. ### Financial sector health and prudential architecture (recommendations) - Raise capital buffers further, notably by restraining dividend payouts and remuneration budgets, taking into account bank-specific circumstances. - Unwind crisis-related public interventions in line with initial program design to reduce taxpayer risk and restore private sector responsibility. - Supervisors should press banks to develop robust new funding models based on a broad mix of simpler and more transparent instruments. - Creation of an FPC with an explicit macroprudential mandate is welcome. - Effectiveness requires close coordination with other countries’ regulators, notably within the EU. - Critical FPC task: identify risk migration into less regulated parts of the financial system and ensure commensurate widening of the regulatory perimeter. - Manage transition to new prudential architecture carefully to mitigate operational risks. - Continue enhancing intrusive, judgment-based, and strategic supervision adopted since the crisis. - Useful measures to assist supervision: - (i) provide the PRA authority to supervise and, if necessary, give formal directions at the financial holding company level to enhance consolidated supervision; - (ii) adopt a “prompt corrective action” regime to strengthen supervisor’s capacity to address emerging risks at an early stage; - (iii) have the supervisor regularly disclose nonconfidential firm-level prudential returns. - Continue constructive efforts to secure an ambitious international package of regulatory reform and rigorous implementation in the EU. - Emphasize concrete tools to address risks from systemic financial institutions (e.g., capital and liquidity surcharges and cross-border resolution frameworks). - Promote internationally coordinated financial sector reform to minimize regulatory arbitrage and phase in reforms gradually to avoid strangling near-term credit supply. ### Procedural recommendation - It is recommended that the next Article IV consultation with the United Kingdom be held on the standard 12-month cycle. ### Key numeric projections and selected statistics (preserved exactly as in source) - Real Economy (change in percent), selected years: - Real GDP: 2005 2.2; 2006 2.8; 2007 2.7; 2008 -0.1; 2009 -5.0; 2010 1.7; 2011 2.0 (table headings indicate Proj. for 2010–11). - Domestic demand: 2005 2.1; 2006 2.5; 2007 3.1; 2008 -0.7; 2009 -5.5; 2010 2.6; 2011 1.5. - CPI, end period: 2005 1.9; 2006 3.0; 2007 2.1; 2008 3.1; 2009 2.9; 2010 2.8; 2011 2.5. - Unemployment rate (in percent) 1/: 2005 4.8; 2006 5.4; 2007 5.4; 2008 5.6; 2009 7.5; 2010 7.9; 2011 7.5. - Public Finance (fiscal year, percent of GDP), selected: - General government balance: 2005 -2.9; 2006 -2.3; 2007 -2.7; 2008 -6.7; 2009 -11.3; 2010 -9.9; 2011 -7.4. - Public sector net debt: 2005 35.5; 2006 36.0; 2007 36.5; 2008 42.7; 2009 53.5; 2010 61.2; 2011 66.3. - Cyclically adjusted balance (staff estimates): 2005 -2.8; 2006 -2.2; 2007 -2.9; 2008 -5.8; 2009 -8.1; 2010 -7.7; 2011 -5.5. - Money and Credit (end-period, 12-month percent change), selected: - M4: 2005 12.8; 2006 12.5; 2007 12.7; 2008 15.5; 2009 6.6; 2010 1.9. - Unsecured Consumer Credit: 2005 9.6; 2006 7.4; 2007 7.0; 2008 4.1; 2009 -1.7; 2010 -1.0. - Interest rates (percent; year average), selected: - Three-month interbank rate: 2005 4.75; 2006 5.3; 2007 6.0; 2008 5.8; 2009 1.2; 2010 0.7. - Ten-year government bond yield: 2005 4.4; 2006 4.5; 2007 5.0; 2008 4.7; 2009 3.6; 2010 3.7. - Balance of Payments (percent of GDP), selected: - Current account balance: 2005 -2.6; 2006 -3.4; 2007 -2.6; 2008 -1.6; 2009 -1.3; 2010 -2.4; 2011 -2.3 (proj.). - Trade balance: 2005 -3.4; 2006 -3.1; 2007 -3.1; 2008 -2.6; 2009 -2.4; 2010 -2.9; 2011 -2.5. - Exports of goods and services (volume change in percent): 2005 7.9; 2006 11.1; 2007 -2.6; 2008 1.0; 2009 -11.1; 2010 5.5; 2011 6.3. - Fund Position (as of September 30, 2010): - Holdings of currency (in percent of quota) 78.0 - Holdings of SDRs (in percent of allocation) 90.2 - Quota (in millions of SDRs) 10,739 - Exchange Rates: - Exchange rate regime: Floating - Bilateral rate (September 30, 2010) US$ = £0.6347 - Selected medium-term projections (Table 5, percentage change unless otherwise indicated): - Real GDP: 2009 -5.0; 2010 1.7; 2011 2.0; 2012 2.3; 2013 2.4; 2014 2.5; 2015 2.6. - CPI Inflation, end period: 2009 2.9; 2010 2.8; 2011 2.5; 2012 1.8; 2013 1.9; 2014 2.0; 2015 2.0. - Current account (percent of GDP): 2009 -1.3; 2010 -2.4; 2011 -2.3; 2012 -2.0; 2013 -1.7; 2014 -1.4; 2015 -1.3. - Unemployment rate (percent, period average): 2009 7.5; 2010 7.9; 2011 7.5; 2012 6.9; 2013 6.4; 2014 6.1; 2015 5.8. *Italic: IMF staff report content as provided in the supplied excerpt.