## _cr11220 ## Source details **Canonical URL:** [_cr11220](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2011/_cr11220.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2011/_cr11220.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2011/_cr11220.pdf.json) --- ### Real sector developments and recovery - Recovery from the financial crisis is underway but bumpy and incomplete: - Output is still 4 percent below its peak in March 2008 (third largest gap in the G7 after Italy and Japan). - Growth was flat in the six months from October 2010. - Average GDP growth was 2¾ percent (saar) in the first three quarters of 2010; average GDP growth over Q4 2010–Q1 2011 was zero. - Inflation: - Headline inflation elevated at 4¼ percent. - Core inflation excluding the effects of VAT hikes is about 1¼ percent. - Labour market and output gap: - Negative output gap at end-2010 estimated around 2¾ percent of GDP (staff). - Unemployment spiked to 8 percent at the start of the crisis, stabilized around this level, and eased slightly to 7.7 percent in recent months. - Policy implication: necessary increase in public saving implies growth must rely on private sector-led demand (lower private saving/higher private consumption, higher private investment, and/or higher net exports). ### Private consumption, housing, and household finances - Private consumption weak due to tightening in real disposable income (sluggish nominal wage growth, higher commodity prices, and indirect taxes). - VAT and confidence: - 2½ percentage-point VAT hike on January 1, 2011 noted as a factor in the slowdown. - Consumer confidence dropped in early 2011 to crisis-era levels, rebounding somewhat later. - Housing markets and household balance sheets: - Housing valuation ratios remain about 30 percent above historical averages. - Staff central scenario assumes a reduction in the house price-to-income ratio of 12 percent over the medium term (house prices still rise slightly in nominal terms). - New home construction muted historically due to tight planning restrictions; supply constraints limit full reversion to historical price levels. - Effective interest rates on outstanding household debt have come down; gross household debt has fallen a bit and net worth recovered with asset prices. - Housing transactions, mortgage approvals, and sales-to-stock ratios remain very subdued. - Mortgages in foreclosure: repossession and mortgage default rates moderate relative to the U.S. - Box—Household saving rate drivers: - Gross household saving rate averaged 4.4 percent in the ten years through 2009 (lowest among G7). - Empirical determinants explain about 30 percent of the UK–G7 saving rate difference. - Ongoing fiscal consolidation projected to reduce the saving rate by about 3½ percentage points by 2016. - Under the central scenario (house-price-to-income ratio falls by 12 percent, modest increase in real interest rates, no change in other variables) the saving rate remains broadly flat (falls just slightly) over the medium term. ### Private investment, net exports, and external sector - Investment outlook: - Investment fell to unsustainably low levels during the crisis and rebounded in 2010. - Staff expects the investment-to-GDP ratio to return to its pre-crisis level by 2016. - Factors supporting recovery: low interest rates, corporates’ high cash surpluses, relatively faster growth in the export sector (more capital-intensive). - Risk: corporates may hesitate to ramp up investment while consumption growth is moderate and macroeconomic uncertainty persists. - External sector developments: - CPI-based REER depreciated by some 25 percent between mid-2007 and early 2009. - Sterling appears broadly in line with fundamentals on standard IMF methodologies; depreciation has not produced sustained narrowing of the current account deficit. - Current account deficit stands at 3 percent of GDP, same as pre-crisis level. - Goods export volumes expanded solidly; service export growth weaker due to global deleveraging affecting financial services. - ULC-based REER appreciated considerably more than CPI-based REER during the crisis; ULC-based measure nearly back to mid-2000s levels. - Weak net export performance may be partly explained by low labor productivity growth due to labor hoarding. ### Financial sector deleveraging, vulnerabilities, and credit conditions - Balance sheet repair and funding: - Core tier 1 ratios above 10 percent for major banks; transition toward Basel III ahead of schedule for major banks. - Banks reducing reliance on wholesale funding, increasing customer deposits, and lengthening liability durations. - UK banks accounted for over a quarter of global cross-border deleveraging since the crisis began. - System-wide profitability improved in 2010; new impairments peaked in 2008–09. - Wholesale funding costs increased moderately since mid-2010; some deposit rate increases though rates remain historically low. - Asset quality and vulnerabilities: - Nonperforming loans continued to increase in 2010, but at a more moderate pace. - Lender forbearance may be disguising risks, particularly in CRE where more than 12 percent of loans were in breach of covenants as of end-2010. - High household and some CRE indebtedness increases vulnerability to rapid interest rate rises, slower recovery, or further property price declines. - Stress tests and liquidity: - FSSA stress tests indicate reasonably solid capital buffers; solvency concerns limited to low-probability confluence of adverse shocks. - Major UK banks have adequate liquidity buffers under most scenarios but remain vulnerable to sustained funding disruptions. - Credit conditions: - Credit growth subdued; net lending to corporates continued to fall. - Credit availability improved for large companies, restrictive for smaller businesses and CRE companies. - 2011Q1 credit conditions survey indicated weaker credit demand; spreads for small business lending rising while spreads for large borrowers are falling. - Household lending slightly positive but subdued; lending standards started to loosen slightly; default rates on secured lending increased in 2011Q1. ### Central scenario, growth, unemployment, and risks - Central scenario: - Rebalancing occurs and financial sector health continues to improve. - Staff project growth led by investment and net exports to rise from 1½ percent in 2011 to around 2½ percent over the medium term. - Projection consistent with output gap nearly closing by 2016, assuming a negative output gap at end-2010 of around 2¾ percent and medium-term potential growth of 2 percent. - Potential growth components: labor force growth of ½ percent and labor productivity growth of 1½ percent. - Okun’s law and output gap: - Dynamic Okun’s law estimate: a 1 percentage point increase in output reduces the unemployment rate by 0.49 percentage points (sample 1988Q2–2008Q1). - Three U* methods imply 2010 output gap between -2.3 percent and -5.6 percent; averaged across models staff estimate -2.7 percent; on balance staff estimate -2¾ percent at end-2010. - Risks: - Key risks include commodity price volatility, euro-area sovereign turmoil, housing market developments, size of output gap, and fiscal multiplier uncertainty. - If growth and inflation stronger than expected: accelerate monetary tightening and save revenue windfalls. - If prolonged weak growth and high unemployment: consider expanded BoE asset purchases and temporary targeted tax cuts (targeted to low-income households, investment, or job creation), accompanied by deeper entitlement reform. - If persistent weak growth coincides with high inflation from a narrower-than-estimated output gap (rapid unit labor cost growth): policies must tighten to re-anchor expectations. ### Monetary policy stance and neutral rate considerations - Current stance (authorities and staff): - Bank Rate maintained at 0.5 percent. - Bond purchases maintained at £200 billion since early 2010. - Rationale: - Accommodative monetary policy appropriate now: projected return of inflation to target and uncertainty on recovery strength; necessary to offset disinflationary impulse from fiscal consolidation. - Markets pricing in at least a 50 percent probability of a first rate hike by February 2012 and a second by August 2012. - Neutral rate: - Medium-term “neutral rate” may be somewhat lower than before the crisis due to rebalancing needs and lower demand for investment/consumption at any given interest rate. - Leading indicators—especially unit labor costs and inflation expectations—should be monitored; tighten if these turn more worrisome. - Household sensitivities: - Variable-rate mortgages account for 70 percent of the market; rapid rate hikes could reduce household disposable income, partially mitigated by higher household interest income. ### Fiscal consolidation, composition, and risks - Fiscal consolidation plans: - June 2010 budget: 5-year adjustment plan to cut the deficit to 1½ percent of GDP by FY15/16. - Progress: overall fiscal deficit 11 percent of GDP in FY09/10; deficit dropped to 9¾ percent in FY10/11; further reduction to 8 percent expected in FY11/12. - March 2011 budget maintains ambitious medium-term consolidation and the fiscal mandate to balance the cyclically adjusted current budget by end of a rolling five-year forecast period and put public sector net debt on a downward path in FY15/16. - Pace and composition: - Fiscal impulse was -2.1 percent in FY10/11 (preliminary); expected to ease to about -1.8 percent of potential GDP in FY11/12. - Consolidation mainly expenditure-based over medium term: cumulative spending-share rises from 53 percent in FY11/12 to 76 percent by FY15/16. - Spending measures include a 2-year wage freeze, means-testing many benefits, and a 29 percent real cut in capital spending; healthcare spending broadly constant in real terms; foreign aid real increase of 30 percent. - Revenue measures already in force include the January 2011 VAT hike, higher capital gains taxes, and a new bank levy on wholesale liabilities. - Risks to meeting fiscal mandate: - OBR judges 70 percent probability that cyclically adjusted current budget will be in balance in five years. - Key risk: size and path of the output gap assumptions (March 2011 budget assumes current output gap -4 percent and -1.3 percent in FY15/16; staff estimate current gap around -2¾ percent and slower potential growth). - Consolidation plan provides little margin for error under staff central scenario; implementation risks rise as consolidation relies more on structural spending cuts. - Structural and institutional reforms: - Accelerate increases in state pension age and index to longevity (proposals: equalize pension age at 65 by 2018; raise to 66 by 2020; currently legislated hikes to 67 by 2036 and 