* ### Annex A: Public Sector Debt Sustainability ### Annex A: Public Sector Debt Sustainability ### Overview - General government gross debt projected to increase from 43 percent of GDP in 2007/08 to about 85 percent of GDP in 2012/13 under the government’s planned consolidation. - Debt ratio projected to come down to 80 percent of GDP by 2015/16 (Table A1). - Baseline scenario builds on staff’s central scenario, taking into account announced policies, focusing on general government gross debt. - Primary deficit expected to have peaked in 2009/10 at 9 percent of GDP and reach a 2 percent of GDP surplus in 2015/16. - Cyclically-adjusted primary balance (CAPB) would improve from 6 percent of GDP in 2009/10 to 2 percent in 2015/16. - Debt ratio on a downward path from 2013/14, reaching 60 percent of GDP by 2025/26 if policies unchanged after 2015/16. - Gross financing needs expected to reach 17 percent of GDP in 2010/11, driven by the high overall deficit, amortization, and an increased share of short-term debt. ### Baseline projections and key statistics (selected from Table A1) - Public sector debt (general government consolidated gross debt, series: BKPX): - 2005: 41.7 - 2006: 42.4 - 2007: 43.1 - 2008: 55.4 - 2009: 71.6 - 2010: 78.5 - 2011: 82.8 - 2012: 84.8 - 2013: 84.6 - 2014: 82.9 - 2015: 80.2 - Change in public sector debt: - 2005: 2.1 - 2006: 0.7 - 2007: 0.7 - 2008: 12.3 - 2009: 16.2 - 2010: 7.0 - 2011: 4.2 - 2012: 2.1 - 2013: -0.2 - 2014: -1.7 - 2015: -2.7 - Identified debt-creating flows (4+7+12): - 2005: 1.4 - 2006: 0.2 - 2007: 0.5 - 2008: 7.1 - 2009: 13.1 - 2010: 6.1 - 2011: 3.9 - 2012: 1.9 - 2013: -0.3 - 2014: -1.7 - 2015: -2.7 - Primary deficit: - 2005: 1.0 - 2006: 0.5 - 2007: 0.5 - 2008: 4.6 - 2009: 9.1 - 2010: 6.8 - 2011: 4.1 - 2012: 2.3 - 2013: 0.5 - 2014: -1.0 - 2015: -2.0 - Revenue and grants: - 2005: 37.6 - 2006: 38.0 - 2007: 38.1 - 2008: 37.2 - 2009: 36.2 - 2010: 36.6 - 2011: 37.4 - 2012: 37.7 - 2013: 38.0 - 2014: 38.2 - 2015: 38.1 - Primary (noninterest) expenditure: - 2005: 38.6 - 2006: 38.5 - 2007: 38.6 - 2008: 41.8 - 2009: 45.3 - 2010: 43.4 - 2011: 41.5 - 2012: 40.0 - 2013: 38.5 - 2014: 37.2 - 2015: 36.1 - Automatic debt dynamics: - 2005: 0.4 - 2006: -0.3 - 2007: 0.0 - 2008: 1.9 - 2009: 3.4 - 2010: -0.6 - 2011: -0.2 - 2012: -0.4 - 2013: -0.7 - 2014: -0.7 - 2015: -0.7 - Contribution from real interest rate (selected years): - 2005: 1.4 - 2006: 0.7 - 2007: 1.0 - 2008: 1.0 - 2009: 1.3 - 2010: 1.1 - 2011: 1.2 - 2012: 1.4 - 2013: 1.2 - 2014: 1.3 - 2015: 1.3 - Contribution from real GDP growth (selected years): - 2005: -1.0 - 2006: -1.0 - 2007: -1.0 - 2008: 0.8 - 2009: 2.1 - 2010: -1.7 - 2011: -1.4 - 2012: -1.9 - 2013: -2.0 - 2014: -2.0 - 2015: -2.0 - Residual, including asset changes (2-3): - 2005: 0.7 - 2006: 0.5 - 2007: 0.2 - 2008: 5.2 - 2009: 3.1 - 2010: 0.8 - 2011: 0.3 - 2012: 0.2 - 2013: 0.1 - 2014: 0.0 - 2015: 0.0 - Public sector debt-to-revenue ratio: - 2005: 110.9 - 2006: 111.7 - 2007: 113.2 - 2008: 148.9 - 2009: 197.8 - 2010: 214.4 - 2011: 221.5 - 2012: 225.1 - 2013: 222.5 - 2014: 217.2 - 2015: 210.3 - Gross financing need (percent of GDP): - 2005: 5.7 - 2006: 6.2 - 2007: 6.0 - 2008: 9.3 - 2009: 15.8 - 2010: 16.7 - 2011: 14.5 - 2012: 12.9 - 2013: 11.1 - 2014: 10.3 - 2015: 7.3 - Gross financing need (in billions of U.S. dollars): - 2005: 133.8 - 2006: 153.3 - 2007: 157.5 - 2008: 266.9 - 2009: 425.7 - 2010: 455.9 - 2011: 415.2 - 2012: 389.8 - 2013: 353.7 - 2014: 348.3 - 2015: 263.4 - Key macroeconomic and fiscal assumptions (selected): - Real GDP growth (percent): - 2005: 2.5 - 2006: 2.6 - 2007: 2.5 - 2008: -1.9 - 2009: -3.7 - 2010: 2.5 - 2011: 1.8 - 2012: 2.4 - 2013: 2.5 - 2014: 2.5 - 