68 by 2046). - Reform public-service pensions per Independent Public Service Pensions Commission recommendations. - Ease tight planning restrictions (e.g., 12-month guarantee for processing planning applications) to boost potential output. - Legislate OBR on permanent footing; OBR expected to publish first fiscal sustainability report in July 2011. ### Financial sector reform, macroprudential framework, and SIFIs - FSSA main recommendations (summary): - Overall oversight: clarify mandates, include financial stability mandate, regulatory power over holding companies, enhance supervisory resources, establish coordination forum, enforce public disclosure, and improve anti-money-laundering risk assessment. - Banking oversight: more intensive on-site reviews, proactive intervention framework with legislative triggers, enhance prudential reporting and data quality. - Insurance and securities oversight: extend intrusive risk-based approaches, increase transaction examinations, clarify conduct authority remit, and intensify supervision including bottom-up on-site examinations. - Payments/CCP oversight: ensure sufficient committed funding options, contingency plans for CCP failure, offer central bank settlement to systemic CCPs, and assess RTGS finality. - Crisis management: establish resolution tools and framework for potentially systemically important non-bank firms. - Strengthening system soundness: - Continue building capital and liquidity buffers; major banks have core tier 1 ratios over 10 percent and must demonstrate at least 4 percent under stressed conditions. - Link dividend and variable remuneration approvals to stress test outcomes. - New liquidity regime implemented in 2010 ahead of international phase-in; more stringent than in other jurisdictions. - Home-host coordination needed for cross-border liquidity in stress. - Macroprudential toolkit and FPC: - Transition to “triple peak” model: Prudential Regulatory Authority (microprudential under BoE), Financial Conduct Authority, and Financial Policy Committee (FPC) under BoE with macroprudential overlay. - Interim FPC created in February 2011; permanent FPC by end-2012. - Candidate tools: countercyclical capital buffer under Basel III; capital risk weights on exposures to specific asset classes; liquidity requirements; limits on loan-to-value and debt-to-income ratios; bank levy on wholesale funding. - Emphasize minimizing regulatory arbitrage and cross-border spillovers; consider jurisdictional reciprocity. - Managing SIFIs: - Improve prevention and resolvability: ring-fencing retail operations and depositor preference (ICB proposals) improve retail resolvability but must be complemented by increased loss-absorption (capital/liquidity surcharges, contingent capital, debt subject to bail-in), recovery and resolution plans, and cross-border arrangements. - Consider tax measures to reduce debt bias (Allowance for Corporate Equity, possibly applied initially to banks with offsetting bank-levy hike). - Ensure robust prudential and risk management standards for CCPs and coordinated contingency planning. - International dimension: - UK financial stability depends on stronger international oversight of cross-border institutions; half of UK banking assets are held by international foreign bank subsidiaries and branches. - Advocate EU CRD4 that exceeds Basel III minima and allows flexibility for national macroprudential tools. - Cooperation with European institutions, the US, and Switzerland and sharing supervisory information is essential. ### Contingency and conditional policy responses - Automatic stabilizers should operate freely (allowed by the fiscal mandate). - If growth and inflation stronger than expected: - Accelerate monetary tightening. - Save any revenue windfalls. - If prolonged weak growth and high unemployment and disinflationary pressures: - Consider expanded BoE asset purchases and temporary tax cuts targeted to low-income households, investment (e.g., temporary investment tax credits), or job creation (e.g., temporary cuts in employer payroll taxes). - Temporary fiscal stimulus should be accompanied by deeper long-run entitlement reform to safeguard fiscal sustainability. - If both persistent weak growth and high inflation: - If due to commodity price volatility, no policy change unless second-round effects occur. - If due to narrower-than-estimated output gap (rapid unit labor cost growth), tightening required to re-anchor expectations. - Authorities’ reaction: - Overriding priority: implement fiscal consolidation to ensure debt sustainability; monetary policy is the first port of call for fine-tuning conditions; automatic stabilizers provide an important safeguard. ### Key macroeconomic and fiscal numbers (selected) - Real GDP growth (annual): 2007: 2.7; 2008: -0.1; 2009: -4.9; 2010: 1.4; 2011: 1.5; 2012 (Proj.): 2.3 - Domestic demand (annual): 2007: 3.1; 2008: -0.7; 2009: -5.5; 2010: 2.7; 2011: -0.1; 2012 (Proj.): 1.4 - Private final domestic demand (annual): 2007: 3.3; 2008: -1.4; 2009: -6.5; 2010: 1.3; 2011: 0.0; 2012 (Proj.): 2.5 - CPI, end period: 2007: 2.1; 2008: 3.1; 2009: 2.9; 2010: 3.7; 2011: 4.5; 2012 (Proj.): 2.2 - Unemployment rate (ILO, period average): 2007: 5.4; 2008: 5.6; 2009: 7.5; 2010: 7.9; 2011: 7.7; 2012 (Proj.): 7.6 - Current account balance (percent of GDP): 2007: -2.6; 2008: -1.6; 2009: -1.7; 2010: -3.2; 2011: -2.6; 2012 (Proj.): -1.9 - General government overall balance (fiscal year basis, percent of GDP): 2007/10: -2.7; 2010/11 (Prel.): -6.7; 2011/12 (2011 Budget): -11.3; 2012/13: -9.8; 2013/14: -7.9; 2014/15: -6.3 - General government gross debt (fiscal year basis, percent of GDP): 2007/10: 43.1; 2010/11: 55.4; 2011/12: 71.5; 2012/13: 76.8; 2013/14: 81.5; 2014/15: 84.2 - Public sector net debt (percent of GDP): 2007/10: 36.6; 2010/11: 43.3; 2011/12: 52.8; 2012/13: 59.8; 2013/14: 65.7; 2014/15: 69.3 - Debt sustainability baseline highlights: - Primary deficit peaked in FY09/10 at 9¼ percent of GDP. - Primary balance projected to reach a surplus of 2 percent of GDP by FY16/17. - General government consolidated gross debt projected: 2011: 81.5; 2012: 84.2; 2013: 84.6; 2014: 83.2; 2015: 80.7; 2016: 78.0 - Gross financing need (percent of GDP): peak 16¾ percent in FY10/11; expected to ease to about 15 percent in FY11/12; 2016: 8.2 percent of GDP. ### Executive Board / Directors’ assessment and recommendations - Growth and inflation projected to improve; inflation expected to return near 2 percent by end-2012. - Current policy mix of tight fiscal and accommodative monetary policy appropriate to keep real rates low and sterling competitive, aiding rebalancing. - Directors recommended: - Continue fiscal consolidation to reduce fiscal risks and maintain market confidence. - Accelerate structural reforms to promote long-term fiscal sustainability and bolster growth potential. - Implement FSSA recommendations and improve public disclosure standards for financial data. - Strengthen financial supervision and regulation to the highest standards and enhance international cooperation on cross-border resolution and group-wide liquidity management. - Continue implementation of regulatory reforms (FPC, PRA, Financial Conduct Authority) and address SIFI risks, including ICB proposals on bail-in and ring-fencing. - Maintain accommodative monetary policy while monitoring risks; adjust policy if inflation or growth deviate materially. _Italic: IMF staff summary from _cr11220._ ### 1. Real Sector Developments .......................................................................................... ### _cr11220 - 1. Real Sector Developments .......................................................................................... ### Focus of the consultation - Recovery from the financial crisis is underway, but is bumpy and incomplete: output is still 4 percent below its peak in March 2008, a gap that is the third largest in the G7 after Italy and Japan, and growth was flat in the six months from October 2010. - Inflation: headline inflation is elevated at 4¼ percent, while core inflation excluding the effects of VAT hikes is about 1¼ percent. - Bank balance sheet repair continues and bank lending conditions are less tight, but credit growth remains soft. - Government strategy centers on strong fiscal consolidation to preserve confidence in debt sustainability. - Consultation focused on: progress on rebalancing demand and financial sector deleveraging (Section II); central scenario, risks and uncertainties (Section III); whether to adjust monetary or fiscal policy (Section IV); contingency policy responses if risks materialize (Section V); strengthening financial system soundness and oversight and potential spillovers from the UK’s large financial system (Section VI). ### The macroeconomic setting — Rebalancing demand - Recovery dynamics: - Recovery from the 2008-09 recession was led by an inventory cycle turn and rebounding private investment. - Average GDP growth was 2¾ percent (saar) in the first three quarters of 2010; growth turned flat in late 2010/early 2011. - Unusually cold weather temporarily lowered GDP in Q4 2010, with an offsetting rebound in Q1 2011; average GDP growth over Q4 2010–Q1 2011 was zero. - Fiscal consolidation: - The financial crisis pushed the overall fiscal deficit to 11 percent of GDP in FY09/10. - The June 2010 budget laid out a 5-year adjustment plan to cut the deficit to 1½ percent of GDP by FY15/16. - Progress: deficit dropped to 9¾ percent of GDP in FY10/11; further reduction to 8 percent of GDP is expected in FY11/12. - Policy implication: the necessary increase in public saving implies growth must rely on private sector-led demand (lower private saving/higher private consumption, higher private investment, and/or higher net exports). ### Private consumption - Private consumption has remained weak due to a marked tightening in real disposable income. - Nominal wage growth has remained sluggish over the past year because of low productivity growth and continued labor market slack. - Higher commodity prices and indirect taxes have reduced households’ real incomes. - VAT and confidence effects: - A 2½ percentage-point VAT hike on January 1, 2011 is a notable factor in recent slowdown. - Consumer confidence dropped in early 2011 to levels last seen during the depths of the crisis, though it rebounded somewhat in recent months. ### Housing markets and household finances - House prices and consumption: - During the boom, rising house prices helped boost consumption and cut the household saving rate to only 2 percent. - Housing valuation ratios remain about 30 percent above their historical averages. - Staff’s central scenario assumes a reduction in the house price-to-income ratio of 12 percent over the medium term (though house prices still rise slightly in nominal terms). - Housing supply and interest rate context: - New home construction in the UK remained relatively muted during the boom due to tight planning restrictions; supply constraints are likely to prevent house prices from fully falling back to historical averages. - If real interest rates remain below their historical average—as expected by markets even in the medium term (Section IV.B)—housing valuation metrics are also unlikely to revert fully to historical averages. - Household balance sheets and cash flow: - Recovery of asset prices has bolstered household net worth, while gross debt has fallen a bit. - Effective interest rates on outstanding stock of household debt have come down, implying significant cash flow relief for indebted households. - Housing market activity: - UK house prices rebounded in 2009 but began drifting down again in the second half of 2010. - Housing transactions, mortgage approvals, and sales-to-stock ratios remain very subdued by historical standards. - Mortgages in foreclosure: relative to the US, UK repossession and mortgage default rates have remained rather moderate. ### Box — What Is Driving the Household Saving Rate in the UK? - Historical context: - The gross household saving rate averaged only 4.4 percent in the UK in the ten years through 2009, the lowest rate among G7 economies. - Empirical determinants (panel regression for G7 with country fixed effects and time trends): - Statistically significant explanatory variables for the household saving rate include: the dependency ratio; the unemployment rate; inflation; the real long-term interest rate; the general government fiscal balance; and, for Anglo-Saxon economies, tangible wealth (mainly housing wealth). - These variables together explain about 30 percent of the difference between the UK saving rate and the G7 average in the past decade. - Historical drivers and recent reversal: - Increases in the value of the housing stock and declines in the real long-term interest rate drove much of the secular decline in the saving rate through 2007. - A house price correction and a spike in the fiscal deficit in 2008-09 are estimated to have undone the entire decline in the past decade. - Projections under the model: - The ongoing fiscal consolidation is projected to reduce the saving rate by about 3½ percentage points by 2016. - The central scenario (house price-to-income ratio falls by 12 percent, modest increase in real interest rates, no change in other explanatory variables) keeps the saving rate broadly flat (it falls just slightly) over the medium term. - The saving rate could deviate significantly if house prices diverge from the central scenario assumptions. *Source: _cr11220 - 1. Real Sector Developments.* ### 9. The outlook for private investment is brighter. After falling to unsustainably low ### 9. The outlook for private investment is brighter. After falling to unsustainably low ### Private investment outlook - Investment fell to unsustainably low levels during the crisis and rebounded in 2010. - Staff expects the investment-to-GDP ratio to return to its pre-crisis level by 2016. - Factors supporting investment recovery: - low interest rates, - corporates’ high cash surpluses, - relatively faster growth in the export sector, which is more capital-intensive. - Risk: corporates may be hesitant to ramp up investment while consumption growth remains moderate and large macroeconomic uncertainty persists (Section III.C). ### Net exports and external sector developments - The CPI-based real effective exchange rate (REER) depreciated by some 25 percent between mid-2007 and early 2009. - Based on standard IMF methodologies, sterling now appears to be broadly in line with fundamentals. - Depreciation has not resulted in a sustained narrowing of the current account deficit. - Current account deficit stands at 3 percent of GDP, the same as its pre-crisis level. - Goods export volumes expanded solidly during the recovery; service export growth was weaker because global deleveraging hindered growth of financial services. - Low degree of import substitution has kept import volumes elevated. - The ULC-based REER appreciated considerably more than the CPI-based REER during the crisis; the ULC-based measure is nearly back to levels observed in the mid-2000s. - Interpretation: weak net export performance may be partially explained by low labor productivity growth due to labor hoarding (Section III.A); if labor hoarding unwinds, UK relative labor productivity may improve and support current account adjustment. If not, sterling may be more overvalued than suggested by standard IMF methodologies. ### Fiscal adjustment and current account prospects - Fiscal consolidations are associated with current account adjustments because they: - compress domestic demand directly (domestic demand growth is projected to be lower in the UK than its trading partners in the coming years), - allow looser monetary policy, helping keep the exchange rate competitive. - Studies suggest that each 1 percent of GDP of fiscal consolidation typically reduces the current account deficit by 0.2-0.6 percent of GDP. - With fiscal adjustment of nearly 7 percent of GDP programmed between 2010 and 2015, this implies the current account deficit might fall by about 2½ percent of GDP over this period, bringing the current account close to balance. - Latest GDP outturn (Q1 2011) is encouraging: net exports contributed 1.3 percentage points to q-o-q GDP growth. ### Financial sector deleveraging: balance sheet repair and funding - Banks have buttressed balance sheets over the last year; core tier 1 ratios are above 10 percent and major banks are ahead of schedule in their transition to Basel III rules. - Banks are reducing reliance on wholesale funding, increasing share of stable customer deposits, and lengthening liability durations. - UK banks have accounted for over a quarter of the deleveraging of global cross-border lending since the start of the crisis. - Modest shift in asset composition toward liquid instruments and away from riskier securities and derivatives. - System-wide profitability improved in 2010, largely driven by lower loan provisioning as new impairments peaked in 2008–09. - Major UK banks raised significant term funding in capital markets and via private placements; refinancing needs for 2010 were fully met and some 2011 maturities were pre-financed. - Wholesale funding costs have increased moderately since mid-2010; some banks raised deposit rates, though these remain at historically low levels. - Securitization recovered from mid-crisis lows but remains less attractive; covered bond issuance increased though still a small part of total debt issuance. ### Banking sector vulnerabilities and credit conditions - Persistent challenges: - Deposits have been growing faster than loans since 2009, but the funding gap remains large and reliance on wholesale funding will remain elevated. - Banks will need to refinance a large amount of public support and private-sector debt over the next two years and remain vulnerable to higher funding costs and wholesale market disruptions. - Asset quality: - Nonperforming loans continued to increase in 2010, though at a more moderate pace than in 2008–09. - Low interest rates have reduced debt-servicing costs and helped contain default rates, which remain low relative to previous crises and to the U.S. - Exposures to some EU periphery countries generated significant impairments for select banks. - Lender forbearance may be disguising risks, particularly in the commercial real estate (CRE) sector where a large number of loans are in breach of financial covenants but not yet declared in default (more than 12 percent as of end-2010). - High indebtedness of UK households and some CRE companies aggravates vulnerabilities. - Combinations of rapid interest rate increases, a slower recovery, and further declines in property prices could inflict significant losses on banks. - Stress tests (FSSA) indicate: - Banks have reasonably solid capital buffers; solvency concerns are limited to a low-probability confluence of adverse macroeconomic shocks. - Risks from exposures to vulnerable European sovereigns seem manageable, but major spillovers to the private sector in those countries and to core European banks would be more problematic. - Major UK banks have adequate liquidity buffers under most scenarios but remain vulnerable to sustained disruptions in funding markets. - Credit growth: - Credit growth remains subdued; credit conditions improved recently but remain significantly tighter than before the crisis. - Net lending to the corporate sector has continued to fall. - Credit availability improved for large companies but remains restrictive for smaller businesses and for CRE companies. - 2011Q1 credit conditions survey indicated weaker credit demand, possibly associated with the slow recovery, contributing to weak bank lending to small businesses. - Large corporates increasingly rely on capital markets for investment finance. - Spreads on lending to small businesses have kept increasing, while those for large borrowers are falling. - Lending to the household sector is slightly positive but still subdued. - Lending standards, though tighter than before the crisis, have started to loosen slightly. - Default rates on secured lending increased in the first quarter of 2011; lenders report increased risk appetite towards borrowers with high loan-to-value ratios. - Availability of unsecured credit has improved, but spreads on credit card lending continue to increase due to significantly higher default rates than for secured lending. ### The central scenario and risks — growth and employment - Central scenario: rebalancing occurs and financial sector health continues to improve as described above. - Staff project growth—led by investment and net exports—to gradually rise from 1½ percent in 2011 to around 2½ percent over the medium term. - This projection is consistent with the output gap nearly closing by 2016, assuming: - a negative output gap at end-2010 of around 2¾ percent of GDP (Box 2; Figure 9), - medium-term potential growth of 2 percent. - The 2 percent potential growth rate is consistent with labor force growth of ½ percent and labor productivity growth of 1½ percent (the latter is slightly below the historical average of 1¾ percent due to lingering crisis effects such as skill erosion from long-term unemployment). - Unemployment: - Unemployment spiked to 8 percent at the start of the crisis, then stabilized around this level for over a year and eased slightly to 7.7 percent in recent months. - The spike was relatively muted compared to the size of the recession, partly reflecting labor hoarding, lower immigration, and lower labor force