2015: 2.6 - Average nominal interest rate on public debt (percent): - 2005: 5.4 - 2006: 5.3 - 2007: 5.4 - 2008: 5.1 - 2009: 3.9 - 2010: 4.6 - 2011: 4.4 - 2012: 4.3 - 2013: 4.3 - 2014: 4.4 - 2015: 4.5 - Average real interest rate (percent): - 2005: 3.6 - 2006: 1.9 - 2007: 2.5 - 2008: 2.3 - 2009: 2.2 - 2010: 1.6 - 2011: 1.6 - 2012: 1.9 - 2013: 1.6 - 2014: 1.7 - 2015: 1.7 - Inflation rate (GDP deflator, percent): - 2005: 1.8 - 2006: 3.4 - 2007: 2.9 - 2008: 2.8 - 2009: 1.7 - 2010: 3.0 - 2011: 2.8 - 2012: 2.4 - 2013: 2.7 - 2014: 2.7 - 2015: 2.7 - Growth of real primary spending (percent): - 2005: 3.7 - 2006: 2.2 - 2007: 2.8 - 2008: 6.2 - 2009: 4.3 - 2010: -1.8 - 2011: -2.7 - 2012: -1.2 - 2013: -1.5 - 2014: -0.9 - 2015: -0.4 ### Alternative scenarios and sensitivity analysis - Absence of fiscal consolidation: - In a scenario with a constant primary balance (in percent of GDP) over 2010/11-15/16, debt would increase to 110 percent of GDP by 2015/16 and be on a firm upward path. - The impact of unchanged policies could be even higher if concerns about sovereign debt dynamics lead to higher interest rates. - Interest rate sensitivity: - Baseline assumes real interest rates average 1.7 percent over the projection period. - If real interest rates increase by half a standard deviation above the baseline, debt would increase to 82 percent of GDP by 2015/16, some 2 percentage points of GDP above the baseline. - Growth sensitivity: - If medium-term growth rates are persistently lower by 1¼ percentage points (½ a standard deviation) each year, and expenditure plans remain unchanged, the debt-to-GDP ratio could reach 96 percent of GDP by 2015/16. - Bound tests and shocks (Figure A1): - Individual shocks are permanent one-half standard deviation shocks. - Additional scenario with permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and primary balance (combined shock). - A 10 percent of GDP shock to contingent liabilities occurs in 2010 in the contingent-liabilities scenario. ### Required fiscal adjustment (Annex Box) - Objective: target a long-term decline in the public debt-to-GDP ratio, not just stabilization at post-crisis levels (Commandment III from Ten Commandments for Fiscal Adjustment in Advanced Economies, IMF, 2010). - Under current policies staff projects gross general government debt-to-GDP ratio will peak at 85 percent in 2012/13 before declining to 80 percent by 2015/16. - To lower debt ratio to 60 percent by 2030/31: - Require improving CAPB by 7.5 percentage points of GDP between 2009/10 and 2020/21. - CAPB must improve from a deficit of 6.1 percent of GDP in 2009/10 to a surplus of 1.5 percent of GDP by 2020/21 and be maintained through 2030/31. - Staff estimates measures in the June budget would bring the CAPB to a surplus of 2 percent of GDP by 2015/16—if maintained at this level, the debt ratio would reach 60 percent by 2025/26. - To lower debt ratio to 40 percent by 2030/31: - Require improving CAPB by 9 percentage points of GDP between 2009/10 and 2020/21. - CAPB must reach a surplus of 2.9 percent of GDP by 2020/21 and be maintained constant through the subsequent decade. - In addition to announced policy plans through 2015/16, further discretionary tightening of about ¾ percentage point of GDP over the following five years to 2020/21 would be needed. - Under this scenario the debt-to-GDP ratio would fall below 60 percent of GDP by 2023/24. *Source: Annex A: Public Sector Debt Sustainability, _cr10338 - Annex A: Public Sector Debt Sustainability_* ### 1. Third quarter GDP growth came in at a relatively strong 3.2 percent (q-o-q, ### _cr10338 - 1. Third quarter GDP growth came in at a relatively strong 3.2 percent (q-o-q, ### Q3 2010 GDP outturn and near-term outlook - Q3 GDP growth: 3.2 percent (q-o-q, saar). - Q3 sector contributions: Construction up 17 percent; services up 2.4 percent; manufacturing up 2.4 percent. - Comparative forecasts (Real GDP Growth, Q3 2010, Percent): - Actual outturn 1/: 3.2 (SA quarter-on-quarter change, annualized); 2.8 (Change over Q3 2009). - IMF staff (Oct. 2010 WEO)2: 2.7; 2.7. - Consensus Forecast (Sep. 2010) 1/1.9: 2.4. - Bank of England (Aug. 2010 Inflation Report) 2/2.4: 2.5. - 1/ Annualization