participation. - Unwinding of these forces is likely to slow improvements in unemployment during the recovery. *Source: _cr11220 - 9. The outlook for private investment is brighter. After falling to unsustainably low* ### Box 2. What Does Okun’s Law Tell Us About the Output Gap? ### Box 2. What Does Okun’s Law Tell Us About the Output Gap? ### Unemployment increase and Okun’s law approach - Unemployment increased sharply during the crisis: the unemployment rate increased by almost 3 percentage points to around 8 percent. - Okun’s law postulates a stable relationship between the unemployment rate and the output gap and can be estimated for the UK to infer the output gap from the distance between the current unemployment rate and the steady-state unemployment rate (U*). - The dynamic Okun’s law estimate used: a 1 percentage point increase in output reduces the unemployment rate by 0.49 percentage points, based on a sample ranging from 1988Q2 to 2008Q1. ### Three methods to estimate steady-state unemployment (U*) - Method 1: Average unemployment rate over the last business cycle (peak in output 1990Q2 to last peak 2008Q1) = 6.8 percent. - Method 2: Slow-moving (HP) filter to extract time-varying trend unemployment rate = 6.4 percent in 2010Q4. Four smoothing parameters were considered: 1600, 10000, 50000, and 100000; the parameter yielding the largest R2 in a wage equation (100000) was used. - Method 3: Office for Budget Responsibility (OBR) measure of steady-state unemployment = 5.25 percent. ### Output gap estimates from Okun’s law - The different U* measures imply that the output gap in 2010 was between -2.3 percent and -5.6 percent. - The range of output gap estimates is directly related to the range of estimated U*s. - Despite output recovery during most of 2010, persistently high unemployment kept output gap estimates fairly constant. ### Comparison with other estimates and staff conclusion - The Okun’s law estimate based on the time-varying filtered U* is close to the lower end of the estimates presented in the Selected Issues paper of the 2010 Article IV consultation (updated). - The estimated size of the output gap for 2010, averaged across all models, is -2.7 percent. - On balance, staff estimates a negative output gap of 2¾ percent at end-2010, though uncertainty around this estimate is large. ### Other considerations that could bias the Okun-based output gap - Factors suggesting the Okun-based estimate could understate the true output gap: - Labor hoarding: the unemployment increase was smaller than expected given the output decline, and productivity fell more than in previous recessions. This may indicate “hidden underemployment” within firms, implying true unemployment is underestimated and the output gap may be wider. - Factors suggesting the Okun-based estimate could overstate the true output gap: - Direct firm surveys about spare capacity and ease of hiring point to a relatively small output gap (see survey indicators and capacity utilization measures). *Italic: IMF staff summary from Box 2. What Does Okun’s Law Tell Us About the Output Gap?* ### 23. The authorities broadly share the ### _cr11220 - 23. The authorities broadly share the ### Outlook and projections - Authorities and independent forecasters broadly share staff’s central scenario, projecting rebalancing away from public and private consumption toward investment and net exports. - The independent OBR (on whose forecasts the budget is based) and the Bank of England (BoE) project slightly higher growth rates in 2011 and 2012, reflecting a higher estimated output gap now and higher projected potential growth. - The BoE’s latest inflation projections are broadly similar to those of staff. - Authorities emphasize elevated sovereign and banking risks in parts of the euro area as particular risks to the central scenario. ### Monetary policy stance and rationale - The current monetary stance remains appropriate for now: - Bank Rate maintained at 0.5 percent. - Bond purchases maintained at £200 billion since early 2010. - Rationale for accommodative policy: - Central scenario projects inflation will return to target within a reasonable timeframe. - Uncertainty about the strength of the recovery. - Need to offset significant disinflationary impulses from fiscal policy. - Market pricing and conditional tightening: - Markets are currently pricing in at least a 50 percent probability of a first rate hike by February 2012 and a second rate hike by August 2012. - Withdrawal of monetary stimulus should be gradual given extended fiscal contraction and potentially large effects of higher interest rates on growth. - Household and housing sensitivities: - Variable-rate mortgages account for 70 percent of the market. - Household debt levels remain elevated by historical standards. - Rapid interest rate hikes could cut into household disposable income, partially mitigated by higher household interest income. ### Neutral rate and monitoring - The medium-term “neutral rate” consistent with stable inflation and full employment may be somewhat lower than before the crisis, supported by: - Need for substantial rebalancing toward private and external demand and the role of low real interest rates in prompting private consumption, private investment, and net exports. - Empirical evidence that expected short-term real rates (embedded in medium-term real rates on inflation-indexed bonds) have fallen significantly relative to pre-crisis levels. - Theoretical considerations that the financial crisis lowered demand for investment and consumption at any given interest rate, reducing the equilibrium interest rate consistent with full employment. - Leading indicators—especially unit labor costs and inflation expectations—should be monitored closely; monetary tightening must accelerate if these turn more worrisome. ### Monetary authorities’ views - The Monetary Policy Committee (MPC) broadly agrees with staff that policy should remain accommodative to meet the inflation target in the medium term. - Differing views on the Committee: - Majority: current policy stance appropriate given temporary recent inflation outturns, subdued wage growth, and contained inflation expectations. - Minority favoring less accommodative policy: place more weight on risks that prolonged high headline inflation could feed into expectations and that external price pressures may persist. - Third view: inflation expectations well anchored and deflationary pressures will dominate, warranting further asset purchases. ### Fiscal consolidation plans and near-term fiscal stance - The March 2011 budget maintains the government’s ambitious medium-term fiscal consolidation plan and the June 2010 “fiscal mandate” to: - (i) balance the cyclically adjusted current budget by the end of a rolling five-year forecast period; and - (ii) put the public sector net debt-to-GDP ratio on a downward path in FY15/16. - The June 2010 budget aimed to meet these targets one year early through structural adjustment of 8 percent of GDP over 5 years; March 2011 budget makes only minor adjustments. - Pace of tightening: - Fiscal impulse (change in cyclically adjusted primary deficit as percent of potential GDP) was -2.1 percent in FY10/11 (preliminary outturns). - Under the budget’s spending plans and staff’s macro forecasts, the fiscal impulse is expected to ease to about -1.8 percent of potential GDP in FY11/12. - Consolidation just starting in 2010 and transmission lags imply fiscal headwinds to growth will remain significant in 2011. ### Composition of consolidation - Consolidation is mainly expenditure-based over the medium term: - Cumulative share of consolidation on the spending side rises from 53 percent in FY11/12 to 76 percent by FY15/16. - Spending measures include a 2-year wage freeze, means-testing of many benefits, and a 29 percent real cut in capital spending. - Some of the largest spending cuts are in public safety and transfers to local governments. - Healthcare spending is kept broadly constant in real terms. - Foreign aid will receive a real increase of 30 percent. - Revenue-side measures already in force include the January 2011 VAT hike, higher capital gains taxes, and a new bank levy on wholesale liabilities—these achieved frontloaded consolidation. ### Risks to meeting the fiscal mandate - OBR’s judgment: 70 percent probability that the cyclically adjusted current budget will be in balance in five years’ time. - Key risk: size and path of the output gap assumptions: - March 2011 budget assumes current output gap is -4 percent and will be -1.3 percent in FY15/16. - Staff estimates a lower output gap now (around -2¾ percent) and a slower potential growth rate such that the output gap nearly closes by FY15/16; under this staff view, the cyclically adjusted current budget will just reach balance in FY15/16. - The consolidation plan therefore provides little margin for error under staff’s central scenario. - Implementation risks rise as consolidation becomes more reliant on structural spending cuts; careful management required to deliver targeted consolidation while shielding the poor. ### Structural reforms and institutional changes - Potential and planned reforms to support fiscal sustainability and medium-term growth include: - Accelerating increases in the state pension age and indexing it to longevity: - Current retirement age: 60 for women and 65 for men. - Government proposal: equalize the pension age at 65 by 2018 (instead of by 2020) and raise the pension age to 66 by 2020 (instead of 2028). - Currently legislated hikes to age 67 (by 2036) and to age 68 (by 2046) could also be accelerated, with indexation to longevity thereafter. - Reforming public-service pensions: - Two-year wage freeze expected to close part of the gap between average public-service wages and private-sector wages. - Independent Public Service Pensions Commission recommended reforms to improve structure and reduce cost; near-term savings could fund growth-enhancing measures (e.g., fewer cuts in infrastructure spending). - Easing tight planning restrictions to boost potential output, including measures such as a 12-month guarantee for processing planning applications; success depends in part on local government implementation. - Institutional reform: - Legislation to put the independent OBR on a permanent footing, expected to strengthen credibility of fiscal analysis and forecasts, including the OBR’s first fiscal sustainability report in July 2011. ### Authorities’ views on fiscal strategy - Authorities view strong fiscal consolidation as the linchpin of their economic strategy and are confident about its success. - Government committed to implementing budget and spending review plans; argue consolidation has allowed monetary policy to remain loose, kept UK sovereign borrowing costs low, and supported business confidence. - Authorities welcome staff support for structural reforms (planning restrictions, public-service pensions) and see merit in reforms to the state pension age. - Authorities do not consider it advisable to revisit the composition of expenditure plans, believing these protect key public services and growth-enabling spending while increasing fairness and opportunities for social mobility. - Authorities view the creation of the permanent OBR as a major institutional advance improving credibility and independence of economic and fiscal forecasts. *Source: IMF staff report section IV, "MACROECONOMIC POLICIES IN THE CENTRAL SCENARIO" (excerpts).* ### 38. Policies will need to react if major risks materialize or appear imminent. On the ### _cr11220 - 38. Policies will need to react if major risks materialize or appear imminent. On the ### Risks and conditional policy responses - Automatic stabilizers should operate freely, as allowed by the fiscal mandate. - Additional policy responses depend on the nature of the shock: - If growth and inflationary pressures are stronger than expected: - Monetary tightening will need to accelerate. - Any revenue windfalls should be saved in this case, even if larger than implied by automatic stabilizers. - If the economy appears likely to experience a prolonged period of weak growth and high unemployment—and if inflationary pressures consequently ease—then consider some combination of: - (i) supplementing the current low monetary policy rate with expanded asset purchases by the BoE; and - (ii) temporary tax cuts. - Tax cuts are faster to implement and more credibly temporary than expenditure shifts. - To increase their multipliers, tax cuts should be targeted to low-income households, investment (e.g., temporary investment tax credits, which would also facilitate rebalancing toward investment), or job creation (e.g., temporary cuts in employer payroll taxes to reduce employment costs). - Temporary fiscal stimulus should be accompanied by deeper long-run entitlement reform (as discussed in Section IV.C) to safeguard fiscal sustainability and market confidence. - In the event of both persistent weak growth and high inflation: - If due to further commodity price volatility, policies need not respond unless there is clear evidence of second-round effects (e.g., higher import prices feeding into higher wage growth). - If due to a much narrower-than-estimated output gap (indicated by rapid growth of unit labor costs): - Policies will have little choice but to tighten to re-anchor inflationary expectations. - A narrower output gap would imply a higher-than-currently-estimated structural deficit and require further fiscal tightening over the medium term. *Authorities’ views on risks and macro policy* - Authorities agreed with the relevance of the risk scenarios and are being watchful, noting the economy was still some distance from these scenarios. - Overriding priority: successfully implement the fiscal consolidation plans to ensure confidence in debt sustainability as a prerequisite for recovery. - Any significant adjustments to expenditure plans would be unhelpful as they would cast doubt on credibility. - Effectiveness of spending stimulus would be hampered by implementation lags; monetary policy would be the first port of call as it better fine-tunes macro conditions. - Fiscal stimulus could be counterproductive if heightened sovereign risk increases sensitivity of borrowing costs to fiscal deficits. - Consolidation plans already build in flexibility: - setting plans to meet the mandate one year early, - with headroom against the mandate in 2015-16, - and specifying the target in cyclically adjusted terms. - Automatic stabilizers provide an important safeguard against risks. ### Financial sector policies: achievements, challenges, and spillovers - UK financial sector recovery is incomplete; vulnerabilities remain in funding and asset quality (detailed in the accompanying FSSA). - Banks have strengthened capital and liquidity positions over the last year. - Authorities are implementing wide-ranging reforms, including in the context of the international reform agenda under Basel III. - Given the large size, complexity, and interconnectedness of the UK financial system, shocks can be amplified across the global economy; ensuring UK financial stability is critical to global financial stability. Box 3. FSSA: Main Recommendations (summary) - Overall financial sector oversight - Revise the legal framework to clarify mandates and include a specific financial stability mandate for the prudential authorities. - Amend legislation to allow for regulatory power over holding companies of regulated entities. - Enhance resources for supervision of banks, insurers, and securities firms based on the agreed-upon supervisory operating model and the new macroprudential overlay. - Establish a forum for ensuring good governance and coordination among organizations in the new regulatory structure. - Enforce public disclosure by banks, insurers, and securities firms, including prudential returns, as appropriate. - Amend risk-based assessment methodologies to ensure adequate assessment of anti-money laundering and combating the financing of terrorism risk. - Banking sector oversight - Enhance supervision via detailed reviews of credit and market risk assessment, verification and selected model replication reviews, better integration of specialist work, and enhanced peer analysis. - Adopt a proactive intervention framework with triggers for contacts and coordination actions with other authorities; amend legislation as needed. - Develop a comprehensive plan to enhance prudential reporting and review data quality systematically. - Insurance sector oversight - Extend the new intrusive risk-based approach to a wider range of insurers. - Increase frequency and number of randomly conducted “transaction examinations.” - Securities markets oversight - Clarify in legislation that the remit of the conduct authority includes market integrity and transparency. - Increase intensity of supervision with greater use of “bottom-up” analysis using on-site examinations to supplement “top-down” risk analysis. - Payments and securities systems oversight - Ensure sufficient and reliable funding options for central counterparties (CCPs), including committed credit lines subject only to presentment. - Develop contingency plans to deal with a potential failure of a CCP. - Offer central bank settlement to CCPs classified as systemic institutions. - Establish close monitoring of concentration of banks’ payments and settlements activities. - Undertake a unified assessment of the real time gross settlement (RTGS) infrastructure, including an assessment of the finality of transactions. - Crisis management - Establish appropriate resolution tools and a framework for potentially systemically important non-bank firms not covered by the Special Resolution Regime. ### Strengthening financial system soundness - Continued build up of capital and liquidity buffers is essential: - Currently, all major banks have core tier 1 ratios over 10 percent and must demonstrate ratios of at least 4 percent under stressed conditions. - Given heightened risks, capital buffers should continue to be built up ahead of Basel III requirements. - Approval of dividend and variable remuneration should continue to be linked to the outcome of stress tests. - A new liquidity regime implemented in 2010 is ahead of the phase-in schedule agreed internationally; liquidity requirements are currently more stringent than in other major jurisdictions. - Home-host coordination is needed to address cross-border liquidity needs in times of stress. - Strengthening supervision (top priorities) - Strengthen FSA’s assessment of banks’ processes, including loan classification, impairment determination, and valuation practices: - Requires more intensive on-site review work involving specialist expertise and greater engagement of FSA senior management. - Introduce a proactive intervention framework with legislative support for early intervention by the supervisor. - Provide the regulatory authority with oversight powers at the holding company level to improve consolidated supervision. - Enhance data reporting standards and publish regular and comparable institution-level data, including non-confidential prudential returns. ### Strengthening the domestic oversight framework - Transition to the “triple peak” model requires careful management to mitigate operational risks: - One organization under the BoE (Prudential Regulatory Authority) responsible for microprudential regulation and supervision. - A separate Financial Conduct Authority responsible for conduct of business and market regulation. - A Financial Policy Committee (FPC) under the BoE will create a macroprudential overlay. - Clear division of responsibilities, close cooperation, and information-sharing between supervisory agencies and the government are crucial. - FPC establishment: - An interim FPC was created in February 2011 to carry out preparatory work; permanent FPC by end-2012. - Important to set realistic expectations regarding what macroprudential regulation can achieve, especially early on. - Macroprudential toolkit considerations: - Tools should be chosen based on effectiveness in mitigating economic cycles and creating buffers, minimizing regulatory arbitrage and cross-border spillovers, and minimizing efficiency costs. - Candidate instruments include countercyclical variation of: the countercyclical capital buffer under Basel III; capital risk weights on banks’ exposures to specific asset classes; liquidity requirements; limits on loan-to-value and debt-to-income ratios; and the bank levy on wholesale funding. - Application of jurisdictional reciprocity would reduce arbitrage possibilities. ### Strengthening capacity to deal with Systemically Important Financial Institutions (SIFIs) - Progress made, but more required to reduce probability of failure (prevention) and impact of failure (resolution). - Measures to improve resolvability: - Ring-fencing of retail operations and depositor preference (proposed by the Independent Commission on Banking) will improve resolvability of the retail entity. - Ring-fencing must be weighed against costs and does not necessarily improve resolvability of the whole entity unless complemented by: - increased loss absorption capacity and burden-sharing with the private sector (e.g., capital and liquidity surcharges, contingent capital, and debt subject to bail-in), - recovery and resolution plans, - cross-border resolution arrangements. - International collaboration is critical; UK authorities should continue exercising leadership. - Ring-fencing should