is an IMF staff calculation. - Sources: Bank of England (BoE), Consensus Forecast, ONS, and IMF staff projections. - 2/ The Bank of England publishes only 4-quarter growth rate forecasts and hence the annualization is an IMF staff calculation of the mode forecast at market interest rates. - Staff projection: GDP growth expected to moderate to about 2 percent in 2011, reflecting headwinds from accelerating fiscal consolidation and near-term indicators suggesting some cooling of construction growth. - Note: Details on the expenditure side will not be released until November 24. ### Spending Review: design and composition - Overall design: - Government announced results of its 2010 Spending Review specifying plans to reduce public expenditure at an even nominal pace over the next four years; consolidation is frontloaded due to frontloaded tax measures. - Total spending envelope remains very close to previous announcements. - Key quantitative elements: - Relative to previous announcements, by FY 2014/15 annual spending on social benefits will be reduced by an additional £7 billion (0.4 percent of GDP). - Of these savings, £2.5 billion come from the elimination of the child benefit for higher-income taxpayers, starting in 2013. - Another £2.0 billion in savings comes from placing a one-year time limit on certain benefits available to those who have a disability but are deemed able to work. - With the new reductions, changes to social benefits now account for 25 percent of the reduction in total primary expenditure, up from 15 percent in the June budget. - Departmental spending (excluding protected areas of health and foreign aid): reduced by 19 percent in real terms by 2014/15—less than the 25 percent real cuts announced in the June budget. - Public employee pension contributions will rise by 3 percentage points on average, yielding 0.1 percent of GDP by 2014/15. - Capital expenditure allocation: slight increase by 0.1 percent of GDP by FY 2014/15, easing the real reduction in this category from 33 percent to 29 percent (relative to FY 2010/11). - Fiscal Consolidation Plan (Cumulative £ billion, unless otherwise indicated): - 2011/12 2012/13 2013/14 2014/15 - Total consolidation plan 39 64 87 111 - Total spending reductions 21 40 61 81 - Total tax changes 18 24 27 29 - Memorandum: Cumulative proportion of four-year consolidation plan (Percent): 35 58 78 100 - Sources: HM Treasury and IMF staff calculations. - Distributional and implementation notes: - Within departmental spending, transfers to local governments and public security face some of the largest spending reductions. - The full elimination of child benefit once a certain income threshold is reached implies very high effective marginal tax rates right at the threshold; the government prioritizes simplicity of the reformed scheme over avoiding “cliff effects.” - The costing of savings from reductions in social benefits was vetted by the newly established independent Office for Budget Responsibility (OBR). The OBR will also take into account the effect of the revised spending plans on its economic growth projections when it next updates its forecasts. Staff does not expect the Spending Review to result in large growth revisions, as it was largely in line with expectations. - Implementation risk: Cuts of this magnitude will be challenging to implement and may strain public service delivery in some areas; the roughly even distribution across the next four years should help ease adjustment costs. The effect on vulnerable segments of society will need to be monitored closely. ### Pension, labor, and long-run fiscal sustainability measures - State pension age proposals: - Equalize pension age for women with that of men at 65 by 2018 (instead of 2020 under current law). - Raise it to 66 for both men and women by 2020 (instead of 2026 under current law). - Public employee pensions: - Public employee pension contributions to rise by 3 percentage points on average, yielding 0.1 percent of GDP by 2014/15. - Ongoing review of public sector pensions due by the time of the FY 2011/12 budget expected to yield additional long-run savings. - Staff assessment: Several announced policies align with staff recommendations (targeting universal benefits, reducing reliance on capital cuts, lowering public sector compensation premia, modestly accelerating pension age increases), but scope for reform—especially on public employee pensions and further acceleration of pension age increases—remains. ### Institutional reforms: Office for Budget Responsibility (OBR) and ratings - Draft legislation to establish the OBR permanently includes safeguards for independence: - Fixed terms for members of the OBR’s executive committee. - Statutory veto for the Treasury Select Committee over appointment and dismissal. - Explicit statement that the OBR has discretion in performing its duties, including determining its own work program beyond statutory tasks. - Full access rights to information required to discharge duties. - Treasury agreed to provide the OBR with a multi-year budget for the period of the Spending Review to help safeguard financial independence. - Credit rating development: - Standard & Poor’s revised its outlook for the UK’s AAA rating from Negative to Stable on October 26, citing the Spending Review as a key factor. ### Monetary policy, financial sector, and balance-sheet policies - Monetary stimulus: - Bank of England policy rate kept near zero. - £200 billion in asset purchases (mostly longer-term government bonds) to depress bond yields and boost asset prices, supporting market confidence, household net wealth, and corporate credit supply. - Banking sector: - Banking sector health improved: banks have raised capital, reduced leverage, and increased earnings. - Ongoing challenges: tightening regulatory requirements, uncertainty about sustainability of bank profits and quality of some exposures, need to raise significant new funding as public support schemes taper off. - Authorities plan to revamp the UK’s prudential architecture, consolidating key responsibilities in the BoE. - Creation of a Financial Policy Committee with an explicit macroprudential mandate; Directors emphasized some macroprudential measures should be internationally coordinated. - Directors encouraged strengthening intrusive, judgment-based, and strategic supervision and looked forward to results of the 2011 Financial Sector Assessment Program update. ### Executive Board assessment and policy guidance - Macro outlook: Recovery underway; GDP projected to grow 1.7 percent in 2010 and 2.0 percent in 2011. Risks are considerable but broadly balanced. - Directors’ views: - Welcomed stabilization and return to growth; praised policy actions including financial-sector interventions, monetary easing, temporary fiscal stimulus, and credible multi-year fiscal consolidation. - Supported frontloaded fiscal consolidation to preserve debt sustainability and restore fiscal space, acknowledging moderate near-term growth dampening. - Endorsed the mix of tax and expenditure measures, and preservation of priority expenditures that promote growth and protect vulnerable groups. - Commended creation of an independent OBR and encouraged eventual replacement of the current fiscal mandate with more permanent fiscal rules. - Agreed highly accommodative monetary stance remains appropriate while fiscal tightening takes hold and financial intermediation normalizes; monetary policy should be nimble: - Raise policy rates gradually if output recovers apace and inflation continues to surprise on the upside. - Resume asset purchases if the recovery weakens and disinflationary pressures mount. - In a significant and prolonged downturn, some Directors considered the pace of structural fiscal consolidation could be adapted, market conditions permitting and ideally combined with longer-term entitlement reforms. - Supported continued efforts to strengthen financial sector health: raise capital buffers over time, unwind crisis-related public interventions, and develop robust new funding models for banks. - Emphasized careful management of transition to new prudential architecture to mitigate operational risks. ### Selected economic indicators (excerpt, 2006–11) - Real GDP (change in percent): 2006: 2.8; 2007: 2.7; 2008: -0.1; 2009: -5.0; 2010 Proj.: 1.7; 2011 Proj.: 2.0. - Domestic demand (change in