not reduce oversight of investment banks or create complacency toward their risks. - Tax measures to mitigate SIFI systemic risks: - Corporate tax bias favors debt over equity due to deductibility of interest. - Introduce an Allowance for Corporate Equity (ACE) as in Belgium and proposed by the Mirrlees Review and IMF Staff Discussion Note Tax Biases to Debt Finance: Assessing the Problem, Finding Solutions. - Given fiscal cost of ACE for all corporates, consider applying ACE initially only to banks with an offsetting hike in the bank levy to be revenue-neutral for the sector as a whole. - Potential intra-group and cross-border taxation issues would need careful study. - Central counterparties (CCPs) - Ensure robust prudential and risk management standards, including sufficient liquidity for CCPs. - Develop coordinated contingency plans to deal with the failure of a CCP. - International coordination on liquidity, capital, risk management, and unwinding regulations for CCPs is important. ### The international dimension - UK financial stability depends on a stronger international framework for oversight of cross-border financial institutions: - International foreign bank subsidiaries and branches hold half of UK banking assets, but UK oversight over branches of foreign banks is limited due to European Economic Area passporting rules. - Cooperation with international partners—especially European institutions, the US, and Switzerland—and sharing supervisory information among home and host authorities is essential. - Progress on cross-border resolution requires international cooperation and high-level political commitment; lack of coordination risks regulatory arbitrage. - Recommendations for EU and international engagement: - Advocate for European legislation under the EU Capital Requirements Directive (CRD4) that: - (i) exceeds Basel III minima by setting ambitiously high capital requirements and significantly topped-up capital demands on SIFIs; and - (ii) allows flexibility for national authorities to use a range of macroprudential tools, including adjusting capital and liquidity requirements or varying risk weights. - Collaboration with other macroprudential bodies is important for home-host coordination and reciprocity. - UK authorities’ unique contribution: - Given the UK’s central role, authorities have informational advantages in assessing emerging global risks. - Collaboration and information sharing between the FPC and other macroprudential bodies could help mitigate global systemic risks. - FPC should consider outward spillovers of its policy decisions. *Authorities’ views on financial sector reform* - Broad agreement on the domestic reform agenda; continued progress indicated on initiatives to strengthen regulatory and supervisory framework. - Authorities recognize risks and challenges in implementing an ambitious reform agenda while the financial sector is still recovering and international standards are implemented simultaneously. - Authorities are cognizant of regulatory uncertainty and intend to address this after the final report of the ICB is published in September 2011. *Italic: IMF staff summary of chapter content.* ### 53. The authorities emphasized the need to achieve an ambitious regulatory ### _cr11220 - 53. The authorities emphasized the need to achieve an ambitious regulatory ### Regulatory framework and international coordination - Authorities emphasized the need to fully implement the internationally agreed Basel III framework in detail, as G20 leaders have agreed. - Emphasized national discretion to: - set higher standards than the minimum levels of Basel III in specific circumstances; and - operate countercyclical macroprudential policy to protect financial stability. - Will continue to work with international partners on outstanding issues, including cross-border resolution. - Welcomed the IMF’s efforts to strengthen the multilateral dialogue, including through spillover reports. ### Macroeconomic outlook and recovery (Staff Appraisal, paragraphs 54–56) - Post-crisis repair continues aided by a wide-ranging policy program: government has cut the structural fiscal deficit, banks have bolstered their balance sheets, and businesses have expanded employment. - New institutions: a new FPC to oversee macroprudential policy and an independent OBR to strengthen credibility of fiscal analysis and forecasts. - Growth and inflation: - Growth and inflation have been worse-than-expected in recent quarters, but are projected to improve over time. - One factor behind recent weak growth is the spike in commodity prices, which dented consumer confidence. - Inflation is expected to return near the 2 percent target by end-2012. - Policy stance in the central scenario: - Current settings of fiscal and monetary policy remain appropriate. - Fiscal consolidation aims to stabilize government debt within a few years. - The current accommodative monetary stance is appropriate given the projection that inflation will return to target in a reasonable timeframe and uncertainty regarding the strength of the recovery. ### Policy mix, rebalancing, and monetary withdrawal (paragraphs 57–58) - Tight fiscal and accommodative monetary policy will: - keep real interest rates low and sterling competitive; - assist public and private balance sheet repair; and - promote expansion of investment and net exports. - If growth resumes as expected, case for reducing monetary accommodation will slowly increase; withdrawal should be measured due to: - extended period of fiscal contraction, and - high sensitivity of house prices (and hence consumption and residential investment) to short-term interest rates. - Real interest rate consistent with stable inflation and full employment may remain low for some time owing to a shift down in demand for investment and consumption. ### Structural fiscal reforms and supply-side policies (paragraph 59) - Recommended structural reforms to support fiscal consolidation and medium-term growth: - Further accelerate increases in the state pension age and index it to longevity to reduce longer-term fiscal imbalances and raise labor supply. - Reform public-service pensions, along lines recommended by the Independent Public Service Pensions Commission, to better align average public-service compensation with private-sector equivalents. - Ease tight planning restrictions to spur construction and productivity-enhancing development. ### Risks, scenarios, and contingency policy actions (paragraph 60) - Key risks: uncertainties surrounding commodity prices, euro-area sovereign turmoil, the housing market, and the size of the output gap and fiscal multipliers. - Policy flexibility required: - Upside: if growth and inflationary pressures are stronger than expected, monetary tightening should accelerate and all fiscal windfalls should be saved. - Downside: if prolonged weak growth and lower inflation occur, fiscal automatic stabilizers should operate freely and monetary policy should be kept loose for an extended period. - To prevent an entrenched downturn, additional stimulus may be required from BoE asset purchases and temporary targeted tax cuts, combined with deeper long-run entitlement reform. - If commodity price volatility temporarily extends weak growth and high inflation, policies need not respond; but if weak growth and high inflation reflect a much narrower-than-estimated output gap (as indicated by rapid growth of unit labor costs), policies will have to tighten to re-anchor inflationary expectations. ### Financial sector stability, supervision, and macroprudential policy (paragraphs 61–64) - UK financial sector stability is a global public good, requiring highest quality regulation and supervision. - Current UK measures seen as proper and necessary: - Stringent capital and liquidity regulations. - Supervisory pressure to build up capital ahead of official requirements. - Linking approval of dividends and variable remuneration to the outcome of FSA stress tests. - Regulatory enhancements recommended: - More intrusive supervision; FSA plans to make improvements are welcome. - Forthcoming framework legislation should provide explicit support for early intervention by the supervisor in dealing with prudential problems and regulatory enforcement powers at the holding company level to enhance consolidated supervision. - FPC role and tools: - Active use of macroprudential tools under FPC purview should help reduce systemic risk. - FPC should focus on tools most effective against the cycle while minimizing efficiency costs and regulatory arbitrage. - Important to set realistic expectations of macroprudential regulation, especially early in implementation. - Too-important-to-fail and CCPs: - Progress made, but more needed. - Consider further tax reforms, such as a revenue-neutral allowance for corporate equity, to reduce incentives for excessive leverage. - Subject CCPs to robust risk management standards and establish contingency plans for possible failures. - Ring-fencing of retail operations and depositor preference, as proposed by the ICB, will improve retail entity resolvability but must be weighed against costs and complemented by measures including improved loss absorption capacity, recovery and resolution plans, and cross-border resolution arrangements; international coordination is critical. - International cooperation: - European legislation under CRD4 should enable strong standards that exceed Basel III minima and allow broad flexibility for national authorities to introduce countercyclical macroprudential tools. - Collaboration between the FPC and other macroprudential bodies important for home-host coordination, reciprocity where appropriate, and information sharing. - Given the UK’s global importance, the FPC should consider outward spillovers of its policy decisions. ### Data transparency (paragraph 65) - The UK lags behind many other countries in standards for public disclosure of bank and insurance sector data. - Work underway to allow publication of regular and comparable institution-level data is welcome. * _cr11220 - 53. The authorities emphasized the need to achieve an ambitious regulatory* ### 66. It is recommended that the next Article IV consultation with the United ### _cr11220 - 66. It is recommended that the next Article IV consultation with the United Kingdom be held on the standard 12-month cycle. ### Recommendation - It is recommended that the next Article IV consultation with the United Kingdom be held on the standard 12-month cycle. ### Key macroeconomic indicators (selected) - Real GDP growth: - 2007: 2.7 - 2008: -0.1 - 2009: -4.9 - 2010: 1.4 - 2011: 1.5 - 2012 (Proj.): 2.3 - Domestic demand: - 2007: 3.1 - 2008: -0.7 - 2009: -5.5 - 2010: 2.7 - 2011: -0.1 - 2012 (Proj.): 1.4 - Private final domestic