percent): 2006: 2.5; 2007: 3.1; 2008: -0.7; 2009: -5.5; 2010 Proj.: 2.6; 2011 Proj.: 1.5. - CPI (change in percent, period average): 2006: 2.3; 2007: 2.3; 2008: 3.6; 2009: 2.1; 2010 Proj.: 3.2; 2011 Proj.: 2.8. - Unemployment rate (percent) 1/: 2006: 5.4; 2007: 5.4; 2008: 5.6; 2009: 7.5; 2010 Proj.: 7.9; 2011 Proj.: 7.5. - Public sector net debt: 2006: 36.0; 2007: 36.5; 2008: 42.7; 2009: 53.5; 2010 Proj.: 61.2; 2011 Proj.: 66.3. - Current account balance (percent of GDP): 2006: -3.4; 2007: -2.6; 2008: -1.6; 2009: -1.3; 2010 Proj.: -2.4; 2011 Proj.: -2.3. - Exchange rate bilateral rate (September 30, 2010): US$ = £0.6347. - Social indicator highlights: - Income per capita (US dollars, 2008): 43,541. - Income distribution (ratio of income received by top and bottom quintiles, 2008): 5.6. - Poverty rate (at-risk-of-poverty rate after social transfers, 2008): 19 percent. - Footnotes: - 1/ ILO unemployment; based on Labor Force Survey data. - 2/ The fiscal year begins in April. For example, fiscal balance data for 2006 refers to FY2006/07. Debt stock data refers to the end of the fiscal year using centered-GDP as a denominator. - 3/ 2010: actual data as of August. - 4/ 2010: actual data through September. - 5/ Average. An increase denotes an appreciation. - 6/ 2010: actual data through July. - 7/ Based on consumer price data. *Public Information Notice No. 10/147, November 9, 2010* ### 2011. While there is some risk that a prolonged period of above target inflation may ### _cr10338 - 2011. While there is some risk that a prolonged period of above target inflation may ### Inflation outlook - Some risk that a prolonged period of above target inflation may cause medium-term inflation expectations to increase. - Expectation that inflation will fall back below the target, given the spare capacity in the economy and labour market. ### Fiscal policy — consolidation measures and priorities - Staff sought a stronger commitment to fiscal consolidation and a more ambitious medium-term fiscal adjustment path in the 2009 Article IV assessment. - The new Government (took office in May 2010) agrees with staff advice; tackling the fiscal deficit in a way that will help promote growth is the most urgent task facing the UK economy. - Government’s June Budget set out an accelerated plan for fiscal consolidation, which at around 2% of GDP by 2014-15 was toward the upper end of outside expectations. - Market reception to the consolidation plan has been positive. - Around three quarters of the consolidation will come from spending restraint, in line with staff advice and international evidence on effective and lasting consolidation. - October Spending Review set out £81 billion of spending reductions to deliver the consolidation plan while seeking to protect priority areas of expenditure that promote economic growth. - Supported priorities and growth-related protections include: - Key transport and infrastructure projects - Real terms increase in the core schools budget of 0.1% a year - Spending on science maintained in cash terms - A £1.4 billion regional growth fund - Protection of the UK’s budget for overseas development assistance and delivery of the target of ODA at 0.7 per cent of GDP - Measures to address longer-term fiscal pressures include: - Reforming State Pension provision by bringing forward the equalisation of State Pension Age for men and women at 65 to November 2018, and accelerating subsequent increase to 66 by 2020 - Considering bringing forward further planned pension age increases - Raising public sector employees’ pension contributions, leading to additional savings of £1.8 billion a year by 2014-15 - Further savings from reforms to social benefits and transfers from central to local government - According to OBR projections, these measures taken together should eliminate the cyclically-adjusted current deficit by 2014-15 and place public sector net debt on a downward path in the same year. ### Fiscal framework — transparency and institutional changes - Creation of a new independent Office for Budget Responsibility (OBR) to strengthen the fiscal framework and provide greater transparency and credibility to the UK’s official economic and