demand: - 2007: 3.3 - 2008: -1.4 - 2009: -6.5 - 2010: 1.3 - 2011: 0.0 - 2012 (Proj.): 2.5 - CPI, end period: - 2007: 2.1 - 2008: 3.1 - 2009: 2.9 - 2010: 3.7 - 2011: 4.5 - 2012 (Proj.): 2.2 - Unemployment rate (ILO, percent, labor force, period average): - 2007: 5.4 - 2008: 5.6 - 2009: 7.5 - 2010: 7.9 - 2011: 7.7 - 2012 (Proj.): 7.6 - Current account balance (percent of GDP): - 2007: -2.6 - 2008: -1.6 - 2009: -1.7 - 2010: -3.2 - 2011: -2.6 - 2012 (Proj.): -1.9 - Trade balance (percent of GDP): - 2007: -3.1 - 2008: -2.6 - 2009: -2.1 - 2010: -3.4 - 2011: -2.0 - 2012 (Proj.): -1.3 ### Public finances (fiscal year basis; percent of GDP; selected) - General government overall balance: - 2007/10: -2.7 - 2010/11 (Prel.): -6.7 - 2011/12 (2011 Budget): -11.3 - 2012/13: -9.8 - 2013/14: -7.9 - 2014/15: -6.3 - Cyclically adjusted overall balance (staff estimates): - 2007/10: -3.1 - 2010/11: -6.7 - 2011/12: -9.1 - 2012/13: -7.7 - 2013/14: -6.2 - 2014/15: -4.7 - General government gross debt: - 2007/10: 43.1 - 2010/11: 55.4 - 2011/12: 71.5 - 2012/13: 76.8 - 2013/14: 81.5 - 2014/15: 84.2 - Public sector net debt: - 2007/10: 36.6 - 2010/11: 43.3 - 2011/12: 52.8 - 2012/13: 59.8 - 2013/14: 65.7 - 2014/15: 69.3 ### Government operations (selected, percent of GDP; Table 2 highlights) - Revenue (2009/10 actual to 2015/16 projections): - 2009/10 Actual: 36.6 - 2010/11 Prel.: 37.3 - 2011/12 2011 Budget: 38.1 - Staff projections to 2015/16 range around 36.3–38.4 with 2015/16 at 38.3 (staff). - Expenditure (2009/10 actual to 2015/16 projections): - 2009/10 Actual: 47.7 - 2010/11 Prel.: 47.0 - 2011/12 2011 Budget: 46.0 - Staff projections to 2015/16 show expenditure declining toward 40.1 by 2015/16 (staff). - Net lending (+)/borrowing (overall balance): - 2009/10 Actual: -11.1 - 2010/11 Prel.: -9.7 - 2011/12 2011 Budget: -7.9 - Staff projections: -8.0 (2011/12), -6.4 (2012/13), -4.3 (2013/14), -2.9 (2014/15), -1.8 (2015/16) ### Medium-term macro projections (selected, 2006–16) - Real GDP (annual): - 2006: 2.8 - 2007: 2.7 - 2008: -0.1 - 2009: -4.9 - 2010: 1.4 - 2011: 1.5 - 2012–2016 (Proj.): 2.3, 2.4, 2.5, 2.7, 2.7 - CPI inflation, end period: - 2006: 3.0 - 2007: 2.1 - 2008: 3.1 - 2009: 2.9 - 2010: 3.7 - 2011: 4.5 - 2012–2016 (Proj.): 2.2, 2.0, 2.0, 2.0, 2.0 - Unemployment rate (period average, percent): - 2006: 5.4 - 2007: 5.4 - 2008: 5.6 - 2009: 7.5 - 2010: 7.9 - 2011: 7.7 - 2012–2016 (Proj.): 7.6, 7.3, 7.0, 6.5, 6.1 ### Debt sustainability: baseline and risks (Annex) - Baseline projections (general government gross debt, fiscal year basis): - Trough: 42 percent of GDP in FY06/07. - Projected peak: about 85 percent of GDP in FY13/14 under the government’s planned consolidation. - Projected decline: to about 78 percent of GDP by FY16/17. - Primary balance path: - Primary deficit peaked in FY09/10 at 9¼ percent of GDP. - Primary balance projected to reach a surplus of 2 percent of GDP by FY16/17. - Debt ratio projected to be on a downward path from FY14/15 given baseline assumptions. - Gross financing needs: - Peak: 16¾ percent of GDP in FY10/11. - Expected to ease to about 15 percent of GDP in FY11/12. - Public Sector Debt Sustainability Table A1 (selected baseline numbers, percent of GDP): - General government consolidated gross debt: - 2006: 42.4 - 2007: 43.1 - 2008: 55.4 - 2009: 71.5 - 2010: 76.8 - 2011: 81.5 - 2012: 84.2 - 2013: 84.6 - 2014: 83.2 - 2015: 80.7 - 2016: 78.0 - Change in public sector debt (year-on-year percent of GDP): - 2006: 0.7 - 2007: 0.7 - 2008: 12.3 - 2009: 16.1 - 2010: 5.3 - 2011: 4.7 - 2012: 2.7 - 2013: 0.3 - 2014: -1.4 - 2015: -2.5 - 2016: -2.6 - Gross financing need (percent of GDP): - 2006: 6.2 - 2007: 5.9 - 2008: 9.2 - 2009: 15.6 - 2010: 16.7 - 2011: 14.9 - 2012: 13.4 - 2013: 11.4 - 2014: 10.6 - 2015: 8.8 - 2016: 8.2 - Gross financing need (in billions of U.S. dollars): - 2006: 155.1 - 2007: 166.6 - 2008: 245.4 - 2009: 343.7 - 2010: 381.0 - 2011: 375.6 - 2012: 355.7 - 2013: 318.0 - 2014: 311.8 - 2015: 273.3 - 2016: 270.4 - Scenario and bound-test results (summary of alternatives and risks): - No fiscal consolidation (constant primary balance over FY11/12–16/17): - Debt would increase to 101 percent of GDP by FY16/17 and be on a firm upward path. - If unchanged policies coincide with higher interest rates from sovereign concerns, the outcome would be worse. - Lower medium-term growth (persistent shortfall of 1.1 percentage points per year relative to central scenario, equivalent to ½ a standard deviation): - With unchanged expenditure plans, debt-to-GDP could reach 89 percent of GDP by FY16/17. - Bound tests illustrated sensitivity to shocks (growth, primary balance, interest rate, contingent liabilities), with combined shocks producing materially higher debt trajectories in the projections. ### Fiscal dynamics drivers (selected contributions; Table A1) - Identified debt-creating flows (sum of primary deficit contribution and automatic debt dynamics and other identified flows) drive most of the debt increases in the crisis years. - Automatic debt dynamics (contribution from interest rate/growth differential): - 2006: -0.3 - 2007: 0.0 - 2008: 1.9 - 2009: 3.4 - 2010: -0.3 - 2011: -0.9 - 2012: -0.5 - 2013: -0.6 - 2014: -0.6 - 2015: -0.7 - 2016: -0.5 - Contribution from real interest rate (selected): - 2006: 0.7 - 2007: 1.0 - 2008: 1.0 - 2009: 1.3 - 2010: 0.9 - 2011: 0.3 - 2012: 1.3 - 2013: 1.3 - 2014: 1.4 - 2015: 1.4 - 2016: 1.5 - Contribution from real GDP growth (selected): - 2006: -1.0 - 2007: -1.0 - 2008: 0.8 - 2009: 2.1 - 2010: -1.3 - 2011: -1.2 - 2012: -1.8 - 2013: -1.9 - 2014: -2.0 - 2015: -2.1 - 2016: -2.0 ### Scenario comparisons (selected lines from Table A1) - Scenario with key variables at their historical averages (projection outcome): - Debt rises in alternative historical-average scenario with numbers shown in the table (e.g., 81.5 in baseline rising to 98.9 in scenario — table entries indicate scenario outcomes). - Scenario with no policy change (constant primary balance) in 2011–2016: - Debt path entries in Table A1 show 81.5 (baseline) to 101.4 under the no-policy-change scenario by FY16. *Prepared by Staff Representatives for the 2011 Consultation (In consultation with other departments) July 12, 2011.* ### 1. The Office for Budget Responsibility (OBR) published its first Fiscal ### The Office for Budget Responsibility (OBR) published its first Fiscal Sustainability Report (FSR) ### Fiscal Sustainability Report: central scenario and projections - Report published on July 13; assumes implementation of the government’s consolidation plan through FY15/16 and unchanged policies thereafter. - Central scenario findings: - Population aging and associated increases in pension and healthcare spending will slowly reduce the primary balance and increase public sector net debt to 107 percent of GDP by FY60/61. - The central scenario assumes healthcare spending per elderly individual grows with per capita GDP. - If annual healthcare spending growth is 1 percentage point faster (historically, healthcare spending per elderly has been 1–2 percentage points faster than per capita GDP growth), the FSR projects that the primary deficit would be more than 5 percent of GDP higher than in the central scenario by FY60/61. - Implications: - Substantial fiscal consolidation after FY15/16 will be necessary to ensure fiscal sustainability over the long run. - The UK’s long-run fiscal challenge from population aging is similar to that of many European economies. - Additional transparency note: - At the same time as the FSR, the Treasury released Whole of Government Accounts for FY09/10, presenting the public-sector financial position on the basis of commercial accounting standards, including future liabilities arising from public-service pensions. This release does not fundamentally affect IMF staff’s view of the fiscal situation, but it is a step forward for fiscal transparency. ### Banking sector: EBA stress tests results - All four UK banks included in the European Banking Authority (EBA) stress tests passed. - Banks and outcomes: - Lloyds Banking Group (LBG), Barclays, Royal Bank of Scotland (RBS), and HSBC would maintain core tier 1 ratios of at least 5 percent (the minimum level set by the EBA) under a stressed scenario. - EBA adverse scenario characteristics: - Low GDP growth over two years, falling property prices, rising unemployment, and moderate haircuts on trading book holdings of peripheral European sovereign bonds. - The EBA adverse scenario of a slight contraction in the first year and small positive growth in the second is roughly equivalent to the mild adverse scenario in the FSAP stress test (approximately a one standard deviation shock to real GDP growth over the first two years of a five-year stress horizon). - Comparability and scope: - Results are broadly in line with those of the FSAP stress tests for these banks. - FSAP solvency stress test sample also includes Standard Chartered, Santander UK, and Nationwide. All major UK banks exceeded the Basel III and Financial Service Authority hurdle rates in FSAP scenarios. - FSAP assumptions include haircuts to bank debt and sovereign debt holdings in both the banking and trading books, and the FSAP includes liquidity stress tests of the major UK banks, building societies, and foreign investment banks. - Exposure detail (EBA chart summary): - Total exposure to Greece, Ireland, Portugal, Spain, and Italy expressed as Percent of end-2010 core tier 1 capital (chart labels in source). ### EU implementation of Basel III: Commission proposal and IMF staff view - On July 20, the EU Commission adopted a proposal to implement the Basel III agreements through new EU-wide legislation, including regulation and a directive (“CRD4”). - Legislative process: - Proposal is subject to approval through the EU Council and Parliament—a process that will likely take at least six months. - IMF staff assessment (proposal falls short of staff recommendations; see paragraph 50 of the staff report): - Common standards are too weak: - Commission suggests a common standard (maximum harmonization) set at the level of Basel III minimum requirements. - Commission has softened the definition of core tier 1 capital relative to the Basel III recommendations in some areas. - IMF staff called for common standards that exceed the Basel III minima, given prevailing balance sheet uncertainties and the lack of EU-wide resolution arrangements and a fully unified fiscal backstop. - More flexibility is needed for macroprudential policies: - National authorities can only set system-wide higher capital requirements on loans secured by real estate or using the Basel III countercyclical capital buffer, although they have more freedom with regard to individual banks. - National authorities are likely to need more flexibility to use a range of macroprudential tools, given the uncertainty surrounding the tools required for effective macroprudential policy and future macroprudential risks. - Lack of firm commitment on key ratios: - The Commission proposal lacks a firm commitment to implement the leverage ratio or net stable funding ratio in 2018, as was agreed under Basel III. - Recommendation: - It will be important to strengthen the legislation as it is finalized, including by creating stronger common standards and ensuring sufficient flexibility for macroprudential policies. ### Closing procedural note - Statement by the IMF Staff Representative on the United Kingdom dated July 26, 2011. - The note reports on information that has become available since the staff report (SM/11/181) and staff supplement were issued and does not alter the thrust of the staff appraisal. *Source: IMF staff note summarizing OBR FSR, EBA stress tests, and EU Basel III proposal materials contained in the provided content.