fiscal forecasts. - OBR responsibilities: - Produce independent macroeconomic and fiscal forecasts on which all budget decisions will be based - Judge the consistency of the Government’s fiscal policy with its fiscal mandate - Assess the sustainability of the public finances - OBR has been operating on an interim basis since May 2010, and legislation was introduced to Parliament on 21 October to establish the OBR and its core functions in statute. - Adopted fiscal mandate: set policy to achieve cyclically-adjusted current balance by the end of the rolling, five-year forecast period. - Supplementary target: public sector net debt as a percentage of GDP to be falling at a fixed date of 2015-16. - On current plans, the UK is forecast by the OBR to meet the mandate and supplementary debt target a year early. ### Monetary policy — stance and instruments - With fiscal policy constrained and the recovery still fragile, the Bank of England has maintained a supportive monetary stance with policy rates at the lower bound and additional stimulus provided through large scale asset purchases. - Programme of asset purchases has had a significant impact on financial markets and particularly gilt yields, and its effects should continue to be felt on the wider economy for some time to come. - Current weakness in broad money growth is likely related to continued adjustment of bank balance sheets and could be seen as a corollary of bank deleveraging. - Monetary Policy Committee (MPC) judgments and settings: - Maintain Bank Rate at 0.5% - Maintain the stock of assets financed by reserves at £200bn - MPC will assess month by month whether a change in policy in either direction is warranted (the MPC’s next decision will be this Thursday, 4 November) - When appropriate to begin tightening policy, this is most likely to occur through a rise in Bank Rate with asset sales conducted later in an orderly programme over a period of time. ### Financial policy and framework — resilience, reform, and oversight - Conditions in the UK’s financial sector are much improved with higher bank capital ratios, increasing bank profitability and a successful conclusion to CEBS stress testing for UK banks, helping build resilience to further shocks. - Authorities remain vigilant; funding challenges remain, exacerbated by renewed uncertainty over the macro outlook. - UK banks envisage (realised and prospective) balance sheet reduction as central to helping meet funding challenges. - Emphasis on appropriate risk management with close monitoring of firms’ governance, culture, policy, processes and systems. - Structural reform in the UK banking sector is being assessed by an Independent Commission on Banking which will report in September 2011. - Systemic risk is being addressed through regulatory and institutional reform, including: - Giving the Bank of England responsibility for macro-prudential regulation and oversight of micro-prudential regulation - Creating a new Prudential Regulatory Authority as a subsidiary of the Bank of England - Establishing a separate, independent Consumer Protection and Markets Authority (CPMA) - Legislating for creation of a new Financial Policy Committee with macro-prudential oversight - Authorities committed to full implementation of Basel III requirements; UK banks appear well placed to meet these new requirements in a timely manner. - Authorities intend to continue to play a full role in international and EU discussions on strengthening the financial sector and enhancing international cooperation, including coordinated macro-prudential analysis, harmonised prudential rules, effective supervision of cross-border firms and fair, orderly global markets. ### Upcoming assessments and engagements - Many financial sector issues will be explored in more detail in the forthcoming Financial Sector Assessment Programme which will be conducted during the first half of 2011 and be discussed by the Board alongside the 2011 Article IV report, in conjunction with a pilot Spillover Report for the UK. *cr10338 - 2011. While there is some risk that a prolonged period of above target inflation may* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2010/_cr10338.pdf_