* ### 1. UK GDP grew at 0.2 percent (quarter-on-quarter, seasonally adjusted) in Q2 ### 1. UK GDP grew at 0.2 percent (quarter-on-quarter, seasonally adjusted) in Q2 ### Q2 GDP outturn and special factors - UK GDP grew at 0.2 percent (quarter-on-quarter, seasonally adjusted) in Q2 according to preliminary estimates. - Several one-off factors affected Q2 growth: the additional bank holiday associated with the royal wedding and supply-chain disruptions following the Japanese earthquake and tsunami. - The Office for National Statistics' broad-brush analysis indicates these special effects may have had a net downward effect on Q2 GDP of 0.4 percent in the services sector and 0.1 percent in the production sector. - The GDP outturn is slightly lower than what staff had projected and will be incorporated into the next update of staff’s projections for the September 2011 World Economic Outlook. - The outturn does not materially alter the central scenario of continued recovery at a moderate pace. ### Executive Board assessment — outlook, inflation, and growth projections - Recent conditions: - Headline inflation expected to remain well above 4 percent during 2011 due to recent increases in indirect taxes and commodity prices. - Inflation is expected to return near the 2 percent target by end-2012 as transitory factors dissipate and spare capacity keeps underlying inflation in check. - Growth projections and risks: - Growth is expected to gradually accelerate from around 1½ percent in 2011 to 2½ percent in the medium term, supported by low interest rates and global growth, led by net exports and investment. - Directors noted large risks around the central scenario, including turmoil in parts of the euro area, headwinds from fiscal consolidation, volatile commodity prices, and the housing market. - Policy mix: - Directors considered the current mix of accommodative monetary and tight fiscal policy appropriate to keep real interest rates low and sterling competitive, aiding balance-sheet repair and rebalancing toward investment and net exports. - If growth and inflation surprise on the upside, monetary tightening would need to accelerate; conversely, evidence of prolonged weak demand would call for looser macroeconomic policies. ### Fiscal policy, consolidation, and fiscal framework - Progress and metrics: - The cyclically adjusted primary balance (as a percent of potential GDP) is estimated to have improved by about 2 percentage points in FY10/11. - The government’s medium-term fiscal consolidation plan remains central to its macroeconomic strategy. - Consolidation composition and implementation: - Of a total consolidation of £126 billion a year by 2015-16, £95 billion comes through spending cuts and £30 billion through taxation. - The Government has delivered the £6.2 billion of savings announced in May 2010 and implemented departmental budgets and reforms to welfare and public service pensions outlined in the October 2010 Spending Review. - The standard rate of VAT was increased to 20 percent (implemented as part of planned 2011-12 tax reforms). - Authorities committed to protecting Overseas Development Assistance (ODA) and achieving the ODA target of 0.7 percent of GDP. - Institutional reforms: - The Office for Budget Responsibility (OBR) established in May 2010 and placed on a permanent, statutory footing; it has produced all official forecasts independently since the General Election. - A Charter for Budget Responsibility requires each Government to set out fiscal policy objectives and a fiscal mandate before Parliament; the Government published the Charter on 4 April 2011. - The rise in the State Pension Age (SPA) from 65 to 66 has been brought forward to 2020 from 2026; authorities committed to proposals to manage future SPA increases more automatically. ### Monetary policy and Bank of England stance - The Bank Rate was set at 0.5 percent and the stock of outstanding asset purchases at £200 billion. - The Monetary Policy Committee’s central view: spare capacity will push down inflation toward the 2 percent target over the medium term as temporary inflationary factors subside. - At its last meeting earlier in July 2011, a minority of MPC members voted for less accommodative policy (preferring a higher Bank Rate) and a smaller minority for an extension of asset purchases. - The MPC’s next decision was scheduled for 4 August. ### Financial sector, FSAP findings, and regulatory reform - Financial stability and buffers: - Banks have strengthened balance sheets and reduced funding vulnerabilities; core tier 1 capital ratios are now above 10 percent for all the major UK banks. - FSAP in-depth stress tests (including haircuts to sovereign and bank debt) indicate increased resilience; only an extreme “tail of the tail” risk with multiple severe shocks would pose a challenge. - Under the Fund’s most severe 30-day liquidity stress test scenario, liquidity shortfalls remain largely contained. - Regulatory reform and implementation: - Reforms to the policymaking framework include moving the microprudential regulator under the Bank of England, establishing a Financial Policy Committee (FPC) for macroprudential oversight, and creating an independent Office for Budget Responsibility (OBR). - An interim Financial Policy Committee (FPC) has been operating since June 2011 with a clear macroprudential remit. - Progress has been made toward the ‘triple peak’ model: clarifying mandates for the Prudential Regulation Authority (PRA) and the Financial Conduct Authority. - A White Paper and draft Bill were published in June 2011 as a blueprint for reforms; primary legislation expected later in 2011. - The Independent Commission on Banking (ICB) interim report considers bail-in and ring-fencing options; the Government endorsed these proposals and will act after the final ICB report in September. - Data disclosure and international cooperation: - Directors called for implementing FSSA recommendations, including improving standards for public disclosure of financial data. - The PRA will seek to publish some regulatory returns; interim-FPC requested enhanced disclosure of sovereign and banking sector exposures as part of major banks’ reporting. - Directors stressed that stability and efficiency of the UK financial sector is a global public good; international cooperation on cross-border resolution, group-wide liquidity management, information sharing, and jurisdictional reciprocity is essential. - The UK is committed to full implementation of Basel III standards worldwide and supports national discretion to go beyond those standards as needed. ### Key selected economic indicators (2007–12 as presented) - Real GDP (change in percent): 2.7, -0.1, -4.9, 1.4, 1.5, 2.3 - Domestic demand (change in percent): 3.1, -0.7, -5.5, 2.7, -0.1, 1.4 - CPI (change in percent, period average): 2.3, 3.6, 2.1, 3.3, 4.5, 2.6 - Unemployment rate (in percent) 1/: 5.4, 5.6, 7.5, 7.9, 7.7, 7.6 - Gross national saving (percent of GDP): 15.6, 15.0, 11.8, 11.8, 11.5, 12.5 - Gross domestic investment (percent of GDP): 18.2, 16.6, 13.5, 15.0, 14.0, 14.5 - General government balance: -2.7, -6.7, -11.3, -9.8, -7.9, -6.3 - Public sector net debt: 36.6, 43.3, 52.8, 59.8, 65.7, 69.3 - M4 (end-period, 12-month percent change): 12.8, 15.5, 6.7, -1.4, -0.2, ... - Net lending to the private sector (end-period, 12-month percent change): 10.8, 4.9, 0.6, -0.4, 0.1, ... - Three-month interbank rate (year average): 6.0, 5.8, 1.2, 0.7, 0.8, ... - Ten-year government bond yield (year average): 5.0, 4.7, 3.6, 3.6, 3.7, ... - Trade balance (percent of GDP): -3.1, -2.6, -2.1, -3.4, -2.0, -1.3 - Current account balance (percent of GDP): -2.6, -1.6, -1.7, -3.2, -2.6, -1.9 - Exports (percent of GDP): 26.6, 29.3, 28.0, 29.4, 30.6, 30.4 - Import volume (change in percent): -0.8, -1.2, -11.9, 8.8, 1.6, 2.4 - Reserves (end of period, billions of US dollars): 57.9, 53.9, 66.4, 78.8, 91.2, ... - Fund position (as of June 30, 2011): Holdings of currency (percent of quota) 69.2; Holdings of SDRs (percent of allocation) 92.1; Quota (millions of SDRs) 10,738.5 - Exchange rates: Bilateral rate (June 30, 2011) US$1 = £0.6228; Nominal effective rate (2005=100): 102.3, 89.3, 78.8, 79.3, 79.1, ... - Social indicators (reference year): Income per capita (in US dollars, 2009): 35,165; Income distribution ratio (top/bottom quintiles, 2009): 5.2; Life expectancy at birth (2009): 78.1 (male) and 82.1 (female); Automobile ownership (2009): 459 per thousand; CO2 emissions (ton per capita, 2007): 8.84; Population density (2009): 256 inhabitants per sq. km.; Poverty rate (at-risk-of-poverty rate after social transfers, 2009): 17 percent. ### Directors’ policy recommendations and priorities - Continue fiscal consolidation to reduce fiscal risks and maintain market confidence; retain credibility to sustain low sovereign yields. - Accelerate structural reforms to promote long-term fiscal sustainability and bolster growth potential (consistent with the authorities’ Growth Review). - Implement FSSA recommendations, including improving public disclosure standards for financial data. - Strengthen financial supervision and regulation to the highest standards and enhance international cooperation on cross-border resolution arrangements, group-wide liquidity management, information sharing, and jurisdictional reciprocity. - Continue implementation of regulatory reforms (FPC, PRA, Financial Conduct Authority) and measures to address risks posed by SIFIs, including ICB proposals on bail-in and ring-fencing. - Maintain accommodative monetary policy while monitoring risks; adjust policy if inflation or growth deviate materially from medium-term targets. *Source: Public Information Notice No. 11/103, August 1, 2011.* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2011/_cr11220.pdf_